Readers reply: why do we pay twice as much tax on earned income than on unearned income?

Readers reply: why do we pay twice as much tax on earned income than on unearned income?

Why do we pay twice as much tax on earned income than on unearned income? What would happen if the tax rates were equalised? Martin h

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Readers reply

Because poor people earn their income and rich people don’t. And rich people make the rules. user0

Because unearned income is usually from assets bought, or investments made, using income that has already been taxed. Einwanderer

I pay for things with money that has already been taxed, but they still stick me for VAT on top of that, so that argument doesn’t fly. davidabsalom

The simplest explanation is not because it’s fair (it clearly isn’t), but because PAYE (pay as you earn) makes it easier for HMRC to collect. In addition, unearned income can come from a range of sources, with varying degrees of difficulty for the taxman to collect. Another reason, unfortunately, is self-interest (many of the lawmakers in parliament are significant beneficiaries of unearned income) and lastly, the UK government has for years promoted rentier economics – some say to the detriment of the productive economy. Tax needn’t be taxing, but it also needn’t be fair. For these reasons, it’s unlikely ever to be equalised. Paul

Because the country is overwhelmingly ruled by the rich and privileged for the benefit of themselves and their ilk, and they are the ones in the best position to receive unearned income. sacco

That depends on the paradigm in which you view the world: cynical, optimistic, or benign. The cynical view focuses on the lobbying of the rich and the vested interests of politicians. The optimistic view is that policymakers genuinely believe that this is most beneficial to the economy and society as a whole; that unearned income creates jobs, and so it is to be encouraged with low taxes. The benign view is that we have sleepwalked into this policy position. The standard rate of tax was set at an arbitrary rate seen as necessary to sustain the function of government, and the various other forms of taxes – such as capital gains – were set separately at a rate that seemed reasonable at the time. Adjustments have been made in response to issues, but never as a large, whole-system change. I suspect the truth lies in a combination of all three. Nathan

The difference between labour and capital mobility plays a significant part. While it is relatively easy for those with substantial capital at their disposal to change their tax residency for the sake of a lower tax burden, it is harder to do so for higher-earning professionals who may often be subject to local qualification and licensing requirements. There are significant monetary and personal costs involved in moving to another country – loss of support networks, weakening of family and professional connections, disruption to children’s education and partners’ careers. These vulnerabilities raise the threshold at which a professional would consider taxes on their earned income no longer bearable. However, once they choose to move out, it will be much harder to bring back the workers than the investors.

Unfortunately, both left and rightwing governments keep falling into the trap of taxing the salaried middle class the most. In the short term, equalisation of tax rates on earned and unearned income would result in capital outflows, lower tax revenue or a combination thereof. More borrowing or cuts would be needed to pay for the policy before tangible benefits would be seen – likely far beyond the timeframe of a single parliament term. In the long run, however, more highly qualified professionals would probably be attracted while the economic and political power imbalance between salaried employees and large investors would start to decrease. Mikolaj S, London

Richer elites gain far more from unearned income, hence control of the political classes that set tax rates in their favour. The abolishment of the pension cap earlier this week demonstrates how this then spreads to lower taxes on earned income as well, for those who can afford it.

If tax rates on earned and unearned income were equalised, inequality would reduce rapidly. NoahDeere

Any interest that is not sheltered within an Isa, covered by the low income relief, or covered by the PSA is charged at the same rates as earned income.

1) Dividends are a distribution of post corporation tax profits. When an acknowledgment of this was attached in the form of a tax credit, they were simply added together and taxed normally. When tax credits were ended, the dividend only was added to income and taxed at a lower rate to compensate.

2) When capital gains tax was introduced in 1965, allowance was made for inflation. The lower rate of charge was introduced once the allowance for inflation was scrapped RetiredTaxman

Not true, Retired Taxman. National insurance (’ees and ’ers) is a significant extra tax on earnings. There used (long ago) to be an acknowledgment of this in the investment income surcharge, an additional 15% charge on investment income. Moomy120650

Three arguments can be made to answer this question. 1) Earned income is tax deductible for the payer and taxed for the payee. The tax collected by the treasury is therefore income tax paid minus corporate tax deducted. Thus, income tax must be significantly higher than corporate tax.

2) Unearned income can be approximated to a flow of coupons for bonds or dividends for equities. Capital gain is simply an accelerated version of that. Dividends are paid by companies out of income that has already paid corporate tax; thus dividends are taxed twice, initially at the corporate tax level, and then as earned dividends. Bonds are different since companies actually get coupons paid deducted from their taxes. The problem with taxes on bond coupons is different because most bonds issued are government bonds. Governments that tax bond coupons increase the cost of their own debt. But because they are not the only ones issuing bonds (banks and corporations do), they are still encouraged to do so. Finally the reason why dividends are often taxed higher than capital gains is sadly that when a government opts for a significant tax on bond coupons, they also tax dividends at similar or higher levels to encourage investors to hold bonds. Since no such issue arises with capital gains tax, it’s usually lower.

3) The last reason is there is level of risk to unearned income that is of a different nature to earned income. If you’re really good at your job, there is no reason to fear a loss of earned income. But when you buy a bond, like the Credit Suisse bonds that were just made nil, or when you buy equities, your holdings could be worth a lot less and even perhaps nothing tomorrow. And yet, growing companies need to issue debt and equities in order to operate. Discouraging such investments with high taxes could be detrimental to the economy. How would you tax such uncertain income? Peter Still

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