How the very rich respond to tax increases

The Institute of Fiscal Studies, in its annual Green Budget, has outlined the main techniques individuals are likely to use to avoid paying the top rate of income tax.

The 50p tax on earnings over £150,000 was introduced as a temporary measure under the previous Labour government.

It currently affects about 320,000 people, or 1% of taxpayers, according to HM Revenue & Customs.

But the IFS said today there will inevitably be an upswing in what it calls "avoidance activity" as high-earning individuals search for ways to mitigate the impact of the tax.

While there are a number of things individuals can do to avoid paying it, some, such as doing fewer hours of paid work or moving abroad, involve a real reduction in income.

Others, it outlined, do not:

How the rich are reducing their taxable income

Increasing contributions to private pensions

Since contributions to private pensions attract tax relief, but pension income in retirement is subject to income tax, this is effectively a way of deferring paying tax on income until an individual's marginal income tax rate is lower. The extent to which this can be used as an avoidance mechanism has been reduced by the government's decision to limit the total amount of pension contributions an individual can make to £50,000 per year. This is still a large proportion of income for those with incomes just above the additional-rate threshold, but is likely to be a binding constraint for many of those with much higher incomes.

Bringing forward or delaying income in the hope the rate is abolished

Doing this can be particularly trivial for some of the incorporated self-employed as they can simply adjust their dividend payouts. There is evidence of this happening: the Financial Times reported on 24 March 2011 that ‘Bigger or accelerated dividend payments by companies where directors own substantial chunks of equity were announced by companies including Hargreaves Lansdown, HomeServe, Pennon Group and Beazley' before the increase in the top tax rate in April 2010.

Converting income to capital gains

The difference between the top income tax rate of 50% and the top capital gains tax (CGT) rate of 28% provides a strong incentive for individuals to obtain remuneration in the form of capital gains rather than income. This option may be available to the self-employed, who can forgo some or all of their salary to increase the value of their business and then sell it on, and to those who use service companies, who can put a proportion of their income - perhaps from
personal endorsements - into a company that will pay corporation tax and allow
income to be deferred.

It also applies to groups such as private equity fund managers who receive much of their income as ‘carried interest', which is treated as a capital gain rather than income.15 It is also relatively easy to convert investment income to capital gains: individuals can shift their asset portfolios towards assets that give returns in the form of capital gains rather than income.

In some cases, income from employment can take the form of capital gains: UK governments have been keen to encourage company managers to align their interests with those of the company by introducing various tax-favoured forms of share-based remuneration such as Company Share Option Plans (CSOPs). Gains made when options are realised are taxed at CGT rather than income tax rates, giving substantial tax savings.

In the long term, individuals may be encouraged by the 50p rate to become self-employed in order to enjoy the resulting tax advantages.

Transferring income between spouses

This is where only one of them pays tax at the 50p rate. This is particularly simple for investment income, as married couples can transfer the ownership of investments to the lower-income spouse without paying any CGT as transfers between married couples are exempt from CGT.