Why the 50% tax rate matters nil to entrepreneurs
25 Oct 2011
A common complaint about the UK's 50% income tax rate is that it is discouraging to entrepreneurs:
[The 50% income tax rate] punishes wealth creation by imposing on entrepreneurs and business people a marginal tax rate in excess of 50 per cent once national insurance contributions are added in. This is particularly damaging when the UK needs to create new businesses in new industries.Economists call for abolition of 50p tax rate (Channel 4 News)
Such concerns typically come from economists, many of whom appear to have no understanding of what an entrepreneur is, or special interest groups: the right-wing press and lobby groups.
They're wrong. There may be reasons for removing the 50% rate, but helping entrepreneurs is not one of them.
First, some definitions. By entrepreneur, I mean an individual who is building a business from the ground up, either self funded or funded from some external source. It is also correct to call a risky venture within an existing business entrepreneurial, and the participants in the venture entrepreneurs, but in the context of the 50% tax rate debate the former definition stands.
To find out why the 50% tax rate does not matter to entrepreneurs, you need to consider both their day-to-day existence and their goals in building a business. Regardless of whether you have excessive amounts of external funding or you are simply bootstrapping, early concerns when building a business from scratch relate to lowering costs and simply getting through each month with your bills paid. In the case of bootstrapping, the concern is greater because there is less runway in terms of available cash to get you from one month to the next.
I was lucky enough to have an understanding employer when I was building my business during my spare time. Given it took about a year to become ramen profitable it's clear that the income from my business was low for an extended period. Today, I am earning enough from my business to have a little spending money but I still earn far less than at my previous day job.
To some entrepreneurs, the idea of a pay packet at all is a luxury. In that light, pontificating over whether an extra marginal rate for salaries above £150,000 should be retained seems trivial, and to earmark entrepreneurs as a group that is discouraged by the rate is picking entirely the wrong target.
So much for entrepreneurs just starting out, but what about the goals of an entrepreneur? Surely the 50% rate will eventually get them, if successful? The entire point is to get rich, right?
Wrong.
There are many reasons for starting a business. Only some of those relate to money. And the ones that do relate to money are not about getting rich. They are about building wealth, which is entirely different.
See the accountant/lawyer/doctor down the road with the golf club membership, the BMW 5-series and the holidays in Tuscany? He's rich, he earns a lot of money. But that doesn't make him wealthy. What happened if he lost his job? All individuals are different cases, but employment is a hamster wheel. Unless you retain and invest your money wisely you will not become wealthy.
In building a business, an entrepreneur is building wealth. He is creating an asset with income producing properties. He is not necessarily deriving an income, but that can come later. In the administration and operation of that business, it is fair that the business pays employed staff in the form of salaries to keep that business going and improve revenues and profits. Indeed, the entrepreneur himself may be involved in the administration and operation of the company, and so can take a salary. But these salaries are simply for being employed by the business, not owning it.
Once the business is producing stable revenues and, profits wise, is healthy, the entrepreneur has built an income producing asset they can either take a share of profits, in the form of dividends, or at some point they can sell the business for a capital gain. This is the crux of entrepreneurship. The payback for assuming the risk of starting a business is free (financially) ownership of a business. Importantly, income tax has nothing to do with this.
For this reason, entrepreneurs do not earn large incomes. They may take a salary for being involved in the day-to-day running of the company. However, their focus is the revenue and profit generating abilities of the business they have built. Similarly, to aid in the business's development, to maximise profits that can potentially be re-invested to realise faster growth, any income an entrepreneur does take is likely to be small. Besides, it would be pointless to take a salary above the basic rate of tax, given that tax rates on dividends are lower than the higher rate.
Any entrepreneur earning over £150,000 is either not really an entrepreneur, or badly advised. £150,000 salaries are the province of the law-firm partner, the well-paid accountant, the GP, not entrepreneurs.
So how can entrepreneurs be helped?
I think entrepreneurs can be encouraged with a focus on the two factors I outlined above. Make their day-to-day existence a little easier, and maintain lower costs of realising capital gains.
To most entrepreneurs, just getting from month to month is hard enough. Getting to the point where you are drawing any kind of income is one of your first goals. If entrepreneurs (particularly those starting out) have low incomes, then it means it would be best to lower income tax rates at the other end of the pay scale.
At the time of writing, the UK tax system's personal allowance (the amount of money you can earn free of tax) is £7,475. An increase in this rate would be beneficial to entrepreneurs attempting to start a business, because it leaves more money for the entrepreneur to pay other bills, clothe their children, pay the mortgage etc.
I am not in favour of specific allowances for mortgage relief. Such targeted benefits risk moralising certain life decisions. While I am sympathetic to entrepreneurs stuggling to pay a mortgage (like myself) I do think that if you make your bed, you lie in it.
In addition, I would argue capital gains tax rates on sales of businesses by owner-entrepreneurs should remain low. This encourages the wealth building aspect of entrepreneurship, and gives just reward for the risks many entrepreneurs take.
I'd be the first to champion a removal of the rate, if it could be proved the UK's balance sheet would benefit. I'm looking forward to the HMRC's report into the effectiveness of the 50% tax rate, due next year. But whatever is decided, real entrepreneurs won't be able to tell the difference.
Thanks to Mukumbura and alancleaver_2000 for the images above.