How the government can tax the rich and make them pay

Getting the rich to pay their fair share of tax requires much more than just the 50p rate.

Nobody likes looking at their payslip and seeing just how much goes to the taxman each month. While most of the UK's low and middle income earners pay their fair share of taxes, some highly paid footballers, celebrities and businessmen pay as little as possible.

Tax avoidance is legal and, with those earning over £150,000 a year subject to a combined tax and national insurance rate of 62%, the rich waste no expense in employing financial experts to exploit the numerous loopholes in the complex mass of tax laws.

It's a modern-day form of alchemy: income can be turned into capital, tax relief helps carefully invested funds to flourish and money flows into offshore accounts in the blink of an eye.

Such practices have given the wealthy a bad reputation. City workers have often boasted of paying less tax than their cleaners by declaring their income as profits from investments.

Highly paid banking and IT professionals are renowned for setting up limited companies to keep more of their hard earned cash for themselves. With some clever accounting, many pay no more than basic rate tax — and make the most of the tax relief on pension contributions and work-related expense rules to boot.

Earlier this year a Sunday Times investigation found that dozens of top level footballers including Wayne Rooney were saving hundred of thousands of pounds a year using shell companies to take payments for "image rights" - that is, earnings from merchandising.

Billionaire retail boss Phillip Green also saw his tax affairs hit the spotlight last year after it emerged he saved millions of pounds in tax by paying a £1.2 billion dividend into an offshore vehicle registered to his wife in Monaco.

So what can be done to make the rich pay their fair share of tax? The old favourite of raising income taxes for the highest earners is a straightforward and politically popular choice but not necessarily the most effective.

The Institute for Fiscal Studies recently warned that the controversial 50p rate of tax, which hits the top 1% of taxpayers, could actually be costing the Treasury revenue instead of raising the previously estimated £2.4 billion.

Billionaire investor Warren Buffett, who has long called for tax hikes on the super-rich, paid $6.9 million in tax last year — equating to 17.4% of his taxable income compared to the 36% paid on average by his staff. He wants to see the tax rate for both income and investment raised for those earning more than $1 million a year. However, to stop the old trick of turning income into capital to qualify for capital gains tax instead of income tax, the rates would need to be the same.

This has been done before. In 1988 the then Chancellor Nigel Lawson aligned the two rates to much criticism. Tax revenues subsequently fell, although as Richard Murphy, director of Tax Research, points out this was largely due to the crash of 1987 which sent stocks and house prices plummeting.

"Revenue from CGT was going to be lower if there weren't the capital gains to be had," he says. He advocates a return to this realignment along with a cut in the capital gains tax allowance.

However, critics warn that the controversial move will discourage new businesses and investment and therefore economic growth. Murphy disagrees: "It would reduce speculation — putting money into shares - but this is not the same as investment: it does not create jobs. Real entrepreneurs will still go out and do business because they're driven by ideas and tax is the last thing on their minds.

"It comes down to the fact that the rich simply don't want to pay as much tax as everyone else". Murphy also suggests abolishing all allowances and reliefs for those earning over £150,000 a year or setting minimum tax rates to address the uncertainty within the current system.

Greg Philo, the research director of Glasgow University Media Unit, has called for much tougher action. He claimed last year that a one-off 20% tax on the personal wealth of the richest 10% of the UK would raise £800 billion.

As most of this wealth is held in property, pensions, investments and fine art, Philo conceded that the rich could take their time in paying off their dues, perhaps paying a low rate of interest on it during their lifetime and clearing it by selling assets on their death.

The government has tried tax amnesties, clampdowns and agreements with tax havens in a bid to recover some of the £14 billion lost through tax avoidance and evasion every year. In its latest move it is putting together an "affluence team" to ensure that the country's 350,000 wealthiest taxpayers with personal fortunes of more than £2.5 million pay their dues.

Treasury chief secretary Danny Alexander claims that closing loopholes and ensuring high earners meet their full tax liabilities will bring in around £7 billion a year by 2015 as it weighs up the political consequences of its actions with the economic.

But if the aim is actually to raise revenue from taxes rather punishing the rich for having money, cutting taxes can be more effective than raising them. In the 1980s, the UK and US governments both reduced higher rates of income tax and got higher levels of tax revenue in return. When the US cut its CGT rate to 15% in 2003, the amount of revenue it brought in doubled in the following two years.

Meanwhile, in its comprehensive review into the UK tax system, the IFS says that the higher rate of tax which can be levied without a reduction in tax revenue is about 40%.

So could a flat tax work instead? This is in place in numerous countries around the world, including several in Eastern Europe along with the Channel Islands and Hong Kong. This system would undoubtedly be easier to administer, and according to a 2005 UK study by Richard Teather would most benefit those on low incomes.

With a single rate of income tax at 22% and a personal allowance of £12,000, those on below average wages would see their after tax incomes rise by 12% with the top earners seeing a modest 0.5% rise.

However, Murphy of Tax Research, says such a system would just see the rich pay less tax than they would under progressive taxation and the amounts raised would fail to cover government spending. Furthermore, he believes tax avoidance will happen regardless. "Hong Kong has a flat rate tax of 15% and no VAT, CGT or inheritance tax and it still has problems with tax avoidance," he adds.

The UK government is desperate to keep the rich from fleeing to the hills of Switzerland and so hard-line actions such as scrapping non-dom status, introducing a mansion tax and doing away with all tax breaks for the highest earners are unlikely to make it through Parliament.

However, until the numerous loopholes in the UK taxation system are closed and the rules are simplified, even the most politically astute plans to make all UK residents pay what they owe in full will not deliver their full economic benefits.