Why working is a mug's game

Our tax system strongly favours rich savers and investors over workers, but you can defeat it!

In 2009, one of my young nieces got something of a financial shock.

In her late teens, she started a paid job for the first time, working a few hours a week in her local Next store. Her jolt came at the month-end, when her first payslip arrived, as a fifth (20%) of her wage had been taken by the taxman.

Taxing stuff

Hence, my niece called her dear, old Uncle Cliff for advice. I explained that, as this is her first job, she needed to complete a P46 form and return it to Next. Her employer would then send this to HM Revenue & Customs (HMRC) to correct her tax code.

Eventually, my niece's tax code was corrected from 'BR' (which deducts basic-rate tax at 20% of all her earnings) to 647L, the tax code for the basic personal allowance of £6,475 in 2009/10. This prevented income tax being deducted from future earnings (because they were too low), plus her overpaid tax was refunded. All's well that ends well.

Taxes on income

In the UK, our taxes on income are rather higher than those levied in most developed countries. Indeed, at 52% of earnings (see below), tax deductions for high earners are up there with Sweden (which has a top tax whack nearing 57%) and Denmark (over 55%).

In my view, earned income is taxed much too heavily, while unearned income (earnings from sources other than work) and capital gains are taxed far too lightly.

To show you what I mean, let's start with a breakdown of income tax and National Insurance contributions (an income tax in all but name) for the 2011/12 tax year:

Income tax allowances and rates

Our tax system is fiendishly complicated, so this is not a definitive list of tax rates and allowances. Even so, it covers most UK residents.

Things get complicated for higher earners, as their personal allowance is withdrawn at a rate of £1 for every £2 of earnings above £100,000. In other words, those earning above £114,950 get no personal allowance whatsoever.

Also, the higher tax allowances for 65-to-74 year olds (£9,940) and the over-75s (£10,090) are withdrawn by £1 for every £2 of income above £24,000 a year.

National Insurance rates

As well as income tax, almost all earned income attracts National Insurance contributions (NICs).

You pay NICs if you're employed or self-employed and aged between 16 and normal retirement age. Currently, this is 65 for men born before 6 April 1959 and 60 for women born before 6 April 1950, but this is rising.

Again, like income tax, the NIC system is hideously complicated, but here are the basic NIC rates for weekly earnings in 2011/12:

• Employed workers pay 12% Class 1 NICs on their weekly earnings between £139 and £817. Earnings above £817 a week attract NICs at 2%.
• Self-employed workers pay £2.50 a week in Class 2 NICs, but only if their yearly profits exceed £5,315. Also, they pay Class 4 NICs at 9% of taxable profits between £7,225 and £42,475 a year and at 2% of profits above this range.

Tax takes a third of most adults' earnings

As I said, the UK's tax system is incredibly complex, so calculating exactly how much tax an individual will pay is no easy task.

However, only one in 10 workers earns more than the threshold for higher-rate (40%) tax, which is £42,475 a year. Hence, most of the UK's 25 million employees lose 32% of their before-tax income to HMRC, made up of 20% basic-rate tax and 12% Class 1 NICs.

Similarly, the majority of the UK's four million self-employed workers pay income tax at 20%, plus £130 a year and 9% of their profits in NICs, which is a combined tax rate of around 30%.

In other words, the government takes roughly a third of most adults' earnings in tax.

Unearned income is taxed less

In contrast, the taxes on unearned income are much simpler.

Of course, unearned income is still taxed, but only at the usual rates of income tax that apply to earnings. However, with no NICs to pay on unearned income, it enjoys a big tax advantage over earnings.

Also, there is a special 'starting rate' of tax for people with savings but low incomes. This is charged at 10% on savings income of up to £2,560, but only for those with non-savings income below this limit, plus their personal allowance.

In effect, income from savings interest, share dividends (the cash paid to shareholders, often twice or four times a year), pension income, property rentals and so on is far more valuable than earned income. Also, as this income tends to flow regardless of whether you're working, it's doubly welcome.

In addition, the taxes on share dividends are lighter. Basic-rate taxpayers pay no extra tax on company dividends, making them a valuable source of earnings for small-business owners.

Above the £42,475 threshold, dividends attract an additional tax of 22.5% of the gross (before-tax) dividend. For those lucky few earning above £150,000 a year, dividends attract an additional tax of 32.5% of the gross dividend.

Capital gains are taxed lightly

Another bonus for well-off Brits is that Capital Gains Tax (CGT) is charged at a lower rate than income tax. You make capital gains from selling shares, property (but not your main home), bonds and other assets at prices higher than their buying costs.

Above a generous CGT nil-rate allowance of £10,600 in 2011/12, the standard rate of CGT of 18% applies on gains which, added to your income, keep it below the higher-rate tax threshold. For those earning above £42,475 a year, CGT is a modest 28%.

Time for a flat tax?

In short, it's quite clear that unearned income and capital gains offer significant tax advantages over earnings. As a result, you could argue that working is a mug's game!

Why tax the working population so much? After all, of the UK's adult population of 48 million people, 29.3 million work. Thus, with over three-fifths (61%) of adults in work, why tax work so much higher than unearned income and gains, which involve much less personal effort?

The simple answer is that, thanks to ceaseless lobbying and self-interest, our tax rates have been created to favour better-off Brits (including MPs and top civil servants), business owners and, in particular, the very rich.

To simplify the tax system and make it fairer to all, reformers urge the UK to adopt a flat tax. With such a system, all income and gains below a generous threshold would attract no tax, with a flat rate applying above this limit.

For example, a tax-free threshold of £12,000 would give every adult a tax-free income of up to £1,000 a month. All income and gains above this level could be taxed at, say, 35%, which would benefit the vast majority, including those on lower and middle incomes. However, tax-dodging tycoons fear a flat tax, as they would have to contribute lots more to the UK's coffers.

How to become a (legal) tax dodger

If you're fed up with ever-rising taxes, there are countless ways you can hit back. To get you started, here are Ten legal ways to dodge tax.

In my view, the two simplest ways to dodge tax are: first, get an ISA to protect future savings interest, share dividends and capital gains from tax. Second, pay more into a pension, which bags you tax relief at your highest rate. As well as lowering your tax bill, these pension contributions will boost your pot to live on after work.

Lastly, I'll leave you with a quote from Albert Einstein:

"Preparing my Tax Return is too difficult for a mathematician. It takes a philosopher."

More: Save and/or invest inside an ISA | The 20 best savings accounts | Five reasons not to buy a pension