Nadhim Zahawi: it was the paltry size of his tax bill that should shock us

Nadhim Zahawi’s tax row reveals an even bigger scandal: the rich are getting a tax break that those on low incomes can only dream of.

While the revelation that the former Conservative chair had to pay a tax penalty was shocking, the bigger concern is that the only tax he was required to pay on £27m was £3.7m. That implies an average tax rate of less than 14%, lower than the rate for someone working full-time on the minimum wage.

Two weeks ago, the Guardian broke the story that Zahawi had been fined by HMRC for not taking reasonable care in his tax affairs. This “carelessness” meant he had not paid £3.7m in tax that he owed from the sale of £27m worth of shares in YouGov, the company he co-founded in 2000.

His belated payment of the tax bill, plus interest and a fine, while he was chancellor, led to a total payment of about £5m. The revelation ultimately led to the ethics investigation that was his downfall.

Assuming Zahawi’s bill was related to unpaid capital gains tax, his startlingly low rate was possible because capital gains are taxed at much lower rates than other income.

While the tax rate for someone earning a salary of £270,000 is 47%, made up of 45% income tax above £150,000 and 2% national insurance contributions above £50,000, someone taking home 100 times as much can pay the much lower 20% capital gains tax rate.

And some gains can qualify for either business asset disposal relief or investors’ relief, bringing the rate on those gains down to 10%, and further reducing the average rate.

These low tax rates tend to benefit the wealthiest in society, the asset-rich. Capital gains are the returns that someone makes on selling an asset that has grown in value – be it a property, shares, classic car or antique vase.

But most capital gains come not from the sale of second homes by the upper middle classes but from the sale or dissolution of businesses by individuals who both own and manage those businesses. And those gains are incredibly concentrated: half of all taxable gains in the entire country go to about 5,000 people, who each receive more than £1.5m in gains.

Perhaps this would be worth it if there was compelling evidence that these low rates had beneficial side-effects for growth and employment. But the current structure of capital gains tax is neither good for growth nor good for all of those who receive money in the form of gains.

It is bad for growth because the gap between capital gains tax and income tax rates encourages people who could be brilliant employees to instead be mediocre self-employed managers, contributing to the long “tail” of unproductive firms in the UK. Someone taking home £1m in gains would pay up to £370,000 less tax than if they were earning the same as a salaried employee.

It is also bad for those actually investing serious cash in companies, because in times of high inflation they can pay large amounts of tax on increases in the value of those investments, even if this increase doesn’t keep up with the price of ordinary goods and services.

So what is the answer? One not particularly radical solution would be to largely go back to the capital gains tax structure imposed by the Conservative chancellor Nigel Lawson in 1988. Lawson taxed capital gains at the same rate as income, and provided an allowance for inflation. A move back in this direction, with also some “smoothing” to account for gains being received less frequently than income, would be eminently sensible.

As a bonus it would raise about £16bn. This could pay for quite a lot of wage increases for teachers, nurses and firefighters who are striking because their incomes are falling relative to the cost of living. Or for green investment. Or for the tax cuts the chancellor so desperately craves.

• Arun Advani is an associate professor of economics at the University of Warwick and a research fellow at the Institute for Fiscal Studies