GUEST COMMENT: Big bonuses were basically a product of the tax system

If you want to trace how the big bonuses that are now so contentious for investment banks came about, you need look no further than the tax system. It's no coincidence bonuses increased greatly after UK income taxes were lowered in the 1980s.

Before the Big Bang, investment banking in the City was very different to today. Many City firms were partnerships, with senior remuneration taken by the partner's share of profits. Below partner level, low salaries and high bonuses were the norm. However, a tax rate of 83% on incomes above just 20k in the 1970s meant large cash bonuses were a rarity.

Instead of paying cash, great effort went into sidestepping the punitive effects of income tax. For much of the 1970s the British tax system favoured capital gains. While the higher rate of income tax was 83%, capital gains tax was just 30%. As a result, highly paid consultants spent time trying to reclassify income as capital in order to avoid tax.

Benefits in kind were also all the rage. During the 1970s, the City was a place of free suits, free cocktails, company cars, and lots of completely free overseas conventions where everyone took their wives for a good time.

Another favourite trick of that era was to buy tax-favoured assets such as shipping containers. Highly paid executives purchased up to 100 containers with their annual bonus, and the whole lot was effectively tax free. The world was littered with shipping containers owned by British bonus recipients; some had never been used.

When Margaret Thatcher came to power, one of her early actions was to lower the top rate of income tax from 83% to 60% in 1979. The higher rate was cut again, from 60% to 40% in 1988. Maggie also increased the rate of capital gains tax to 40%, with the result that both income and capital gains were for the first time taxed at the same rate. This had the immediate effect of doing away with many tax planning consultants, whilst also raising returns for the Treasury without leaving anyone feeling mistreated.

So what happens now that income tax rates are creeping up again? I'm assuming that we will get a new government in 2010. They will then need to decide how to get incentive back into the economy. I very much hope that a Conservative government will lower the 50% tax rate. Its yield will be tiny and with capital gains taxed at 18%, the amount spent on avoidance is going through the roof. As a tax, this will be a failure - it's doomed, like the poll tax.

Experience proves that to increase the tax yield from highly paid private and public sector staff you must lower not increase the top rate of income tax.

Peter Brown is chairman of Synergy Holdings, founder of the Reward Group, The Top Pay Research Group, Independent Remuneration Solutions and a former director of MM&K remuneration consultants. He also chaired four listed public companies. He can be contacted at Peter@synergyholdings.co.uk.