Capital gains tax reform is a tricky juggling act

Taxes that are not levied on the average voter have undeniable public appeal. On those grounds, capital gains tax is an attractive revenue raiser. Fewer than three in 100 adults paid it over the decade to 2020. The Labour manifesto only briefly mentioned the tax, in a promise to block the private equity carried interest “loophole”. But the party has not ruled out other changes.

In a 2018 pamphlet Rachel Reeves, a then-backbencher who is virtually certain to be the next chancellor, suggested that capital gains could be taxed at income tax rates. There are good theoretical arguments in support. The case was made by the late Conservative chancellor Nigel Lawson in 1988. He argued that different rates distort investment decisions and fuel the tax avoidance industry.

There is a yawning gulf — normally 25 percentage points — between the top tax rate on income and capital gains. That creates a big incentive to convert income into capital. Contractors and others selling their services through their own companies often take money out in the form of capital rather than income. An analysis of tax filings concluded that three-quarters of all gains over two decades could just as well have been received as income.

The incentive to retain earnings in a business is amplified by a tax break lowering the CGT rate to 10 per cent on its sale or winding-up. It was meant to keep serial entrepreneurs in the UK.

In 2020, this tax break’s name was changed from Entrepreneurs’ Relief to Business Asset Disposal relief. The moniker “Bad” relief is a clue to the Treasury’s view on its effectiveness at stimulating business investment and risk-taking. Curbs to its generosity in 2020 more than halved its cost to £1.2bn.

Equalising CGT and income tax rates, meanwhile, might not raise as much as hoped. The UK’s rate is currently only slightly below the international average. Moving far out of line with other countries might encourage business owners to move abroad to make a sale. Asset owners might also delay sales in the hope of a policy change. A 1 per cent increase in rates typically reduces realised gains by at least 0.3 per cent, according to US research.  

Capital gains tax also is not a huge revenue raiser. The Office for Budget Responsibility expects CGT to raise £15.2bn in the year to next March. That is just 1.3 per cent of all receipts. Labour would need to decide whether the gain was worth the pain of radical reform.

If so, it should soften the blow by reintroducing an allowance for inflation, to avoid the taxation of paper gains from rising prices. Labour chancellor Gordon Brown swept it away in 1998 on the grounds that inflation was too low to justify the complexity of indexation. That argument has not aged well.

Reforms to CGT need to take account of fairness, simplicity and enterprise. That makes for a difficult juggling act.

vanessa.houlder@ft.com

Letter in response to this article:

CGT rate should encourage people to sell not hoard their assets / From Andrew Joy, Bentley, Hampshire, UK