Can we reform Capital Gains Tax to go for growth?
Rumours abound that the government will raise capital gains tax in its October budget, possibly aligning marginal tax rates with those for income tax. That would mean the (standard) top rate on capital gains rising from 20% to 45%, and basic rate taxpayers paying 20 rather than 10%.
Sometimes people argue that such an approach must be acceptable to free marketeers, since it’s the one Nigel Lawson took in his famous 1988 budget. I’m often told that investors cheered as the top marginal rate rose from 30% to 40%.
Perhaps so, but there are important differences between then and now to bear in mind. Crucially, inflation was generally (and persistently) much higher in those days, which meant that people frequently paid tax on purely paper gains. As well as aligning capital gains and income tax rates, Lawson indexed gains to inflation and effectively wrote off any gains made before 1982. In the same budget, the top rate of income tax fell from 60% to 40%. You can see why the City was pleased.
The contemporary appeal to Lawson and 1988 is not, then, as compelling as people seem to think. And of course there are genuine problems with capital gains tax, mostly stemming from the way it distorts economic decision-making. For one thing, when CGT increases are expected, people may rush to realise their gains before the tax rate rises. That might lead to a bump in revenues before the announcement but, perversely, lower revenues once the tax rate goes up.
This phenomenon is compounded by the so-called “lock-in effect” – people deciding not to realise capital gains (when they otherwise would) in the hope of a lower tax rate in future. The extreme version of this is holding assets until death, at which point historic gains are usually written off (inheritance tax is obviously a complicating factor).
To counter these effects, some economists favour a “mark-to-market” CGT, in which people pay tax on increases in the value of their portfolio, whether those gains are realised or not. Portfolio losses would attract tax relief. But this has never struck me as a workable alternative in the real world – not least because many assets are quite difficult to value until they are sold on the open market.
Besides, it doesn’t deal with the biggest economic problem with taxing capital gains – that it introduces a systematic bias against saving and investment into the tax system, favouring present consumption over future consumption, and thereby undermines long-run growth. (I explain these “double taxation” dynamics in more detail here.)
From a pro-growth perspective, I think there are three potential ways forward. First, we could simply decide not to tax capital gains at all. Some other countries take this approach, at least for the main asset classes like shares. You would have to rigorously police the sometimes blurry border between income and gains, however, and the politics would be tricky.
Second, you could have a simplified, preferential tax regime that just taxed capital gains at a low, flat rate. This is roughly what Alastair Darling tried to do as chancellor in 2008. It’s an expedient and practical approach, but it doesn’t really address the problems outlined above.
The third, and I think best, option is to tax capital gains like ordinary income while also giving complete tax relief for all savings and investment. This would effectively turn income tax into a progressive consumption tax (since income – saving = consumption) and eliminate the personal tax bias against investment. In a sense, this is equivalent to the “full expensing” policy recently introduced (with cross-party support) for corporation tax.
The downside is that revenues might fall in the short term, even as they rise in the long run. For a perpetually cash-strapped government, that’s an issue. Furthermore, the debate about pension tax relief suggests that people don’t understand deferred taxation and that this can easily be exploited by those who advocate higher taxes on the well-off – irrespective of the underlying economics. You would also need other reforms to minimise the lock-in effect.
Nevertheless, an enlightened government might sensibly combine each of the approaches in a single reform package. A de minimis exemption for small gains (option 1). A simple flat tax for gains on investments that have already been made (option 2). And a new way of taxing future investments (option 3) that makes the tax system more neutral and pro-growth overall.
Capital gains tax has been a political football for many years. It would be nice if the next round of reform could be economically rational and durable.
Tom Clougherty IEA executive director & Ralph Harris fellow
