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Not such a capital idea

May 30th, 2010 Posted in Uncategorized by

At the moment we don’t know exactly what the Coalition’s plans are for changing capital gains tax, so the various campaigns against it are speculative. However in principle we understand non-business capital gains will rise to either income tax or near income tax levels from their current rate of 18%; potentially 40 or 50%. Capital gains on business activity may also rise, but not as much. Allowances may be cut. All changes likely next April, rather than June.

The principle behind the change is that capital gain is like income and so should be taxed like income. The problem with the principle is that most capital gains are not like income, capital investments have downside risk.

If for example you invest in shares, a second home, or a new business venture, you bear the entire risk of losing that asset should market conditions deteriorate. You cannot offset capital loss against income tax.

Capital Gains Tax though means the state shares any upside. Higher rates reduce the incentive to invest, particularly in high risk but valuable economic activity like employing people. The IEA have a good example on this and why the income comparison is erroneous.

Historically we used to have indexation relief then taper relief as methods of treating capital gain differently. The thinking here was to reward holding assets for a long time and discourage short-term or speculative behaviours which are assumed to have a social cost. Both though were complex and hard to administrate. It is also not clear such incentives reduce systemic risk.

The solution tried by Labour was to cut CGT to a single rate of 18% and scrap taper relief. Done for reasons of simplicity and in respect of international competition. Most capital, unlike most income can move around the world with ease. Several countries don’t have CGT, and those that do all have rates below 30%. At 40% Britain’s rate would be the highest in the Western world.

They also retained a form of pro-small business discrimination with Entrepreneurs relief, which reduced the rate to 10% for the first £1m of gain.

So any changes in the emergency budget towards levels of income tax run the risk of increasing complexity, reducing investment incentives, and increasing avoidance including encouraging mobile capital abroad. All of this would reduce the tax return from CGT, fail to provide returns the government can use to raise personal allowances, (the intent of the change), and do little to tackle the deficit.

A counter-argument to this, deployed by Nigel Lawson and Ronald Reagan in the 1980s is that big differences in rates between income and CGT encourage a different kind of avoidance, declaring income as capital gain. For example contractors setting themselves up as companies, or saliariate becoming contractors to do so. But this is very small beer and arguably entrepreneurial.

There is less of a case against raising CGT on second homes, although doing so will encourage flipping, housing gain is more reliant on supply shortages than investment.  An unrelated, simple, but less counter-productive reform with redistributive intent would involve replacing stamp duty with a low level of CGT on home sales. This would benefit the young and asset poor and reduce disincentives to invest in homes in downturns.

So it will be interesting to see what the proposals actually are on June 22nd. Big rises will be a mistake encouraging capital flight and avoidance.  More complexity will be a mistake extending the tax code. Targeting second homes will seize up part of the housing market. Not an easy challenge to get right.

One Response to “Not such a capital idea”

  1. tim leunig Says:

    Indexation and the ability to offset losses against future profits are all that is needed. The rest is deadweight. Lawson was right on this.