President Obama has announced proposals to increase taxes on the wealthy and help those on lower incomes (such as by boosting tax credits). The plans include reforms to capital gains tax (CGT): increasing its rate and ending a loophole. Should we do the same in the UK, and how do the Lib Dems’ proposals compare?
It’s worth pointing out first that the UK has already been through many CGT reforms. It was introduced in the 60s, modified by inflation-proofing in the 80s, which was replaced by taper relief in the 90s, which was in turn scrapped in the 00s. It’s important that any reform in the next parliament gets it right!
- Obama proposes increasing their top CGT rate to 28%, as it was under Reagan. This is (coincidentally?) the UK rate, after the Coalition increased it. However, Lib Dems want to go further in the next parliament and are (with some big caveats below) right to do so. We should be seeking marginal rates equal to those on earned income, including employee and employer National Insurance, and we’re some way from that. Similarly, Lib Dems are rightly proposing to (all but) end the separate capital gains tax-free allowance – £11,000 this year. Any unused Personal Allowance should be used instead.
- Where the US and UK systems are even more in need of improvement, and where ‘the right’ should focus, is on (returning to) a rate of return allowance you can receive without paying any tax. This might be the rate of inflation – so we’re not taxing people on savings that aren’t going up in real terms – but the theoretical backing is stronger for matching the risk-free market borrowing rate, e.g. medium-term gilt yields. If you get this right you can encourage saving, investment and equity (rather than debt) financing, without compromising on fair rates. In short, if the risk-free rate of return (e.g. gilts) is 1%, it doesn’t matter how heavily you tax the excess on a (risk-adjusted) 8% return – there won’t be a shortage of people wanting to make that investment. Such ‘supernormal returns’ are a sign of economic rent or blind luck – precisely what the tax system should target.
- Any increases in the CGT rate beyond 28% should consider the fact that corporation tax may already have been paid on profits. Dividend taxation already accounts for this, but CGT does not. So second homes and other non-productive assets should face a higher CGT rate than shares – which comes with its own economic benefits and political appeal.
- One of the biggest parts of Obama’s proposal would be the ending of the loophole whereby the capital gains slate is wiped clear when inherited. The UK should do the same. Even with inheritance tax, this is a perverse tax break: it favours only one kind of income and only if held right until death. As the IFS conclude, “there is no case for forgiveness of CGT on death.”We could also look at restricting entrepreneurs’ relief, which may not be worth the £3 billion a year it now costs.
The Lib Dem pre-manifesto is encouraging on much of this, but isn’t quite there, while Labour have simply hinted at returning to the taper relief system they scrapped in 2007.
There is a lot of revenue to be raised here for deficit reduction, but reform needs to be for the long term too, tackling inequality while also promoting growth and building a simpler, more coherent tax system. The above would be a good place to start. Obama’s proposals, and the rest, are unlikely to be realised in the US anytime soon: perhaps they’ll see the light of day in the UK first.
* Adam Corlett is an economic analyst and Lib Dem member
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14 Comments
As I understand it, one of the critical reasons that this is essential in the US is to try and recoup some of the income tax discounted by the uber rich who claim to receive income only through share income and only pay 15% on it.
Just tax inherited wealth as income, maybe spread over a few years.
To follow on from Keith; it is difficult to be individually prescriptive for the UK tax system based on the us does in that area, without considering the totality of the system in which this change will sit.
A good article. I charge hourly fees, but face the prospect of paying VAT, Corporation Tax and then Dividends or Capital Gains Tax out of them. It can feel that taxes are too high and Lib Dems need to stop talking about equalising CGT with income tax because all the other taxes hit us too.
I notice you mention this which is good, but it is something that the majority of Lib Dems do not seem to understand and seem to think capital gains tax should be ramped up to 50%, making the net tax rate much higher.
Tax the super rich by all means, but it is unfair to tax employment income less than profits.
My point about VAT is important too. In economics if we assume demand is measured by prices and sales then VAT does eat into profits. Yes companies try to pass this on, but in my opinion most of the time they cannot pass all of it on.
By the way: I am unsure about the idea of a higher capital gains tax rate for second homes. People pay income tax on rent, which is similar to corporation tax on profits.
When it comes to commodities such as gold: possibly, but these assets are usually bought out of post tax income too and simplicity is good. The current system with generous tax reliefs for investment and then companies blamed for claiming them is a mess.
Thanks for the article. I’m in a rush, so I can’t make a comment as detailed as I would like.
I agree with quite a bit of what Adam is proposing here, which closely mirrors the IFS Mirrlees Review proposals – particularly on the structure of CGT and the need to avoid double taxation of corporate profits.
But at least as far as I understand them, Lib Dem plans are much more punitive than this. They seem to involve raising CGT rates and slashing the tax-free allowance – without either reintroducing an indexation allowance (to prevent taxing purely paper gains) or introducing a Mirrlees-style rate of return provision.
Without at least an indexation allowance, a high CGT rate applied to the appreciation of a long-held asset amounts to a back-door capital levy, taxing purely nominal gains and biting capriciously into the original capital. This causes arbitrary and unjust redistribution based on how long an asset is hold (the longer it’s held, the more punitive the tax), and how successful the Bank of England is at controlling inflation.
Nor is there any recognition of the other issue which Adam rightly points out, the fact that company profits that give rise to capital gains have already been subject to corporation tax. Therefore, as Adam says but Lib Dem spokesmen never mention, there is a strong case for taxing shares more lightly to avoid double taxation (mirroring the dividend tax credit in income tax). Failing to do this penalises those who invest in companies rather than, say, physical property. This defect exists under the current system but would obviously be magnified at higher rates of tax.
Even by the standards of modern tax systems, CGT is a horribly complex area. Simply aligning rates as per Lib Dem policy would seriously over-shoot the supposed aim of taxing capital gains on an equivalent basis to income. This is one reason why there are few countries worldwide that tax capital gains at marginal rates of anything like 40% or 50%.
I’m afraid I expect Adam’s caveats to fall on deaf ears, since too many Lib Dems seem to think that if a tax mainly affects the well-off then that by definition makes it fair.
As a starting point we should recognise that capital gains tax is a necessary evil whose main role is to act as a backstop to the income tax system. High capital taxes (unlike taxes on economic rents) discourage saving and investment, the source of future economic growth and indeed productivity and wage increases. They are just as damaging, if not more so, as high taxes on labour income. Of course we need taxes to provide revenue to the Exchequer, but there is no simple good/bad dichotomy between income taxes on the one hand and capital/savings taxes on the other.
In Item 3, would it not be a simpler solution to abolish the dividend income rate and use the proceeds to reduce corporation tax.
Rich UK investors in UK Limited companies would pay about the same as they do now.
Those below the tax threshold would gain a little.
Multi-nationals would have more of an incentive to declare profits here
UK companies would find it easier to attract overseas investors.
@Peter, I’m not sure about that exact idea but I’ve been thinking about something similar: If we have dividend and capital gains taxes that account for corporation tax, would it be possible to account for the actual corporation tax rate they paid (rather than the standard UK rate)? If we get that right then shareholders should have much less incentive to chase the lowest corporation tax rate as the combination of corporate and personal taxes would give the same rate regardless. I imagine there’d be EU legal issues and many other complexities, but it’s worth exploring.
@Alex, I think the LD tax paper did say we should return to inflation indexing, but that didn’t make it into the pre-manifesto. So it’s not clear what the position is.
A good article – but on point 4 I disagree – CGT and IHT are meant to wok together. The reason that CGT is not payable on the capital gain on an asset when someone dies is that at that point the whole asset, not just the gain on the asset, becomes subject to IHT if the estate is above the threshold. So to subject it to CGT in addition is surely wrong.
A really good response to by Alex Sabine – I particularly agree with “I’m afraid I expect Adam’s caveats to fall on deaf ears, since too many Lib Dems seem to think that if a tax mainly affects the well-off then that by definition makes it fair”. As a party of government we need to be shouting louder about how we have cut the burden of tax for most people but increased the burden on the richest – you wouldn’t think this is true from what Labour say but it’s true. And rightly, given the state of public finances, the ones with the boggest pockets should shoulder the biggest burden. However…. I don’t subscribe to the “squeeze them until their pips squeek” school of thought but sadly there are quite a few in our party who do. More worryingly there are many who seem to blame the rich for the mere fact that they’re rich. This is not the party I signed up to – while it’s only right that the rich pay their fair share we shouldn’t be forever finding ways to squeeze ever more money from those who already contribute a great deal.
Adam: When you say you want marginal rates “equal to those on earned income, including employee and employer National Insurance”, by my calculations this would mean CGT of 53% at the top end, right? So this is going further than current Lib Dem proposals albeit with your important mitigating features.
Out of interest, are you aware of many countries that charge CGT rates above 50%? Or even 30-40%? I just wonder whether this is a case where optimal tax theory and practice might differ quite a bit. Didn’t the Treasury state that on its analysis we are already at (or above) the revenue-maximising rate?
@Alex, Yep, that’s right, though I expect that including employer NI is a pipe dream. But rates of 20/40/45 or 32/42/47 (before accounting for corporation tax) seem plausible. The international competitiveness and revenue-maximising rates would be affected by the introduction of a rate of return allowance so it’s hard to compare figures, but I don’t think the package I outline would be a big tax increase (if at all – quite possibly the reverse) for long-term investment in businesses.
@Julian, It’s worth making a few comparisons. e.g. If you sell the asset just before you die, you pay CGT on your gain and then inheritance tax if it’s transferred. If you receive a big dividend before you die, you pay income tax on your gain and then pay inheritance tax if it’s transferred. If you have a job you pay income tax on your earnings and then inheritance tax if it’s transferred.
In the case of this tax break, inheritance tax is levied as normal but no-one ever pays an equivalent of income tax on the initial gain. Why should it be a special case? What is the difference between someone selling the asset moments before they die and passing on the cash or a different asset (taxed twice), or someone holding the same asset right until they die (taxed only once)?
The IFS have more on this here.
Thanks for your response Adam. I take your point that investors would look at the whole package, not just the headline rates, but (as with the high US corporate rate for example) rates are important in both perception and reality and high marginal rates are undesirable.
Of course, I think high marginal rates on earned income are bad too, but the reason I asked about international comparisons was that I had an inkling that most countries that levy a CGT don’t believe they can get away with rates in the 50% range and would rather go for lower rates and perhaps a less than purist approach to indexation or the interaction between CGT and corporation tax – ie the problems of inflation and double taxation are magnified at high rates.
I had a quick look and the latest figures I could find were from the OECD for 2011. Using their definition of the top tax rate on long-term gains, the range is from zero (in a whole heap of countries including European social democracies like the Netherlands and Portugal as well as the likes of New Zealand ) to a maximum of 44.5% in Italy. Other than Italy, the only countries with CGT rates of more than 30% were France and Denmark. The average top rate of CGT in the whole OECD was 17.8%.
I’m not saying that in itself invalidates your proposal, but it may be food for thought?
@Alex. Thanks for your excellent comments, as ever.
Firstly, I’d just stress again the importance of indexation. The highest OECD rate of tax on real gains is actually infinity, where countries including the UK tax assets that haven’t changed value in real terms or have even fallen. If we introduced a rate of return allowance of 3%, and you somehow received returns of 6% in a year, then even with a 47% marginal tax rate (and that’s without accounting for corporation tax), your effective tax rate would only be 23.5% as currently measured.
Secondly, I’d be interested in your views of how tax competition would actually work here. We’re not talking about companies just moving HQs. Wouldn’t people have to physically leave the UK (for whatever proportion of the year it is) in order to avoid paying UK CGT? How many actually do that, and should we be forming tax policy around them? (Is there a problem that foreigners may have a greater incentive to invest in UK shares than Brits?) And for UK real estate – which is where the main tax rate increases should be – what is there to worry about? That the super-rich will be put off buying up UK homes for BTL or speculation? – isn’t that almost an explicit goal of most parties at the moment?
Adam: Again, I agree with you on the importance of indexation/rate of return provisions – if you have influence in Lib Dem policy-making circles I only hope they will listen to you!
Without that, and an allowance for corporate equity to avoid double taxation of shares, the plan to align rates and slash the allowance looks draconian and would be a backward step in my view, as it magnifies the existing defects of CGT. (You could see a lower rate on gains as a kind of rough-and-ready proxy for indexation, although of course it is crude and unsatisfactory.)
My point about international comparisons wasn’t so much about tax competition, but about international experience, ie what type of CGT other countries have found workable and acceptable. I am not concerned for BTL landlords but entrepreneurs and investors in businesses, especially if entrepreneurs’ relief were to be abolished or scaled back as part of the package.
(Actually in principle I don’t think entrepreneurs’ relief is a great feature of the system, since really CGT shouldn’t discriminate between ‘business’ and ‘non-business’ assets. People should be left to decide unbribed whether to put heir money in a bank account, housing, shares or into their own business based on their judgement of the risks and returns involved. But it does have the effect of softening the potentially negative effects of CGT for an important category of economic actors, so scaling it right back while simultaneously hiking rates would be problematic.)