IEA Debate: Should Capital Gains Tax be abolished?

The Chancellor has asked the Office for Tax Simplification to undertake a review of Capital Gains Tax (CGT) to ‘ensure the system is fit for purpose’ and to look again at how capital gains are taxed compared to other types of income. But should he go further and simply abolish CGT completely?

Philip Booth, the IEA’s Senior Academic Fellow, says YES

The Institute for Fiscal Studies was founded as a response to the 1965 budget in which CGT was introduced. One of the founders was IEA author John Chown. The group who founded the body regarded that budget as half-baked. No amount of sitting in the oven in the last 55 years has brought the capital gains tax to fully-cooked status.

The argument is regularly made that the rates of CGT should be brought into line with income tax in order to remove the incentive to turn income into capital gains. This is a fallacious argument. Instead the tax should largely be abolished.

Perhaps the most pertinent example we can use is CGT on company shares. Share prices can go up when companies retain profits, thus raising the value of assets in respect of each share. They also rise when investors anticipate higher profits in the future. So-called unicorn shares often see very high valuations before they make profits for this reason. In both these situations, the profits that companies have earned and retained or will learn in the future are taxed at the time they are earned through the corporation tax system. The valuation of a unicorn company already reflects taxes that will be paid on profits in the future. CGT is an unjust double tax.

Of course, share prices also fluctuate because of changes in interest rates, changes in risk, monetary booms and busts and speculation. But these factors do not lead share prices to rise systematically. The downward trend in long-term interest rates is causing high valuations relative to expected dividend levels at the moment. But the next 20 years might see that trend reversed. When we buy an asset or a property, we buy into a long-term income stream. There is no reason to tax those owners who happen to buy into an asset before prices rise (and then have to provide reliefs to those who buy before prices fall).

There is a range of situations in which CGT is charged where no other taxes may be due. This includes first and second owner-occupied homes. But the underlying problem here is that we do not have a good system for taxing imputed income from owner-occupied property. Taxing capital gains is a very bad way to deal with this.

It is true that much energy can go into disguising income as capital gains. However, HMRC is already wise to that. The best way to deal with this problem is to ensure that income disguised as capital gains is taxed as income – at the point at which income accrues. Perhaps HMRC should re-double its efforts in these areas (and perhaps CGT makes HMRC lazy in so doing).

It is possible that there are some assets such as paintings and antiques which are intrinsically non-income-bearing on which a capital gains tax could be levied. But, even here I am unconvinced. We should not be taxing transactions. To do so is complex, inefficient and also unfair given the absence of any indexation of capital values for inflation. Raising CGT rates will probably lead to a drop in revenue given the complexities of the tax. Indeed, if we keep this problematic tax, one thing is clear: its optimal rates are much lower than our current rates of income tax.

Julian Jessop, IEA Economics Fellow, says NO

Capital Gains Tax is a bad tax, but then most are. There are three main argument against its abolition.

First, it raises a meaningful amount of revenue – about £10 billion a year. These days that may not be a huge sum in the context of the public finances. Nonetheless, it is still money that would have to be found elsewhere.

Put another way, £10 billion is roughly the entire annual budget of the Ministry of Justice, which pays for civil and criminal courts, prisons and the probation system in England and Wales. Or this sum could be used to fund other tax cuts that would have more obvious benefits, such as reducing the burden on lower-paid workers and on the businesses that employ them.

Second, and at least as importantly, CGT protects other revenues that might be lost if people can artificially reduce their tax bills by converting income into capital gains. As a starting point, the principle of ‘tax neutrality’ suggests that these gains should be taxed at the same rate as other forms of income, whether from savings (dividends or interest) or from employment.

Third, CGT is a relatively progressive tax, mainly paid by the better off. Abolition would therefore lead to windfall gains for those who already have the ‘broadest shoulders’ and further undermine confidence in the tax system.

Of course, CGT itself can distort incentives. In particular, it affects the timing of decisions to buy and sell assets, because it is only charged when a transaction takes place. But most existing taxes create significant distortions, unless we ditch the lot in favour of the sort of pure expenditure tax advocated in the Meade Report.

Similarly, many resources are undoubtedly wasted on ‘tax planning’ to minimise liability for CGT. But if CGT did not exist at all, even more effort would be devoted to finding new ways to ensure income is taken in the form of capital gains.

There are some valid concerns about ‘double taxation’, especially when gains in asset prices reflect expectations of increases in income that will be taxed separately anyway. However, this is not a convincing argument for getting rid of CGT completely. Instead, it is an argument for continuing to charge CGT at a lower rate on gains which might already be subject to other taxes, now or in the future, so that the combined rate of all taxes is the same as that on alternative forms of income.

That said, the current system of CGT is definitely a mess. It has a myriad of different rates, allowances and exemptions, and messy interactions with other taxes (notably inheritance tax). It is certainly crying out for ‘simplification’. But ‘abolition’ would be a step too far.

This debate was first published by the IEA

One thought on “IEA Debate: Should Capital Gains Tax be abolished?

  1. I’m pleased that a review of CGT is eventually underway, although what the Treasury will class as ‘fit for purpose’ is anybody’s guess! Reading this post, it appears there are good arguments for and against – I was in agreement with Philip before reading Julian’s points.
    Indeed, Julian’s third point reminds me of some previous work of Rory Meakin who claims that wealth taxes such as CGT are a problem because they are levied without regards to the cash necessary to pay them, and they are associated with a large behavioral response as people try to avoid paying them in the first place. They also encourage people to spend instead of save or invest which restricts productivity.
    If the aim of the Treasury is to encourage people to grow their own wealth, it makes sense to either abolish CGT or to keep rates low. Could any reduced tax revenues into Government be offset by wealthier people? Gut feeling tells me that the Treasury is likely to try and maximise its own revenues, however!

    Like

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