Capital gains tax ‘needs wholesale reform’

Capital gains tax is, perhaps, the most contentious of all taxes in the UK.
It is often cited by the left as a totemic means of squeezing revenue from the rich. The right, meanwhile, slaps away any increase to the main rates of capital gains tax (CGT) on the grounds that it will steer investors away from Britain. The truth probably lies somewhere in the middle.
Countless capital gains tax reliefs and rates have been introduced. The main relief people can claim is “business asset disposal”, which limits the tax to 10 per cent or 20 per cent on up to £1 million of business gains.
Rachel Reeves, the chancellor, is considering raising the rate on share sales and other assets from 20 per cent for higher-rate taxpayers by several percentage points at the budget on October 30. The rate paid by private equity bosses on profits, so-called “carried interest”, is also likely to rise from 28 per cent.
In sum, capital gains tax is a complex web that is best left to be untangled by accountants.
Introduced in 1965 at a flat rate of 30 per cent, CGT is a tax on profits above £3,000 on assets. It is a discretionary tax insomuch that it is triggered by individuals’ deciding when and how to sell their assets. The most common rates paid are 10 and 20 per cent.
Capital gains tax revenues hit £15 billion last year, representing about 1.5 per cent of all government income. About 350,000 people pay the tax each year, with some 12,000 individuals generating two thirds of revenue. This latter group realised an average gain of £4 million, and tend to be very wealthy.
The typical argument against lifting the rates is that it will curb entrepreneurialism. A study by Evelyn Partners, a professional services firm, released last Friday suggested that nearly half of business owners would be deterred from creating a new company if the chancellor did increase rates at the budget.
In a counter argument, the Institute for Public Policy Research, a left-leaning think tank close to the Labour government, claimed: “CGT matters very little at the crucial early stages of entrepreneurship … issues around financing, management and logistics are far more relevant than the eventual return founders might make on selling the business.”
Experts agree that capital gains tax requires a root and branch overhaul to generate serious revenue for the Treasury while still stimulating investment.
Famously, Nigel Lawson, the proclaimed inspiration for countless Conservative MPs for his tax-cutting stint as chancellor under Margret Thatcher, aligned the marginal rates of capital gains tax and income tax in 1988.
Central to the argument for reinstating this policy, which would lift the rate to something like 45 per cent, is to strengthen incentives to generate income through work.
Lower capital gains tax rates relative to income tax can motivate individuals’ work preferences. Rather than electing for the most productive activity possible, they could choose a form of work that lowers their tax bill, a detriment to economic growth.
However, simply raising headline rates without wider reform would be “a very bad mistake”, according to Dan Neidle, founder of the Tax Policy Associates think tank. “It would greatly exacerbate the current effect of CGT to discourage long-term investment … It could lose money.”
Under the present set-up, individuals pay the tax when they sell assets that have increased in value only in line with inflation.
For example, an investor who purchased an asset for £1,000 in 2014 and sells it for £1,500 in 2024 would have made a gain of £500. If inflation accounts for £400 of that gain over that period, then the investor has actually made a real gain of £100.
If the investor then has to pay 20 per cent of capital gains tax on that £500 gain, it equates to an effective 100 per cent tax rate on the real gain. This structure depresses investment incentives, especially when interest rates are high and investors can simply park their cash in risk-free savings accounts and earn decent returns.
Fixing this bug is pretty simple: exempt the inflation-tied-wedge of profits. Britain did have a CGT inflation allowance up until 2008. Reintroducing it would amount to a cut in the tax.
Indexation would certainly improve the regime, but Treasury officials can do better. They can cut capital gains tax bills for less wealthy investors who make smaller gains and extract greater revenues from larger investors in one stroke.
Neidle recommends introducing a “normal return” allowance that, broadly speaking, exempts real terms gains up to 40 per cent from the tax. Anything above that threshold could be subjected to a higher capital gains tax rate of, say, 45 per cent.
If an individual retains an asset until they die and passes it on, no capital gains tax is payable by the inheritors, who instead pay tax on gains realised from the day they receive the asset. This allowance motivates people to hold on to assets for as long as possible even if they would prefer to sell them and use the proceeds in more productive ways.
The Institute for Fiscal Studies said: “On death, if an asset has accrued gains, it is appropriate to tax these just as much as if the asset were sold the day before death, when it would currently be taxed.” Any such move would subject individuals, in some cases, to pay both CGT and inheritance tax on their estate.”
Taken together, these reforms, fleshed out in a report by the Centre for the Analysis of Taxation earlier this month, may raise £14 billion for the Treasury.
The study’s authors concluded that the tweaks “will shut down opportunities for tax avoidance and improve investment incentives and growth”.
“We emphasise that these measures are essential alongside any increases in the tax rate in order for CGT reform to be effective.”