The consequences of high Capital Gains Tax
Jan 2013 02

new study from the Cato Institute, released over the Christmas break, looks at a number of reasons why low Capital Gains Tax (CGT) rates are best. They are concerned about a potential increase in the CGT rate in the United States. But here in Britain we are already paying the price for very high taxes on many capital gains. Writing about the new study in the Investor’s Business Daily, the author Chris Edwards sets out six reasons the tax should be kept low – all of which apply in Britain as well:

  • Inflation. “If an individual buys a stock for $10 and sells it years later for $12, much of the $2 in capital gain may be inflation, not a real return.” Investors are being taxed on inflation, not real capital gains.
  • Lock-In. ”Taxpayers delay selling investments that have large unrealized gains to avoid the tax hit.” In Britain, there are billions upon billions of pounds sitting in the wrong investments which could be put to more productive use. But the owners can’t sell one asset and buy another without getting hit by high taxes. By starving growing businesses of funds this costs all of us in lower wages and fewer jobs.
  • Double Taxation. “Corporate share values generally equal the present value of expected future earnings. If expected earnings rise, shares will increase in value, creating a capital gain to the individual. But those future earnings will be taxed at the corporate level when they occur; thus hitting individuals now with a capital gains tax is double taxation.” This is really important. Those earnings will also normally be taxed at the individual level as well. CGT is an unfair double tax and the common belief that the fair rate of tax on capital gains is the same as the tax rate on income is wrong as a result. The fair rate of tax on genuine capital gains is zero. The study quotes from a paper by Bruce Bartlett who noted that Britain did not tax capital gains until 1965 because “capital gains were not income … hence were not subject to taxation.”
  • Competitiveness. Why invest in Britain when any gains on your investment will be taxed much more heavily than in other developed economies? Our top Capital Gains Tax rate is even higher than the rate in the United States. Yes there are exceptions for smaller investments and others which qualify for certain reliefs. But those limited exceptions only help certain businesses and are no substitute for a broad low rate.
  • Growth Companies. “Reduced capital gains taxes encourage entrepreneurship because the capital-gain payoff from a successful start-up is improved relative to a wage job.” Again there are exceptions in Britain for some entrepreneurial investment but the limitations on those exceptions can mean unfair results and limit the ambition of the new firms that create the most jobs.
  • Government Revenue. When the CGT rate goes down, CGT revenue goes up. The argument is that CGT is needed to stop people turning income into capital gains. But research by Entin quoted in the 2020 Tax Commission suggests that the overall effect of higher CGT rates on revenue is still negative. And at the moment we are in the worst of both worlds. CGT at nearly 30 per cent is a terrible double tax putting off investors who might make legitimate capital gains. But it is still much lower than the combined top Income Tax and National Insurance rate of nearly 60 per cent so there is still a strong incentive to turn income into capital gains if you can. It would be much better to close some of the loopholes in taxes on income instead, as the 2020 Tax Commission recommended.

According to data from Ernst and Young quoted in the Cato Institute study, the top tax rate on capital gains in the United States was 19.1 per cent in 2012. That rate is higher than the 16.4 per cent average across the developed OECD economies and it is set to rise. But it is much lower than the 28 per cent top rate in Britain. After the annual exempt amount – normally £10,600 – our taxes on capital gains are absolutely punishing.

130102 CGT rates

If we want to get our economy growing again, we need to cut CGT. Britain’s high taxes on capital gains are distorting economic activity and undermining economic growth. The right rate for this tax is zero.

Matthew was the Chief Executive of the TaxPayers' Alliance, author of Let Them Eat Carbon and editor of How to Cut Public Spending (and still win an election)

  • Saymwah

    Such a good point about being taxed on inflation!

    • blarg1987

      IS not the tax free allowance increased anyway which compensates?

  • Stephen Wigmore

    What utter gibberish. For a start, not all capital gains are on shares. What about on housing ownership and speculation? Or commodities? Secondly, corporation tax does not mean shares are doubled taxed, just the same as it does not mean income tax on dividends is double taxation. Thirdly, share value is linked to future expected earnings, but precisely the fact those earnings are in the future, and hence have not been taxed yet mean you need to tax the capital gain now if disposed of. And I’m all for generous tax incentives for genuine entrepreneurs but not all capital gains are taken by entrepreneurs, I would guess not even a majority. Hence this is a deliberately misleading point.

    That said, the point about inflation, and incentivising people not to realise gains is a good one. The answer though is to make headline rates equivalent to income tax rates and provide an annual inflation or Rate-of-Return allowance to take account of that when calculating the tax rate.

    Abolishing capital gains tax is just a sop for plutocrats at the expense of every ordinary person.

    • Rory Meakin

      I’m not sure what relevance the fact that not all capital gains are on shares. Matthew’s blog didn’t say they were.

      You ask ‘what about on housing ownership and speculation?’. Well, all the blog’s points hold with respect to that, too. Just as the purchase price of a share certificate reflects the net present value of expected future cash flows, so also the purchase price of a house reflects the net present value of expected future cash flows from owning the house.

      This is most obviously clear in the case of a rental property occupied by someone other than the owner. But it is also true in the case of an owner-occupied property. The owner-occupier values the property he purchases as the net present cash value of the expected future accommodation benefit (possibly measured by the rent he would no longer have to pay to someone else) plus the net present value of the expected future sale price if he ever expects to sell it.

      As for your contention that the disciplines of economics and financial theory are wrong and that, in fact, Corporation Tax not represent a double tax on investors’ incomes, think about why people own shares: dividends. Suppose profits were taxed at 100 per cent. What would happen to dividends and the value of shares if investors could no longer receive any financial benefits because it was entirely confiscated in tax? And then what would happen to investment and the jobs and prosperity that depend on it?

      Finally, you say ‘precisely the fact those earnings are in the future, and hence have not been taxed yet mean you need to tax the capital gain now if disposed of’. Why?

      Investors aren’t getting ‘something for nothing’ on a capital gain. Suppose Investor A sells his shares to Investor B and makes a capital gain and then the company goes bankrupt and the shares become worthless. Investor A’s capital gain is exactly the same as Investor B’s capital loss, which he can use to reduce his tax liability. Investor A’s Capital Gains Tax paid to HMRC is off-set by Investor B’s off-setting loss. HMRC is no better off. Yet the problems Matthew identified still exist.

      Alternatively, suppose the company does not go bankrupt and the shares retain their value. Why must a huge and distortionary tax be paid simply because two investors swap assets (cash for shares, and shares for cash)?

      Abolishing Capital Gains Tax would remove a massive roadblock to recovery and stimulate savings and investment with all the economic activity, new jobs and growth that would bring about. For a highly inefficient tax that doesn’t raise all that much revenue, that’s a big prize for every ordinary person who could benefit from an economy with more and better paid jobs.

  • Steve Collins

    Someone somewhere will pay dearly for every tax cut the TPA proposes and it sure as hell won’t be their wealthy backers.