The consequences of high Capital Gains Tax
A 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.
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.
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