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  1. Spotlight on Policy
27 September 2021

Fix the taxation of capital gains

Reforming capital gains taxation is an efficient and fair way for the government to raise substantial revenue.

By Arun Advani

Tax has, unusually, been on the front pages in recent weeks. The government recently announced contentious plans to pay for health and social care by raising National Insurance contributions. As well as breaking a manifesto commitment, these plans will hurt workers, young people and those on low incomes much more than increasing income tax or implementing more comprehensive reforms to National Insurance. Meanwhile, Labour has announced plans to end the carried interest loophole, which currently allows private equity fund managers to have their performance fees taxed as capital gains rather than income.

In these two announcements, we see two different visions for the role of tax. The Conservative rise in National Insurance focuses on raising large sums to pay for nice things, but without regard for whether the burden is shared fairly. The Labour announcement removes some obvious unfairness in the current tax system, but brings in relatively little money.

What is really needed is a way to marry these two together: to raise substantial revenue while reducing the unfairness in the system. As it happens, the British tax system has plenty of existing unfairness, and fixing it can actually raise sizeable sums.

The place to start is the taxation of capital gains. This is money received from the sale of assets for more than they were purchased. Examples include selling shares or a second home at a profit, although actually most of the value of capital gains comes from selling small businesses. These gains are essentially the compensation received for working, rather than anything to do with arms-length investing. And they are highly concentrated: 92% of all taxable gains went to individuals receiving more than £100,000 in gains.

But, while ordinary workers pay income tax and National Insurance – including from 2022 the new government levy – that together cost 33% of income for someone on the basic rate and more than 48% for those at the very top, capital gains tax rates can be as low as 10%, even for individuals receiving £1m in gains.

Work published by the CAGE Research Centre showed that in 2017 the average person receiving £10m in income plus capital gains paid a tax rate of just 21%; lower than the rate paid by someone on median earnings of £30,000. One in ten people with income plus gains of £1m paid a lower rate than someone earning just £15,000. This kind of egregious unfairness can and should be ended.

A straightforward reform would be to raise capital gains tax rates to line up with the tax rates on earnings, so that individuals are not taxed differently depending on where their money comes from. An allowance would be added to ensure gains purely due to inflation were not taxed.

This would not be a radical position for the Labour Party, or indeed the Conservative Party, to take. It was the system for taxing capital gains between 1988 and 1998, introduced by Nigel Lawson – hardly the epitome of Marxism – with the rationale that “there is little economic difference between income and capital gains”. More closely aligning capital gains and income tax rates was also recommended last year by the Office of Tax Simplification.

This reform has three things to recommend it: efficiency, fairness and revenue.

Economists like it because it is efficient: it removes the incentive for someone who is a very good employee to set themselves up as a less good owner-manager of their own business merely to benefit from the lower tax rates.

It is fairer for two reasons. Firstly, it removes the regressivity present in the current system, where people with high levels of gains pay lower rates than people on much lower incomes. Secondly, it removes the horizontal inequity that two people who take home the same amount of money in a year end up paying very different levels of tax because one of them has structured the money as gains.

Finally, unlike the change to carried interest, it raises substantial revenue. Just equalising capital gains tax rates would raise more than £14bn, more than will be raised from the recent change to National Insurance. Fixing other problems, such as removing the ‘death uplift’ – wiping out the tax owed for people who can afford to hold assets until death – and reducing the very large amount of capital gains that can be received before any tax is owed, would raise even more.

And what of the unintended consequences? Will everyone pack up and stop investing? This doesn’t appear to be what happened in the 1990s, nor is there any economic evidence that there are big discouragement effects from higher rates. Indeed, when reducing tax relief on the sale of businesses in his 2020 Budget, the Chancellor noted that “less than one in ten claimants [said] the relief has been an incentive to set up a business”.

Politics is full of hard choices. But there are also some easy ones out there. Fixing the taxation of capital gains is one of the easy ones.

Arun Advani is an Assistant Professor at the University of Warwick.

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