Flip-flops on CGT cost us in the long term

If any one tax illustrates the problems and incoherence of tax policy making it is capital gains tax. In one of the bigger changes yesterday, George Osborne cut the main rates from 28 per cent to 20 per cent for higher-rate taxpayers and from 18 per cent to 10 per cent for basic-rate taxpayers. This is the same chancellor who increased the rate from 18 per cent to 28 per cent for higher-rate taxpayers back in 2010.

He is in good company among chancellors — it is remarkably common for them to change their minds on CGT. Gordon Brown reduced the rate for most business assets to just 10 per cent. The Labour government subsequently reformed the system again and raised the rate to 18 per cent. Go further back and you see a series of reforms and counter-reforms ever since the tax was introduced in 1965.

Mr Osborne has also continued the long history of imposing different rates of CGT on different assets. The new lower rates will not apply to gains on residential property, for example. He extended the reach of entrepreneurs’ relief as well. This imposes a tax rate of just 10 per cent on a pretty hefty £10 million of gains for owner-managed businesses. This relief will now apply to gains on newly issued shares in unlisted companies, provided they are held for a minimum of three years.

This regular yo-yoing reflects a real tension between wanting to minimise disincentives to save and wanting to minimise avoidance opportunities. Low rates of CGT allow some well-advised and better-off individuals to convert income into capital gains and thereby reduce tax payments.

High rates of CGT may disincentivise saving and investment, especially as CGT applies to purely inflationary gains at present. In other words, if the value of the asset I hold rises just in line with inflation I still end up having to pay tax even though the real value of the asset hasn’t changed.

Perhaps not surprisingly, it was a former Tory chancellor, Lord Lawson of Blaby, who got closest to solving the conundrum by charging CGT on real gains only and at the taxpayer’s marginal income tax rate. Just one small step from that would have solved a large part of the conundrum: charge CGT on returns above a “normal” or risk free return.

Yesterday’s changes address few of the real problems. Inflationary gains will still be taxed, though at a lower rate. The increase in the gap between income tax rates and CGT rates will encourage the taking of income as capital gains.

Generous treatment of particular sorts of business assets creates obvious distortions. The fact that CGT is entirely relieved at death also creates a very big incentive for people to hold on to assets until then.

This comment piece was first published in The Times and is reproduced here with permission.