Capital gains tax hike a very bad idea

Allister Heath
IT is time for the new government to pause for thought on capital gains tax. John Redwood, the former Tory minister, is right on the money in his article for this newspaper today (see p16): a massive increase in capital gains tax to 40 or even 50 per cent, as envisaged by the government, would be a disaster for the economy and would cripple millions of investors who own shares, investment properties or other assets.

The main argument in favour of hiking capital gains, made in particular by Vince Cable, the business secretary, is that it has become far too easy for taxpayers to dress up income (taxable at up to 50 per cent) as capital gains (on which tax is only payable at 18 per cent).

There are undoubtedly abuses – but it is simply not true that most investors are able to do this. If Cable can’t see that, he ought to ask any small shareholder, investor in an ETF or buy-to-let entrepreneur. They are trapped. As the Adam Smith Institute points out in a new report, if it were so easy to convert income to capital gains, then how do countries that have a zero capital gains tax still manage to raise significant revenue from income taxes? US income tax receipts did not collapse when the capital gains tax rate was cut. What about Hong Kong, which has no capital gains tax? Or Belgium, which also has no capital gains tax but a top income tax rate similar to that in the UK? Why can it still collect income tax at these high rates? Or the Netherlands, with an income tax rate of 52 per cent and capital gains tax of zero? Or New Zealand, which also doesn’t tax capital gains at all? Converting capital gains to income is nigh on impossible for most people and the authorities ought to be capable of limiting attempts at income arbitrage by professionals. If the current legislation isn’t sufficient, passing new anti-avoidance legislation would be easy and wouldn’t require hiking the tax rate for everybody else.

The Adam Smith research looks at the experience of other countries, notably the US and Australia. Increases in capital gains tax rates actually caused a drop in tax receipts, while decreases led to rises in revenue. People can decide when to cash in their gains. As the proposed increases in the UK will be seen as temporary, many investors will hold on to assets to await a lower rate – and fewer realised gains will mean reduced tax receipts. Already, many investors are busily selling their assets to avoid the looming hikes. Paul D. Evans of Ohio State University’s study The Relationship Between Realised Capital Gains and Their Marginal Rate of Taxation, 1976-2004, which reviews the econometric evidence, confirms that taxpayers report fewer gains when rates are raised. He found that at current US tax rates, a 1 percentage point reduction in the capital gains tax rate would lead to a 10.3 per cent rise in realised gains. The revenue maximising rate, he discovered, is just under 10 per cent – and the welfare and growth maximising rate even lower. A 50 or even 40 per cent UK?top rate of capital gains tax would be very high by international standards and would hit revenues.

It is not too late for the coalition to back down and propose an amended, less damaging plan; chancellor George Osborne ought to study Redwood’s proposals carefully. They are much more sensible than the wholesale attack on private investors proposed by some misguided, anti-capitalist elements within the coalition.