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Self’s assessment: who gains – and how should we tax them?

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Most of the discussion about how much tax the rich should pay focuses on income tax – whether the top rate of income tax should be 45%, 50% or some other number. But recent articles in The Guardian (‘Top 1% of British earners get 17% of nation’s income’, Larry Elliott, 21 May) and The Times (‘Time for the wealthy self-employed to pay fair share of tax on capital gains’, Philip Aldrick, 23 May) point out that capital gains can be a large part of the total amounts that the top 1% receive. Overall, it is estimated that when taxable capital gains are taken into account, the income share of the top 1% in 2017/18 was 16.8%, rather than the 13.8% previously thought.

In a subsequent opinion piece in The Guardian (‘Under cover of capital gains, the hyper-rich have been getting richer than we thought’, 21 May), Polly Toynbee says that: ‘With a deft sleight of hand, wealthy individuals and business managers can take large amounts of their earnings in the form of shares or other assets to avoid it being taxed as income’.

The news articles are based on the Who gains? report issued on 21 May by the Resolution Foundation. The purpose of the report is to highlight that ignoring capital gains in the analysis of income statistics risks distorting the picture. As the introduction says: ‘This report looks at what we know about taxable capital gains; how our understanding of top income shares changes if we include capital gains in our analysis; and whether definitions of income used in official statistics should be changed or supplemented.’

The report makes a persuasive case for including capital gains in official statistics about income distribution. However, it does not go into the more difficult question of what that means for the tax system. Not surprisingly, the articles in The Guardian and The Times do make this leap and they assume that the answer, or at least a large part of the answer, to the need to raise more money is to increase capital gains tax.

We’ve been here before. Almost exactly ten years ago, on 6 June 2010, Robert Chote – then head of the Institute for Fiscal Studies (IFS), but shortly to move to the Office for Budget Responsibility – wrote a piece in The Sunday Times about the new coalition government’s plans for taxing capital gains (‘ Solutions to the taxing issue of capital gains’, 6 June). The IFS itself was founded in frustration at the increasing complexity of the UK tax system, and in particular the way in which capital gains tax (CGT) was introduced in 1965.

As Robert Chote points out, CGT was originally at a fixed rate of 30%. The high inflation of the late 1970s and 1980s meant there was a need for indexation relief, so that inflationary gains were not taxed, and this was introduced by Geoffrey Howe in 1982. There has only been a brief period, from Nigel Lawson’s reforms in 1988 to Gordon Brown’s introduction of taper relief in 1998, when capital gains and income have been taxed at the same rate (which, at the time, was 40%). In turn, Alistair Darling abolished taper relief in 2007, and proposed a flat rate of 18%. However, he was soon persuaded to create entrepreneurs’ relief, which gave a 10% rate for the first £1m of capital gains. Entrepreneurs’ relief was reduced back to £1m, from £10m, in Rishi Sunak’s first Budget in March 2020.

When income was taxed, but capital was not, taxpayers had an obvious incentive to claim that receipts were capital and not income (and conversely, that expenses were trading deductions and not capital). And throughout much of the last 55 years, it has generally been more beneficial to receive capital rather than income whenever possible. Not surprisingly, there is a plethora of tax cases where taxpayers argue that receipts are capital and expenses are revenue, with HMRC arguing that the opposite is true.

So why don’t we just tax capital gains at the same rate as income? Surely that would make everything simpler, and raise lots of money? Well, maybe – or maybe not.

Robert Chote poses many of the key questions: ‘CGT is applied to the increase in the value of an asset between its acquisition and disposal. This sounds simple, but the devil lies in the many attendant details. For example, to which assets should it apply? Which part of the gain should you tax? And should the tax rate be uniform or vary with the type of asset, the length of time it has been held or the income of its owner?’

The Resolution Foundation report points out that around half of the taxable capital gains relate to people’s occupations, rather than investments, and note that this includes ‘carried interest’ of £2bn per year, which it describes as ‘a form of bonus for investment fund managers’. There is certainly a case to be made for simplifying CGT and reducing what may seem to be perverse incentives. However, many would argue that entrepreneur’s relief (at least at its current level) provides a valuable stimulus to encourage job creation, which is going to be sorely needed as we emerge from the current crisis.

A difficulty with taxing all capital gains as income is that it would produce different perverse incentives; in particular, unless you were to move to a full wealth tax (which has its advocates, but would bring a whole raft of different complications), capital gains will be taxed only on realisation. So, imposing a high rate of tax would distort the decision about whether to hold on to or sell an unproductive asset – leading, potentially, to ‘zombie’ businesses being continued, rather than sold to someone else who could inject new energy into the operations. And if inflation re-emerges, the gains which are taxed would not represent real gains.

Robert Chote pointed out in 2010 that governments tend to consider major changes to CGT every ten years or so – so perhaps the time is ripe for a more fundamental look at the system. But the government will need to be clear on what it wants to achieve: raising money, reducing inequality or stimulating investment? It is rarely, if ever, possible to do all three at the same time.