The chancellor has a chance to fix an unloved tax. I hope she doesn’t blow it

“The failure to tax capital gains is widely regarded … as the greatest blot on our existing system of direct taxation. There is little dispute nowadays that capital gains confer much the same kind of benefit on the recipient as taxed earnings more hardly won. Yet earnings pay tax in full while capital gains go free. This is unfair to the wage and salary earner.
“Moreover, there is no doubt that the present immunity from tax of capital gains has given a powerful incentive to the skilful manipulator of which he has taken full advantage to avoid tax by various devices, which turn what is really taxable income into tax-free capital gains. We shall only make headway against avoidance of this sort when capital gains are also taxed.”
That was James Callaghan, introducing capital gains tax (CGT) in his 1965 budget. His argument was sound. It would seem, though, to imply not just taxing capital gains but taxing them at the same rate as earned income. Yet that is not what happened in 1965, and it is not what happens today.
There are reasons for that. First, capital gains are measured in cash terms: purely inflationary gains are subject to tax. Second, if you are to tax capital gains at the full rate applied to other income then you risk disincentivising investment: if I invest in my business out of taxed income and then pay at the full rate on returns in the form of capital gains then I face a kind of double taxation. I may well decide it is not worthwhile making an investment that, absent taxation, would be economically worthwhile.
And therein lie the reasons for the complex and chequered history of this unloved tax. Tax at a rate below income tax rates and you create a vehicle for tax avoidance. Tax at income tax rates and you risk economic harm through lower investment. Our current system reflects the fudge and the mudge that come out of trying to reconcile these two opposing forces, with a series of different rates for different assets, all set below what would be paid on earned income. Business owners enjoy a preferential rate of 10 per cent on the first million pounds of capital gain on a privately held company.
This is not something that is going to worry most of us most of the time. In 2022 only 0.65 per cent of the adult population realised taxable gains. They paid £15 billion in CGT, £10 billion of which was paid by 12,000 people realising average gains of £4 million. Payment of this tax is very, very concentrated among the seriously wealthy. Many of those realising the biggest gains have in fact invested very little; they have earned a lot and kept their earnings in their business. These gains are essentially the returns to their labour and should be taxed as such.
As Rachel Reeves prepares her first budget, it is evident that she is thinking hard about CGT as a means to raising more money. She should not try to do that simply by raising rates. Doing so would probably lead to substantial behavioural change that could be costly to the economy and would limit how much revenue she could get. That, though, is not a counsel of despair. There are ways of making the tax much fairer, more economically efficient and more lucrative for the exchequer. It is not often you can say that.
What Reeves needs to do is to think about the tax base — the measure of gains on which the tax is charged — as well as the tax rate. She also needs to close some obvious routes through which payment can be escaped.
One way to change the base would be to give an allowance for inflation, as happened between 1982 and 1998, plus a “normal return”, let’s say 2 per cent for simplicity. That way you would pay tax only on real returns, above a normal interest rate. That is the appropriate subject for taxation, and for taxation at the same rate as applies to earned income. Doing this avoids creating disincentives to invest in the first place while ensuring that different forms of income are taxed at the same rate.
This would be perfectly straightforward but it would not work unless you closed two other big leaks in the system. The first is forgiveness, or uplift, at death. If you hold on to an asset until you die then it passes to your heirs and is revalued at that date, so any CGT is subsequently payable only on gains from the moment of inheritance. This provides a huge incentive for people to hold on to assets long after it is productive to do so. While that remains in place other reforms, and certainly rate increases, will be much less effective.
The second leak to the system applies to the internationally mobile. If you make a whacking great capital gain in the UK, move abroad and then realise the gain: hey presto, no CGT. Conversely, in principle at least, we try to tax capital gains made by people while abroad if they subsequently become resident. Raising rates while leaving this system in place could again be counterproductive. Other countries, including Australia and Canada, have demonstrated that sensible reform is perfectly possible. You tax people on gains made while they are resident in the UK and only on those gains.
Chancellor after chancellor has messed with CGT and left it in a mess. It needs to be reformed in a rational and principled way, with a view to long-term stability. That should bring economic benefits and avoid the future political embarrassment of having to undo half-baked changes: embarrassment suffered by our last two governments.
Our new chancellor has her chance. Let’s hope she doesn’t blow it.
Paul Johnson is Director of the Institute for Fiscal Studies