Why are the rates of capital gains tax (CGT) so much lower than income tax rates?
It’s a historical thing. When CGT was introduced in April 1965 it came in at a flat 30%, which was significantly lower than tax on income at that time. Before 1962, when Financial Secretary Anthony Barber introduced a speculative gains tax, capital gains were not taxed at all.
The rate of CGT remained at 30% until 1988, when Chancellor Lawson equalised it with the taxpayer’s highest marginal income tax rate.
From April 2008 the Labour government severed that link with income tax and set a flat rate of CGT at 18%. Although Chancellor Brown did fiddle around with various CGT reliefs.
Chancellor Osborne reintroduced a link between tax on gains and income, with a higher CGT rate at 28% paid by higher rate taxpayers, and a standard rate of 18% paid by basic rate taxpayers. The CGT rates have been stuck in those higher and standard rate bands since 2010, with the actual rates dropping as low as 10% and 20%.
Trustees generally pay the higher rate of CGT, irrespective of the trust income.
Would a flat rate of CGT be the simplest option?
It’s superficially attractive to impose a flat rate. However, as HMRC statistics reveal over half of the CGT collected is paid by about 5,000 wealthy people, so I feel it would be more equitable to align CGT with the taxpayer’s highest marginal rate of income tax.
Which income tax rate would you take as the marginal rate – the rate on earnings/profits/savings or that paid on dividends?
The CGT rate should be aligned with income tax payable Taxation Services Provider on earnings and profits. However, there is a good argument for CGT arising from shares being charged at the dividend rates of income tax which are slightly lower.
Scottish residents pay higher income tax rates on earnings and profits than residents in the rest of the UK. Would they also pay CGT at higher rates than in the rest of the UK?
This is a complication, but in principle, Scottish residents should pay CGT in line with the tax rate they pay on their earned income or profits.
Would you also abolish the CGT annual exemption?
I see no reason for retaining a full personal allowance of £12,570 plus the CGT annual exemption of £12,300. I would merge these two allowances, so that once the personal allowance has been used all capital gains would be taxable.
To simplify reporting a de-minimis level of gains (say up to £1,000 per year) could be tax free in a similar manner to the sundry trading allowance.
HMRC has estimated [link downloads document] that scrapping the CGT annual exemption would raise about £900m.
The rate of inflation is now around 10%, and expected to rise. Would you tax all those inflationary gains?
There is a good argument for reinstating an indexation allowance so that inflationary gains aren’t taxed. The pros and cons of this and other approaches are discussed by Arun Advani in his 2021 Warwick Economics research paper.
A simpler solution to indexation would be to follow the Mirrlees Review recommendation of giving an allowance equal to the risk-free return on government bonds.
Various government ministers have claimed that high rates of CGT stifle business investment. Is this borne out by research?
No. In fact, the IFS research has found that the current low CGT rates don’t increase investment, but they do save plenty of tax for investors.
If business asset disposal relief is retained this should cushion the owners of small businesses from gains realised on sale. But the current lifetime limit of £1m for this relief is quickly exceeded for significant business disposals.
How much would this tax rate alignment raise?
The behavioural effect of equalising CGT with income tax rates would mean that individuals would stop trying to convert income into gains to lower their tax burden. Thus, some of the extra revenue would be received as income tax rather than as CGT.
In total, including the savings from abolishing the annual exemption, I estimate that approximately £8bn of extra revenue per year could be raised in this way.