Fewer gains, more tax

Still, runs an argument, there is a solution. It's tried and tested and was used effectively for 16 years until Gordon Brown saw fit to scrap it, though in practice it protected investors from inflation's effects for over 30 years. So why not use it again?

It's called 'indexation', whereby the inflationary gains from a disposal are wafted away and its time may be due again. But the trouble with indexation is that it comes - or, logically, should come - with other measures that mean investors may end up paying more capital gains tax, not less. As we said, be careful what you wish for.

One problem with any discussion about tax - capital gains tax (CGT) included - is that it's a complex subject. So the first thing may be to break off from reading this and skim through 'CGT - a quick tour' in the box on the right; that way you will get an idea of how CGT developed, helping you understand what follows.

Now let's turn our attention to the main table, 'A bit weird' (below), so called because it is based on a theoretical purchase of 2,000 shares in Scottish engineering group Weir way back in March 1982. If you have read the box copy, you'll know why that date was chosen. Besides, it gives us the best chance to explain the idiosyncrasies of the CGT systems on offer.

A bit weird

How CGT works under three systems:

The columns of data are lined up in the chronological order of how CGT was applied. On the left there is a schedule of the indexation method, which was in force in 1982, as if it's still running today. So the purchase cost of the shares would be uprated for the change in the retail price index between March 1982 and today. The UK's price level has risen just over three times since then - really - so the £595 cost would be deemed to be £1,863 in today's money. That's still small fry compared with the disposal proceeds thanks to the marvellous performance of Weir's shares over a generation.

Under the rules of indexation all the gains would be chargeable to CGT at a taxpayer's marginal rate of income tax, which we assume to be 40 per cent. Of course, in practical terms everyone gets an annual allowance, which currently protects the first £10,600 of gains from tax. But, for the purposes of this comparative exercise, we have ignored that.

In the middle column - and next in chronological order - is the taper relief system. Imagine that was still running today, then, for a holding bought in March 1982, it would have allowed indexation of the purchase cost until 1998 when that was replaced by taper relief. The amount of relief available depended on how long a disposed asset was held. Hold it for two years 11 months - during which time there could be a fair bit of inflation - and no relief was available. Relief only kicked in after three years, at which point just 5 per cent of the gain on disposal was knocked off the amount charged to CGT.

Thereafter, it rose by five percentage points a year, peaking at 40 per cent for assets held for over 10 years. Chargeable gains would then be taxed at the marginal rate of income tax.

In the right-hand column is the working of the current - and simplest - system. It could not be more straightforward. The cost is deducted from the disposal proceeds to find the gain, which is then taxed at 18 per cent for people whose taxable income and gains are less than the upper limit of basic-rate income tax and 28 per cent for others.

It is clear which CGT method taxes investors the most heavily - the much-regretted, endearingly-yearned-for indexation system, which, theoretically, would best combat the evils of inflation. Under an indexation system as it was applied, from gross proceeds of £44,340 raised from selling 2,000 Weir shares earlier this month, the net gain would be £25,486 and £16,991 would be paid in tax. For 45 per cent tax payers, the result would be even worse. They finish with just £23,362, having paid £19,115 in CGT.

By contrast, the current system - had it been applied since way back in 1982 - would have produced a net gain of £31,496 after the chargeable gain was taxed at 28 per cent. And the best outcome for investors would be Gordon Brown's system of taper relief. From a gain of £43,122, just £25,873 would have been charged to tax and, at a rate of 40 per cent, would have meant a net gain of £32,773. Thanks, Gordon.

At this point, let's add that the results shown in the table, "A bit weird", are quite typical. The 'taper relief' method consistently produced the best outcome for investors using three holding periods - since indexation began, over 10 years and over three years - and for shares in a great investment (Weir) and an indifferent one (security printer De La Rue). True, for an investment showing small gains - such as a holding in De La Rue over some periods - indexation could get the best result for taxpayers.

But that wasn't a typical outcome.

The reasons behind the benefits of taper relief are clear enough. True, it was complicated to apply - especially for multiple purchases and disposals of the same asset - and its underlying logic was anything from flaky to downright ridiculous (why is it reasonable that gains on assets held for a long time should be taxed lighter than assets sold quickly?). That said, the allowance was generous. Once taper relief clicked in - after three years - it was raised by five percentage points a year. That's a fair lick, since, with the exception of 2011, the annual rate of inflation in the UK has not been more than 5 per cent since 1991.

In addition, taper relief was applied to the profits of a sale, so it would always have a bigger impact on cutting a CGT liability than a corresponding rate of indexation since the latter just uplifted the cost of an asset.

Then there is the issue of the rate of taxation. From 1988-89 until 2007-08, CGT was applied at the marginal rate of income tax, which – for the purposes of our exercise and almost certainly for most CGT payers – is 40 per cent. Taxing gains at the marginal rate is logical since it aligns capital and income taxes thereby removing incentives to dress up capital gains as income. The anomaly is the rate of CGT since taper relief was scrapped in 2008.

This lower rate - it started at 18 per cent then George Osborne raised it to 18 per cent or 28 per cent - is a sort of consolation for the loss of indexation. Yet that also implies that, should indexation be restored (don't hold your breath), then aligning CGT rates with marginal rates of income tax would also be restored. In other words, the rate of CGT in practical terms would jump to 40 per cent.

As we said earlier, be careful what you wish for.

How much is paid and how it compares

Whence it comes

How it compares

*Amount paid on share purchases

Source: HM Revenue & Customs