We have a wealth tax in all but name

It is a truth universally acknowledged that a government in need of a fortune will override the fair treatment of its taxpayers. This truth is so fixed in the minds of all concerned that the government and its agents would doubtless consider the tax revenues so derived the rightful property of the state anyway.

With a little help from the first two paragraphs of Jane Austen’s favourite novel, this sets the scene for the strange case of HM Government, its taxpayers and capital gains tax (CGT) – arguably the tax most disliked by investors. Perhaps the tale is more the mystery of the missing billions than an Austen romance, and the government, so easily cast as the bounder, Wickham, is actually more the revolting yet useless Mr Collins. Anyway, let’s begin.

Obviously, the present-day government is desperately in need of a fortune, or at least the means to reduce the state’s burden of debt, which currently stands at £2,537bn, or 101 per cent of the nation’s annual output. In those circumstances, every little helps. While CGT is a minor tax – in 2022-23 it raised £18bn, or barely more than 2 per cent of the total tax take – its receipts are growing fast. Ten years ago, they were just £4bn and the Office for Budget Responsibility, the government’s spending watchdog, reckons CGT will raise £26bn in 2027-28.

This is where fair treatment of taxpayers comes in – or the lack of it. It’s not just that the chancellor, Jeremy Hunt, has halved the annual amount of realised gains that can be offset against a CGT liability from £12,300 to £6,000 for the current tax year, but also that he will halve it again to £3,000 for 2024-25. Worse, this is happening against the backdrop of persistently high inflation, the effect of which is to make a meaningful slug of capital gains illusory anyway. To be taxed on the sale of most assets is miserable; to be taxed on profits that don’t really exist seems close to legitimised theft.

Has CGT morphed into a wealth tax?

To put it another way: arguably CGT has morphed into a wealth tax in all but name. True, there is a sensible discussion to be had about whether the government should levy such a tax. However, sidestepping the discussion altogether and creating a de facto wealth tax is hardly the mark of fair government.

Besides, CGT doesn’t just sting the wealthy. Quite the reverse. In the tax year to April 2021, the latest figures for which a full breakdown is available, people with taxable income below £37,500 – effectively, basic-rate taxpayers – made up 37 per cent of those who paid CGT. True, their contribution comprised just 4 per cent of the total gains assessed for CGT, but the tax they paid was presumably a heavier burden for them than that faced by the 2 per cent of CGT payers with gains of over £1mn.

Then there is the injustice that CGT wasn’t always like this. Once it was a fair tax because it took account of inflation. Indeed, from 1982 until 1998 there was ‘indexation’. So the gain on the sale of a qualifying asset was calculated by linking its cost to inflation during the period it was owned. Thus – and in simplified terms – buy a shareholding for £10,000 in January 1990 and sell it for £15,000 in January 1995 and the profit, rather than being £5,000, was £2,800 to take account of the 22 per cent uplift in retail prices during that period.

However, Tony Blair’s first Labour government scrapped indexation in 1998. The chancellor, Gordon Brown, said it was unnecessary in a low-inflation environment (prices were rising at 3.5 per cent at the time), adding that it was “a major complicating factor”. Then, with no sense of irony – though characteristically – Brown introduced something even more complicated into the CGT regime, taper relief. This sheltered more of the gains from a sale the longer an investment had been held. As such, taper relief was somehow consistent with the dour mien of a son of the manse. It presumed that only spivs traded quickly in and out of investments while responsible investors held for the long term. Therefore, long-term holders should be rewarded for their virtue while the spivs should be penalised.

Be that as it may, and after much tinkering, taper relief was scrapped by Brown’s government in 2008. In its place came an ultra-simple form of CGT – no indexation, no nothing; just an annual allowance against realised profits and a flat-rate tax. As compensation for the loss of indexation, CGT was no longer charged at a taxpayer’s marginal rate but at 18 per cent for everyone.

Give or take, that brings us back to the present. Tinkering has been minimal. The basic rate was pushed to 28 per cent, which is where it remains for assessable residential property, and is now 20 per cent for everything else. Meanwhile, annual allowances are in the process of being scalped.

This leaves us in an unhappy place where CGT is both unfair and penal. Maybe. Let’s put that to the test by comparing the current system with what we got under the indexation regime and what we would get under a rational CGT set-up.

A rational CGT set-up

Rationality demands both equity and consistency, which is what was delivered in Tax by Design, a big 2011 study of an optimal taxation system for the UK from the Institute for Fiscal Studies, a think tank, and led by Nobel Prize winner in economics Sir James Mirrlees. Similar to indexation, Tax by Design presumed that tax must be levied only on real profit. So all capital invested would receive a notional risk-free rate of return, which, in effect, was the reward for choosing to save rather than to spend (for what it’s worth, this also meant interest from bog-standard savings accounts would be tax-free since they, too, could deduct this risk-free return from their interest income). Anyway, profit for CGT purposes would be assessed only after the risk-free return was deducted. Also, in common with other aspects of CGT, tax losses would be created if actual returns were less than the risk-free amount. Post-allowance profit would then be taxed at an investor’s marginal tax rate. This meant taxpayers would have no incentive to dress up income as capital or vice versa.

All that is fine, but the trouble is that record keeping using the notional risk-free rate “would be somewhat more onerous than under some other systems”, the Mirrlees report acknowledged. It also suggested the complications would be no worse than under indexation rules, but both statements seem way too optimistic.

Take the figures shown in the table, which compares outcomes for the three CGT systems using a theoretical purchase of 5,000 shares in drinks distributor Diageo (DGE) at the end of 1989, when the price was 346p, and a sale just now at £33.98. The choice of Diageo was arbitrary except it has a long price history, and a rising price so any long-term investment in a decent quantity of shares is likely to produce a CGT liability; the chart shows the real and inflation-indexed share price performance over the period under review.

The £65,513 allowance shown in the column of the table dealing with the Tax by Design system is a guesstimate figure for the risk-free return that would have been generated over the 23-year holding period. The figure could vary considerably depending on precisely how the actual risk-free return was calculated. The amount shown is the product of the holding’s average value and income being generated at 3 per cent interest, roughly the average interest rate on 10-year UK government bonds over the relevant period. So it seems to be an acceptable ballpark figure. Yet the detail of how risk-free returns are calculated matters greatly since – much as investment theory tells us – the risk-free component comprises a big part of an investment’s total return; in this particular case, well over half the £118,000 generated.

That figure leaves far behind the net return produced by full indexation of the cost of the investment. Between the December 1989 purchase and today, the price level, as measured by the retail price index, rose almost 3.2 times. That inflated an actual purchase price of £17,300 to almost £55,000. Even so, tax the £109,000 of assessed profit at the 40 per cent marginal rate and our theoretical investor is left with £71,000, including his allowance.

Granted, it won’t always be as conclusive as that. If, on average, inflation is higher than the risk-free rate – as it is often enough – then indexation will produce a superior return. Yet there is some justice when use of a risk-free allowance produces a better result than linking to inflation. After all, the risk-free rate should include both the time value of money as well as inflation.

Still, who would have thought it? The best result is produced by the current – and much vilified – CGT system. The reason is simple and obvious – profit is taxed at 20 per cent, half the marginal tax rate. Sure, most likely it’s more a matter of luck than of judgment that the current illogical system produces roughly the same result as the beautifully rational Tax by Design.

But this comparative exercise also carries a warning for investors. If indexation both produces the best tax yield for governments and is sorely missed by investors in these high-inflation times, then why wouldn’t the government seek to restore it? After all, a government in search of tax revenue will always find a way to justify its means. That, too, is a truth universally acknowledged.

bearbull@ft.com