Rumour has it Rishi Sunak is planning to hike Capital Gains Tax (CGT) at the next budget. His hands are tied. Sunak’s predecessor backed him into a corner. The Conservative manifesto ruled out rises in Income Tax, National Insurance, and VAT leaving Sunak with limited options for raising revenue to pay for spending on the COVID-19 crisis.
Some of the likely measures can be gleaned from a recent review from the Office for Tax Simplification, commissioned by the Chancellor in July, which concludes in favour of aligning the CGT and Income Tax rates, paring back the Annual Exempt Amount and abolishing Business Asset Disposal Relief (the unfortunately named successor to Entrepreneurs’ Relief).
Entrepreneurs, who often receive the majority of their income in capital gains, are understandably concerned. Groups such as E2E and data provider Beauhurst are speaking out. Many prominent entrepreneurs have expressed their dismay to us in private.
So who’s right? Is there a case for aligning Capital Gains and Income Tax rates? Would it discourage entrepreneurship and investment? The answer, unfortunately, is that it’s complicated.
Policymakers are faced with an inevitable conflict between two compelling ideas.
The logic behind alignment
On the one hand, they don’t want to favour one type of income over another. Why do some types of earning deserve special treatment? After all, it would be strange to favour income from accountancy over income from plumbing. In fact, it would not just be strange, it would be inefficient. By taxing different activities at different rates we distort the ability of markets to function. In the above case, we end up with too many plumbers and not enough accountants (or vice versa). And if the wealthiest are more likely to receive income from one source over another the case for unequal treatment is weaker still. Treating income from different sources differently can also create avoid opportunities. Ordinary income liable for tax at full whack can, by crafty accountants, be relabelled as capital gains. In some cases, this can allow the very wealthy to pay a much lower rate of tax.
The trade-off: Risk-taking and Investment
At the same time, policymakers also understand that entrepreneurship and investment are the engines of growth. Both of which are discouraged by CGT as it taxes the return to investment. People save or invest to finance future consumption. If the return to saving is taxed, then there’s an implicit incentive to consume now rather than later. In effect, it creates a tax wedge between present and future consumption
This is why a poll of leading economists by IGM Chicago found a plurality agreed that “taxing capital income at a permanently lower rate than labor income would result in higher average long-term prosperity, relative to an alternative that generated the same amount of tax revenue by permanently taxing capital and labor income at equal rates instead.”
Under the status quo, CGT also hits risk-taking as the upside is taxed at a higher rate than the downside is subsidised. Entrepreneurship is an inherently risky activity, so this is a major problem.
When people advocate equalising rates, they often want to reform taxation in other ways. For instance, when Nigel Lawson equalised rates of CGT and Income Tax in 1982, he also indexed capital gains to inflation. The alternative would have been to allow individuals with investments that fail to keep up with inflation to be left with massive tax bills despite being worse off in real terms.
But this still doesn’t resolve the problem. CGT will still discourage saving and it will still discourage entrepreneurship.
In a recent debate over the future of CGT, Stuart Adam from the IFS pointed out that while a reduced rate of capital gains tax may lessen the disincentive effects on entrepreneurship and saving, it also provides the largest benefit to the people making the highest returns. High returns could occur for many reasons, many of which wouldn’t warrant a lower rate. For instance, if high returns are predictable (e.g. I have a surefire investment) then it is still worth making the investment even if part of my return is taxed away. Likewise, if my return is the result of good fortune (e.g. I bought Zoom stock before the pandemic) then it isn’t clear why I should be rewarded for factors out of my control.
Effort and skill complicates the issue. Intuitively, we might think high returns generated by the hard work or talent of an entrepreneur building a successful company are more deserving of a lower-rate. Yet it’s not clear why hard work warrants a lower tax rate only when it's done by an employer rather than by an employee. We want the tax system to interfere as little as possible with the decision to start a business. As such, we should avoid creating a system where highly-skilled workers decide to start their own companies purely to reduce their overall tax bill. Some people can create more value as an employee rather than as an entrepreneur and that’s fine. Not everyone has to be an entrepreneur, and tax policy should not try to push everyone towards it.
If we are concerned the tax system discourages hard work, then it is a case for lower taxes on all work, not just lower taxes on capital gains.
A balanced approach
But there is a middle option. We can equalise rates, while reforming the base to avoid discouraging investment and risk-taking.
On investment, there are two ways to do this. You could deduct the upfront cost of any investment made by an entrepreneur. It would mirror the pension system, where pension savings are sheltered from tax when they’re paid in and only taxed on withdrawal. It is also similar to the Annual Investment Allowance where capital expenses can be immediately written off for Corporation Tax purposes. The key drawback with such a system is that it can generate large negative tax bills, which may create avoidance opportunities.
Alternatively, and more likely, you could index investments to inflation and the risk-free return on capital. This is known as a rate of return allowance (RRA). Under this system, if I invest £1000 in my business, the RRA is 5% and then I sell up next year for £1100, I am only taxed on half of my £100 gain. In other words, I am only taxed on the excess return. When Capital Gains Tax and Income Tax were aligned in the 1980s when Nigel Lawson was Chancellor, gains were indexed to inflation.
For risk, it is more complicated. The problem with CGT is that while it taxes lucky gains, it doesn’t fully subsidise or offset unlucky losses. The lack of symmetry in the system creates a bias against risk-taking. To resolve this problem, entrepreneurs should be able to offset capital losses against their taxable income (from any source). In some cases, where capital losses are large, this may mean spreading the loss over multiple years’ tax returns. Policymakers should be careful here. There is a risk that unlimited deductions for losses can create avoidance opportunities. The best approach would probably be to allow losses to be carried forward into future years but with an interest factor to ensure the losses don’t lose their value going forward.
The latter reform may create perception issues. For instance, Amazon is often criticised for carrying forward losses from past years to reduce their annual tax bill. Even though this is the tax system working as intended, it can be hard to explain to the public and create a sense of unfairness.
A system with the above caveats would have many advantages over the status quo, but it would not be the revenue raiser the Chancellor seems to desire. Past estimates from the IPPR (see page 15) suggest that the cost of introducing a Rate of Return Allowance based on bond yields would wipe out most of the revenue gains from aligning rates with income tax. The reform would only raise revenue if the annual exempt allowance was cut significantly (or abolished) and Business Asset Disposal relief was abolished altogether.
However, the IPPR’s calculation does not include measures to make it easier to deduct losses. I suspect once they are included the proposal may end up revenue neutral or even mildly negative.
What are the risks of raising rates?
Lock-in
If Capital Gains Tax were to be equalised with Income Tax then the lock-in issue would need to be addressed. Individuals only pay Capital Gains Tax when they realise their gain (i.e. when they make the sale). However, when capital is passed on at death the gain is re-indexed. This creates a massive incentive to hold onto assets until death even if more profit could be made by selling and reinvesting in new assets. Under the low rate status quo, lock-in is a problem, but the higher the rate is set then the stronger the lock-in effect is.
This can be resolved, however, by removing the relief at death. To avoid increasing the inheritance tax at the same time, any revenue raised could be used to fund cuts to Inheritance Tax.
This might not resolve the lock-in problem altogether as there are other causes too, but it would address the main problem. At higher rates of Capital Gains Taxation, it becomes increasingly important to resolve these problems.
Mobility
A key fact about high-growth entrepreneurship in the UK is it is disproportionately done by migrants. Research we carried out in 2018 revealed that while just 14% of UK residents are foreign-born, 49% of the UK’s fastest-growing startups have at least one foreign-born co-founder. The UK’s 45% rate of Income Tax may not have led to the Brain Drain some predicted, but we should take seriously the risk that the UK may be a less attractive place to start and sell a business if capital gains were taxed at 45%.
There’s also a risk that it will become harder for startups to access international talent. High-growth startups typically pay their employees in stock options (taxed as capital gains) as opposed to high salaries. After all, why would a top coder leave the safety of a job at Google to work for a company that might go bust in six months. Under the status quo with Business Asset Disposal Relief, startup employees in the UK pay less tax (10%) on the exercise of stock options than in any other OECD country.
One study by Paul Gompers and Josh Lerner found that tax-exempt institutions were just as responsive to capital gains tax cuts as taxable investors. This has an important implication: venture capital activity responds to the supply of entrepreneurial talent. A less attractive environment for entrepreneurs and startup employees may also make it harder to raise funds.
There’s more direct evidence too. A cross-country analysis by Magnus Henrekson and Tino Sanandaji found that a 1% (not percentage point) drop in the tax rate on share options is associated with a 1% increase in VC activity. This is why we’ve argued that in response to places like France getting their act together on stock options, that the UK should expand the Enterprise Management Incentive to businesses with 250 to 500 employees and £100m in assets to attract in-demand product managers to the UK.
There might be a case for trying to treat innovative entrepreneurship differently. Stanford’s Charles Jones points out that many of the most beneficial business innovations such as Uber’s algorithms and Amazon’s logistics are difficult to protect with patents or subsidise with R&D credits. In fact, the Nobel Prize Winning economist William Nordhaus estimated that innovators only capture about 2.2 percent of the total surplus from innovation. Taxing entrepreneurial capital gains at a lower rate may have merit as an indirect research subsidy to ensure innovative risk-taking is properly rewarded.
What does it all mean?
I think there are three key takeaways.
Aligning Capital Gains Tax and Income Tax should not be seen as an easy way to raise revenue. If it is treated that way, then alignment will create more problems than it will solve by deterring investment and entrepreneurial risk-taking.
But there is merit to alignment provided you fix the base at the same time. Reform should be a strategic exercise designed to eliminate perverse incentives and opportunities for avoidance. By removing distortions, this would be a pro-growth approach.
There may still be a case for not treating all income the same. Taxing stock options at a lower rate may help attract and retain highly mobile skilled workers to the UK’s startup scene. A system where rates are aligned, the base is fixed, but EMI is functionally unchanged (e.g. startup employees only pay 10% tax on the realisation of their gains) could be the best of both worlds.