Capital gains tax reform: If the Chancellor wants to go down in history as a great reformer, their are some big tax changes he could make, says Arun AdvaniWednesday 27 Oct 2021
Today’s budget will not be a big revenue raiser. Rishi Sunak has already raised £40 billion in tax this year. A combination of freezing the income tax thresholds while inflation is roaring, and expanding national insurance contributions, mean that he has raised tax as a share of the economy to the highest level in history. But if the Chancellor wants to go down in history as a great reformer, rather than merely a revenue raiser, there are some big tax changes he could make.
Top of that list is fixing the taxation of capital gains. This is money received from the sale of assets for more than they were purchased. While people often imagine this is the sale of second homes or shares, most of the value of capital gains comes from selling small businesses.
Capital gains have skyrocketed in recent years. They trebled from £22 billion to £63 billion between 2012-13 and 2019-20 (pre-pandemic), while average incomes remained broadly flat. Almost all these gains went to a tiny minority: 92% of taxable gains went to people with more than £100,000 in gains. The rise in total gains has gone hand-in-hand with the growth of ‘super gainers’: individuals receiving more than £1 million in gains in a single year.
More than half of these ‘super gains’ come from gains from the sale of small businesses which the person works for. The money they receive is essentially the compensation for working. But, while ordinary workers pay income tax and national insurance – costing 32% of income for someone on the basic rate, and 47% for those at the very top – capital gains tax rates are only 10% up to £1 million for these small business sales, and 20% thereafter.
Fixing this doesn’t require radical innovation or out-of-the-box thinking. The Chancellor merely needs to look to his political hero, Nigel Lawson. In 1988 Lawson, recognising “there is little economic difference between income and capital gains”, equalised the rates at which these were taxed, along with an allowance for inflation. The chancellor should embrace this history, and – with some tweaks – return us to that system. A move in this direction was also recommended last year by the Office for Tax Simplification.
This would have three major benefits. First, it would make the system fairer. In 2017, almost quarter of people taking home £1 million paid the headline tax rate, while one in ten paid a lower effective tax rate than someone earning just £15,000. The differences, both between rich and poor, and among the rich, are striking.
Second, it makes the economy more efficient. The current system rewards being a mediocre business owner rather than highly productive employee. Someone taking home £1 million could save almost £370,000 in tax if it can be classed as capital gains compared if it were classed as income.
Third, it would raise substantial revenue. In 2019/20, the static tax revenue raised from taxing capital gains like income would be almost £16 billion. Going beyond Lawson to remove peculiarities like ‘death uplift’ – whereby the tax is wiped out on death – and reducing the very large amount of gains that can be received without any tax, would make the system fairer and raise more.
The Chancellor may well say that he has raised enough already, so reform is unnecessary. But this is to confuse revenue-raising with reform. In our new, higher tax state, an important question is who should pay. The current system is full of inequities, including taxing income from work at much higher levels than income from wealth. Reforming the taxation of gains would be a first step towards fixing that.
Making tax fairer
1. Reform the taxation of capital gains
By value, most capital gains come from activities that are otherwise taxed as income. But by structuring that income as capital gains, individuals can benefit from much lower tax rates. Someone taking home £1 million could save almost £370,000 in tax if it can be classed as capital gains rather than income. This could be fixed by returning to 1988, with gains taxed at the same rate as income, and an inflation allowance. Even better would be also removing ‘death uplift’, allowing gains to be smoothed over time, and reducing the tax-free allowance for gains.
2. Extend national insurance contributions
National insurance contributions are an additional tax on income from work. Landlords and investors do not pay them. Nor do those over state pension age, even if they keep working. They are also charged at a higher rate on lower incomes: 12% between around £10,000 and £50,000, but only 2% thereafter. A simple extension of national insurance to cover all income equally would, on a static basis, raise £31.4bn. This treats income from work and wealth more equally, and the revenue raised could be used to cut income tax rates: even a cut of 4p would still raise money.
3. Fix inheritance tax
Most households will not pay inheritance tax: currently around 4% of estates are valuable enough to pay inheritance tax. But the tax looms large in the minds of many. One objection to the current system is the presence of large reliefs, that mean the wealthiest pay less than the'merely well-off': an estate worth £2-3m pays around 20% tax on average, while an estate worth more than £10m pays only 10%. Removal or capping of some of these reliefs could fund a revenue-neutral reduction in the 40% headline rate to just 25%.
Arun Advani is Assistant Professor in Economics at the University of Warwick and a CAGE Associate
This article was first published in The Guardian: Why capital gains tax reform should be top of Rishi Sunak's list, 26 October 2021