Entrepreneurs’ relief reduces capital gains tax, when you sell your business, from 20% to 10%, on gains of up to £10 million (or the first £10 million of larger gains).
The initial free-market response is that this is a tax relief, tax reliefs distort investment, meaning that money goes to where the government directs rather than where it can best be used, so it reduces economic growth and makes us all poorer.
That is true. What we want is lower, flatter taxes.
Unfortunately, that isn’t what is on offer this week. What we need to look at is the system that entrepreneurs’ relief operates in, and what changes to that system are likely, to see whether it is beneficial.
First, the distortion caused by entrepreneurs’ relief is a big-picture one; it encourages investment into small(ish) businesses, rather than property, quoted shares, bonds or other broad categories of investment. It does not generally discriminate between businesses and does not try to channel investment into particular business sectors.
This is not the sort of tax relief that tries to favour e-commerce or eco-transport or whatever the latest government fad might be. It does exclude a few things (such as property investment) that don’t count as “trading”, but mostly it leaves the question of what to invest into the investor, where it should be.
Nor does it discriminate (much) between business structures; it can be used for sole traders, partnerships and limited companies. Yes there are a few restrictions, sometimes a few hoops to be jumped through, and that can be a waste of resources, but they can usually be jumped through and the wasted resources, while real, are small in comparison to the headaches caused by the tax system as a whole.
Entrepreneurs’ relief, as the name implies, used to discriminate in that it only really applied to people who were actively involved in the business, but even that is no longer the case; since 2016 it has also applied to outside investors (although with a few more conditions, but again broadly-based ones rather than ones that seek to favour particular industries).
I am not trying to say that entrepreneurs’ relief is therefore a good thing to have in the tax system. Yes, it is far less damaging than it might be, if politicians tried to meddle with what people invest in on a more targeted level. But it is still an unnecessary distortion to investment, and it would be better if such distortions were swept away and replaced by a flat system with a low rate.
The problem is, a flat system is not what is on offer (nor are lower general tax rates). What is being proposed is simply the abolition of one particular tax relief.
Doing that would leave many other reliefs and exemptions in place, even just within the capital gains tax system. In particular the “private residence relief” that makes the profit on selling your home free from tax, and the individual savings account (ISA) exemption that allows tax-free profits on investing in quoted shares (up to a limit). There is no suggestion at all of abolishing or even restricting the other two.
Both of these would remain, and note that these are full exemptions, whereas entrepreneurs’ relief is only a partial exemption, reducing the tax rate to 10% but not to zero.
So the choice, in practical reality, is not between a system of multiple reliefs and a flat, non-distorting system. If it were then I would support the flat system – I’ve been pushing for flat taxes for nearly twenty years.
Alternatively, there is a strong free-market argument that capital gains tax should be abolished entirely, but again that is not what is on offer.
Instead the debate this week is whether we should continue to have capital gains tax, with reliefs for residential property, quoted shares and small businesses; or if we should scrap entrepreneurs’ relief and be left with the capital gains tax and its exemptions for residential property and quoted shares.
Once you look at the real alternative, it is far from obvious that abolishing entrepreneurs’ relief is a good idea. Yes, if it were the start of a broader movement to flatter, lower taxes, but that isn’t on the table.
Abolishing entrepreneurs’ relief – without changing the rest of the system – would leave us with exemptions for residential property and quoted shares, but without the balancing relief for small businesses. Is that really a good idea? I am not demanding that small businesses should be favoured by the tax system (that would be a distortion in itself), but they should certainly not be significantly disadvantaged.
If we were designing the tax system from scratch, and were offered the choice of favouring residential property, quoted shares or small businesses, the free-market answer would be to say “none of them”. But what sort of demented system would choose to favour the first two but not the third? Yet that is what is being proposed.
Yes, let’s abolish entrepreneurs’ relief – but as part of a more fundamental reform of the tax system. Simply abolishing it, as a stand-alone reform, whilst leaving unchanged the rest of the tangled mess that makes up our tax system, would unbalance the incentives, make capital gains tax overall more distortionary, and end up with things worse, not better.