Tax and Fiscal Policy

It’s Lafferble: Why hiking capital gains tax would only depress revenues

The Liberal Democrats have proposed raising the top rate of capital gains tax (CGT) to 35 per cent in order to reduce taxes on the least well off. Go to the back of the class! CGT is a bad tax implemented badly. There is no more revenue to be raised.

The case against CGT on investments is overwhelming. Capital gains tend to arise when investors anticipate future profits or if companies retain profits for investment. But the profits that are retained have already been taxed and, if profits are expected in the future, they will be taxed too – when they materialise. CGT on equities is therefore simply a double tax.

Furthermore, since the indexation allowance was abolished, CGT is levied on those gains which only arise as a result of inflation. So, for example, if you held a portfolio of shares from 2000 to 2010, the value would have had to rise by over 30 per cent just to keep pace with inflation. And then, under current CGT rates, that increase in value would be taxed at up to 28 per cent. In other words, purely illusory gains would be taxed.

The only justification for CGT is to prevent investors hiding income as capital gains. However, the tax authorities already have ways of dealing with this problem which were not available when the tax was first introduced in 1965.

Higher rates of CGT also discourage investment, discourage entrepreneurship and encourage avoidance. Both individuals and institutions can devise methods to avoid the tax, one of which is simply to hold on to investments for longer in order to time their sale more carefully. This can have the effect of reducing the yield from the tax at higher rates.

Indeed, when the top rate was increased to 28 per cent under pressure from the Lib Dems, it was felt by the Treasury that this was the rate that maximised the revenue from the tax. As it happens, CGT revenue has roughly halved since the rate was increased, although this may have been for other reasons. Nevertheless, it is quite possible that we are already on the wrong side of the Laffer curve – in other words, beyond the revenue-maximising rate. Certainly, we are not far away from the top of the Laffer curve.

In fact, the Treasury’s own explanation of their modelling suggests the top rate of CGT should be lowered to boost revenue. They judged that 28 per cent was the rate at which the marginal gain to revenue of reduced avoidance in terms of reclassifying income as gains would be exactly offset by the marginal reduction in revenue arising from the ‘lock-in’ effect – more people holding onto assets they otherwise would not want to hold (in order to avoid the tax).

That calculation was made, of course, when the top rate of income tax which people might seek to avoid was 50 per cent. Since then this rate has been lowered to 45 per cent. With a lower top rate of income tax, the gap between the tax rate on income and gains will be smaller and so the incentive to avoid income tax lower. If the two effects of a CGT hike were equal before, the lock-in effect must now be larger. This implies that the 28 per cent CGT rate should be cut if the goal is revenue maximisation – assuming that the Treasury’s previous analysis was indeed accurate.

In the menu of available tax options then, it is difficult to imagine how Nick Clegg could have chosen a worse tax to propose increasing. If the proposed rise in the tax does somehow raise more revenue, it will be as a result of taxing investment returns that are already taxed at least once and by eroding the real value of investors’ assets. Furthermore, the yield will be volatile and depend on share prices from year to year. It’s more likely, however, that Clegg’s policy will lead to revenues falling, and taxes on the poor will actually have to rise to compensate for those revenue losses. Paradoxically, reducing CGT in order to generate the revenue to reduce other taxes might be the best policy.

A previous version of this article was published by City AM.

Academic and Research Director, IEA

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

Head of Public Policy and Director, Paragon Initiative

Ryan Bourne is Head of Public Policy at the IEA and Director of The Paragon Initiative. Ryan was educated at Magdalene College, Cambridge where he achieved a double-first in Economics at undergraduate level and later an MPhil qualification. Prior to joining the IEA, Ryan worked for a year at the economic consultancy firm Frontier Economics on competition and public policy issues. After leaving Frontier in 2010, Ryan joined the Centre for Policy Studies think tank in Westminster, first as an Economics Researcher and subsequently as Head of Economic Research. There, he was responsible for writing, editing and commissioning economic reports across a broad range of areas, as well as organisation of economic-themed events and roundtables. Ryan appears regularly in the national media, including writing for The Times, the Daily Telegraph, ConservativeHome and Spectator Coffee House, and appearing on broadcast, including BBC News, Newsnight, Sky News, Jeff Randall Live, Reuters and LBC radio. He is currently a weekly columnist for CityAM.

3 thoughts on “It’s Lafferble: Why hiking capital gains tax would only depress revenues”

  1. Posted 10/10/2014 at 09:43 | Permalink

    Yes, but have you ever tried a rational discussion about the Laffer Curve with anyone of left wing persuasion? They simply denounce it, denying it exists, even though it is very easy to demonstrate that it must exist and that the issue is simply one of its shape, at which point revenue is maximised, and how it varies according to the type of tax we are discussing.

  2. Posted 10/10/2014 at 22:56 | Permalink

    yes, I know. One is painted as an extremist to simply believe that there is a revenue maximising level of tax (not that I think that tax rates should be set at that level)

  3. Posted 17/03/2016 at 14:04 | Permalink

    I’m of a left wing persuasion. I don’t deny the Larger curve, in fact I think it’s worth detailed consideration.

    What I find astonishing is how those of a right wing persuasion seem to think it always implies that taxes should be lower, without ever providing any evidence as to the shape of the curve.

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