12 September 2019

The case against aligning wealth and income tax

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On Tuesday, Shreya Nanda of the IPPR argued in these pages that capital gains tax rates should be aligned with income tax rates. She framed this as an issue of fairness – why should those who get their income from work pay a higher tax rate than those who get their income from investment? – and suggested alignment was “a proposal that should appeal to parties on both the left and the right”.

On the face of it, Nanda makes a reasonable case. It does seem odd – at first glance, anyway – that employment earnings are taxed at higher marginal rates than capital gains. Surely that’s both unjust and distortionary?

What’s more, the idea of aligning income and capital gains tax rates is hardly beyond the pale among conservative thinkers. As Nanda points out, Nigel Lawson did exactly that in his historic 1988 budget, and it’s still considered something of a high watermark for pro-growth tax reform.

But there are, nevertheless, real problems with a tax system that treats capital gains just like earned income. One is that unless you fully account for inflation, it’s easy for people to end up paying tax on paper “gains” that leave them no better off in real terms.

To its credit, the IPPR report on which Nanda’s article is based raises the possibility of indexing gains to inflation – or to a risk-free rate of return based on gilt yields – once income and capital gains tax rates are aligned. In my view, this would have to be an essential component of any such reform, and not an optional extra.

Unfortunately, there are other problems with higher capital gains tax rates – and, indeed, with capital gains tax in general – that are less easily solved. The big one is that taxing capital gains as ordinary income creates a tax bias against saving and investment.

To see why, imagine two people – let’s call them Spender and Saver – who each earn £100. Spender consumes his income straight away. Saver invests his in a productive asset that rises in value by 5% a year for a decade. In a tax-free world, Spender gets to consume £100, while Saver eventually gets to consume £160 after realising his gain.

Now imagine that we have a 20% flat tax on all income, regardless of its source. The £100 earned by Spender and Saver becomes £80 in take-home pay. For Spender, the tax situation is straightforward: a 20% income tax means he gets to consume 20% less than he would in a world without taxes.

For Saver, though, things are more complicated. For one thing, rather than investing £100, he can only invest £80. So a decade later, his investment is worth £130, rather than £160. And once his £50 gain is taxed at 20% he is left with £120 to consume. That’s 25% less than in a world without taxes.

In other words, Saver faces a higher overall tax burden than Spender, solely because he wants to consume in the future, rather than today. That too seems unfair – why should the tax system punish someone for saving their money rather than spending it right away?

More importantly, this savings penalty is economically damaging. Our future prosperity depends heavily on private investment, which raises productivity, incomes, and living standards in the long run. And the more you tax something, the less you get of it.

On this view, taxing capital gains as ordinary income looks a lot like stealing from the future. That’s why most conventional economic models suggest that the optimal tax rate on capital income (a broader concept than capital gains) is actually zero – however politically unpalatable that might be.

Of course, capital gains tax doesn’t just discourage people from investing in the first place; it also distorts their behaviour once an investment has been made.

In particular, capital gains tax creates a “lock-in” effect. Instead of selling one asset and reinvesting in another with a higher rate of return, investors are more likely to simply leave their money where it is in order to defer tax payments. That leads to a misallocation of capital and, over time, lower rates of economic growth.

This lock-in effect also points to another, more immediate problem with raising capital gains tax. If higher rates of tax discourage the realisation of capital gains, then they can also – perversely – diminish revenues.

Indeed, the last time the Treasury hiked capital gains tax, it relied on econometric evidence that suggested every percentage point increase in the tax rate would reduce the capital gains realised by 2.75%. More interesting than that assumption, though, was the analysis that stemmed from it.

Back in 2010, the Treasury believed that the revenue maximising capital gains tax rate for the highest earners was 28%. Any higher, and the revenue losses from fewer capital gains being realised would begin to outweigh the revenue gains flowing from a higher tax rate. There’s no reason to believe the revenue-maximising rate would be higher today.

Of course, none of this is to deny that there are some weird distortions in the way we tax income in the UK (I’m looking at you, National Insurance), or that our tax code is too complicated, and riddled with exemptions and allowances that don’t make a lot of sense when you consider them all together.

Moreover, I’m sensitive to the IPPR’s charge that some capital income arises from “economic rents” rather than genuinely productive investment. And there clearly are circumstances in which very short-term capital gains ought to be treated as ordinary income for tax purposes.

Nonetheless, for all its intuitive appeal, simply aligning capital gains and income tax rates would hurt investment, damage growth, and – at best – deliver disappointing revenue gains.

So while you can make a strong argument for various narrowly targeted fixes, or indeed for a more fundamental move towards taxing consumption – rather than income – in a progressive way, an across-the-board rise in capital gains tax rates would be a step in the wrong direction.

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Tom Clougherty is Head of Tax at the Centre for Policy Studies.