16 October 2024

Think again, Chancellor – this is a tax on entrepreneurs

By

A fortnight from today, Rachel Reeves will stand up at the Despatch Box and deliver her first Budget. It will not be the one she wishes she could give. Ever since moving into Number 11, the Chancellor has insisted that, far from there being no money left, there’s a whopping black hole of £22 billion in the public finances that needs to be plugged. As such, some spending pledges will have to be put on hold, while taxes will need to increase.

Constrained by her manifesto promise not to raise more money from working people, Reeves is scrabbling around for other ways to make up the shortfall. A rise in the rate of capital gains tax looks all but certain. What’s still up for debate is how high it’ll go. According to a report in The Guardian, civil servants have modelled the impact of a 39% rate – meaning earnings from employment and those from capital gains would be taxed roughly equally for higher-rate taxpayers.

You might wonder whether this would be such a bad thing. Indeed, at a first glance, it seems strange that there should be a discrepancy at all. One of the key principles of a sound tax system is that it should not be distortive, in the sense that it should not necessarily favour or incentivise one thing over another (unless there’s good reason to, such as taxing negative externalities).

However, what might seem logical in theory doesn’t always end up making sense in the real world. A few reasons stand out as particularly damning critiques of aligning tax rates on income and capital gains.

First is that it would create a bias against investment and towards present day consumption. This is because investments are usually made with earnings that have already been taxed. If these are only going to be taxed again, at a much higher rate, an investor might well think it’s not worth the bother. Consume the fruits of your labour now; we’re all dead in the long-run, after all.

Second is the issue of inflation. Failure to adequately index capital gains – no easy feat – could just result in people getting taxed on what are simply ‘paper gains’, where the nominal value of their investments have risen, but less than the price of everything else in the economy.

Third, and perhaps most importantly, is to think about the signal this would send to  entrepreneurs – a crucial component of any healthy economy. The startups they create are vital for bringing new and innovative goods and services to market, as well as keeping incumbents on their toes. But hiking capital gains rates will only further discourage people from taking the risk of starting a business.

Moreover, the ‘lock in’ effects of capital gains tax – where people hang on to investments for longer than they ideally might want to, in order to avoid paying the tax – would only be compounded by higher rates. This would be especially problematic for ‘serial entrepreneurs’, a particularly fruitful breed of founders who are adept at building successful companies, selling them, and then starting more with the money they made.

Lastly, it’s imperative to note that a common form of remuneration for employees of startups is not a monthly salary but shares in the company they work for. This is because scrappy new businesses are often resource-constrained, so don’t have wads of cash to throw around on wages, but the most promising ones can credibly offer a stake in the future success of the business. Any increases to capital gains tax would erode the value of these shares, leaving startups less attractive as places for ambitious individuals to work. 

For all of these reasons, it’s no surprise that, when surveyed, economists are much more likely to agree than disagree with the statement that: ‘taxing capital income at a permanently lower rate than labour 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 labour income at equal rates instead.’

And while they certainly have a vested interest in keeping rates competitive, it’s also no surprise that so many founders are rallying against the speculated rise to capital gains tax. At the time of writing, no fewer than 934 were happy to endorse an open letter penned by The Entrepreneurs Network which urges Reeves to keep capital gains tax competitive – including the likes of founders of unicorns like AI startup Synthesia, fintech OakNorth and medtech CMR Surgical. (We’ve organised a fair few of these letters in our time, and none amassed signatures as quickly as this one.)

At the last general election, many entrepreneurs put their faith in what they recognised was a changed Labour Party. If Rachel Reeves wants to keep the new believers onside, she must resist hiking capital gains tax.

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Eamonn Ives is the Research Director of The Entrepreneurs Network.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.