We are facing one of those delightful clashes between equity and efficiency. Sadly, it looks like equity might win, which would mean a ‘fairer’ society – by the estimation of some people – but also a decidedly poorer one.
I refer to this from Zack Polanski – the unthinking man’s Left populist du jour:
‘And to get our economy moving we need to look again at all of the levers we have to pull. That must include equalising capital gains tax with income tax.’
You can, if you fancy some rabble-rousing – and many do – claim that it would be fairer if capital gains paid the same tax rate as income more generally. But it’s not one of those things that is going to get our economy moving again – quite the opposite. And while ‘why shouldn’t those rich bastards pay the same we all have to?’ sounds like a plausible populist grievance, as with so much rhetoric, the facts are more than a bit problematic.
Let us, just for a moment, concede the idea that what the economy requires right now is more tax revenue. The simplistic will say that requires higher tax rates. Those who know a little on the subject will mutter that that’s not quite true – there is always that Laffer Curve to consider. It really is true that there is a revenue-maximising tax rate, one where if you go higher then tax revenues fall. But, this is not all – the rate is different for each and every tax within an economy. A top rate of stamp duty on house purchases at the same as the top rate of income tax – 45% – would obviously not work. We all can see that immediately. Setting a VAT rate of 45% is also unlikely to work: we’d all be buying everything off Rodney and Trotter Enterprises.
With capital gains tax (CGT) this has been gone through. When the rate was lowered from 40% to 18%, the claim was that the lower level was the rate at which revenue, over time, was maximised. We can believe, or not believe, that claim as we wish. But it was backed by more empirical research than just the usual political pinkie promise.
There is also the little matter of inflation. A 40% rate for CGT came with ‘indexation’. That is, you were not taxed on the mere money gain, but that minus inflation. The 18% rate didn’t have that inflation connection – no taper relief. And yes, the inflation part does make a difference. If you bought £100 of shares in 2016 that are now worth £138.50 and you sell at a 40% CGT rate without indexation you would pay £15.40 in tax. But £138.50 now is £100 in 2016. You have, in fact, made no gain, but you’re being taxed as if you have.
This problem also gets greater the longer you have held on to the asset: since 1996, inflation has been 100% and change, meaning prices have roughly doubled. Now, surely another thing all right-thinking people know about the British economy is that we should have much more long-term, patient investment? Sorry, but we’re simply not going to get any of that if everyone gets fully taxed on inflationary gains.
Oh dear. Equity and economic efficiency turn out not to be quite the same things.
It’s even possible to insist that CGT already is equal to income tax rates, at least in some cases. Let me explain. We charge corporation tax on corporate profits at 25%, thus lowering the value of shares. (For a thought experiment proof of that, consider: would shares rise in value if we abolished corporation tax?) Well, if we’re already cutting the profits made on shares, add that to the 18 or 24% (higher rate) from CGT on disposing of said shares, plus a little inflation, and we’re there at the 45% top rate of income tax.
Yes, it is true that the tax rate upon something is the addition of all the taxes upon that something. Look at dividend taxes. Dividends are taxed at 8.75%, 33.75% and 39.35%, depending on the gross income of the recipient. Why? Because dividends are paid out of corporate profits, and those profits have already paid the 25% corporation tax. Thus it’s the addition of both taxes that gives us the true tax rate.
This is not controversial. Some of the more sophisticated advocates of equalisation of rates – say, the IFS – note this point and agree with it. We would have to have a separate system of rates for capital gains from things that have already paid corporation tax than things that haven’t. And even for capital gains on other assets, Polanski and his fellow travellers will still have to get to grips with the aforementioned matter of inflation indexation, which once again kills the case for equal rates, in this case across all investments.
Which means that we’ve now wholly exploded the populist cry of ‘Same rates, innit?’ You quickly end up double-taxing the same profits twice or taxing phantom, inflationary gains.
We can even dig deeper and note further complexities. A large portion of CGT revenues comes from people cashing out unlisted shares which may well have paid a different corporation tax rate over time. All of which would require more headline rate variation in order to get to actually equal rates.
Which brings us back to this equity versus efficiency argument that bedevils so many economic conversations. It is wholly possible, as Polanski demonstrates, to make the argument that all forms of income should pay the same tax rate. But as we’ve seen, look at the detail and the case that the same headline rate spells equal treatment falls apart.
And equalising rates is not just inequitable, it’s inefficient as well. Rates that are ‘too high’ reduce economic growth. That’s one very useful definition of a tax rate that is too high in fact: one that reduces how rich our future, that of our children, is going to be.
Which reveals the biggest gap in the thinking of the economic populists: considering how the impact of something that sounds fair now will play out over time. Here, the economist Lant Pritchett is essential reading. His work shows that economic growth, in and of itself, is what makes the poor richer. It’s also what reduces inequality. Further, mere and simple economic growth is, in and of itself, not just necessary but sufficient to do these things, to enrich and reduce inequality.
That is, we do not face an equity and efficiency trade off over time. Sure, we can have an inefficient but superficially equitable tax system now, but only by making the future poorer and less equal. Any true, long-run advocate of equity should run with the efficient tax system now so as to increase equity in the future. What we have instead is the populist baby demanding its rusk now and the adults in the room insisting upon waiting for lunch and the proper meal, with or without strained banana, to taste.
So, who’s willing to bet against the infantilisation of the British body politic?
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