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University of New South Wales Law Journal

Faculty of Law, UNSW
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Gammie, Malcolm --- "Taxing Capital Gains - Thoughts from the UK" [2000] UNSWLawJl 41; (2000) 23(2) UNSW Law Journal 309

TAXING CAPITAL GAINS – THOUGHTS FROM THE UK

MALCOLM GAMMIE[*]

Capital gains taxation is a compromise and, as is so often the case with a compromise, it functions badly and pleases no one. It is a compromise because neither under a model ‘comprehensive’ income tax nor under a model personal consumption tax would a capital gains tax play any significant role. But as the practicalities of taxation mean that tax systems fail to satisfy the requirements of either of these models, the capital gains tax is called upon to plug the embarrassing hole that arises from that failure. Nevertheless, accepting its imperfections, one might suppose that a consensus would emerge as to what is the best – or perhaps the least troublesome – method of taxing capital gains. There is little sign, however, that after 35 years of trying the UK has found a satisfactory method of doing so.

In the UK, the capital gains tax has a relatively short history. Initially, the income tax acquired various accretions in the form of anti-avoidance provisions designed to discourage the conversion of highly taxed income into untaxed gains. The Finance Act 1962 took the more general step of bringing short-term gains into charge to income tax. Finally, the Finance Act 1965 introduced the capital gains tax as a new tax, distinct from the income tax. The separate tax charges on short and long term gains survived until 1971, when they were amalgamated in a single charge to capital gains tax. (Since 1965 chargeable gains have been included in company profits charged to corporation tax. This article deals only with the capital gains tax charge on individuals and trusts.)

Initially, the tax was charged at 30 per cent on the nominal gain arising on a disposal. And while this rate contrasted favourably with a top rate of income tax of 98 per cent on investment income, inflation over the 1970s increasingly led to the tax being levied on inflationary rather than real gains. The combination of high effective tax rates and abusive tax avoidance schemes, available to many, but by no means to all taxpayers, demanded radical solutions. The UK’s response changed the prevailing tax climate dramatically. The development in the early 1980s of a judicial anti-avoidance doctrine cut out the most artificial anti-avoidance schemes. And by 1988 the Thatcher government had reduced top income tax rates to 40 per cent. Between 1982 and 1988, the government moved to full indexation of capital gains based on 1982 values and, from 1988, started to charge capital gains at income tax rates.

The underlying trend of these and other reforms was towards broader based, lower rate taxes. Charging capital gains at income tax rates was certainly designed to reduce any remaining incentive in the system to convert income into capital gains. But throughout there has remained (from a comprehensive income tax perspective) a variety of unsatisfactory features of capital gains tax. The tax has always only been levied on realisations, and this has offered many opportunities to defer or avoid the tax. In addition, the tax has incorporated various exemptions (such as owner occupied housing) and reliefs (such as reinvestment relief and business ‘retirement relief’). An indexed annual exemption, given in addition to the personal allowances available against income, has ensured that most people do not pay the tax. And since 1971 death has washed out any liability for unrealised capital gains.

After 1988 there were two continuing complaints about capital gains tax: indexation was excessively complicated and a top rate of 40 per cent (albeit on real gains) was unrealistically high. It was against this background that in 1997 the new Labour Chancellor, Gordon Brown, announced his intention to reform the tax. His 1998 Budget froze indexation at April 1998 and introduced a system of ‘tapering’ relief. Over a 10-year period the 40 per cent rate of tax would have fallen to an effective 24 per cent rate for non-business assets and 10 per cent for business assets. At the same time reinvestment relief was combined with an enterprise investment scheme, ‘targeted’ at small high-risk companies, and retirement relief was phased out over 5 years.

The stated aim of these reforms was to provide a spur to investment by encouraging longer-term holding of assets. It always eluded this commentator as to what the relevance was to investment for the tax system to favour holding the same asset over a particular period. And the structure of the 1998 taper regime has lasted barely two years. The Budget 2000 has reduced the taper period for business assets from ten to four years and expanded the category of assets that qualify as business assets. Notably these now include all shareholdings in unquoted trading companies and all employee shareholdings in quoted trading companies. The effective rate of capital gains tax on business assets is accordingly 10 per cent after four years. According to Chancellor Brown in 2000, his changes this time “will boost productivity”, encourage “serial entrepreneurs”, promote employee share ownership and increase the provision of risk capital through “business angels”.

It is very difficult from this to discern a clear strategy as to how we should tax capital gains. A cynical person might suggest that the greater the mess the tax becomes, the greater the incentive to sort it out once and for all. This thinking underlies the support that some people have given to the UK project to rewrite its entire direct tax code in plain English: the idea being that once politicians can understand what a mess the tax system is in, they will do something to improve it. But 35 years of constant tinkering with capital gains tax suggests that the UK is no closer than it was in 1965 to knowing how best to tax capital gains. A cynical investor might more rationally take the view that if he does not like the tax in its current form, he need only wait a year or two for a new Chancellor to change the tax again, hopefully in a way that favours the investor. In the meantime, the principal beneficiaries of the tax are, always have been and remain tax advisers.

The best way to think about capital gains tax is probably not to think about it all: start by thinking about other aspects of the tax system. The economic arguments between the choice of an income- or a consumption-based personal tax system are finely balanced. Where a consumption tax base scores over the income tax base is in its ability to achieve better overall neutrality and in its administrative practicality. To understand this, you need look no further than an economist’s definition of income. Hicks suggested that “income is what a man can spend and still expect to be as well off at the end of the accounting period as he was at the beginning”. There are three things to note about this definition: first, it defines income in terms of consumption; second, what a man spends in a period is common to both the income and the consumption base. Thus, for every problem with a consumption tax base that arises from the need to define or identify consumption, you can identify an equivalent problem with an income tax base. But, third, an income tax base requires you to define what you mean by “expect to be as well off” at the end of the period. None of the problems related to those words arise under a consumption tax base, which concerns itself solely with actual rather than prospective consumption.

Two particular developments in recent years have emphasised this practical superiority of consumption taxes. Computer technology has facilitated the recording of the cash transactions that underlie the main forms of consumption taxes, and has reduced the cost of doing so. And open financial markets have made it increasingly difficult to impose and enforce income taxes. It is not surprising, therefore, that tax systems world-wide have been evolving towards a consumption tax base, irrespective of the political persuasion of the governments concerned. In the UK, the return to most personal savings goes untaxed, largely through tax-exempt housing, national savings, insurance policies, individual savings accounts and tax-free roll-up pension plans.

This is not the place to debate the merits or otherwise of particular tax privileged savings vehicles. The point is that unless someone cracks the practical problems associated with measuring and taxing income, taxes on the return to personal savings are likely to remain at best a residual charge. To the extent that the return on personal savings is the product of profits generated through corporate or other business entities, the return may reflect tax borne on those profits. The problem is that the effective incidence of any tax on corporate profits may not fall on the owners of capital as compared with less mobile economic factors, such as labour and consumption. Ideally, therefore, we might want to extract some tax directly from the owners of the savings, reflecting as best we can the continuing large discrepancies in the distribution of holdings of financial assets.

It is in this context that we need to approach capital gains tax. In many respects, it is inappropriate that someone with consumable resources derived from a mixture of income and gains should benefit from a lower effective tax rate than if those consumable resources had been derived solely from income. This is the effect of giving a separate annual tax-free capital gains allowance in addition to annual income tax allowances. The annual gains allowance, however, serves the administrative purpose of ‘disapplying’ the tax for the vast majority of people. As a result, only some 170,000 individuals and trusts pay the tax, as against a total taxpaying population of around 26 million. It raises around 2 per cent of all revenue taxes (and considerably less than 1 per cent of all government revenues).

The sheer complexity of the present tax makes it impossible to contemplate a reform to the annual allowance that would extend the application of the tax more generally. And no country has found a simple—or acceptable—way to tax gains as they accrue. But a realisations basis tax distorts taxpayer portfolio choices and provides an incentive to the institutionalisation of savings, and a taper system compounds the distortion. Who but the poorly advised would trigger a disposal of a business asset within four years of acquisition? But the prospect of significant gains being taxed at only 10 per cent is unlikely to be consistent with any ideal of taxing income in all its forms at similar rates.

There are no easy or quick solutions, and suggestions for change are bound to be second best by any standard. Nevertheless, we should be able to sketch a rational direction for reform, accepting that most savings are exempt and that we are seeking a residual tax on large holdings of personal assets and (to the extent that other measures do not achieve this aim) the proper taxation of retained entrepreneurial earnings in private companies. First, the computation should be as simple as we can make it, allowing that any computation depends upon maintaining a record of aggregate costs. This excludes both indexation and tapering. Second, we should re-approximate income tax and capital gains tax rates. Third, we should find a way to amalgamate income tax and capital gains allowances. Fourth, we should eliminate the ‘wash out’ of gains on death. Finally, we should eliminate asset exemptions and seek practical ways to facilitate deferral on changes in asset holdings where the proceeds are reinvested. This final measure may take the tax in the direction of a personal consumption tax but in doing so it reflects the scope (which complex anti-avoidance provisions seek to restrict) for well-advised taxpayers to defer or avoid tax by holding assets offshore.

At present, the UK regime is highly complex, awash with detailed rules, involving a variety of exemptions and reliefs and a multiplicity of effective tax rates that distort asset and portfolio choices. I would not offer odds on the suggestions that I have made materialising in the UK. The changes in 1998 and 2000 have largely moved in an opposite direction. It remains to be seen how they develop over time but a safer bet at least would be that recent changes to the tax will prove no longer lasting than previous ones.


[*] Malcolm Gammie is a Barrister and Chartered Tax Adviser in practice at the Revenue Bar in London. He is also Research Director for the Tax Law Review Committee of the Institute for Fiscal Studies.


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