Perhaps a Labour raid on capital gains tax isn’t such a bad idea

·5 min read

In the last few days, we have had a clear demonstration of the Labour Party’s attitude to the taxation of well-off people. First, it pledged to reverse the Chancellor’s removal of the cap on pension pots. Then came hints that it might substantially increase Capital Gains Tax (CGT) rates. If you are not that well-off, you might reasonably react by saying “so what?” But these matters are relevant to you too.

The possible raising of CGT rates elicited howls of protest from all the usual suspects, including many Conservative MPs. Allegedly, much higher rates would hammer savings and investment.

Yet Labour surely has a point. Gains are taxed at 20pc regardless of how rich the person is or how substantial the gains are. By contrast, the top rate of income tax is 45pc. People at the lower end of the income distribution typically do not have any assets on which they can make capital gains. So, a concessionary rate of tax for capital gains favours the well-off.

The present CGT rate of 20pc for higher rate taxpayers is very recent. It was brought in by the Conservative chancellor George Osborne in 2016. The previous rate was 28pc. By contrast, in 1988, that well-known socialist chancellor, Nigel Lawson, aligned the rates of CGT with rates of income tax. So the top rate of CGT became 40pc. I wonder how many of today’s outraged protesters against tax equalisation realise this.

And Nigel (now Lord) Lawson didn’t equalise income tax and CGT out of zeal to clobber the rich. On the contrary, he believed that this would boost efficiency by ending the incentive to turn income into capital gains.

This is of key relevance today. Why do so many successful small business owners sell up early? One of the reasons is that any salary, bonuses or dividends they pay themselves are taxed at 45pc, whereas if they capitalised their profits by selling the business, they would be taxed at only 20pc. Is this in the interests of society at large? Probably not.

Mind you, if income tax and CGT were equalised, to avoid adverse consequences for the economy, it would be wise to add two other measures. First, indexation should be re-introduced, under which capital gains would be adjusted for inflation so that only real gains were taxed.

Second, improved concessions could be introduced for genuine entrepreneurs. This was the idea behind the Entrepreneurs’ Relief scheme, under which a business founder would pay CGT of only 10pc on capital gains of up to £10m over their lifetime. In 2020, the scheme was renamed as Business Asset Disposal Relief and the limit was radically reduced to £1m. Admittedly, the original scheme was widely abused but it should be possible to devise a reformed scheme that met the original objective but tightened up eligibility.

Labour’s reaction to the abolition of the cap on private pension pots was extremely illuminating. It was obliged to recognise that the limit had been instrumental in persuading many senior practitioners in the NHS to retire early. So, Labour’s suggestion was to design a special scheme for such NHS practitioners to escape the cap while keeping it for everyone else. The reaction was howls of protest from other public sector professionals including senior police officers and teachers. I suppose Labour’s scheme could be extended to cover other such groups of workers deemed to be “worthy” or essential.

But what about people in the private sector, including those who have struggled to build up a small business? Aren’t they worthy? In Labour’s pantheon of the deserving, apparently not.

This whole debate about the tax treatment of pension savings betrayed a widespread misunderstanding of the nature of the tax concession in the treatment of pensions. Essentially, pensions are treated the opposite way to PEPs (personal equity plans) and ISAs. With the latter, payments are not tax deductible, but withdrawals are not taxed. With pensions, payments into a scheme are tax deductible but the benefits are taxable.

But there is one major concession that sets pensions savings apart, namely the ability to take 25pc of a fund out tax-free. So, this means that someone can put money into a pension fund and get tax relief on that contribution and then not pay tax on 25pc of the accumulated fund at retirement.

The right approach to dealing with this is to abolish the 25pc tax-free allowance. But this is a political minefield. As it happens, as part of the reforms announced in the Budget, the Chancellor has moved to restrict the amount of money that can be taken out tax-free. Moreover, it seems likely that this limit will not be increased over time. In this way, the value of this concession will decrease gradually over time as all money values tend to rise. So, it would wither on the vine, much as happened with mortgage interest tax relief on your principal private residence until it was finally abolished. Labour would be well-advised to follow this path on pensions.

Similarly, a clever move for Labour would be to combine the equalisation of income tax and CGT with abolition of the 45pc top rate of tax. After all, Blair’s Labour government operated with a 40pc top rate, until Gordon Brown upped it to 50pc to lay a trap for the Tories. Instead, there is a reasonable chance that Labour would increase the top rate back up to 50pc.

Coming on top of other measures, including a restored cap on pension pots and the equalisation of income tax rates and CGT, this would be suicidal. The tax base has become very narrow. At present, the top 1pc of taxpayers pay some 30pc of total income tax receipts. If a significant proportion of these people left the UK for sunnier (and less taxing) climes, then the public finances would be in a real mess. Then the taxman would have to come down hard on households near you.

Roger Bootle is chairman of Capital Economics