A Capital Idea

According to the Financial Times, "Chancellor John Healey has rejected calls by senior Labour figures to raise capital gains tax to the same level as income tax, amid warnings that such an increase would hit Britain’s attractiveness to investors." The report is based on four unamed sources, one of whom "called the proposal 'batshit crazy', while another pointed to the argument that people would change their behaviour by leaving the UK or delaying sales, resulting in a drop in income for the Treasury." One of the few people quoted by name, former Conservative Chancellor Jeremy Hunt, said "equalisation was always a non-starter. Every chancellor is briefed that the revenue-maximising rate of capital gains tax is 24 per cent after which you start losing money. Officials will never say [economist] Arthur Laffer has a point but that is the gist of it." (Nice to see the FT feels the need to explain to its financially-savvy readership who Arthur "napkin" Laffer was). The only other named source is Jim O'Neill, who claimed that equalisation "would pour more fuel on this idea that every other wealthy person is planning to move to Place X".

It's entirely possible that this is a bit of misdirection by Healey's sherpas, but he doesn't strike me as someone who likes to pull rabbits out of hats. He does strike me as a typical product of the Labour right, being obsessed with an image of probity (recall his self-important resignation as Defence Secretary under Starmer) and fiscal rectitude, the latter less a firmly-held principle than an unwillingness to challenge Treasury mandarins or the Governor of the Bank of England, which places him in a tradition that dates back to Philip Snowden in 1929. Whatever the outcome in two weeks time, it is worth understanding the debate around the equalisation of capital gains tax (CGT) with income tax, both as an indicator of the interests the government feels it must placate and the role of investment in our political economy, or at least its rhetorical role. The contingent argument in favour of equalisation is that CGT was not among the taxes that Labour's 2024 manifesto explicitly ruled out increasing, so it presents an opportunity for the Chancellor in filling his fiscal "hole".

The fundamental argument in favour of equalisation is that capital gains are just another form of income. This is actually made clear by HMRC when you do a tax self-assessment. The different rate is not because CGT is a distinct tax, despite the name, but because income tax is applied at different rates against different categories of income, e.g. pay and pensions, bank interest, share dividends etc. The more moral argument, traditional to socialists, is that a capital gain is unearned income, like rents. If we are to "euthanise the rentier", in John Maynard Keynes's phrase, then we should actually tax unearned (or "passive") income at a higher rate than earned (i.e. wages), not at a lower rate. Historically, starting in the nineteenth century, the UK has tended to do just that. This culminated in the 15% Investment Income Surcharge, applied on top of the income tax rate, in the mid-1970s. Under Margaret Thatcher, the higher rates of income tax were drastically reduced and in 1998 Nigel Lawson abolished the difference between income and capital gains with both now equalised at 40%. This is a fact that Jeremy Hunt either never knew or has conveniently forgotten.

The move towards favouring capital gains relative to earned income came under New Labour when Gordon Brown introduced taper relief in 1998 to encourage more patient investment (the tax rate would go down the longer you held the asset before selling). The flat rate of 18% was introduced by Alistair Darling in 2008, 20 years after Lawson's equalisation, along with a lower 10% Entrepreneur's Relief rate. In 2010, George Osborne reintroduced a tiered system with the higher rate at 28%. There have been lots of other tweaks to the rates, to special reliefs and to the annual exempt amounts (currently £3,000). There are two lessons to take from this potted history. First, that it is Labour that has been the more generous party in government to asset-holders since 1990. This, as much as the "pro-growth" shibboleth, suggests that John Healey is unlikely to break from tradition, despite his own voting record. The second lesson is that UK governments have never settled on a consistent approach to the taxing of capital gains, which is why equalisation remains a live issue. The two together explains why some in the Labour Party, and not just those on the left, think that CGT should be equalised with income tax.

There are three key arguments against equalisation, or more broadly against taxing capital gains at all. The first is the idea that people won't invest in UK assets. The second is that they will be dissuaded from selling their assets when they appreciate, leading to lower economic activity and macro inefficiency. The third, that they will be encouraged to leave the country (as per Jim O'Neill). These arguments are often deployed in combination even though they are not complementary - e.g. if you're not investing in UK assets then you won't have any to sell. The argument that having to pay a little more CGT might tip you into exile ignores that the sort of people who choose to become tax-resident abroad (e.g. Jim Radcliffe in Monaco) are thinking in much larger terms and avoiding many more taxes. The more coherent argument, though it often rests on these three, is that the tax will distort investors' behaviour. This is more credible, if you substitute "change" for the value-laden "distort", simply because tax is often meant to change behaviour (e.g. Pigouvian taxes on alcohol and tobacco). The question is what kind of changes are likely to arise if we tax capital gains? To answer that, you first need to ask who pays the tax.

According to the government, "Broadly, those paying Capital Gains Tax are business owners (for example, holding shares in an unquoted trading company), investors (for example, holding a buy-to let property, a second home or a portfolio of listed shares outside a pension or ISA) and employees (for example, who participate in share schemes)." To translate that into flesh and blood, the first category are people who start private businesses that they later either float on the stock exchange or sell to a competitor. Many of those businesses will already have a diluted share ownership because of options awarded to staff, particularly senior management incentivised to stick around after flotation or a trade sale. It's not just the founders who realise gains at an IPO, and it's not just in Silicon Valley that such options are widespread. The second category mixes rentiers (buy-to-let landlords), the well-off (second home owners) and the wide range of people who hold shares, from those who inherited holdings to day-traders. The last category, employees in share schemes, is thought to number around 1 million people. 

In short, it's mainly the middle classes, not the "entrepreneurs" beloved of financial journalism. Obviously not everyone who pays CGT has the same number or value of assets. At the top end, there will be people who have grown and floated a business, without diluting their ownership, who would face a considerably larger bill, and there will be speculators in UK shares and property who would also have to pay more tax. But neither is an issue as there are always loopholes by which the really wealthy and professional investors can lower their tax bills. There is an entire industry devoted to this. The people who actually pay CGT are predominantly those who already pay UK income tax and who treat their occasional capital gains (and regular dividends) as just another income stream. For the 2017-18 tax year, there were 265,000 taxpayers who paid some CGT (quoted in a government report from 2020), which is broadly 1 in 12 income taxpayers. So how would a higher rate of CGT, let's say 40%, change their behaviour?

The argument that CGT disincentivises investment is based on the idea of risk. Matthew Elliott (the Taxpayers Alliance, Vote Leave and ennobled by Liz Truss) puts it this way: "Start with the principle. A capital gain is not a wage. A salary is paid for showing up doing a job; a capital gain is the reward, if one ever arrives, for putting money and time at risk with no guarantee of return. The farmer who sinks a lifetime’s savings into land and machinery, the entrepreneur who forgoes a salary to build a company, the investor who backs a business before anyone else will: none of them are paid until, and unless, the risk pays off". This obviously ignores the level of risk entailed in zero-hours contracts, the gig economy, and the fact that wage-earners can be fired at will. But it also ignores that much farming does not produce enough savings to reinvest, which is why so many farmers have large debts and others are selling up. It also ignores that an entrepreneur who forgoes a salary must have other income lest she starve, and that investors who back startups operate on the principle that risk can be spread across a portfolio (they rarely back just one business) and hedged through insurance and derivatives.

As ever, the capitalist imaginary bears little relationship to the real world. For the vast majority of asset-holders who may pay CGT there is very little risk, if any, involved. Property prices might be flattening, but they aren't about to crash. The well-known imbalance of supply and demand won't disappear any time soon. And even if you have to hold on to an asset for longer, you may still have an income stream (e.g. dividends or buy-to-let rents). Likewise, while share prices may fluctuate, most shareholdings are through unit trusts or otherwise diversified portfolios. The idea that you need a 16-19% risk premium (the difference between CGT and income tax rates) to allow you to hold property or shares is ridiculous. Elliott quotes a HMRC model from 2025 that estimated the impact of specific rate changes on tax revenue. This assumed an annual loss of as much as £3.5bn by 2029 based on behavioural changes if the higher CGT rate went up by 10%. Given that the total CGT revenue is currently around £20bn, that's some pretty big changes.

The source for this was an Office for Budget Responsibility paper about anticipated taxpayer behaviours in respect of the 2025 budget. This foregrounded changing the date of asset sales in two ways: "forestalling", i.e. selling before the new tax rates come into effect, and "locking in", i.e. hanging on to assets in the hope of a more favourable future tax regime or avoiding CGT altogether through inheritance. The second behavioural change was shifting between asset classes for better tax rates or shifting between gains and wage income. The other changes were tax planning (i.e. avoidance), migration (defined as "either becoming non-UK resident for tax purposes, or diverting some or all activity to jurisdictions where the tax liability is lower"), and non-compliance (i.e. evasion). The paper itself is cautious on these impacts: "[forestalling is] not possible for the increase in main CGT rates as it takes effect on the day of the Budget", while "migration is not a significant factor in the response to the increase in the higher main rate of CGT". 

It's worth emphasising that this model only makes sense in relation to the proposed budget in 2025 and cannot be assumed to hold in all circumstances. Most of the claimed behavioural changes would be irrelevant if CGT rates were increased as part of a wider reform (and simplification) of the tax system, namely a move to treating all sources of income (capital gains, dividends, inheritance, gifts) as income and taxing them at the same (and ideally more progressive) rates. In fact, all that would be left would be non-compliance, i.e. tax evasion. It's also worth noting that an earlier report, by the Office for Tax Simplification in 2010, which contra the OBR said that "More closely aligning Capital Gains Tax rates with Income Tax rates has the potential to raise a substantial amount of tax for the Exchequer", saw the major "distortions" of CGT being due to its use as a means of tax avoidance, e.g. treating income as capital gains or converting cash bonuses into share awards. 

My own guess is that Healey won't do anything dramatic with CGT precisely because he isn't about to propose a sweeping and radical reform of the tax system. Given the institutional resistance at the Treasury, the ideological priors of the media, and the general timidity of the Labour Party in respect of fiscal engineering (New Labour notwithstanding), this is going to be a cautious and unimaginative budget, which means we can expect to see more cheese-paring on welfare. Investors will be happy, but those investors are not the entrepreneurs and market-movers of lore (though no doubt they will also be untroubled), but the petty capitalists who abhor risk and have no intention of becoming tax exiles. Sociologically, they are a step up from the traditional "savers" (nowadays, more likely to be young workers trying to get a deposit together for a flat). They are middle managers with share options, people who inherited unencumbered property (including ex-council houses), and people who started and sold a small business. The overlap with MPs is considerable.