CGT: A Troublesome Tax

Andrew Vaughan - Mon 21 Jan, 2008

Since its introduction in 1965, capital gains tax (CGT) has generated little revenue for the Exchequer, but has anguished investors and generated plenty of political heat. The latest twist was the shock announcement of a proposed removal of taper relief and the introduction of a single 18% rate of tax. Irrespective of the merit of these moves, the overriding impact is the sense of utter unpredictability that these political manoeuvres bring to CGT...

Since its introduction in 1965, capital gains tax (CGT) has generated little revenue for the Exchequer, but has anguished investors and generated plenty of political heat. The latest twist was the shock announcement of a proposed removal of taper relief and the introduction of a single 18% rate of tax. Irrespective of the merit of these moves, the overriding impact is the sense of utter unpredictability that these political manoeuvres bring to CGT. In an open economy such as that of the UK, dependent on attracting global capital flows, it is unfortunate that the golden egg of investment should be treated as a political football, particularly at a time of such economic upheaval. Nonetheless, this is the framework within which investors must operate. Media comment on the proposed changes to CGT has tended to focus on the implications for the entrepreneur selling his or her own business.

The impact of CGT on the private portfolio investor Let us ask a very simple question; if saving for retirement is seen as a good thing, and one that should engender government encouragement through tax incentives, why is the business of private investment – outside of a pension scheme – taxed so harshly? On one hand, the Treasury subsidises pension contributions with relief from income tax, and permits those contributions to grow free of tax. On the other hand, for those who choose or have no alternative but to invest outside of a pension scheme, the Treasury gives no income tax relief and it charges CGT on any growth in the investments.

This harsh disparity implies that pensions are the only legitimate vehicle for providing for retirement. But they are not. In fact, in many cases pensions are either inaccessible (because an investor is ineligible under the legislation to make adequate contributions) or unsuitable (perhaps because access to the capital will be required before statutory retirement age). There are many different effects of CGT on investments. Foremost is the impact of inflation.

Let us consider the case of an individual trying to build up sufficient capital during their working life to fund an income in retirement. If that sum is to maintain its purchasing power, it must keep pace with the annual rate of inflation. Prior to 1998, CGT featured an indexation allowance. Introduced in 1982 as a tardy response to the high inflation of the 1970s, indexation allowance had intellectual rigour, removing the inflation element from the charge to tax. Its discontinuation in 1998 was palatable because of the correspondent complexity it removed from the calculation of tax. Low rates of inflation, strong investment markets and reduced complexity were perhaps seen as trade-offs for the technical flaw that the removal of indexation allowance brought to CGT. Since its discontinuation, however, CGT has once again become a tax on inflation.

Let us look at some numbers. With interest rates at around 5%, the capital sum required to generate a pre-tax retirement income of £25,000 – an approximation
of the UK national average income in 2007 – is £500,000. Inflation, currently in the region of 2.5%, would erode £12,500 each year in purchasing power from this capital sum. The CGT legislation to some extent compensates for this by awarding an annual exempt allowance. However, pitched at £9,200 for 2007/08, the allowance is inadequate to shield even this modest level of capital from inflation.

Another unfortunate impact of CGT is the distortion to the investment decision making process, and hence to the allocation of capital, that the tax can create. Anyone sitting on substantial unrealised gains will be familiar with this situation. The logical investment decision may be to sell a particular holding. However, the resulting charge to CGT could be such that it is better to keep holding the investment and endure a significant drop in value rather than sell-up and suffer CGT on the realised gain. Assuming a marginal tax rate of 40%, a holding that has risen by 100% needs to drop by 20% to make it worth selling and paying the tax. The situation can become even more acute when modest annual gains have compounded over many years – a typical scenario for any investment portfolio constructed to build capital for retirement.

CGT can cause a similar distortion to the investment decision when a holding suffers a loss. Here the temptation can be to sell a holding in order to crystallise a loss – and thereby reduce the CGT on any realised gains – rather than continue with a holding on the basis of its investment merit. Taper relief, by linking the rate of tax to the length of time that an investment has been held, has been causing behavioural distortions of its own. Here, although the logical investment decision may be to sell a holding, its future eligibility for taper relief may encourage a sale to be deferred.

There is no escaping the fact that taper relief has been a central plank of CGT legislation, and yet it looks set to be removed in April with just a few weeks’
warning. Stakes in businesses and properties cannot always be sold within that time frame, even when market conditions are favourable. Investors seeking simply to secure the tax relief that they have earned over a 10 year period are turned into forced short-term sellers. The removal of taper relief at short notice at a time when investment markets are so weak raises eyebrows, to say the least.

Arguably, taper relief is conceptually flawed because it is predicated on the notion that a short-term gain is bad, and a long-term gain is good. Investment practitioners will confirm that the opposite is true. Ten per cent delivered over one year is a superior return to 10% delivered over two years. Markets do not deliver their returns in a straight line, but rather with wide fluctuations around a long-term mean. While an investor may not set out to make short-term gains, sometimes that is how they happen.

The ability to take gains or avoid losses as they arise is key to the successful management of investment capital. Furthermore, the holding period for obtaining
maximum taper relief was set arbitrarily at 10 years. There was no technical investment foundation for this, and it effectively penalises any investment over a
longer or shorter time period. The dangling fate of taper relief highlights another
incongruity of the UK’s investment tax framework.

While taper relief may seek to encourage long-term investment, instant gains from gambling and profits from the sale of wasting assets such as fine wines remain outside the scope of tax. Share ownership is subject to both stamp duty and CGT, but spread betting escapes tax entirely. The message is confusing.

This brings us to the question of whether capital gains should be taxed at all. Indeed, many countries of have no equivalent of CGT, and interestingly prominent amongst these are Singapore and Hong Kong, two financial centres known for strong economic growth and government fiscal surpluses. The abolition of CGT, however, could be an equally distorting development encouraging businesses, for example, to retain earnings rather than distribute dividends. The Chancellor’s proposed new single rate of 18% for CGT, though pleasing for investors in absolute terms, is below the rate of both of income tax and corporation tax, and therefore could encourage the synthetic, though
legitimate, manufacture of capital gains in preference to income or trading profits. For the avoidance of investment decision distortions, a level playing field would be preferable.

Together with the removal of the charge to CGT on inflation (by replacing taper relief with a simplified indexation allowance), reform of the personal CGT annual exemption could bring enormous benefits both to investors and to the Treasury. In the absence of introducing different rates of tax which could serve to distort capital allocation decisions, the annual exemption is the only remaining mechanism for equalising the tax treatment of investment inside and outside of pension schemes.

The cost to the Treasury in lost revenue of providing the annual CGT exemption is a maximum of just £3,680 (40% of £9,200) per taxpayer. Over, say, 40 years that equates to £147,200. Conversely, within a pension scheme, investors are able to accumulate £1.65m (the Lifetime Allowance for 2008/09) of capital not only free from CGT (pensions schemes are exempt), but with income tax relief on contributions.

As an outlandish example, a 40% taxpayer making £1.65m in gross pension contributions could cost the Treasury £660,000 in income tax relief alone. The gap between tax relief for pension and non-pension savers is staggering. Treasury men arguing that a significant expansion of the annual exemption would be too costly in lost tax revenues are overlooking one key point; there are vast savings to be made from persuading savers to invest for retirement outside, rather than within, a pension scheme. The case for levelling the playing field with a vastly increased annual exemption from CGT is unequivocal. 

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