The Benefits of Capital Gains Tax
There is resistance to increasing the rate of capital gains tax (CGT). There are loud complaints from some quarters, and pseudo-academic studies from others. Is all this anything more than special pleading? A broad definition of income includes anything that increases a person's assets or allows them to consume more. Capital gains clearly come within that definition, thus providing a prima facie justification for their taxation.
Back in 1964, a Royal Commission described capital gains as the growth of a tree, and contrasted income, described as the fruit of the tree. The commission concluded that, despite the difference, CGT was justified because they increased the beneficiary's ability to pay, an important criterion in the fair levying of taxes. A Canadian commission sidestepped the need to make the distinction by saying "A dollar gained through the sale of a share, bond or piece of real property bestows exactly the same economic power as a dollar gained through employment or operating a business".
It seems obvious that indexation is needed in some form, otherwise CGT will be levied on illusory gains brought about by inflation. This is especially so while moderate inflation is the aim of government monetary policy. Further, possibly quite elaborate, arguments could be made on how indexation should be achieved. Leaving that aside for the moment, suppose that indexation is achieved by a simple scheme of relying on CPI, or the even simpler scheme of assuming that the target rate of CPI (currently 2% per annum) is a good enough approximation. Once inflation has been excluded, is there any reason not to tax gains as income?
For financial assets, the difference between capital gains and income is not always significant. Think for example of a corporate bond where the yield to redemption is a combination of nominal interest rate and the difference between market value and par value. It is hard to see why the two elements should be treated differently. Indeed it is wasteful to try to determine the distinction in every case.
Reduced tax avoidance is an obvious reason for taxing gains as income. It is certainly true that most people do not have any opportunity to turn income into gains. But those that do are almost invariably very highly paid, and therefore there is an important argument of fairness in applying equal treatment to gains and income.
Taxing income and gains also results in distortions that are economically inefficient. If companies are encouraged to retain earnings with the aim of increasing the share price on account of the different taxation applied to income and gains, this will reduce allocative efficiency. It is desirable to remove fiscal considerations from questions about investment and distribution.
Against this, it is claimed that CGT makes it more expensive to raise capital and thus constrains the movement of money into productive assets. This objection is unconvincing because of the many different routes whereby new productive assets are funded. The role of bank lending is very important in this respect, and since lending is a rationed resource, there are other ways to encourage investment in productive assets.
It is also argued that CGT reduces the propensity to save. Economic studies have been inconclusive in this regard. Much of the data that claims to support arguments for reducing CGT ignore the huge distortions caused by a situation (such as has happened in the US) where the rate is frequently varied (leaving the probability that a high rate will later be reduced) with advance notice being given of changes. The claim that tax raised falls as CGT rises are highly suspect for reasons of this kind. There may well be some element of truth in the claim that increasing CGT will reduce savings, but that is related to the fact that capital gains are skewed to the wealthier members of society who have a higher propensity to save. Research and debate continue, but the evidence tends to support the idea that higher CGT rates yield higher revenues.
The primary arguments in favour of CGT are that it avoids making an arbitrary distinction between different ways in which people receive financial benefit, it reduces opportunities for avoidance, and it widens the tax base thus allowing, other things being equal, lower rates of taxation.
For these reasons it makes for fairness if gains, once indexation has eliminated the effects of inflation, are straightforwardly taxed as income. Unfortunately, there is one complication which is that gains on assets held for a number of years would be unfairly treated if taxed as income in a single year. For this reason CGT on long term assets needs to have a higher limit for the transition to higher rates of tax. This should not be unlimited, though, as that would favour the very rich against others.
The rest of the arguments against setting CGT at similar levels to income tax are largely special pleading. Some claim that they have made financial decisions that would be upset by a change. But that is always a risk with any long term plan. The argument arises especially in relation to buy-to-let housing. However, investors in that area should always have taken into account the fact that tax rates may change, especially where there is an anomaly such as taxing capital gains at a different rate from income, and a highly illiquid investment is not easily disposed of when changes come.
There are thus plenty of reasons, based on fairness and efficiency, for rates of CGT to match rates of tax on incomes.