CGT, saving and investment
It has been argued that higher taxation of capital gains will result in lower savings and in particular lower investment in productive assets. On the other hand, since capital gains (after adjustment for inflation) plainly add to the ability to spend or save, it is hard to see why they should be treated differently from income. If a lower rate of CGT could be shown to damage the economy, then there might be an argument in its favour.
A recent paper by the Adam Smith Institute makes such a claim. It states that when capital taxes are raised investment falls and vice versa. No evidence is offered for this assertion.
Perhaps the assertion relies on neo-classical economics, which assumes that if the price of something falls then more of it will be purchased. While this will be so in some situations, it is by no means guaranteed to be the case; it is simply an assumption that lacks empirical confirmation as a general principle.
It is, therefore, reasonable to ask whether there is any evidence to support the claim that savings or investment are reduced if capital taxes are increased. The answer is that there is not.
Before looking further at the savings question, it is worth a digression on the topic of how CGT raises revenue for the government. Again, perverse claims are made by the Adam Smith Institute (ASI) (op.cit.) that figures show that increasing the rate reduces the tax take. However, these are deduced from a crude view of raw figures without any consideration of even the most obvious of other factors.
Referring to the USA (as is done by the ASI) the total tax received closely follows the pattern of capital gains realizations over a 50 year period. The variability of realizations is generally much larger than the change in tax rates, implying that any attempt to draw conclusions about the connection between CGT rates and tax revenues from raw figures is likely to be highly misleading.
However, realizations correlate strongly negatively with CGT rates, which is to say that when rates are reduced, people realize their gains. The data that results from this can be misinterpreted to conclude that lower rates yield more tax. Clearly this is only the case if the rate is regularly varied, because it is a short lived effect. A permanent change to taxing capital gains as income, while allowing indexation to cater for the effects of inflation, would be fair and could be expected to realize significant extra tax revenue.
Back to savings. The raw argument that people will save less in the face of higher capital taxes is, in fact, offset by other factors. A lower level of CGT means that a household needs to save less to achieve a target level of wealth. Neo-classical economics assumes that individuals make rational decisions, equipped with complete information. Empirical evidence does not support this view.
Individuals often use simple rules of thumb and seek to achieve some target level of wealth. Once this is achieved, many individuals will cease to save. There is no evidence that saving is significantly affected by CGT rates.
Another consideration that is sometimes cited is the need for risk capital. But the fact is that the majority of venture capital is provided by institutions, sources that are not affected by the CGT applied to individuals. In fact, the ability to offset gains by losses reduces the effective risk to individuals of investments of this kind, making it more likely that individuals will choose to provide venture capital.
Overall, reducing the rate of CGT reduces public saving and cannot be shown to have any significant on private saving. The overall effect of reductions on saving is therefore negative.
When it comes to relating savings to investment in productive assets, there is no reason to suppose that there is a gain in favouring capital gains over income in respect of taxation. Corporate bonds are inclined to deliver a mixture of capital movements and income, and it could be regarded as economically inefficient to distort corporate decisions on retention versus dividends by fiscal considerations. On the face of it, fiscal neutrality between different kinds of investment is the policy that will lead to greatest economic efficiency.
It is worth briefly looking at the distribution of capital gains. UK figures are not immediately to hand, but US figures indicate that in 2005, the bottom 95% of the population received only 10% of total capital gains income while the richest 0.1% (about 114,000 households) received 50%.
[With regards to distribution of capital gains, some analysts including ASI argue that capital gains income can temporarily make a low or moderate income household appear rich. That would make capital gains appear to be received by the rich. Consequently, capital gains income is excluded from household income when assigning households to income categories in the statements relating to the US above.]
The UK figures may be less extreme, but are likely to follow a similar pattern. It is therefore hard to see that there is an argument of fairness for taxing capital gains at a lower rate than income. It also suggests that keeping CGT rates low is likely to help a group of people who are more likely to save than spend, an undesirable outcome at a time when more demand is the most urgent economic need.
Inevitably, the conclusion is that raising CGT to similar levels as income tax would both be fairer and also economically beneficial.