If Rachel Reeves Hikes Capital Gains Tax, She'll Be More In Line With Nigel Lawson Than Gordon Brown

2nd July 2024

With Labour heavily predicted to win the upcoming UK election, there has been much talk about future tax plans.

Keir Starmer insists the party's priority is economic growth, but many believe it will have to raise taxes to shore up the public finances. With increases in income tax, employees' national insurance and VAT all ruled out, capital gains tax (CGT) is a potential target.

CGT is payable when you sell an asset that has risen in value since it was purchased. This includes property, though not your main residence. Starmer has already denied that Labour might remove the main residences exemption, but has otherwise been silent on CGT. Yet he and his shadow chancellor, Rachel Reeves, have reportedly drawn up possible CGT reforms that could raise £8 billion a year.

One idea that is sometimes mooted is to bring the CGT rate into line with income tax. As it stands, the lower and higher rates of income tax in England and Wales are 20% and 40%, with a tax-free allowance of £12,570. The CGT rates are 10% and 20%, or 18% and 24% for property, with a tax-free allowance of £3,000. For both taxes, the threshold for moving from lower to higher rates is £50,270.

You might think a more left-leaning government would be more inclined to tax wealth and salaries at the same rates. Interestingly, however, most movement in this direction has historically been by the Conservatives.

CGT was introduced in 1965 by Labour Prime Minister Harold Wilson and his chancellor, Jim Callaghan. This was to deter certain types of income from avoiding tax by being classified as a capital gain.

Callaghan's economic adviser, Hungarian-born Nicholas Kaldor, argued that capital gains and income should be taxed at the same rates. Yet Callaghan made CGT different, following advice from the Inland Revenue, HM Treasury and Bank of England. All capital gains above £1,000 (£16,414 in today's money) were taxed at 30%, whereas the standard rate of income tax was 41% (and more on annual earnings above £2,000).

This system endured until it was reformed by Conservative Chancellor Nigel Lawson in several announcements culminating in his March 1988 budget. He partly helped investors by removing the problem that inflation on capital gains was not stripped out of the tax calculation. If, say, an asset had risen in value by 20% and the rate of inflation was 10%, CGT had been payable on the whole 20% gain, not the 10% gain net of inflation.

At the same time, however, Lawson announced that capital gains and incomes would now be taxed at the same rate. The flat CGT rate of 30% was replaced by 25% for lower earners and 40% for higher earners.

The next significant change came in 1998 under New Labour. Chancellor Gordon Brown did away with the indexation allowance that was used to strip out inflation from gains, considering it unnecessary in a low-inflation environment. He introduced a new system called taper relief, which encouraged investors to hold assets for longer, particularly shares in businesses, taxing them at successively lower rates depending on the length of ownership.

For higher-rate taxpayers selling shares in a business, the rate ranged from 40% for shares owned for up to a year to 10% for those held for at least ten years. For non-business assets, the rate tapered from 40% for the first three years of ownership to 24% for ten or more years.

Over the next few years, Labour cut the maximum taper on shares from ten years to two years. Many on the left argued this was excessively generous to the investor classes, with much anger focusing on private equity firms, whose model was to buy assets, aggressively strip out costs and sell several years later.

In October 2007, with Brown now prime minister and Alistair Darling chancellor, Labour scrapped taper relief and reintroduced a flat rate of CGT for the first time since 1988. It was set at 18%, below the income-tax rates for lower and higher earners of 20% and 40%.

Business owners nearing retirement complained that they now faced paying almost twice the tax rate if they sold up. So in January 2008 Darling introduced entrepreneurs relief, which taxed gains of up to £1 million from business owners selling their shares at just 10%.

He didn't address objections from the left over the flat rate, however. Many pointed out that employers paying themselves in shares were being taxed at a lower rate than their cleaners.

Reforms since 2010
When this unfairness was (partially) addressed, it was by Chancellor George Osborne under the Conservative-Lib Dem coalition. In 2010, he introduced a CGT rate of 28% for higher earners - still not parity with income tax, which remained at 20%/40%, but a move in that direction. Osborne offset this by substantially increasing entrepreneurs relief to £5 million (and then £10 million a year later).

In his final budget in 2016, he then cut the CGT rates to 10% for lower earners and 20% for higher earners. Capital gains were now payable at half the 20%/40% income tax rates, though this was still less generous than the New Labour regime. Osborne also continued to tax capital gains on property at the 18%/28% rates.

Subsequent reforms to CGT have been good and bad for investors. Chancellor Rishi Sunak in 2020 cut entrepreneurs relief from £10 million to £1 million, still with a tax rate of 10%, and renamed it business asset disposal relief. In 2024, his government then reduced the higher CGT rate for property sales to 24%.

So in CGT's 60-year history, Labour has often done more to help investors than the Conservatives. Paul Johnson, the highly respected director of the Institute for Fiscal Studies, has described as "dreadful" the Brown/Darling decision to decouple CGT and income tax rates in 2008. He also views entrepreneurs relief as "especially egregious".

Johnson favours restoring indexation, essentially a return to the pre-1998 system, though he would scrap the exemption on main residences, calculating it costs HM Treasury £25 billion a year. Nonetheless, few countries impose CGT on such gains.

At any rate, if Labour win the election and Starmer and Reeves decide to increase CGT or even bring it into line with income tax, they'll be following in the tradition of whatever is left of the party on the opposition benches.

Author
Robert Gausden
Senior Lecturer in Economics, University of Portsmouth

Note
This article is from The Conversation web site. To read it with links to more information go HERE