Capital Gains Tax Reform
6th October 2024
Should the government raise capital gains tax in the Budget?. What is the case for reforming capital gains tax? What are the options for reform?. The Institute for Fiscal Studies looks in depth at a poorly designed tax.
Key findings
1. Capital gains tax (CGT) raises around £15 billion per year, less than 2% of total tax revenue. Revenues have risen significantly over time and are forecast to rise further, partly reflecting the increasing role of wealth accumulation in the UK economy.
2. CGT is paid by around 350,000 people (0.65% of the adult population). 3% of CGT taxpayers realised gains of more than £1 million and this group accounted for two-thirds of CGT revenue. The average gain among this group of 12,000 people (0.02% of the adult population) was £4 million. Around half of taxable gains relate to unlisted shares in private businesses.
3. CGT rates vary across assets. They are lower than tax rates on earned income and, in most cases, income from capital. These rate differentials are unfair and create a range of undesirable distortions.
4. The design of the tax base is flawed. Ultimately, by discouraging saving, investment and risk-taking and distorting who holds assets and for how long, it reduces productivity and well-being.
5. Higher rates of CGT would worsen these problems caused by the tax base. But keeping tax rates low cannot solve those problems. There is a strong case for reform.
6. The tax base could be reformed so that CGT does little to discourage saving and investment. This requires giving more generous deductions for purchase costs and losses. There are several ways to do this in practice.
7. Ultimately, we advocate aligning marginal tax rates across all forms of gains and income, while reforming the tax base. Tax rates could be aligned at any level; for example, rates on capital gains (and capital income) could be increased while rates on employment income were reduced. In practice, the ‘big-picture' solution we set out would include substantially higher CGT rates.
8. Higher CGT rates would increase the incentive for people to leave the UK before realising gains to avoid UK CGT. One option to address this would be to tax people emigrating from the UK on their accrued but unrealised gains, whilst exempting new arrivals from UK CGT on gains they made whilst living abroad. There are challenges with this approach, but it is operated by some other countries.
9. Steps could be taken towards a better-designed system. Low CGT rates on business assets are poorly targeted at entrepreneurship. They lead to more money being held in companies, but do not achieve the commonly stated policy goal of increasing owner-managers' investment in their own businesses. Business asset disposal relief should be scrapped in favour of more generous deductions for investment costs. Removing CGT uplift (or ‘forgiveness') at death should also be a priority.
10. The government should seek to make reform credibly lasting. It should set out clear principles and a rationale for reform and commit to the new regime for the length of the parliament. Instability and unpredictability are bad for investment.
7.1 Introduction
There is widespread speculation in the run-up to her first Budget that the new Chancellor, Rachel Reeves, will raise capital gains tax (CGT).
Increasing CGT is one option that was not ruled out in the Labour Party manifesto. And it is easy to explain the inequities that arise from taxing capital gains at substantially lower rates than earned income and, in most cases, capital income. Taxable capital gains are heavily concentrated at the top of the income distribution and those receiving gains pay much lower tax rates than people receiving similar amounts but in the form of employment income.
However, at first glance, CGT might not seem like an obvious choice for a Chancellor looking to raise significant sums. According to official estimates of the revenue effects of different tax changes produced by HM Revenue and Customs (HMRC), a 1 percentage point increase in the higher rates of capital gains tax in April 2025 would raise a measly £100 million in 2027-28 while a 10 percentage point increase would actually reduce revenue by about £2 billion that year.
In the absence of sufficient information as to how these estimates are produced, it is difficult to assess their credibility. Our view is that HMRC's published estimates are not a good guide to the revenue effect over a longer time horizon and that a rise in CGT rates would, up to a point, raise revenue in the medium run. But increasing headline rates in isolation would involve difficult trade-offs. More revenue would be raised, and with tax rates on capital gains closer to tax rates on income, there would be less distortion to how people chose to work and to take their income. But distortions created by the tax base - the definition of what is subject to tax - would be worsened. Among other things, higher rates would increase unwelcome distortions to commercial decisions about how much to save and invest, which assets to choose and how long to hold them for (see Section 7.3).
Removing the harmful distortions created by the poor design of the UK's CGT should be a key focus of policy. CGT creates unfairness by arbitrarily favouring one action over another and thereby penalising otherwise-equivalent people who behave in the tax-disadvantaged way.
CGT also creates economic inefficiency. The cost to taxpayers of CGT is not just the money they hand over and the resources they spend complying with their obligations, but the lower well-being that results when CGT leads them to change how they behave. For example, there is a cost to people when they hold on to assets for longer than they would want to absent tax considerations. People also waste time and resources undertaking legal arrangements aimed at saving tax by repackaging income into capital gains. And because it leads to reduced investment and skewed patterns of capital allocation, CGT acts to lower productivity. We are collectively made poorer by a poorly designed CGT.
The good news for Ms Reeves is that the tax base could be reformed to greatly reduce - and in some cases largely remove - the distortions to saving, investment and risk-taking. In short, this would require giving more generous deductions for purchase costs and losses and removing CGT uplift (or ‘forgiveness') at death. There are several ways that base reforms could be achieved in practice. With a reformed tax base, tax rates could be increased with much less distortion to choices over whether, when or how to invest. We summarise a ‘big-picture solution’ that involves reforming the tax base while aligning overall marginal tax rates across all forms of gains and income (see Section 7.5). This would represent a major change in tax policy, but also offers a significant prize. Importantly, reforming CGT would be worthwhile in its own right: regardless of how much revenue the government would like to raise, it could raise it in a way that was fairer and less damaging to economic growth and well-being. Reform is even more important if the government wishes to raise additional revenue.
The UK currently charges CGT on disposals that an individual makes while they are UK-resident. Higher CGT rates would increase the incentive for those who have accrued large gains to move to a lower-tax country – to retire abroad, for example – before realising them. One option to mitigate this incentive would be to introduce ‘deemed disposal on departure’ for CGT purposes, matched by ‘rebasing on arrival’ for new arrivals (Section 7.5). Effectively, this would move to taxing gains that accrued while a person was living in the UK, rather than those realised here. There are challenges with this approach, but it is already operated by some other countries.
If the government chooses to reform only some rates or elements of CGT, there would be inevitable trade-offs that require careful management (Section 7.6). But there are smaller steps that could be taken in the right direction. For example, we describe a reform that would include removing business asset disposal (BAD) relief – a preferential CGT rate for business owner-managers which is not well targeted at entrepreneurship and leads to a range of undesirable distortions – alongside giving up-front tax relief for investment in shares. The new up-front relief could be thought of as a replacement for BAD relief – a reorienting away from tax relief on large gains to tax relief on investment. Empirical evidence suggests that implementing the two measures together would boost investment and raise revenue. It would be a progressive change: revenue would be raised from the top of the income distribution, while recipients of the new relief are less well off: those investing the most, rather than those making the biggest gains, would benefit most.
Reforming the tax base at the same time as increasing rates would create winners as well as losers (see Section 7.8). Those making relatively low returns (e.g. those making low-risk arm’s-length investments and those taking risks that do not pay off) would pay less tax. Those making very high returns – which could reflect some combination of effort and skill, privileged access to scarce opportunities, and luck – would pay more. But note that raising taxes on high returns could equally be described as removing the tax advantages they receive under the current tax system. We do not take a view on how high tax rates should be, but there is no good reason to tax work less heavily if it generates a capital gain than if it generates employment income.
Whatever changes are made to CGT, a decision would have to be made on the transitional arrangements for existing accrued gains (see Section 7.7). Specifically, to what extent would any benefits of a narrower base and any costs of higher rates be applied to gains that have already been accrued but not yet realised? Giving more generous allowances for past investments would come with a cost but not improve incentives. Applying higher tax rates to past gains would be an efficient way to raise revenue. But it may lead to objections that it is retrospective – though almost all tax increases are retrospective to some degree.
7.2 What is CGT and who pays it?
What is capital gains tax?
CGT is a tax on the increase in the value of an asset between its acquisition and its disposal. Broadly speaking, this means its sale price minus its purchase price.2 If an asset is held until death, any capital gain up to that point is subject to uplift (the tax is ‘forgiven’): the deceased’s estate is not liable for tax on any increase in the value of assets prior to death, and those inheriting the assets are deemed to acquire them at their market value at the date of death.
CGT only applies to assets sold by individuals and trustees; gains made by companies are included in profits and subject to corporation tax. The rest of this chapter focuses exclusively on capital gains made by individuals.
Not all assets are subject to capital gains tax. Most notably, increases in the value of owner-occupied homes are exempt from CGT. There is also no CGT charged on assets held within pension funds or Individual Savings Accounts (ISAs) and there are reliefs for various venture capital and employee share schemes.3
Broadly, CGT is based on where people live when they realise capital gains. As such, people who move to the UK can – in principle – be taxed on gains that accrued before they came (though in practice there is a ‘grace period’ during which they are not taxed on gains made on overseas assets), and people who leave the UK can avoid UK tax on gains that accrued while they were here. We return to the specific details below.
As with income tax, there is an annual threshold below which CGT does not have to be paid. In 2024–25, this ‘annual exempt amount’ is £3,000 (having been reduced from £12,300 in 2022–23). This is subtracted from total annual capital gains before calculating the tax due.
Read the full report IFS HERE
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