Budget Analysis: CGT - the shape of things to come?

One racing certainty for next month’s Budget is a recast of Capital Gains Tax (CGT), following the Chancellor’s announcement of a review of the tax. Despite the rumour that this produced 120 submissions with about 140 ideas, one assumes they have been narrowed down to coherent proposals.

CGT actually raises little money in the grand scheme of things. That said, its current yield of #1.3bn from individuals and trusts is useful money and considerably up on the #800m of a couple of years ago. But this is barely 1% of the Inland Revenue’s take and it is a notoriously complex tax.

Perhaps the country needs some form of CGT. Without it, taxpayers might argue that their profit is a capital gain – hence not taxable – rather than an income-taxable receipt. This happened a good deal in the 1950s before CGT arrived.

So let’s accept that CGT is anti-avoidance and should be operated as such, rather than as a revenue-raising measure. Revenue that is raised will potentially come from capital that would otherwise be available for investment.

The current CGT system has useful reliefs in it, in line with this theory. They include re-investment relief, rollover relief and principal private residence rules.

Most CGT comes from investments, as well as property, such as second homes and rental property. Some tax comes from antiques and works of art.

There is clearly an argument that income-producing investments, at least, should not be subjected to a gains tax. After all, the money invested has probably come from after-tax income and the income produced by the investment will be taxed.

An anti-avoidance CGT leads us to a tax on short-term gains. Any quick buying and selling of shares, for example, would come into the tax net – with no indexation.

The simplest route is to include the ‘gain’ as income and to tax accordingly.

There would be no small gains exemption.

The corollary is there should be relief for losses against income but that, I fear, will stick in the Revenue’s throat. The government wants to encourage long-term investment. That argues for a lower rate of tax on long-term investments or none at all.

So why not have a simple system that sets three tax rates based on the length of time the investment is held. This could be that an asset held for less than six months should be taxed as income, usually at 40%, that an asset held for six to 24 months should be taxed as income at 20%, and an asset held for more than two years should be free of tax.

There would have to be some exemptions/reliefs for ‘involuntary’ disposals, such as takeovers and compulsory purchase, but many other reliefs would drop away.

Pension funds would continue with their CGT exemption by virtue of the fact that they do not pay income tax. I fear, though, that this simple system would be seen as too extreme. But the government should accept that raising tax is not the key aim of the reformed CGT.

That would lead to significantly lower rates for longer-term gains – perhaps a 20% rate after five years.

And scrapping indexation, which leads to many complexities in calculation and anti-avoidance, could follow that pragmatic rate cut if inflation really is kept down.

So even if my structure above is too simple, I would hope it offers a good starting point.

Assuming CGT is to remain, even at the lower long-term rate, we have to build in many of today’s reliefs to stop the tax damaging capital.

This means a simple re-investment relief – as long as monies from a disposal are re-invested appropriately, in assets of the same type or, perhaps to a limited extent, other types – so that any tax would be deferred.

That could sweep in reliefs on takeovers, principal residence and demergers.

It would not cover retirement disposals – better to have a time-based cut-off for the tax – and it would falter when people moved from their large house to a smaller one when the children left home, so the principle residence exemption should continue.

The result of my ideas would probably be a cut in tax revenue. But does that matter, given the sums involved in the context of the total tax revenues – and the potential benefit to the investing community? After all, CGT is a tax that is currently feared and its top rate of 40% is the highest in the EU.

Simplifying it would have another key benefit: it would help self-assessment flow more smoothly. At the very least, there is a need to have the basic exemption in terms of proceeds realised rather than gains made.

Why make people work through all the sums to see if they qualify for a small gains exemption? Why not just say that proceeds of less than #20,000 a year are outside the tax net, unless they are caught by the short-term income tax ‘hit’?

Undoubtedly, this over-complex tax needs radical reform to stop it becoming totally unworkable. Reforms should concentrate on simplification and on not damaging investment. But I fear that reforms being considered are concentrating on raising more tax from the system.

That, I suggest, is the wrong way to proceed and runs the risk of damaging more than just the wealth of those taxpayers who pay it.

It would damage the general health of UK Plc.

John Whiting is head of direct tax at Price Waterhouse