IFS urges Labour to make ‘serious reforms’ to current CGT system

The Institute of Fiscal Studies (IFS) is urging the Labour Party to make “serious” reforms to the capital gains tax (CGT) ahead of the party’s first Budget later this month.

According to a new report published by the IFS, while CGT raised £15bn last year, accounting for less than 2% of total tax revenue, its current design reduces UK productivity by “discouraging saving, investment, and risk-taking”.

As a result the IFS has said that the current CGT is flawed as these rate differentials are unfair and create a range of undesirable distortions.

It also highlighted that higher rates of CGT would worsen these problems caused by the tax base, and the tax base could be reformed so that CGT does little to discourage saving and investment.

The tax reduces the return the saver can expect to receive on their investment, so some investments that would have been worthwhile in the absence of taxation are made unprofitable by the tax.

Ultimately, IFS said it advocates for aligning marginal tax rates across all forms of gains and income, while reforming the tax base. This would represent a “major change” in tax policy, but also offer a “significant prize”.

The institute also highlighted that gains on different types of assets are taxed at different rates. As a result, IFS stated that this creates a bias towards taking any rewards in the form of gains rather than income and towards putting effort into activities that generate gains rather than income.

Additionally, the current tax system does not treat profits/gains and losses symmetrically. When people make a loss, they are able to ‘offset’ the loss against other gains such that tax is then levied on the net gain. But loss offsets are incomplete.

IFS argues that losses often cannot be relieved immediately; they can be carried forward to offset in future, but the delay reduces the value of the relief; and sometimes the losses can never be offset at all. As a result, the system discourages risk-taking.

Moreover, higher CGT would make the UK a less attractive place for people to live at the time they realised a capital gain. It would affect incentives to work and invest in the UK.

One option to address this it suggested would be for the UK to introduce ‘deemed disposal on departure’ for CGT purposes, matched by ‘rebasing on arrival’ for new arrivals. This would aim to ensure that all gains accrued by an individual whilst UK-resident are taxed in the UK, even if they subsequently moved abroad, but would correspondingly exempt from CGT any gains accrued prior to arrival.

IFS said: “The current design of CGT discourages saving and investment and distorts choices people make about which assets to buy and sell and when. And it creates unfairness, with some people able to access much lower tax rates than others.

“Politicians over the decades have chosen different points on this perceived trade-off but, since neither aim is ever achieved, the system is subject to constant tinkering. Moreover, the compromise creates many boundaries in the tax system – including between capital gains and capital income – which then require great effort to define and police. The UK is not alone here: most governments choose low capital gains tax rates (relative to income tax rates) on nominal gains, and as a result they face the same set of problems we set out in this chapter.”

It added: “We argue that the two aims – economic efficiency and fairness – can both be achieved, and the tension overcome, by using tax rates and the tax base. The design of the tax base is often overlooked, but it is critical for creating a capital gains tax that does not discourage saving and investment. We have sketched out a ‘big-picture’ solution that would vastly improve – and in many cases largely remove – the problems of the current system in a domestic context.

“The details of any reform will be crucial. The government should take care to get these right. It should also seek to ensure that any reform is credibly lasting. CGT has been reformed many times in the past decades. If people believe that any policy choice will be reversed in future years, it will distort behaviour. And if people expect rates to rise in future, they will be more inclined to sell assets in advance. Similarly, it is undesirable to leave people thinking that any reform is simply more upheaval, with more unknown reforms likely in coming years.”