When commentators point out a lack of Lib Dem ‘wins’ in the Coalition government, remind them of the Capital Gains Tax hike undertaken in 2010. Sure, the ‘progressive’ party wanted to increase it further to replicate the income tax bands, but at the time the hike for higher rate income tax payers from 18 per cent to 28 per cent was still a significant increase, especially for a tax that optimal tax theory suggests is so damaging for the economy.
This is important. The debate on CGT in particular has often been framed purely on the likely effects on revenue, as it is a tax where the peak of the Laffer curve (or the revenue maximising rate) is thought to be at a low rate.
In a CPS report released yesterday, Lord Flight and Oliver Latham engage in a thorough review of the economic literature and come to the following conclusions:
The conclusions from the literature are clear. CGT should be kept low for reasons of economic efficiency. Cuts in CGT rates from the current level need not have substantial budgetary implications. And the overall optimal rate is often well below the revenue maximising rate.
Nevertheless, the Government’s declared rationale when increasing the rate of CGT was to ameliorate tax avoidance (i.e. get the rate closer towards the top rate of income tax in order to reduce the incentive to reclassify income as gains) and set the rate such that it maximised overall revenue. They suggested that this entailed balancing off two effects: the loss of revenue due to the lock-in effect, and the increase in revenue arising from lowering tax reclassification.
The problem for the Treasury now is that it cannot claim the 28% rate maximises revenue when the top rate of income tax was 50% without acknowledging that we will be on the wrong side of the Laffer curve once the top rate falls to 45% in 2013. After the top rate of tax is cut, the difference between the tax rate on income and gains will fall and so the incentive to avoid income tax will be reduced. This implies that if the two effects were equal before, the lock-in effect will be larger now because the cost of reclassification has fallen – so the 28% rate should be cut if revenues are to be maximised.
Now, of course, the Treasury are likely to be reluctant to reduce the rate, not least because the opposition parties will label it a tax cut for a rich (though bizarrely many support QE despite the distributional impacts). This is quite incredible, particularly because the 18% rate was inherited from the Labour government!
Nevertheless, it makes absolutely sense to continue with a tax rate which loses the Government potential revenues.
The Government should therefore use all of this evidence to set out short-term, medium-term and long-term ambitions.