Post-pandemic recovery: a Capital Gains Tax reform?
By Dong Liu
Senior research analyst at King’s Private Equity Club.
The COVID-19 pandemic has had a significant impact on the UK government’s public finances.
Indeed, the government’s cash requirement in the first half of the fiscal year has reached its highest record of £246 billion since 1984. To fill the fiscal hole, the government is pressured to find ways to control the mounting public debt and to preserve its public spending in the post-pandemic recovering period.
In order to find solutions to the fiscal problems, Rishi Sunak, the Chancellor of the Exchequer,
requested for a review of Capital Gains Tax (CGT) in July. Upon the chancellor’s request, the Office of Tax Simplification (OTS) investigated CGT and produced a report on November 11th, titled ‘OTS Capital Gains Tax Review: Simplifying by design’. Drawing on a range of economic perspectives, this report sets out a framework of policy choice that could simplify the current taxation systems.
In particular, the report by OTS, identified CGT as ‘counter-intuitive’ and creating ‘odd incentives’. At present, the government sets CGT at a rate of 28% for higher or additional taxpayers, whereas the Income Tax is set at a rate of 40% for higher taxpayers and 45% for additional taxpayers. It is found that in the 2017-2018 tax year, £8.3 billion of CGT was paid compared to £180 billion of Income Tax. Whether it is appropriate for CGT to be at a much lower rate than the rate of Income Tax is of a huge dispute. The large discrepancy between tax rates comes to the government’s attention notably under the pandemic, as the government is in urgent need of generating tax revenues to provide the economy with supporting packages. According to the report, the low rate of CGT can distort investors’ behaviour, such as re-characterising income as capital gains. Therefore, a Capital Gains Tax reform, constituting the alignment of CGT rate to Income Tax rate, has come under consideration.
Such an alignment of CGT rate to Income Tax rate certainly will impact the industry of private equity. The PE industry has always been adept at minimising tax bills, such as using the tactic of offshoring. PE executives’ income consists of ‘carried interest’, which is a share of a fund’s profit. Carried interest in the taxation systems, however, is not considered as income, but as capital gains instead. The tax rate that PE executives currently pay at, as follows, is at a much lower level. It is clear, an overhaul of the taxation systems has not been and certainly will not be favoured by PE executives.
There are valid reasons for the government to raise the CGT rate. A higher revenue will help the government cover the costs of the pandemic and spend towards an economic recovery. According to the findings in OTS’s report, the current annual CGT exemption amounts to £12,300. A CGT reform could raise an extra revenue of £440 million in a year. This may be a small amount compared to the fiscal hole that the government needs to fill. Yet, additional philosophical and political considerations also fall under the proposal of such a reform. As the report argued, CGT is a barrier both to economic growth and to social equity. The pandemic has clearly made this issue more salient.
Nevertheless, it should be considered whether a CGT reform can be effective in achieving raising tax revenues. The reform can be ‘a two-pipe problem’. On one hand, an economic recovery requires a change in the taxation systems that can repair the damages caused by the pandemic. On the other hand, business reliefs have been used to stimulate investment and risk-taking. Such a reform, as a result, can reduce the incentives of entrepreneurs and risk-takers. This rationale, however, may apply differently to the PE industry. Since PE executives invest loans and rarely their own money into funds, these investments have large potential for profits with low personal risk. Indeed, the PE industry is one of the industries least affected by the pandemic. Yet, even though the PE industry is not subject to the same level of risk of the entrepreneurial industry, the CGT reform may still remain ineffective if investors restructure their behaviours. Tax revenues generated from the reform, therefore, could be
much lower than the government’s expectation.
An additional factor that may influence the feasibility of a CGT reform is a political one. Aligning CGT rate to Income Tax rate will most likely affect the interest of wealthy asset holders. If the conservative party wishes to secure more votes from the Tories, they may hold back from raising the rate of CGT drastically. The decision of a CGT reform is crucial for the incumbent party. Thus, the UK government will have to carefully consider the various consequences of the reform, as well as alternatives to increase its revenues in order to solve the economic problems resulting from the pandemic.
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