Memorandum by the Oxford University Centre
for Business Taxation
CAPITAL GAINS
TAX
Why do we tax capital gains received by individuals?
The main reason is that it seems fair to tax individuals who have
increased their wealth through a capital gain in a similar way
to those who have increased their wealth through income receipts.
If we choose not to tax capital gains, then there is likely to
be an avoidance problem as individuals seek to convert income
into gains.
This suggests that income tax rates are a good
starting point for setting tax rates on capital gains. Indeed,
this was the system inherited by the Labour government in 1997.
However, the taxation of capital gains brings
its own problems. These include the following.
— Typically, part of any gain is due
to an increase in the general price level. In principle, only
the real gain over and above inflation should be taxed. Although
the operation of the indexation allowance was complex in certain
areas, we believe that in balance it is better to retain such
an allowance and to seek administrative solutions to any complexities.
— Gains are typically not taxed until
realisation. This has two effects. First, since the tax payment
relating to a gain may be delayed, the effective tax rate on a
gain is lower—ie there is a tax advantage in deferral. This
would, in principle, be a reason to set higher statutory rates
on capital gains than on income. Second, the realisation basis
of capital gains tax creates a lock-in effect, as taxpayers seek
to delay the tax payment by delaying realisation of the gain—that
is by delaying the sale of the asset.
— In the case of gains made on the
sale of company shares, there may be double taxation, as the underlying
income generated in the company may also be subject to corporation
tax. In this case, there may be a case for special treatment of
such gains, in a similar way to the personal tax treatment of
dividends. On the other hand, not all corporate income and gains
have been or will be subject to corporation tax; where they have
not, there is no need for further relief.
These considerations already indicate that an
ideal capital gains tax is impossible to attain. In these circumstances
there is much to be said for a simple system which may not be
perfect, but which is reasonably fair, and which does not create
too many economic distortions.
We now turn to comments on the specific proposals
in the Finance Bill which need to be considered against this background.
— The underlying rationale for taper
relief was weak. As already noted, the realisation basis of capital
gains already induces a "lock-in effect" which discourages
a sale of an asset. By inducing taxpayers to hold assets for a
longer period, taper relief exacerbated this effect. There is
no economic rationale for encouraging assets to be held for a
longer period. The original idea was to discourage short term
speculation, but there is no obvious link between taper relief
and such speculation. The reality is that taper relief has introduced
its own complexities, for example, a distinction between business
and other assets—a distinction which it also difficult to
justify on any economic rationale. We therefore support the abolition
of taper relief, though we regret the re-introduction of the distinction
between business and other assets in Entrepreneur's Relief, discussed
further below.
— It has been argued that a single
rate of capital gains tax represents a simplification. We do not
find this argument persuasive, compared with a system in which
capital gains are taxed at the same rate as an individual's taxable
income. We believe that the benefits of a single rate are overstated.
It is true that "lumpiness" in receiving gains over
time could shift taxpayers temporarily into a higher tax bracket,
when their overall pattern of receipts would more reasonably put
them into a lower tax bracket. But this problem exists anyway
as long as there are exempt gains, and can be addressed with spreading
provisions. What is more important for a simple tax system is
that different forms of income and gains are taxed at similar
rates. With an 18% capital gains tax rate, a higher rate income
tax payer now faces a clear incentive to convert income into a
capital gain. The boundary between income and gains is therefore
an important boundary which the HMRC has to control. Of course,
with taper relief, this distinction already existed, especially
for business assets. But the 18% rate does little to lessen the
importance of this distinction.
— If there is to be a single rate of
tax, then the choice of an 18% rate has no obvious rationale.
It might be justified as being close to the basic rate of income
tax of 20%, which would imply that the incentive to convert income
to capital gains for basic rate tax payers is small. A rate lower
than 20% could perhaps be roughly justified by the lack of an
indexation allowance, though a rate higher than 20% would instead
be suggested by the realisations basis of the tax. However, according
to the latest statistics available (for 2004-05), total taxable
gains declared by individuals amounted to £8.7 billion. Of
these gains, over 60% were received by higher rate taxpayers,
who face a marginal income tax rate of 40%. If there were to be
only a single rate of capital gains tax, then there is a reasonable
case to suggest that it should be set at 40%, rather than 18%.
But a better system would allow more than one rate.
ENTREPRENEUR'S
RELIEF
Entrepreneur's Relief will give a lifetime exemption
of £1 million for the disposal of specified business assets.
This includes the whole or part of a business and shares in a
personal company. The business in question does not need to be
new, or to be operating in a specific sector of the economy.
The economic rationale for Entrepreneur's Relief
as set out is unclear. BERR's document "Enterprise: unlocking
the UK's talent" lists five strategies to develop enterprise
in the UK: culture, knowledge and skills, access to finance, regulatory
framework, and business innovation. None of these five strategies
include Entrepreneur's Relief for CGT, or indeed any other form
of reducing tax on successful enterprise.
Further, an entrepreneur that has already gained
the benefit of the relief has a (comparatively) reduced incentive
to undertake a new enterprise. This may be thought to balance
the need of fairness in the tax system with the need to create
incentives to invest. But the basic relief itself, which allows
£1 million of gains for a single individual to be tax free,
in any case raises questions of fairness.
ENTERPRISE INVESTMENT
SCHEME
In contrast, the EIS (and Venture Capital Schemes)
are designed to ease problems of raising finance for small businesses,
and therefore correspond to one of the strategies outlined in
the BERR's document.
Although capital market failures are often cited
as a problem for small firms, it seems that in the UK there is
no evidence of any general failure, although there may be particular
problems for early stage businesses to attract small amounts of
risk capital (Bank of England, 2004). 79% of small businesses
seeking finance are successful on their first attempt to raise
external finance (IES, 2005). The principal finance gap is for
new and start-up businesses rather than small businesses (Graham
Review, 2004).
The Enterprise Investment Scheme, Venture Capital
Trusts and the Corporate Venturing Scheme seek to meet the perceived
"equity gap" for unquoted trading companies. However,
it is not clear that they are well targeted, and the jury is still
out on their effectiveness (see Boyns et al (2003); Cowling
et al (2008)—see below for further discussion). Non-tax-based
assistance is given through the Small Firms Loan Guarantee, which
has been remodeled following the Graham Review to focus on firms
within their first five years of business rather than small firms
generally. Unlike the tax relief schemes, this is consistent with
evidence that the focus should not be on size but on other characteristics.
The specific reform in the Finance Bill—the
proposal to raise the limit which an individual can invest from
£400,000 to £500,000 (subject to EC consent) is unobjectionable.
Other limits in the EIS—for example, on the size of the
company—are unaffected. It is not clear whether relaxing
this limit will affect the total amount of funds invested, but
there is no obvious reason why £500,000 is more or less appropriate
than £400,000.
The EIS is open to investment in any small business
other than those in areas of activity that are excluded (which
the Finance Bill extends to shipbuilding, coal and steel for EU
reasons). The rationale for the list of exclusions is unclear.
The Consultation document indicates that the scheme is targeted
to higher-risk trading companies. But the only way we can identify
such an effect is if the list of exclusions is intended to represent
lower-risk companies. This seems hard to justify.
HMRC and HMT have issued a consultation document
on the EIS (March 2008). This deals with administrative issues
but these issues cannot be divorced entirely from the rationale
for the scheme. For example, consultees are asked whether the
rules surrounding connected parties work in a way that seems at
odds with the purpose of the scheme. There seems to be little
economic rationale for the connected parties rules which arise
through fears of abuse of the relief.
HMRC REPORT 44
As noted above, the EIS and VCT schemes are
intended to address the "equity gap": the difficulties
that small businesses have in raising external finance. Success
for these schemes might therefore be reflected in:
— more small companies being created;
— companies which receive funding through
the schemes investing more than they otherwise would have done;
and
— additional investment proving to
be worthwhile.
The Cowling et al (2008)/HMRC study provides
an assessment of these schemes. However, it does not address the
first issue raised here.
Arguably, it does not address the second question
either. A broad problem with the study is that it compares the
performance of companies which received EIS or VCT funding with
similar companies which did not. That would be a reasonable approach
if the allocation of funding were random. But that seems unlikely.
If the matched companies are indeed similar, then they would be
eligible for EIS or VCT funding: an important question is therefore
why they did not receive any such funding. Reasons might include
the fact that they did not have any suitable investment opportunities,
the owners did not want to permit external suppliers of finance
to become part of the business, that outside suppliers of finance
were unwilling to provide finance (for unobserved reasons), or
that they simply did not know about the scheme. All of these (and
other possible reasons) imply that the "matched" companies
cannot really be "similar".
In this context, the first results of the study
are not surprising. For example, the study found that companies
in receipt of EIS and VCT funds invested more, and had higher
sales and employment. But it is possible to turn this around and
question the direction of causation. Companies which seek to grow
faster need to raise more external finance: these are also likely
to be the companies which are in receipt of finance through the
EIS and VCT schemes. Under this interpretation, there is no evidence
of an effect of the schemes.
One possibly surprising element of the results
is that investments made under EIS and VCT tend to have lower
profit margins, and lower survival rates. Taken at face value,
this would suggest that the schemes are not inducing very worthwhile
additional investment. This could be explained if, say EIS investors
have a required post-tax rate of return, equivalent to that which
they could earn elsewhere. Given a required post-tax rate of return,
tax relief on an EIS investment will imply that that investment
requires a lower pre-tax rate of return. However, the empirical
results, and this interpretation, should be treated with caution:
further study on these issues would be useful.
CENTRE FOR
BUSINESS TAXATION
The Centre for Business Taxation was established
in 2005. It is an independent research centre of Oxford University,
based in the Saïd Business School, with close links to the
Faculty of Law and the Department of Economics.
The Centre's primary aim is to promote effective
policies for the taxation of business. It undertakes and publishes
multidisciplinary research into the aims, practice and consequences
of taxes which affect business. Although it engages in debate
on specific policy issues, the main focus of the Centre's research
is on long-term, fundamental issues in business taxation. Its
findings are based on rigorous analysis, detailed empirical evidence
and in-depth institutional knowledge.
The Centre provides analysis independent of
government, political party or any other vested interest. The
Centre has no corporate views: publications of the Centre are
the responsibility of named authors. The Centre is not a consultancy:
it reserves the right to publish the results of its research.
Michael Devereux is Professor of Business Taxation
at Oxford University and Director of the Centre. Professor Judith
Freedman is KPMG Professor of Taxation Law at Oxford University,
and Director of Legal Research of the Centre.
REFERENCES
Bank of England (2004), Finance for Small Firms—An
Eleventh Report.
Boyns, N, M Cox, R Spires and A Hughes (2003),
Research into the Enterprise Investment
Scheme and Venture Capital Trusts, Public and Corporate Economic
Consultants, Cambridge.
Graham, T (2004), Graham Review of the Small Firms
Loan Guarantee: Recommendations, HMSO, London.
IES (2005), Annual Survey of Small Businesses:
UK, Institute for Employment Studies, CN: 6622b, Brighton.
7 May 2008
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