Recent announcements suggest that Chancellor Rachel Reeves is considering raising Capital Gains Tax (CGT) rates to as high as 39% in the upcoming budget. By analysing this potential development through the lens of intertemporal choice theory, we can gain valuable insights into how such a tax increase might influence economic activity.
Capital Gains Tax is levied on the profit realised from the sale of non-inventory assets, such as property, stocks, or businesses. Currently, CGT rates in the UK are up to 20% for most assets and 28% for certain property transactions. These rates are notably lower than income tax rates, which reach up to 45% for the highest earners. The proposed increase to 39% represents a substantial rise, potentially altering investment strategies and asset allocation decisions.
Intertemporal choice theory examines how individuals make decisions involving trade-offs between costs and benefits occurring at different times. In the context of a CGT hike, investors face a temporal dilemma: should they sell assets now to benefit from current lower tax rates, or hold onto them in the hope of future policy reversals or greater capital appreciation?
An increase in CGT rates intensifies the lock-in effect, where investors are disincentivised from selling appreciated assets to avoid higher taxation. This phenomenon can lead to suboptimal asset allocation, as individuals retain investments longer than their financial strategies would otherwise dictate. The lock-in effect not only affects individual portfolios but can also have broader implications for market efficiency and economic growth.
One immediate behavioural response to an anticipated tax increase is a rush to sell assets. Investors may expedite the sale of assets to lock in gains at the current lower rates. This behaviour aligns with intertemporal choice theory, where the immediate benefit of lower taxes outweighs potential future gains. The market may experience a temporary increase in supply, potentially depressing asset prices due to the sudden influx.
Conversely, some investors may opt to retain assets indefinitely, especially those with significant unrealised gains. By postponing the sale, they hope to benefit from potential future tax reforms or to pass assets to heirs, exploiting the current provision where CGT is not levied upon death. This strategy can lead to a misallocation of resources, as capital remains tied up in less productive investments, hindering economic dynamism.
A mass sell-off prior to the CGT increase can temporarily boost market liquidity, increasing trading volumes and affecting asset prices. However, following the implementation of higher rates, a pronounced decline in trading activity may occur as the lock-in effect takes hold. Reduced liquidity may hinder the efficient functioning of markets, making it more challenging for investors to execute trades without significantly impacting prices.
Lower trading volumes impair price discovery, the process by which markets determine the fair value of assets. With fewer transactions, prices may become more volatile and less reflective of underlying fundamentals. This inefficiency can deter investment, as uncertainty over asset valuation increases, and may lead to higher risk premiums demanded by investors.
The potential CGT hike could have pronounced effects on specific sectors:
- The property market, particularly for second homes and investment properties, may experience heightened volatility. An initial surge in listings could depress prices due to increased supply. Over the long term, reduced turnover might inflate valuations because of decreased availability, potentially exacerbating affordability issues.
- Given that around half of taxable gains relate to unlisted shares in private businesses, these sectors could see significant shifts. Entrepreneurs and investors might delay exits, affecting capital recycling and the funding of new ventures. This hesitation can stifle innovation and slow economic growth, as startups and expanding businesses rely on the fluidity of investment capital.
The proposed CGT increase aims to address a substantial fiscal deficit and to fund critical public services. By targeting wealth rather than income, the government seeks to uphold its commitment not to raise taxes on “working people.” However, several potential pitfalls accompany this approach.
Firstly, there is revenue uncertainty. Higher CGT rates may not yield proportional increases in tax revenue. Behavioural responses, such as asset retention or emigration to lower-tax jurisdictions, could reduce the taxable base. If investors choose not to realise gains, the expected increase in tax receipts may not materialise, undermining the policy’s fiscal objectives.
Secondly, the economic impact of elevated CGT rates could be detrimental. Such rates can deter investment and entrepreneurship by reducing the returns on capital. The disincentive to realise gains may limit the capital available for new ventures, affecting job creation and economic dynamism. The UK could become less competitive internationally, with investors favouring jurisdictions with more favourable tax regimes.
Calls for Comprehensive Reform
Economists and policy experts suggest that merely raising CGT rates without addressing underlying issues may exacerbate existing problems. Recommendations for a more effective approach include:
- Reforming the Tax Base: Adjusting the CGT structure to minimise distortions, such as by providing more generous deductions for investment costs and losses. This change could encourage investment by reducing the tax burden on productive activities.
- Aligning Tax Rates: Harmonising marginal tax rates across different forms of income to reduce incentives for tax-motivated behaviour. This alignment could enhance fairness and efficiency, as individuals would have less incentive to reclassify income to benefit from lower rates.
- Abolishing Uplift at Death: Removing the provision that exempts unrealised gains at death could prevent lock-in effects and improve intergenerational equity. By ensuring that capital gains are taxed irrespective of when they are realised, the tax system could become more neutral and less distortive.
The potential increase in Capital Gains Tax presents a complex interplay between fiscal policy and investor behaviour. Through the lens of intertemporal choice theory, we observe that such a policy shift can lead to significant market adjustments, both immediate and long-term. While the government’s objectives to address fiscal deficits are clear, the economic consequences of heightened CGT rates necessitate careful consideration.
Balancing the need for revenue with the imperative to maintain a healthy investment environment is crucial. Policymakers must weigh the benefits of increased taxation against potential drawbacks, such as reduced market efficiency and inhibited economic growth. Comprehensive tax reform that addresses structural issues may offer a more effective solution than isolated rate increases.