CGT at 40% without reliefs?
My post anticipating the CGT changes in the Budget estimated the different chances of an increase in the rate to about 40% being accompanied by one or other approach to either taper relief or indexation of costs for general inflation. It has been suggested I was too generous in giving virtually no weight to the possibility the Coalition Government would raise the rate with no reliefs for either length of holding period or inflation. I did not think they could be that stupid but the Tory right obviously fears they might be and CGT has prompted the first stirrings of revolt. In this further post I show why a 40% effective rate of CGT makes much risk taking look irrational before the event and is therefore either unlikely or deserving of revolt.
People’s employment income is not generally sensitive to tax rates. High tax rates may, at the margin, act as a disincentive to work but when bills have to be paid we don’t have an opt out. When capital is employed, things are very different. We don’t have to make it work hard or expose it to risks and will only opt in to risk-taking activity if the return probabilities appear to make it worthwhile. The relevant returns are after all taxes. Theoretically this justifies a different tax regime for employment earnings and savings income. But in practice not keeping the income tax rates similar leaves too much scope for arbitrage by altering the source from, say, salary to dividend. This means the capital element of investment growth is the only candidate for different treatment.
If capital gains are taxed at the same rate as income, with no relief for holding period or general inflation, we can compare the after-tax returns on risky ventures with a risk-free rate of return to see what impact it might have on people’s choices about risk taking.
The historical real rate of return, from both income and capital, earned by equity investments in the UK and other markets, before charges, is about 6% pa with deviations, even over long periods, of about half or twice this. At zero inflation, this is also the nominal return. The typical expenses of managed exposures to risky investments are about 1.5% pa so this brings the ‘captured’ growth to about 4.5% pa. At an equalised 40% tax rate on both income and gains, a realistic ‘pocketed’ return expectation for long holding periods is therefore 60% of this, or 2.7%.
If you had no particular view about the future, this historical rate would also be a reasonable estimate of the mean future rate, with a 50% chance of being exceeded. However, actual estimates will reflect investors’ beliefs about whether the past is representative. Survey evidence suggests (rightly or wrongly) the coming decade is expected to provide lower returns than historically. If the expected real gross return is 4%, instead of 6%, the pocketed return drops to 1.5% pa.
The alternative to risk taking is to hold some ‘safe harbour’ asset. In any formal investment decision process where capital only ventures out of safe harbour because it is attracted by the range of possible returns from risky assets, a doubling of the tax wedge on gains means either some taxable risk assets are pulled back to safe harbour or the owner decides to increase their risk tolerance. There is always some level of indifference for any individual investor between accepting the certain return and gambling on the likely range of uncertain risky returns. That is what defines risk tolerance.
If investors’ viewed cash as the natural safe harbour asset, this is only safe in money terms and leaves them exposed, over long periods, to inflation. Not having a particular view about the future, a reasonable estimate of their real, after-inflation, cash return would be in line with historical averages which would be about 1%. This implies at zero inflation a mean risk premium after tax and charges of just 0.5% and a very substantial risk of falling short of the cash return.
In practice, investors increasingly do not view cash as their safe harbour, for the same reason that they view equities and property as at one and the same time risky investments, offering a risk premium for business and economic uncertainty, and inflation hedges, offering over long periods compensation for general inflation. The only asset safe in both nominal and real terms is an index linked gilt as it allows certainty in planning purchasing-power outcomes. The current level of index linked gilt yield, which is a real yield after inflation, is also about 1%. The true expected ‘pocketed’ risk premium for bearing both business and inflation risks in equities is therefore also about 0.5%.
The effect of a doubling of the tax wedge on expected risk premiums is sensitive to the actual level of inflation when there is no or incomplete indexation.
At 5% inflation, the 1.5% expected net return on risky assets becomes 7.5% gross and 4.5% net. Holding an index linked gilt, the nominal after-tax yield would be 5.4% because most of the return is in the form of CGT-free uplift to the redemption proceeds. With most of the possible return distribution below the risk free rate, very few personal levels of risk tolerance would justify moving out of safe harbour.
Even if we were more optimistic about the growth compared with historical rates, a 50% chance of achieving at least 6% translates into 5.7% net of tax with inflation at 5%, only fractionally above the 5.4% after tax ‘nominal’ return on index linked gilts. Still in safe harbour.
I do not think using equity return examples alters the position greatly where rented property would be the risky opportunity. The income element of total return is typically thought to be greater for property because net yields after expenses are higher than for most equity markets (although this is not necessarily the case in fact if the investor suffers periods without tenants). This ignores the reinvestment required to maintain a property at the ‘current market rent’. If this is built into expectations, the impact of a higher CGT rate should be broadly the same as in public equity markets.
My examples use current yields for risk free asets. The incentive for leaving safe harbour are in fact constantly changing, not least as a response to the yields themselves, in a feedback loop. In the current situation, marked by heavy deficit financing by governments, debt is likely to be quite expensive in both nominal and real terms. With borrowing rates artificially suppressed in countries adopting quantitative easing, this is not necessarily evident yet in debt markets and therefore in risk free yields. Competition for risk taking is likely to get tougher, not easier.
One solution to an increase in taxes and a reduction in after-tax risk premiums is that equity and property prices fall untill they are again competitive. Since this is not obviously a good solution for the economy generally or tax revenues in particular, it contributed to my belief that increasing the rate of CGT without reliefs was a rank outsider in my possible scenarios.
This explanation deliberately gives no credence to alternative theoretical possibilities, which are that the geared impact of the increase in unrelieved CGT on risk premiums is conveniently offset by an increase in the average taxable investor’s risk tolerance, or that their withdrawal from risk taking is conveniently substituted by ‘gross’ investors, such as pension funds.
You might think, reading this, that individual investors do not in real life gather and process information in this ordered, rational way. Of course this is true, and ever was. But the implication of the historical evidence of time-varying absolute and relative returns is that these returns are in fact constrined by collective, crowd behaviour in a way consistent with rational risk and return trade offs. The numbers are not just random and they matter.
They matter not least to politicians. It worries me that anyone thinks political leaders might be ignorant or casual about such fundamental assumptions about economic decision making. That it has brought people like John Redwood, a former Treasury minister, into open revolt is therefore a useful warning to a Coalition Cabinet that gives some appearance of treating important tax policies like bargaining chips. Like me, the media have also not really taken the risk of this worst-case scenario seriously enough to date. Let us all up the ante.