Budget compromise on CGT
The Chancellor has tried to square the circle between a political concept of equity, that does not differentiate between the earnings from labour and those from capital, and the underlying economic reality, where incentives to each are fundamentally different. This is not a winning – or winnable – compromise.
The CGT rate increases to 28% from midnight tonight for investors with chargeable gains that, added to income, would take them into the higher rate band. Otherwise the rate remains at 18%. The Chancellor has set this rate in preference to a higher rate combined with relief for inflation or holding period, for simplicity’s sake.
Advisers and discretionary managers will not welcome the return to the old regime whereby the effective rate of tax on a realised gain is dependent on the investor’s income. For high earners this is not an issue but in some cases the effective rate will not be known at the point that realising a gain is being considered. Gains added to income may straddle the higher-rate threshold and be partly charged at 18% and partly at 28%.
Wealthier investors will probably greet 28% as a lot better than they feared and the impact on forward-looking risk premiums that I discussed in my posts before the Budget is much less serious. But the fact remains that this is an effective rate of tax higher than most investors with control over the timing of their realisations have paid in the past, when indexation and taper relief were available.
As a tax incurred at the point at which capital absolutely has to be converted to consumption, and cannot be further deferred, 28% without inflation relief is a high rate, considering the real returns at which private capital has accumulated over many years. But this stock of latent gains is essentially a captive that the Government can pluck at will. If it can be deferred all the way to death, it will pluck it then, as part of the IHT bill. It is between these extreme cases that CGT is a discretionary tax.
The 18% rate was set at a level that did not significantly defer discretionary realisations but 28% will (and indeed should) cause deferral. The Chancellor suggested that Treasury advice was that setting the rate higher than 28% would reduce revenues. We believe the same will hold for the increase from 18% to 28% and that the additional projected revenues of £700-800m pa are heavily dependent on plucking the captive stock.
Deferring realisations is not cost free. It usually conceals a great deal of inefficiencies in capital management, such as inappropriate risk levels and risk concentrations. Not being able to rebalance portfolios, changing strategic asset allocations, is likely over time to reduce returns, even if not by as much as if paying CGT. On the other hand, slowing down the turnover of individual holdings caused only by active managers’ selection preferences is likely to help returns.
The industry will not want its portfolio activity hampered by externalities like CGT and we should expect more use of unitised investments, including unitising discretionary management portfolios, and a revival in the sales of investment bonds, even though the taxation of the ultimate gains is now broadly equal to deferred gains in an unwrapped unitised product. The problem with bond sales has always been that the profitability of the product made it very tempting to tell half truths about the tax position.
Amongst the captive victims of higher CGT rates are investors who chose lumpy holdings like property that cannot be disposed off gradually using annual allowances. This might be a welcome tilt away from the popular bias favouring bricks and mortar over financial assets. This is also, incidentally, the fastest growing area of tax collection from investigations, as HMRC trawl through Land Registry data.
The Chancellor referred in his speech to a loss of revenue from people converting income into gains of £1b pa. I would like to know where this comes from. One large hole in the CGT net, the treatment of carried interest in private equity, remains in spite of the fact it was the source of the canard about ‘paying more tax than a cleaner’ that George Osborne could not resist bringing into his speech to support the Budget’s ‘progressive’ credentials.
The lifetime ‘entrepreneurs’ relief’ goes up from £2m to £5m. Considering entrepeneurial wealth creation is probaly less affected by tax rates on expected gains than portfolio investments, but much more sensitive to risk sharing or subsidy in the event of losses, this is a curious incentive to pick out for special treatment.