On October 30, Rachel Reeves will present the first Labour budget in almost fifteen years. Looking back over a decade and a half of economic stagnation, she says that her priority is growth.
Growth is clearly a good thing. Despite the protestations of a few, it is hard to argue that we should not want to be able to produce more from less. It would allow us to maintain our standard of living while reducing our use of the planet’s resources. It is clearly possible, since many of the countries we once considered our peers have continued to grow in a way that we haven’t managed since the global financial crisis of 2008, and increasing growth has the benefit of easing the trade-offs the Chancellor faces, by bringing in more tax revenue without raising taxes.
But getting growth requires more than just wanting it. Countless academic papers and thinktank reports have been written on the topic of why growth has been so slow in recent years, and clearly there is no silver bullet. Some of the prime candidates holding back growth include stuttering public services, including record NHS waiting lists, low private sector investment, and a tax system that continues to encourage poor decision making.
The good news for the Chancellor is that there is scope to tackle these challenges together. Take capital gains tax (CGT). This is the sixth largest tax in the UK in terms of the revenue raised for central government, and gains have more than tripled in the last decade. It taxes increases in the value of an asset: the difference between the sale (or disposal) price and the original (base) cost.
The current design of CGT encourages some people to work in unproductive ways, discourages many profitable investments, and raises less money than it could. A sensible reform could simultaneously solve each of these problems.
Currently CGT rates on most gains are taxed at 20 per cent, though the majority of these would be taxed at 45 per cent if they were treated like earnings, as well as having national insurance contributions on top. This means that excellent employees leave their jobs to become mediocre managers of their own business, a business they never intend to grow beyond themselves. Even though total profit is lower, the tax differential means they take home more. It is also part of the reason why the UK, alongside many fantastic small businesses, has a long tail of low growth, low productivity companies. Equalising CGT and income tax rates would remove this incentive to focus on tax, rather than what is actually most productive, when deciding how to work.
CGT in its current form also doesn’t account for the cost of financing real investments, effectively taxing the cost of borrowing. When interest rates rise, this makes it increasingly expensive to fund a business. A straightforward solution would be to provide an investment allowance, providing an additional relief for capital put at risk, and increasing with interest rates. This directly supports private sector investment. For capital intensive businesses, it can more than offset the effects of a higher rate, so that less tax is paid in total.
A further discouragement to investment comes from taxation at death. Or rather, non-taxation. CGT applies when assets are sold, or otherwise passed on. However, assets which are held until death have all the capital gains that have been built up completely wiped out, with no tax due. Alongside business relief, companies of any size can be passed on free of tax. An aging founder who would like to sell on a productive business to someone who will continue to manage it well therefore has strong incentives to hold on to it, even at a cost to the total value of the business. They should also hold off on making new investments, because the credit for these will also be lost. If instead the recipient(s) of the business also inherited the base cost, there would be no disincentive to invest. Tax would be paid on the full gain, whenever the recipient ultimately decides to sell, as it would if the original owner sold before death.
Equalising income tax and CGT, adding an investment allowance, and removing the uplift at death could have positive direct effects on growth. This package of reforms would also raise revenue, which can then be spent on additional growth-enhancing investment policies. While no single reform will solve the UK’s growth problems, a benefit of our dysfunctional tax system is that sensible reform can be pro-growth in multiple ways.
Find out more about the Centre for the Analysis of Taxation (CenTax) at www.centax.org.uk
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