There has been some discussion on Twitter and some mention in comments on this blog on the subject of indexation relief for capital gains tax purposes. The suggestion has been made that I should include the reintroduction of this relief in my proposed reforms.
I completely disagree. Let me explain the practicalities first and then offer some theory.
Indexation relief supposedly allows for the impact of inflation on capital gains. So, instead of a capital gain being computed by deducting the cost of the asset sold from the proceeds of sale, it is computed by deducting that cost as inflated by an index such as the consumer prices index for the period during which it was owned, with this inflated sum then being deducted from sales proceeds.
For example, if an asset was acquired for £1 million and sold for £1.5 million with the relevant price index increasing by 20 per cent during the period of ownership, the unadjusted gain would be £500,000 (£1.5 million, less £1 million) but the inflation-adjusted, or indexed, gain would be £300,000 (££1.5 million less £1 million and less £1 million multiplied by 20% indexation relief, or £200,000).
I suggest that there is no logic to this in a tax system where horizontal tax equity is sought and the only relevant capital maintenance concept is financial. Indexation was simply a ruse to maintain capital and the advantages of wealth by way of undertaxing it, in my opinion.
The theory of this is explained in the following note that was included in the note already published on the methodology of The Taxing Wealth Report 2024.
The principle of horizontal tax equity requires that all increases in the financial well-being accruing to people in equivalent circumstances within a population be taxed in equal amount whatever the origin of that increase in financial well-being might be.
To put this in context, it should not matter whether this increase in financial well-being arises from employment, self-employment, a rent, a return on savings in whatever form paid, a capital gain or, maybe, a gift. Each of these activities increases the financial well-being of the recipient and in that case if a tax system is to be equitable there should be no discrimination in the amount of tax paid by persons in equivalent circumstances if they are to enjoy an increase in their financial well-being for any of these reasons.
Importantly, horizontal tax equity applies to all sources of increase in a person's financial well-being, and not just to their income. In other words, it is indifferent to whether that increase in financial well-being arises as a consequence of income earned (whatever its source) or increases in wealth (again, irrespective of the origin of that increase) or gifts.
This logic is based upon standard microeconomic theory. Based upon that theory, which in this case appears to accord closely to observed reality, there is no reason to think that a person should, or does, value their increase in financial well-being differently as a consequence of it source. What matters to them is the fact that their well-being has been enhanced. As a consequence, tax differentials that discriminate between the origins of increase in financial well-being are contrary to the principles of horizontal tax equity.
This concept of indifference as to source is also implicit in modern accounting theory and in the accounting standards used to record the income of companies both in the UK and internationally. The primary method of computing the income of any entity using these standards is to compare the net worth of a company at the end of a period (£A) with the net worth of that same company at the beginning of the period (£B) having allowed for sums withdrawn from the entity during the period by its owners, whether by way of dividend, share buyback or other means (£C), and the issue of new shares or other equity (£D).
In other words, profit or income (£Y) is calculated as:
£Y = £A - £B + £C - £D
This may come as a surprise to those who presume that the income of an entity during a period is the figure included as net profit after tax in the profit and loss account or income statement of the entity in question (£E). This is not the case. The movement in the value of the balance sheet at the end of a period (£A) is, instead, reconciled with the value at the beginning of the period (£B) by publication of three separate statements:
- The income statement (or profit and loss account, as some might know it), which estimates the net sum earned from trading, having allowed for tax during the course of the period (£E).
- The statement of comprehensive income for the period, which recognises the change in the market value of the assets and liabilities of the enterprise during the course of the period when stated at fair market value at both the opening and closing dates, some of which movements may be taxable. (£F)
- A statement of the change in equity arising during the course of the year, which explains the sums withdrawn from the entity during the period by its owners, whether by way of dividend, share buyback or other means (£C), and the issue of new shares or other equity (£D).
As a result, and given that the changes in equity have already been included in the calculation noted above, earnings (£Y) can also be stated as:
£Y = £E + £F
To translate this to the context of this note, the earnings a person has during a period broadly equate to the earnings a trading entity records in its income statement (£E). It is this figure that most think represents their total income in the year. This idea is also implicit in most tax systems, largely because almost all of our taxes were created before modern theories of income and accounting were created.
This idea of income is, however, wrong. Within the context of taxation, the only relevant criteria of capital that can be used for measurement purposes is a financial one since tax can only be paid using money and can only be charged on tax bases that can be measured in monetary terms. In that case, a person's total income in a period must be their increase in net worth having allowed for what they have consumed and should therefore also include the change in the fair value of the assets that they own and sums that they owe during the course of period, as is reflected in modern accounting (£F). In that case, horizontal tax equity needs to be based upon this concept.
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Anybody opposed to indexation relief should also have principal private residence relief in their sights as the most egregious example of income that isn’t taxed.
Where does the gain on sale of a private property come from? Most of the time it will just represent inflation in property prices, but it isn’t taxed at all, even when the gain exceeds property price inflation.
At the very least it should be replaced by some sort of roll over relief so there is at least the pretence that all those gains will be taxed eventually.
The only people likely to pay capital gains tax if rollover relief was available would be people downsizing, gifting their property to a relation, or selling up prior to leaving the country.
I have go principle private residence releif in my sight….next week probably. The draft is done….
I’ve read that last para twice and it only make sense if unrealised capital gains are taxed, and unrealised losses are deductible.
Have I understood that right?
Since when were they capital gains?
If there’s no allowance for losses, that means a portfolio of shares could drop in overall value but would still generate a tax charge, because only the shares that had risen in price would be considered. How is that taxing a person’s capital gains? Or indeed fair? Surely the concept of fair taxation would be to see a person’s wealth in the overall net gain or loss, not just looking at gains only?
Why would there be no allowance for losses?
There are now in capital gains tax. Have I suggested changing that?
So in any given year its the net position of all assets that counts then? House value goes up, share portfolio goes down by same amount, no tax charge? And would net asset value losses incurred in one tax year be able to be offset against gains in another?
How exactly are all these valuations going to be achieved? There’s an awful lot of property in the UK(and indeed non publicly traded shares), and everything would all have to be valued every year in order for gains to be taxed. And all valued at the same time as well. It would require an army of valuers working around the clock. Would the cost of the valuation be offsettable against any gains in asset value?
I am not proposing a wealth tax.
No, but you are proposing that unrealised gains in asset values be taxed. So surely every asset will have to be valued every year to see if its value has gone up or down? The value of publicly quoted shares is easy to value, there are daily prices. But things like houses, commercial property, unlisted shares and unincorporated businesses all have subjective value, and would all need to be valued every year to see if their capital value had altered, wouldn’t they?
And you didn’t answer my questions – would capital losses in one tax year be allowable to be offset against gains in a subsequent one?
I am not proposing unrealised gains be taxed
I have said no such thing
Any more than I have said nothing about chnaging loss rules
Why are you making stuff up?
I’m following all these points on equity in taxation, both horizontal and vertical, and so far have totally agreed they seem just. I’ve stumbled this morning on the following “the change in the fair value of the assets that they own and sums that they owe during the course of period, as is reflected in modern accounting (£F). ” How does this differ from the information needed for a wealth tax, which I agree with you would involve far too much admin and legal hindrance?
It by and large does not – but this provision only applies to the largest companies in reality and so the data set would be small and nothing to do with people.
As I was hinting in a comment yesterday evening ( https://www.taxresearch.org.uk/Blog/2023/09/11/aligning-capital-gains-tax-and-income-tax-rates-might-raise-more-than-12-billion-in-tax-a-year/#comment-941502 ), there is no real economic difference between investment income and capital gains.
Horizontal tax equity must imply, therefore, that the same tax rates should apply to both investment income and capital gains, and that indexation relief should either be allowed to be set against either investment income or capital gains, or not available at all. Proposing that it should be re-introduced for capital gains, but not for investment income, is asking for less horizontal tax equity.
Alternatively, proposing that indexation relief should be allowed against either gains or investment income is novel – it’s never been allowed against investment income before – so one issue with that is whether it’s a practical immediate proposal. No indexation relief is what we already have, so it’s very practical!
The other form of horizontal equity to consider is between investment income and gains on the one hand, and earned income on the other. This is where the broader background of a large increase in wealth, taxed much more lightly than income, is relevant. Is taxing a gain/income which is “just keeping up with inflation” really a tax on wealth? In a sense, perhaps it is. But if wealth taxes are not wrong in principle, just difficult to do in practice, what’s wrong with that?
It was a good comment on your part – and neatly accurate as well as precisely targeted
Thanks for uploading this article! You really put your point across well on why you disagree with the premise of this article.
In your proposal, will you still be able reduce tax by pretending your wife works in your business and paying her via dividends?
How will increases in the value of pension schemes be taxed?
See tomorrow morning’s recommendation
I am nnot taxing wealth as such, and so your second point is not relevant
I am proposing less tax releif on contributions instead
Makes sense.
Putting my bond trader hat on I wonder where gilts fit in. At present they are capital gains tax free (assuming they weren’t issued at deep discounts).
I am uncertain if this applies to index linked gilts but if it does (and I think it does) then they are substantially tax advantaged over conventional gilts.
It is a bit niche for your report but might merit a footnote.
It might – it was not on my list and it may be now.
HMRC provides no estimate of the cost of the relief.
For conventional gilts, and also for qualifying corporate bonds, the theory might be that there is no need to tax any gains, because the issue and redemption prices are very nearly the same, so any gain for one holder is roughly balanced out by a loss for another holder. The flaw in this theory is that the gains may more often be made by taxpayers, and the losses by tax-exempt holders (e.g. pension funds). E.g. some taxpayers are currently buying very short-term gilts which are trading at less than face value (due to the BoE’s interest rate rises), which will give them a predictable tax-exempt gain if held to maturity.
Index-lined gilts do have the additional issue that gains due to indexation are also tax-exempt. Though this will be partly counteracted by some index-lined gilts having been issued at very large premiums to their face value. (I think this has been done because real yields on IL gilts have been significantly negative, and presumably nobody has worked out how an IL gilt with a negative coupon would work.)
Thanks
I agree with the principle of aligning capital gains tax and income tax rates. However, I’m struggling to understand the logic of your argument against indexation relief. It makes sense for gains made over a shorter period, certainly for those under a year or less. But for gains made over a longer period, the longer the more problematic, it does not make sense to me.
You seem motivated by the principle of horizontal tax equity yet define this by reference to increases in financial well-being. If someone holds an asset for many years and on disposal has made a nominal gain but a real-terms loss, in what sense has their financial well-being increased? You have failed to explain this. It appears that you are begging the question or have exhibited the money illusion.
Your explanation is by reference to accounting standards of companies. It is revealing that in that explanation you mainly refer to “the period” but in a couple of places you slip up and refer to “the year”. For of course company accounts are prepared on an annual basis. If you re-worked the argument with say a ten year period is it convincing?
I submit that without indexation relief for assets held longer than a certain period (say two years – but to be decided) and in the absence of any alternative adjustment such as a rate of return allowance, then what you are proposing is a tax on inflation. It would be less disingenuous if you admitted that what you’re actually doing here is taxing the underlying capital wealth.
It would be preferable if you could make the case for this rather than denying that that is the effect of your proposal. Any explanation needs to explain why taxing wealth directly is fair when it only applies to wealth from disposed assets rather than to all wealth.
Furthermore the absence of indexation relief encourages short-term capital gains by penalising long-term capital gains. Is this socially useful? Where is the horizontal tax equity between high-frequency trading and investing in the shares of a socially useful business to support its organic growth over a multi-year period?
“If someone holds an asset for many years and on disposal has made a nominal gain but a real-terms loss, in what sense has their financial well-being increased?”
They have more cash now. And that is the yardstick we use for taxation, and rightly so since tax exists to cancel money creation. So your comment makes no sense.
And nor does you claim that I am taxing the underlying welath make sense – I am taxing gains on it, neasaured financially. What measure are you proposing?
If it is a capacity mneasure then would you agree that those charged to inmcome tax must get relief for the cost of childcare, travelling to work, student loans and much else? After all, they create capcity to work and are not subject to releif. Why should cgt have what income tax does not?
Nor does your demand for indexation make sense. What index? And most especially, why a consumer price index as that is irrelevant to asset prices?
You have to be a mlot more coherent than this to make sense – because right now you have not made a case for anything, except the retention of the bias to wealth in our tax system. Why do you want that?
I agree Richard. To Michael I would say your analysis makes sense except the holder of the asset has had the benefit of not paying tax on the appreciation for years and years. The income has been sheltered and the untaxed money continues to grow. It is also taxed at a preferential capital gains rate. Finally, often the asset is land which in many countries is taxed as capital though humans did not produce it. It was a gift of nature as per Joseph Stiglitz . https://www.youtube.com/watch?v=2NsTeeb-87w&t=465s
Richard has already pointed out some key flaws in Michael’s latest defence of indexation.
I’d like to add a rebuttal to the specific claim that the absence of indexation favours short-term gains at the expense of long-term gains. This is simply arithmetically wrong. Long-term gains are still treated more favourably, because they are compounded over multiple years before they are taxed.
E.g. suppose pre-tax return is 5% per year, and the tax rate is 40%.
With gains realized annually (or equivalently, with annual income of 5% instead of gains), the net annual return is 3%. After 10 years, that compounds to 34.4% total net gain.
With an asset held for 10 years, 5% annual gain compounds to 62.9% total pre-tax gain, which is 37.7% net of 40% tax.
Also, while I agree that it would be nice to encourage socially useful investment instead of the useless (or even destructive) forms investment often takes, favouring long-term gains is not an effective way to do this. E.g. you can get long-term gains by making secondary purchases of shares already listed on stock exchanges, and then holding them for a long time; but this not a useful activity – it is unrelated to real investment (in the economist’s sense of the term).
Superb analysis. Reminds me of some Henry George lectures.