How capital gains tax encourages bad investment decisions

Last month, at the request of my wife, we went to see the Grumpy Old Women show at Oxford's New Theatre. I don't know whether she was trying to tell me something, but, fortunately, I am pretty thick skinned in such matters. Anyway, the theatre was packed to the rafters, almost exclusively of middle-aged women nudging each other with cries of 'Oh yes! My husband never cleans the bath either!' and then roaring with laughter.

As far as I am concerned a little moaning goes a long way and after almost two hours of listening to Jenny clair, Linda Robson and Dilly Keene sounding off about modern life I was getting pretty grumpy myself. All the same, judging by the obvious success of this show, its TV equivalent and programmes like Room 101, there is a good market for grumpiness. So here are a few contributions of my own:

BBC announcers who use the phrase 'strong language' when what they really mean is 'bad language'. Solicitors who always use the most expensive notepaper available, thus spending your money in an effort to impress you. Gratuitous use of digital technology what was wrong with those central heating controls that simply involved sticking pins around a dial? Any interview by John Humphreys. The last guy who shouts out 'Come on Tim' just as Henman is on the point of serving. And last but by no means least all successors to the slotted or crosshead screw, which either requires a tool that you don't have or in the case of a fiendish device called the security screw means that, screwed in, you will never be able to unscrew it for as long as you live.

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Shall I go on? Or is that enough? One thing I am not grumpy about is the state of the stock market. This has been a bit rocky over the last few weeks, but as I said last month this inevitably happens from time to time. The reasons are always different and are never well understood anyway. The market always fights its way higher given time, and confidence is already starting to build again.

Capital gains tax: why the rules encourage us all to be long-term investors

But I do have one seasonal moan. This is the time of year when I fill in my tax return and, boy, do I hate this! It is not just the incomprehensible tax rules or the time-consuming gathering of all the necessary information, although these are bad enough. What gets me is the absurdity that the capital gains tax rules are designed to encourage us all to be long-term investors.

This is achieved through 'Taper Relief', which means that for every year that you hold on to a share, your potential tax liability is reduced. Although the exact rules are different for AIM shares and for those quoted on the main market, the principle is the same. And it reveals a total misunderstanding of the stock market.

Let me explain...

The function of the stock market is to match the nation's savings with opportunities to finance business.

This is important for the economy, and it is especially important that our savings are used to support the very best investment opportunities. To make this happen we need two things. First of all we need as much information as possible so that, to use a bit of government-speak, we can make 'informed choices'.

Secondly, we should be encouraged to move swiftly out of bad investment propositions into ones that are more promising. Instead of which the CGT tax rules reward investors for doing nothing. The result is a great mass of passive shareholders who stick with faded heroes like Woolworths, partly to reduce a tax liability built up years ago, and partly in the misguided notion that their loyalty is doing a favour to the workings of the UK economy.

Capital gains tax: missing the point

In fact, what they are doing is prolonging the life of

a) businesses that should be allowed to fade away and b) management teams that could more usefully turn their talents elsewhere. Investment does no service if it is directed at bad businesses, or into businesses that are overvalued. You only have to think back to the dot-com boom to remind yourself of the dangers of directing capital at over-priced shares. Billions of pounds were lost once and for all.

The CGT rules miss the point that the stock market is a discounting mechanism. Share prices attempt to place a value today on the flow of profits and dividends in future years. Suppose you do your homework and pay £1 for a share that you judge to be undervalued. You think that the shares are worth £2, but you have no real idea when they might get there. In fact what happens is that other investors immediately spot the undervaluation, and drive the share price up to the £2 fair value. Then momentum investors jump aboard and, in their excitement, push the share price up to £3.

Having done the economy a service by directing your savings into an undervalued share, you can now do it a second favour by taking your cash out of one that has become overvalued. Instead of which the CGT rules discourage you from selling. They treat you like a punter who has had a lucky break, instead of someone who has researched the situation, weighed up the long-term attractions of an investment proposition, and come to a considered judgement of its value.

The essential fallacy is that taking a long-term view and holding shares for a long time are entirely different. You should be rewarded for the former, but not for the latter.

Tom Bulford for The Daily Reckoning. You can read more from Tom Bulford and many others at www.dailyreckoning.co.uk.

And if you'd like to learn more about penny share investing, read the report below...