A simple tweak for a better tax system

One thing we all agree on is that our tax system is too complicated and provides too many perverse incentives.

We like the idea of a flat tax, and have written about it many times here. However, the odds of the coalition suddenly announcing either that or our other favourite – a location tax – are not particularly good.

That means that we need to think less about how the system can be radically changed, and more about how it can be tweaked. A good idea arrives from a reader (John Reeve) in response to my blog of a few weeks ago on how a mix of lower taxes and better enforcement might work.

The tweak? A cut in the top rate of income tax to 35% and a rise in the rate of capital gains tax to 35%. That hints at the flat tax we all rather fancy, and in the process abolishes the “primary taxation distinction between capital and income, the source of huge complexity and massive tax planning endeavours.”

But there’s more to it. Reeves suggests that there are then two lower bands for capital gains tax. If an asset is held for two years, the rate falls to 28%; if it is held for five or more years it falls to 20%. This would mean that all assets bought and sold with the short term in mind would effectively be reclassified as providing not capital gains, but trading income, and hence taxed identically to other income while those held for the long term would be considered – as now – as provided capital gains (or losses).

All this, says Reeves, would provide the incentive to generate the income that is the foundation of our economy, but also create an incentive to hold investment assets for the long term, with all the “ancillary benefits” that brings: “more stable wealth creation and greater attention to ownership and governance issues” being the key ones.

You can argue with the rates here;  I think that 20% is still too high (there is evidence here that a high rate of CGT lowers revenues) and I am certain that capital gains taxes should always come with inflation compensation built in (otherwise they are not taxes on gains, but taxes on wealth).

But if we want to encourage people to hold their assets for the long rather than the short term, and – in the equity markets in particular – to engage with the managers of those assets, this wouldn’t be a bad way to start.