A worrying tit-bit in the FT today. It seems that the Lib Dems would like to see capital gains tax (CGT) rise from its current levels of 28% to the same levels as income tax rates. That would mean higher earners (and lower earners making big capital gains) paying 40% or 45% on any gains made on assets. This might sound perfectly sensible in some ways. After all, the difference between the two rates at the moment creates a trying incentive for people to work to convert income into capital in order to cut their tax bills. But there's a big problem with it. Inflation.
Back in the 1990s, Gordon Brown cut capital gains tax from 40% to 18% and at the same time removed any kind of inflation indexing relief from the equation. There was very little fuss about this at the time for the simple reason that most people felt a low and simple rate was in itself a good thing and that short-term investors and traders would be big winners from the cut. However, CGT at 28% is already a different matter and CGT at 40% would be a very different matter.
I've written about this beforehereandhere,but think about it like this.Imagine that you buy some shares for £20,000. Over the next ten years, inflation averages 8% a year. The value of your shares also rises by 8% a year. After a decade, you can sell them for £43,200 - and £43,200 now has the same purchasing power as £20,000 in 2013. You sell. You get £43,200. In the old days, that would have meant no tax bill you have made no gains above inflation so there is nothing to tax. No more. Today, you would get a capital gains tax bill.
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You've made a capital gain of £23,200 for tax purposes on which you will pay 18% or 28% (mostly the latter, given the way the bands are calculated) over the annual allowance, currently £10,600. You made a good investment choice, but you have just lost purchasing power anyway. How much? In my last column on this, I assumed that the CGT allowance would rise at half the rate of inflation every year (it is likely to be even less). If that was the case, you would end up with £38,016 after tax. Because CGT is no longer indexed, you have paid tax on that inflation.
The point? Non-indexed capital gains tax effectively confiscates purchasing power from those selling assets. At 18% that was sort of almost OK. But at 40%? It's a very transparent attempt by the Lib Dems to sneak in the wealth tax they really want.
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