Why are capital gains taxed at less than half the main rate of income tax?

In an unexpected move, the Chancellor 'simplified' the capital gains tax regime with effect from 6 April 2008. When the announcement was made in his 2007 Pre-Budget Report everyone seemed to focus on the effective increase from 10% to 18% on business assets. But that was never the main story.

No one seems to have explained the related policy reason for reducing the rate of capital gains tax (CGT) on short-term speculative gains from 40% down to 18%.

Little media attention appears to have been focused on this change presumably because no one wants to be seen to look a gift horse in the mouth. But I don't understand the logic for the change given that the income that we work for can quickly become subject to 40% income tax. This is more than double the 18% rate of CGT that you pay for making short-term speculative investments on shares, property or other assets. This seems to be rewarding the risk takers who do not work to earn their gains.

Before the change short-term capital gains were taxed at the same rate as income (40%). Only business assets held for more than two years qualified for the taper relief that resulted in an effective rate of only 10%. Prior to 5 April 1999 all capital gains were treated as the top slice of income and taxed at the appropriate income tax rate - typically 40%.

In 1998 Gordon Brown reduced the tax payable on investments held for at least ten years. This was "to encourage longer term investment". Then in 1999 he reduced the holding period down to five years:

"the Budget will make a more radical reform to promote not just hi-tech investment, but long term investment across the economy in Britain.

I will say to Britain's prospective and actual investors and entrepreneurs: invest for three years and the capital gains tax rate will not be 40 per cent but 22 per cent.

Invest for five years and the tax rate will not be 40 per cent, or 22 per cent - it will be 10 per cent"

In my view Lord Forsyth correctly predicted (22 Apr 2008 : Column 1461) the inevitable consequence of now halving the rate of CGT on short-term gains. With the standard rate of CGT at only 18% there is an enormous incentive for high earners to seek to find ways to recategorise their income as capital. Doing that means paying tax at less than half the 40% higher rate that applies to most income. HMRC were well aware of this and published a list of FAQs including one on this issue, where the answer said:

"There are already a number of tax rules to counter schemes to convert income into capital gains. However, the Chancellor has asked officials to continue to monitor the CGT rules and reliefs to ensure they cannot be abused by those who wish to pay less than their fair share of tax."

I would expect more changes in the forthcoming Budget but even more in the future once tax returns have been filed for the 2008/09 tax year.

The only response I have seen so far to the question as to 'why make this change?' is the, frankly insulting and disingenuous, suggestion that it was done in response to requests to simplify the tax system. The fact is that no one was seeking this change or anything like it. And it doesn't make fiscal sense.

Still, accountants and tax advisers like it as it provides tax planning opportunities!

I'll be returning to this subject in a future post on this blog. In the meantime do share your views as comments below please.