A key problem for proponents of capital taxes over the years has been how to equitably deal with the ravages of inflation. Here, we’ll look at how the system has aimed to make things fairer for individuals. That’s not to say that I don’t care about companies, but companies (OK, strictly "businesses", but you know what I mean...) tend to have other reliefs available to them, such as rollover relief, that can mitigate capital gains. Individuals, who eventually need to monetise their gains, don’t.

What’s the big deal?

Firstly we need to explain a bit about how capital gains tax is calculated. Broadly speaking, you pay tax on any gains in value you make from buying an asset at once price and selling it at another price. Individuals are granted an annual exempt amount (2010/11 amount: £10,100), up to which amount capital gains are not taxable. Gains made above the annual exempt amount are taxable.

Inflation makes capital gains unfair by generating increases in value that are the result solely of the ravages of inflation, not a genuine gain. The problem is easy to demonstrate. Imagine you’re a person aged 20 with £10,000. You decide you want to squirrel this away for your retirement. You buy shares worth £10,000 with the money and the central bank manages to keep inflation constant at 2%. 50 years later you cash in your investment (imagine for the purposes of this exercise that the individual has already used up their annual exempt amount on other disposals). Good news – the shares have kept up with inflation and are now worth £26,916! Bad news – the government deems that this gain of £16,916 is taxable and sends you a tax bill of £6,766. Even worse news – the £20,149 you’ve got left is worth only 75% of your original money. You’ve lost 25% of your original investment just because the government taxed your inflationary gains. Seeing that inflation is a direct result of government policy, this is very unfair.

And, most criminal of all, the higher inflation is, the greater this iniquity becomes. At 5% inflation, you’ll lose nearly 40% of your original investment to tax just for standing still. You’ll even get taxed on investments that have lost money in real terms.

If you want to play with these numbers yourself, or you just want to check my workings, you can do so here.

OK, so what do we do about it?

Individuals were able, to a certain extent, to reduce their capital gains tax payable through the practice, known curiously as ‘bed and breakfasting’. This was where at the end of the tax year you sold shares to realise gains up to the annual exempt amount and then immediately bought them back in the new tax year so as to increase their base cost for capital gains purposes. In part this may have helped to reduce the impact of inflation in CGT. However, HMRC doesn’t much like bed and breakfasting and has introduced a slew of anti-avoidance legislation to stomp on it.

However, governments aren’t entirely cruel. They have in the past tried two basic approaches to solving the problem of inflation.

The first is indexation. Indexation uplifts the base cost of an asset for inflation, ensuring that the resulting gain is measured on an inflated basis. To take the first example above, it would replace the original base cost of £10,000 with its inflated cost of £26,916, meaning that there would be no capital gain to tax.

Of course things are never quite this simple. The indexation regime was brought in as a result of the high inflation 1970s and 1980s. So you only got indexation for inflationary gains made since 6 April 1985. On top of this, the whole system was rebased in 1988 to ensure that gains made before 1982 were no longer liable to capital gains taxation at all.

The whole indexation regime was ditched, thuggishly, by Gordon Brown in his 1998 Budget. Gordon Brown introduced the second method of addressing the problem of inflation: taper relief. Instead of rigging the base cost of an asset, it taxes gains made over a long period at a lower rate than gains made over a short period. In a low inflation environment, this approximates broadly to the same thing. Taper relief applied at a confusing variety of rates, but ranged from 5% for non-business assets held for three years to 75% for business assets held for at least two years.

Under the indexation regime, all resulting gains were taxed at the individual’s marginal rate. So there was limited scope for avoidance by converting income to capital. Conversely, the taper relief generated massive opportunities for avoidance, because a fairly short wait could convert income, taxed at 40%, into capital, taxed at perhaps as little as 10% (calculated as higher rate tax at 40% with 75% taper relief). Of particular public concern was the use of taper relief by private equity firms, who structured their transactions to ensure that their profits were all in the form of capital gains. As they pertained to business assets and were held for two years or more, these gains were taxed at 10%.

So in 2008, Gordon Brown rejigged everything again. Taper relief was abolished and all capital gains were to be taxed at a flat rate of 18%. This was good news for speculators, who saw their short term gains taxed at 18% instead of 40%. And it was bad news for private equity bosses, who saw their tax increasing by 80% (from 10% to 18%). It was also very bad news for entrepreneurs, who previously had been able to shelter some of their gains behind indexation and taper relief. To help them, the government introduced an entrepreneurs’ relief that provides a lifetime allowance of £1 million in respect of gains made on the disposal of a business. Within the allowance, gains are taxable at the ‘old’ rate of 10% instead of 18%. (Although as Mark Lee points out here, it's more technically correct to say that a fractional multiplier of 5/9 is applied to the gain itself to give a reduced gain which is then taxed at 18%).

Why is this a problem again?

The issue of capital gains is again a major problem because of Coalition plans to once again increase the rate of capital gains tax. They may even increase it back up to the marginal rate. This shouldn’t trouble entrepreneurs too much, as they will still be able to enjoy their entrepreneurs’ lifetime limit. But it’s bad for a lot of other people who might not welcome seeing their capital assets taxed at a high rate, just because of inflation.

There’s really no way out, other than one of the two solutions outlined above. If government doesn’t want a protest from rich pensioners, it will necessarily have to introduce either indexation or taper relief. Of the two, indexation is probably fairer. But it leads to a lot of complexity in calculating the tax due. So my money’s on taper relief being rediscovered.

Further information

The information in this post was informed by a fabulous tax textbook, Taxation: Policy and Practice (2009/10 - 16^th edition) by Andy Lymer and Lynne Oats. It's a mine of information on how tax is calculated in practice, without ever getting too technical.

And I am heartily, truly sorry about the tapir pun. Although, I'm still laughing like a drain about it.

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Filed under: Current issues, Taxation with tags andy lymer, capital gains tax, entrepreneurs' relief, gordon brown, hmrc, indexation, inflation, lynne oats, rollover relief, taper relief