Capital Gains Need Not Be So Taxing

How should capital gains be taxed? Some gains are essentially indistinguishable from income – the predictable rise to maturity of a bond issued at a deep discount – but other types of gain are altogether different in character. Suppose the price of wheat rises because of a crop failure on the other side of the world. It would be unreasonable to add the increase in the value of a farmer’s property to the cash he earns from selling his products. To do so would be to tax him both on the receipt and on the expectation of it.

It might seem that carefully crafted legislation would distinguish one kind of gain from another. Attempts are made to do this, as in some regimes for taxing deep discount bonds. But the task is just too hard. Changes in capital values mostly result from changes in expectations, and expectations are not things that tax inspectors can measure. There is another practical problem: it is often impossible, and inequitable, to collect tax on a capital gain if the gain has not been realised.

Any attempt to legislate complex distinctions inevitably has unintended consequences. The results frequently benefit people whom the framers never had in mind. Britain’s attempt to make concessions for business assets had the preposterous consequence of giving favourable treatment to “carried interest” – the bonuses of employees of private equity houses.

So the usual compromise is to tax all capital gains, but to tax them more lightly than income. It is not a happy compromise, like imposing a short sentence because you cannot tell whether the defendant is guilty. The fudge works better when income tax rates are low. When rates are higher, problems multiply, especially since the distinction between income and capital gain is not fixed by nature but susceptible to manipulation by taxpayers.

Are recipients of capital gains more deserving than recipients of income? They are certainly, on average, richer: most capital gains accrue to people who already have some capital. But here too, the answer is that some beneficiaries of capital gains are deserving and others are not. Most of us wish the people who build up successful businesses well, and hope there will be more of them. But day traders and people who invest their inheritance in gold bullion also hope to be recipients of capital gains, and it seems wrong to tax them more lightly than those who work all day for the same money.

People who might be liable to capital gains tax are probably more mobile than people who make their living in other ways. But we should be careful of this argument. The purchase of lavish central London properties with money stolen from impoverished Russians does Britain little credit, and the same is true of the tax concessions that attract the oligarchs. It is also shaming when hedge fund managers pay a lower rate of tax than the people who clean their offices.

If the cost of putting these things right is that the rest of us have to pay a little more – and I am not sure there is such a cost – then I for one am willing to contribute my share. Our society depends on the willingness of ordinary people to pay considerable amounts of tax with a fair degree of honesty and only modest levels of complaint. We jeopardise that fragile construction, rare in time and place, at our peril. The taxation of capital gains sustains the revenue, and equity, of the income tax.

There is no simple answer to the question: “How should capital gains be taxed?” So there are as many different regimes as there are national tax systems and they are often, as in Britain, in a state of seemingly endless flux. The people who express strong views are usually self-interested individuals who have not thought about the question for very long. The issue is quite properly a subject for political compromise.

But the most objective test of how much capital receipts enhance taxable capacity is to observe what people do with them when they receive them. That is why the best answer to the question is taxation of consumption rather than income.