Thursday, 27 May 2010

The folly of Capital Gains Tax increases

All taxes are bad, but some have worse effects on the economy than others. In difficult times, soak-the-rich taxation can be good politics, but it is never good economics. The team at Critical Reaction have produced two good articles on the folly of increasing Capital Gains Tax.

Graham Riddick writes

Frequently budding entrepreneurs take monumental risks to start a new business. They give up their secure jobs. They re-mortgage their homes to the hilt. They invest their life’s savings in their untested new enterprise. They pay themselves nothing while they establish their businesses. In some cases they stretch their mental and physical health to breaking point. Why? For all sorts of reasons, but the main one is to create a valuable enterprise from which they and their families will benefit in years to come. Yes, they hope to become millionaires and why not? For many entrepreneurs that is one of the things which drives them on and makes the sacrifices worthwhile.

Tax these entrepreneurs at 40% or 50% and the Government will kill the incentive to create wealth. And that is what will happen despite Government protestations that entrepreneurs will be protected from any CGT increase.
As Riddick observes,
It is ironic that even Gordon Brown understood the need for enterprise and effectively kept CGT at levels well below the rates of income tax. He needed the wealth-creators to do their bit so that in time he could fleece them with other taxes.
Barry Legg highlights the risk that "capital allocation solidifies and loses its dynamism":
the investments which offer the highest returns for the future will find it more difficult to obtain capital with adverse consequences for jobs and profits ... The public sector deficit cannot be controlled unless the economy is able to benefit from the dynamics of capitalism.
Dynamism is a word that has been horribly abused by marketing types, but it is an important principle. Free markets are highly dynamic, constantly reallocating capital and human resources to best meet the needs of consumers, with greater efficiency than a central planner could ever manage. Government taxation and regulation creates friction, disrupting and discouraging beneficial transactions. Jamie Whyte's article on the deadweight costs of taxation is well worth reading.

Government intervention causes entrepreneurs to spend less time and energy satisfying the needs of customers, and more effort gaming the system. A key concern is tax avoidance, as Riddick explains:
If CGT rates go up to 40 or 50%, the UK will have the highest rates of capital gains tax anywhere in the world. This is not a message that a Conservative led Government should be sending out. The Government is right to target deficit reduction but higher CGT rates will not yield any more cash for HMRC. People will delay the sale of assets to avoid paying the higher rates and we can be sure that the accountants and tax lawyers are gearing up for a major advertising campaign. Tax avoidance will once again become a growth industry.
Legg concludes:
The Osborne proposals for CGT ... attack the many small shareholders who invest in British enterprise, they encourage consumption over investment and they make the alternative for successful British investors of seeking overseas tax residence that much more attractive. Under Labour in the 1970s there was a brain drain, under Cameron, Clegg and Osborne in the 2010s there will be a wealth drain.
Let us hope the Coalition sees sense.

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