Why capital gains suffer less tax than income

13 February 2024

Late last Friday afternoon, the prime minister published details relating to his tax return entries for the year to 5 April 2023. The timing of the release may have helped in limiting the number of associated headlines but if there was a spotlight, it wasn’t so much on the prime minister that it fell but rather on capital gains tax (CGT) itself.

The prime minister had a significant amount of capital gains during the 2022/23 tax year, from an investment portfolio held in a “blind management arrangement”. As is the case for capital gains generally for UK tax residents, these are subject to tax at a lower rate than income. Quite reasonably, that will lead some to ask the question why and whether this is fair.

CGT was first introduced in 1965 by the then chancellor James Callaghan, with the aim of preventing ‘the skilful manipulator’ from avoiding tax by reframing income as capital gains. Since then, it has been subject to various changes over the years. Perhaps the most notable change was by Nigel Lawson who, as chancellor in 1988, aligned CGT rates with those of income tax. The disparity between CGT and income tax rates was then reintroduced by Alistair Darling in 2008 and CGT rates have been further tinkered with by George Osbourne from 2010 onwards.

Why then do we have this apparent preferential treatment for CGT compared to income tax? The forthcoming Budget is likely to focus any tax cuts on workers again to try and improve the country’s ailing productivity levels. Yet neither major political party has sought to suggest that CGT rates should be increased on what some might consider include passive returns. There are a number of arguments that are often made to support the difference in tax treatment, which presumably underlie the political reticence to look at it. 

A common one is that there is the potential for capital gains to be ‘bunched’ when compared to income. What this means is that a capital gain might arise in a single year, whereas an equivalent amount of income might be spread over many years. If income and gains were taxed in the same way, it could mean that capital gains were effectively subject to a much higher rate of tax than income as it could be taxed all at once as a lump sum. 

In contrast, income broken down over the years may be subject to lower rates of tax as a result, given the progressive nature of income tax. This could particularly impact business owners who have not taken an income in prior years and reinvested, on the basis that there would be a more preferential tax rate on an eventual exit or retirement.

As with inheritance tax, some critics also consider CGT to represent a further tax on income that may have been taxed. That may be true in some cases but will not ring true for everyone, such as those who have inherited property and seen large passive gains arise.

Perhaps the more pertinent point for politicians at the moment is not to be seen to be introducing measures which could be seen as anti-business or adversely impact an already subdued mergers and acquisitions market. 

Latest statistics show that over 42% of all CGT revenues, over £7bn, were paid by individuals with gains over £5m, around 0.5% of all CGT taxpayers. Increasing the rate of CGT has been shown to distort taxpayer behaviour in the past. Ultimately, a significant increase could see individuals simply sitting on their assets or structure sales in a different way that didn’t trigger a large CGT liability. 

With such a large amount of tax revenues concentrated on a relatively small number of taxpayers, perhaps politicians are wise not to be gambling on a rise in CGT rates to try and generate further funds for election spending pledges. It could prove a shot in the foot for the economy and the Treasury’s bank balance rather than a shot in the arm.