Nov 22, 2020

This is no time to heap more tax on job creators

written by Lisa Eason

A government quango called the Office of Tax Simplification recently published a report compiled for the chancellor about reforming capital gains tax. There are, apparently, concerns that the current system for individuals may distort behaviour.

The Treasury is interested in tax yield and compliance costs; we should all be more focused on the economic implications of increasing rates. Currently, capital gains tax produces about £8bn a year — less than 5% of the take from income tax. Even if the levy rose substantially, the likely proceeds would be insignificant relative to taxes such as VAT and national insurance, but the damage to job creation, start-ups and the entrepreneurial spirit from a less favourable regime would be severe.

Unemployment could rise to four million next year thanks to lockdowns and the pandemic. Consequently there is a desperate need to foster new businesses that create jobs, so we must retain incentives for entrepreneurs and investors — otherwise the task of recovery will be even harder.

There are essentially two sorts of capital gains: passive and active. The former occurs when you sell your home after owning it for 20 years and make a windfall profit because the property has appreciated in value. The latter occurs when an entrepreneur and risk-taking investors build a business over a number of years, create value and sell it for a profit. It has been transformed by the efforts of the owners.

There is an intrinsic difference between the two: passive windfalls do not benefit society, but active gains do — in multiple and vital ways.

Starting and growing enterprises is an utterly crucial activity for any thriving society. A majority of new jobs are generated by younger, growing companies started by entrepreneurs — often backed with funds from high-net-worth investors.

If this ecology is disrupted, there will be fewer such ventures and they will find it harder to get backing. Britain remains relatively successful at attracting talent and capital to start and fund ambitious companies. However, the coronavirus and lockdowns — in particular, the harm done to hubs such as London — are likely to make it harder for the country to retain the best entrepreneurs. This is especially true when places such as Switzerland and Singapore have low or zero capital gains tax.

HM Revenue & Customs data reveals that an extremely small number of taxpayers contribute a large chunk of the capital gains bill. Only 2,000 taxpayers paid more than a third of the total in 2017-18. These individuals are likely to be highly mobile, and may choose to emigrate if tax levels increase markedly. This brain drain happened in the 1960s and 1970s, and would be sure to increase now, since the world is better connected and the super-wealthy can choose to live almost anywhere.

Such risk-takers supply a crucial form of angel investing to early stage businesses, which institutional venture capitalists do not provide.

Similarly, research shows that a small proportion of start-ups generate most new jobs. Perhaps 5% of new companies — so-called gazelle firms — account for as much as 75% of job creation. These businesses are likely to be much more innovative and productive than typical new companies — they are more likely to be founded by a team of entrepreneurs, and to attract external capital. Many such companies today have a choice of where to be based. If we increase capital gains tax sharply, this type of value-added firm will be founded elsewhere, and the economy as a whole will suffer.

I do think that short-term capital gains should be taxed at higher rates to longer-term gains. Real businesses take time to develop: they need patient equity capital to mature. This sort of funding does not compare to short-term, speculative dealing in the stock market, which is more akin to gambling and contributes little to society

Backing small companies or start-ups is a dangerous undertaking — you can lose your entire investment if the project doesn’t work. That is the nature of capitalism and progress. For the entire exercise to make financial sense, the winners must deliver big rewards. When the longer-term capital gains rate paid in America is typically 15%, Britain cannot afford to levy more than 20%.

Instead, we should be trying to replicate America’s success in stimulating world-beating companies such as Google, Netflix and Amazon, not discouraging the risk-takers. Increasing capital gains tax would be pandering to the politics of envy, and would damage our chances of economic revival post-coronavirus.