Increasing CGT rate would be economically pointless

18 November, 2011

With all the fuss about the release of the Government’s budgetary plan to German politicians, one aspect of the plan seems to have escaped with little or no comment.  There is apparently a statement that €100 million would be raised from a reform of capital gains tax (CGT).  For “reform”, presumably we can assume an increase is planned, probably a large one.

I’m puzzled as to how the Government expects to generate additional tax revenue by increasing the rate of CGT from its current rate of 25%.  The opposite effect is in fact likely.  (Increasing Capital Acquisitions Tax on legacies would no doubt increase the yield from capital taxes somewhat, although there would be significant leakage as estate planning strategies would become more cost effective, and thus more prevalent – more fees for lawyers and accountants).  CGT is largely a voluntary tax which very often can be avoided by the simple expedient of deferring the sale of the asset in question.  If the gain is large enough, one has the option of leaving the country to legitimately avoid the associated tax (as Denis O’Brien did when he sold Esat).

A Joint Economic Committee of the United States Congress in 1999 said this in the foreword to their report “Cutting Capital Gains Tax Rates: The Right Policy for The 21st Century“:

Proper taxation of capital gains is a complex issue. Capital gains differ from ordinary income in several respects. Because capital gains occur over time, their size is influenced by inflation. And, unlike most ordinary income, the realization of capital gains is largely a matter of choice.

In addition, there is a concentration issue – most people realize sizeable capital gains on only a few occasions such as when they sell a business or farm. As a result of these factors, capital gains are more sensitive to the rate of taxation than ordinary income.

The tax treatment of capital gains is particularly important since they are derived from entrepreneurial ventures. In modern high-tech economies, these activities are the engine that propels economic growth.

The report concluded (see its executive summary) that:

The optimal tax rate is the rate that is best for the economy, and it is lower than the rate that provides the government with the most tax revenue. The current top statutory rate of 20 percent significantly exceeds the optimal tax rate.

Here in Ireland, the 1997 Budget reduced the rate of CGT from 40% to 20%. The then Minister for Finance, Charlie McCreevy, was heavily criticized on the grounds that this would reduce revenues. He argued that revenues would rise substantially as a result of the lower rate. McCreevy was proved right (for once!) and revenues almost trebled , greatly exceeded official predictions.

Increasing the rate of CGT to 30% (as Fine Gael have proposed), or even higher, is unlikely to raise additional tax revenue in the medium term, and will reduce it in the long term. It would be a purely optical change, designed for political reasons to pacify left-wingers and give a spurious impression of greater fairness.

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