On Optimal Capital Gains Tax

The government is contemplating an increase in capital gains tax (CGT) rates. The Chancellor warned that tough decisions on spending, welfare, and taxation would be necessary to address the £22 billion shortfall in public finances inherited from the previous administration. In addition, the prime minister said those with the "broadest shoulders should bear the heavier burden". Raising CGT thus seems a natural option on the table.

At present, for most assets the UK's CGT rate stands between 10% and 24% - one of the lowest among developed economies that levy such a tax. However, the complexity of CGT comparisons, owing to various exemptions, makes direct comparisons challenging. But the prospect of aligning CGT rates more closely with income tax rates has triggered a wave of asset sales among business owners and investors. Given its complexity, how to raise CGT warrants careful consideration. 

The debate over CGT is related to broader discussions about fairness, economic growth, and the role of government in wealth redistribution. Advocates of higher CGT argue that it is essential for funding public services and ensuring economic stability, while critics contend that it prevents investment and hampers growth. 

CGT serves to ensure that wealthier individuals, who are more likely to own and profit from investments, contribute their fair share to public finance. This aligns with the principle of a progressive tax system in many developed economies, where those with greater financial resources bear a proportionately larger burden. Without CGT, income from investments would be taxed at a lower rate than income from labour, potentially exacerbating income inequality, as the rich typically derive a significant portion of their earnings from investments. Additionally, CGT can contribute to economic stability by discouraging speculative trading and short-term market volatility, thereby encouraging longer-term investments that are generally more beneficial for the economy. 

Critics, however, argue that higher CGT disincentivises investment and innovation, both of which are critical drivers of economic growth. Investors might be reluctant to commit capital to new business or the stock market if they anticipate a substantial portion of their gains will be taxed heavily. This could dampen entrepreneurial activity and delay the development of new businesses, typically engines of economic dynamism. 

My recent research, ​(Benhabib, Cui, & Miao, 2024)​ produced with economists specialised in wealth concentration, show that the nature of capital gains/income suggests a nuanced approach. Instead of looking at all-component capital income and sales, targeting taxation on infrequent, substantial surges in capital income, or from selling capital assets, can reduce wealth inequality effectively with minimal distortion to economic growth. This finding rests on the notion that extremely high capital income/returns, which occur infrequently, are relatively insensitive to taxation, as compared to raising the tax rate for all capital income and sales. For an entrepreneur achieving huge success with a new product, the difference between an after-tax 5,000% return and an after-tax 3,500% return is marginal, given the low probability of such outcomes. In economic text-book language, investments exhibit low "elasticity" in response to this form of taxation. Notice that, in the aggregate, there are always some people experiencing extraordinary gains. As a result, taxing these extraordinary gains can generate significant revenue without markedly diminishing investment or innovation. This could be particularly relevant to profits earned from cryptocurrency trading.

Thus, if CGT targets infrequent substantial gains, rather than all gains, it can effectively fund government expenditures, achieve redistribution, and almost barely disrupt the economy. The key lies in taxing the "lucky" components of capital income—those returns that are beyond the control of the investor and occur infrequently. Since the likelihood of such windfalls is typically low, economic agents remain relatively indifferent to the tax. However, to sustain an environment where such gains are possible, the government must ensure that infrastructure and economic networks are robust to boost productivity, connected to a previous article I wrote for the UCL Policy Lab. Well-maintained transport systems, for instance, are crucial for businesses to thrive and achieve significant gains, even if taxed at higher rates.

A related factor to consider is the impact of leverage on returns. When capital is borrowed to fund investments or innovations, the potential returns (if successful) can be significantly magnified. For simplicity, assuming a zero interest rate: with a 20% down payment on an asset yielding an annual return of 30%, leverage boosts the investor’s return to 150%. Even with a 5% interest rate as the borrowing cost, the leveraged return remains high at 125%.

It's important to note that higher returns reduce the sensitivity of investments to taxation since these returns are likely well above the "normal rate" of return. Economists refer to the portion of returns above the normal rate as "economic rents." Economic rents represent the opportunity to earn significantly higher returns, well beyond the cost of producing goods and services. Economic theory suggests that taxing these rents won't alter producer behaviours - or the behaviours of those who benefit from rents - because there remains a strong incentive to exploit the profit opportunities tied to economic rents. Leverage thus amplifies economic rents, making investment less sensitive as leverage increases. As a result, capital gains from leveraged investments should be taxed at a higher rate.

However, it is worth noting that for investments and innovations, exceptionally high returns might be necessary to incentivise participation due to the high failure rate. This creates a trade-off between subsidising investment/innovation with relaxed borrowing condition and taxing it because of its rent-like nature. Nonetheless, ​research (Bassetto & Cui, 2024)​ demonstrates in a calibrated model that when government budgets are tight, as is currently the case given the £22 billion shortfall, taxing economic rents is optimal. Their analysis suggests that the sensitivity of investment to taxation decreases with leverage, as returns are further amplified, justifying a higher optimal CGT rate when government budgets are constrained.

In conclusion, the economic costs of CGT can be minimised if the tax is strategically applied to significant, exceptional gains. Determining what constitutes a "lucky" return is therefore crucial, as it influences investment elasticity. Of course, considerations of fairness and redistribution add complexity to this calculation. For instance, even if large, proceeds from the sale of a primary residence used to upgrade living arrangements for a growing family should probably be excluded as a "lucky" return. A well-designed CGT system must balance the various considerations outlined in the debate. A targeted approach, focusing on abnormal, high returns, may prove more efficient than a blanket tax on all capital gains and income. The implementation is, naturally, complex; individuals may attempt to divide an abnormal gain into multiple regular gains. The policy must carefully consider the equity structure.

Given the constraints of the current government budget, the issue isn't whether to raise the capital gains tax rate, but rather how to do so optimally. The goal should be to increase government revenue while minimising the negative impact on investment. One potential approach is to maintain the standard CGT rate for most returns but significantly increase the rate for exceptionally high returns, for instance, those exceeding 500%. However, further research is necessary to determine the precise threshold above which the rate should escalate rapidly, based on investment sensitivity. 

Dr Wei Cui is an Associate Professor in the Department of Economics, University College London.

Works cited:
​Bassetto, M., & Cui, W. (2024). A Ramsey Theory of Financial Distortions. Journal of Political Economy, vol 132, pp. 2612-2654. 
​Benhabib, J., Cui, W., & Miao, J. (2024). Capital Income Jumps and Wealth Distribution. Quantitative Economics, forthcoming.