The capital gains tax change will not deter enterprise

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If very rich people are to pay much lower tax rates than the doctors who care for them or the teachers who made their careers possible, there needs to be a compelling demonstration of widespread economic benefits.

Capital gains tax in Britain has been subject to endless modification since it was introduced in 1965. From 1988 to 1998, the regime was logical though harsh. Capital gains were measured after allowance for inflation but then taxed as income, so for most individuals the rate was 40 per cent.

In 1998, indexation was scrapped and taper relief introduced, so that the rate of tax on business assets fell over 10 years to 10 per cent. The 10-year period was reduced to four in 2000 and to two in 2002. Thus the effective tax rate on the sale of a privately owned business was cut from 40 per cent – one of the highest rates in the developed world – to 10 per cent – one of the lowest rates in the developed world.

Further change was inevitable when it became widely known that “carried interest” – performance bonuses to employees of private equity houses – was treated as a capital gain on business assets and taxed at only 10 per cent. The government’s surprising – and controversial – response is to replace the whole regime with a flat capital gains tax rate of 18 per cent.

Business lobbyists assert that this reform will damage new enterprise. The evidence cited rarely seems to go beyond knowing someone who knows someone who might move to California, in the (mistaken) belief that he will pay much less tax. There has been little research on the consequences of the changes of the past decade, which are large enough to represent a controlled experiment.

The best data source on business start-ups is the rate of new registrations for value added tax. Anyone with a new venture who expects annual turnover of more than £64,000 must tell revenue and customs of their plans. The number of new registrations has been rising slowly for many years – 167,000 in 1994, 178,000 in 2005. There was a peak in 1997-98, during the dotcom boom, and again in 2003. Each year, almost as many people discontinue their businesses as set them up. New registrations are probably a better indicator of the vibrancy of entrepreneurship than the increase in overall registrations: still, the addition to registrations attained a high of about 3,000 a month in 1997-98 and has fallen since. These trends are broadly confirmed by other sources, such as the number of new business bank accounts.

The main influence on numbers is the general economic cycle. It is difficult to detect any effect at all from the capital gains tax measures. But what really matters is not the number of new businesses that are established, but their quality. Most people who set up in business have no ambition or capacity to employ more than one or two people and are unlikely ever to pay capital gains tax. Perhaps the truly entrepreneurial are different.

Studies of entrepreneurs – and their own accounts – suggest they may be really different. Establishing a business is hard work and the people who succeed are fired by enthusiasm for business in general and their own, in particular. The capital gains tax on an eventual sale is rarely at the front of their minds.

There is a large difference, in motivation and in achievement, between the originator of a new or differentiated product or service and the supporter – whether venture capitalist or office fitter. The interest of the latter is in the money the business will make rather than in the business activity itself. Both the entrepreneur and the supporter are necessary, but the first is the unique dynamic of the capitalist economy and the second the product of a competitive market. Where the first is found, the second will follow.

Few people grudge Bill Gates his fortune, because the practical benefits of his activity are evident – or John Terry his salary, because his footballing talents are plainly unique. Neither of them needs or deserves tax breaks. If very rich people are to pay much lower tax rates than the doctors who care for them or the teachers who made their careers possible, there needs to be a compelling demonstration of widespread economic benefits. Otherwise the legitimacy of not only the tax system but also the market system as a whole is undermined.

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