Tapir relief

Like many other animal lovers, I support tapir relief.  All four species of tapir are endangered.  Subsidising the bodily functions of this prehensile-snouted odd-toed ungulate (closest living relatives horses and rhinoceroses) is obviously a worthy use of public funds.

True animal libertarians may argue that tapirs can perfectly well relieve themselves, without government assistance or special incentives. The sign below, found in the Belize City Zoo, supports this argument.

Nevertheless, I am convinced that a sound utilitarian case for tapir relief can be made. There are bound to be positive tapir externalities meriting a subsidy or regulatory intervention (e.g. tapirs are considered cute, and not just by other tapirs).  In the unlikely case  that  an externalities-based case for granting fiscal favours to the tapir cannot be made, the proponents of the new (or indeed the old) paternalism can no doubt find failings in the cognitive skills of the tapir, or weaknesses in his capacity for long-term commitment, that would warrant a tax break.

Taper relief

There is, however, no case in fairness, efficiency or paternalism for the continuation of taper relief in the UK capital gains tax regime.  Chancellor Alistair Darling deserves brownie points (he won’t get any Brown points) for attempting to simply the unholy mess that is the UK income tax and capital gains tax regime.  Taper relief is a singularly pointless and distortionary feature of the UK capital gains tax, one which benefits not the tapir, but a different collection of mammals, ranging from owners of small businesses to owner/managers of private equity funds. Although, like the tapir, often pig-like in shape and keen to put their snouts in the trough, they are in no way endangered or in need of special tax advantages, either for efficiency reasons or because of fairness concerns.

I have argued elsewhere that, because of considerations of fairness, efficiency, tax compliance, tax administration, evasion and avoidance, the only  income tax, capital gains tax and corporate profits tax regime that makes sense would have the following features: (1) It adds all labour income, capital income (dividends, interest etc.) and capital gains together and applies a single tax schedule to this total, regardless of its composition; (2) It abolishes corporation tax or makes it into a pure withholding tax.  This means that taxes paid at the level of the company can be fully offset against the personal capital income (interest, dividends) tax liability. 

I would add the following: (3) It fully indexes the entire income tax structure (allowances, bands and capital gains); (4) It consolidates employers’ and employees’ national insurance (social security) contributions into the personal income tax; this could both raise the average income tax rate (across all income tax payers) and lower the highest marginal income tax rate;  national insurance contributions themselves would, of course, no longer exist as a separate tax; (5) It makes all interest income taxable, and allows all interest paid (on mortgages, credit cards, other loans) to be deducted from taxable income (in view of (3), only real interest payments should be deducted); and (6)  It imputes the implicit rental value of owner-occupied accommodation as income.

It would be possible, by deducting the value of inflation-corrected saving from taxable income calculated according to (1) through (6), to turn this into a consumption tax, but I would be happy with either.

Chancellor Darling’s proposals unfortunately took one step backward at the same time that he took a step forward by proposing the abolition of taper relief and its replacement by a single 18 percent capital gains tax rate. That is because he also proposed the abolition of the last remaining bit of indexation of capital gains, which means that you now pay capital gains taxes even if the nominal capital gains that are taxed do no more than make up for the erosion by inflation of the real value of your assets. 

But the abolition of taper relief can be viewed as a helpful first step on the road towards a promised land where all income is taxed according to the same tax schedule.  If nothing else changed, this means that in a sensible world, the highest marginal tax rate on capital gains would be the same as on labour income and dividends (assuming corporation tax is abolished).  Currently this would be 40 percent, but with the other changes I am proposing, the highest common marginal rate could be lower.

The two key features of taper relief are that the capital gains tax rate is (1) lower the longer an asset has been held and (2) lower for business assets than for other assets.  Neither feature makes any sense.

Should the owner of an asset be encouraged to hold it as long as possible?
The answer is a clear and unambiguous: ‘no’.  Especially when it comes to business assets whose effective deployment requires entrepreneurial and managerial skills, there is no presumption that the current owner is the best owner/manager.  Bad owners (that is, owners who either are poor entrepreneurs and managers themselves or who are poor at selecting good managers) should be encouraged to sell as soon as possible.  Good owners should hang on to their assets.  Governments have no way of knowing who the good or bad owners are.  There is no presumption that the current owners are the best possible owners -  something that is a necessary condition for encouraging long-term ownership of (business) assets. I would have thought that when the current owners are bad owners, both they themselves and the market of possible interested buyers of their business assets would be at least as likely to figure this out as the government or some government-sponsored agency.  The presumption underlying taper relief that, left to their own devices, owners of assets, and especially owners of business assets, would dispose of these assets too soon is not based on a single thread of evidence.

Should business assets be taxed more lightly than non-business assets?
The answer is again a clear and unambiguous ‘no’, based on the absence of any efficiency or equity argument in favour of this feature of taper relief.  A building owned by a small firm owned by an owner-entrepreneur  is not more or less  valuable from a social point of view that a similar building owned by  a ‘natural’ person, or indeed that same building owned by an investment fund specialising in property.  This feature of the tax system distorts investment decisions and decisions on whether or not to incorporate.

A number of other spurious arguments in favour of the continuation of taper relief have been made:

"We were promised….".
The then Chancellor Gordon Brown introduced taper relief in 1998 with the declared purpose of encouraging entrepreneurship, long-term investment and risk-taking in the UK.  Abolishing it now would be unfair, a breach of promise, and amounts to confiscation of profits resulting from a commitment to investment that took place only because the investor trusted the promise of the Chancellor.

Well, tough luck and/or more fool you.  Clearly it would be better if the structure of taxation, benefits, regulations and other factors relevant to investment decisions and under the government’s control were (a) sensible and (b) stable over time.  Stability of tax structures matters.  Sometimes it is better to have a second-best tax system that is stable over time than a first-best one that is at risk of getting changed frequently.  However, the distortion associated with taper relief is such that its elimination makes welfare-economics sense, provided that it is not followed by a sequence of further changes in the opposite direction.   

Furthermore, governments act on behalf of the sovereign. This means, in non-legal language, that they can do what they jolly well like.  A government cannot credibly commit itself to a specific course of future actions.  It can certainly not commit its successors.  Anyone who believes that any particular government decision or legislative act is irreversible, is terminally naive and should not be in business.  In the case of the 1998 Chancellor Gordon  Brown, this applies with special force.  Gordon Brown was pretty good at ensuring overall macroeconomic and financial stability.  He was also a maniacal micro-structural tinkerer.  There wasn’t a single economic or social problem or Gordon Brown was addressing it with a handful of tax incentives, a few subsidies and some regulatory measures.  Each budget would contain literally hundreds of such micro-tinkering measures.  And there would be different ones each budget, often reversing or neutralising other measures contained in the same budget or in earlier budgets. 

Any change in any feature of the tax system, the subsidy system or the regulatory framework will be, at least in part, a surprise to the private economy.  It will benefit some and hurt others, including persons, households, small and large firms, that had made investment decisions on the basis of guesses about the future tax, subsidy and regulatory regimes that were falsified by the government’s subsequent actions.  Unfortunate, painful and inefficient, perhaps unfair.  But an intrinsic feature of the the political landscape since the beginning of time.  The notion that the UK small business community is entitled for the rest of time to the most favourable tax treatment bestowed on it at any time in the past, is rather silly.

Encouraging risk taking
Then there is the notion that low rates of capital gains taxation encourage risk taking and that risk taking needs to be encouraged.  Let’s take the last one first.  Risk is bad.  Other things being equal, we want less of it.  More risk makes sense only if it is offset by a(n at least) compensating increase in expected returns.  To say that the government should encourage risk-taking is as silly as to argue that the government should encourage the pursuit of lower expected returns.

Is there too little risk taking in the UK economy?  Features of the corporate legal environment, especially limited liability, create incentives for excessive risk taking, because losses that would, with unlimited liability, result in negative equity, are not in fact borne by the entrepreneur under a limited liability regime,  Do businesses  overestimate risk and underestimate expected returns?  Entrepreneurs are congenial optimists who tend to overestimate returns and underestimate risk.  Managers of quoted companies that have but a limited equity stake in the firm, face a large number of incentives affecting their behaviour towards risk, not all of which point towards excessive caution.  The net effect will depend on the capital structure of the firm, the governance structure of the firm, including the relationship between management and the board(s),  the remuneration package of the manager, the market for corporate control in which the firm operates, and the nature of the managerial market place.  The case that there is too little risk taking in the UK economy, relative to the expected rewards on offer, has not been made effectively by anyone.

There may be too little risk capital available for launching new firms or new ventures by existing firms.  Capital gains taxation, however, is a very inefficient instrument (both from the point of view of its ability to correct the distortion that is targeted and from the point of view of the revenue effects for the tax authorities) to address the problem of the inadequate availability of external finance.  Capital gains taxation means taxing capital gains on the existing stock of capital assets.  Reductions in capital gains taxes benefit owners of existing capital assets.  Expectations of future low capital gains tax rates will have a favourable effect on investment today, but lower capital gains taxes today only increase the returns to investment decisions already made.

If governments want to boost investment, the revenue-efficient way is to work at the margin of new investment, say through a marginal investment subsidy, or through an investment tax credit, accelerated depreciation of new investment etc.  If governments want to encourage the availability of external finance for new firms and, more generally, for those enterprises whose access to external finance is inefficiently constrained, lower capital gains taxes (which come at the end of the investment process) are a singularly ineffective means to achieve this.  Measures to encourage venture capital funds that can pool the risk of many (hopefully imperfectly correlated) investment projects are one.  So are measures to strengthen the rights of external financiers vis-a-vis the owner-entrepreneurs. 

Encouraging small business
After the incredible lobbying power of the agricultural sector in advanced industrial countries, the cult of the small business is, to me, the second most incomprehensible feature of the industrial political-economic landscape.   Small businesses are ‘the seed-corn of economic growth’, ‘the backbone of the economy’, ‘the engine of growth’, the ‘well-spring of innovation and dynamism’, the ‘life-blood of the nation’.  Perhaps.  To me, the key feature of small businesses is that they are small.  And small is small.  Other things being equal, I would rather have a lot of medium-sized businesses, and much rather a lot of large businesses than a lot of small businesses.

Most small businesses stay small.  A lot die quite soon following their birth.  A few grow and become medium-sized businesses.  Very few grow and become large businesses.  Then, every 30 years or so, there is a Microsoft or Google. 

Are small businesses discouraged from growing and becoming medium-sized or large by capital gains taxes?  Most small businesses probably want to stay small.  I have a very small business, with two shareholders, two directors and two employees - my wife and myself.  I definitely neither expect nor want the business to grow significantly.  It does what I intended it to do.  I don’t expect to retire on the capital gains I will make from selling the business.  Most small businesses I am familiar with fall into that category.

There is a chronic tendency to romanticise and dramatise the role of the small business and the solitary entrepreneur.  Let’s face it, business is mostly boring; very little of it is glamorous, creatively challenging or intellectually exciting.  It’s mostly hard work - grinding and grafting.  Rather like farming or paid employment, in fact.  There is a small chance that an entrepreneur will be quite a bit worse than the wage slave, and an even smaller change that (s)he will make a staggering fortune and end up creating a lot of jobs for other people.  There is no clear evidence that, in the field of small business, the private risks are significantly greater than the social risks or the private returns much lower than the social returns.

Again, if there is a problem facing small businesses, it relates not to the taxation of capital gains, but to the cost and availability of external finance.  Much of this is due to the fact that new businesses have no track record on which to base a request for a bank loan or an injection of equity from a venture capital fund.  That problem should be tackled right at the point where the distortion arises. Subsidising small loans to small businesses that have never received a loan before, might help.  So would the possibility of postponing for a number of years the payment of business-related taxes by start-ups, while ensuring that in present discounted value terms, all taxes get paid in due course. But the selection criterion would be not size, but being new.

Granting small businesses special privileges (such as the rumoured proposal for a £100.000 tax-free allowance for capital gains from the sale of a business on retirement) is putrid pandering to the lobbyists from the UK small business community.  It is a waste of public money and unfair to those retirees who have only non-business assets to sell.  To belabour the obvious: assets are assets; the identity of the owner, whether they are business assets, personal assets, assets held in the investment portfolio of  an insurance company, or state-owned assets is irrelevant.  And small is small.  Not inherently good. Certainly not better than medium-sized or large.  And most definitely not obviously deserving of capital gaints tax breaks. 

I hope the current Chancellor will be able to see off his predecessor in this matter.  If we are ever going to get an income tax structure in the UK that is transparent and understandable, let alone simple, the original reforms proposed by Alistair Darling are a good place to start.    

November 4th, 2007 in Uncategorised | Permalink