Taxes on Capital.

Part of Ways and Means – in the House of Commons at 3:31 pm on 15 March 1988.

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I now turn to taxes on capital.
The emergence of the capital-owning democracy has been one of the most remarkable features of the 1980s. Encouraged by Government policy, more than 2½ million families have bought their homes, bringing the total to nearly two households in three. And our proposals for personal pensions, which come into effect in July, will give a new dimension to pension ownership.
But the most dramatic change has been in share ownership. In last year's Budget I announced the results of a joint Treasury/Stock Exchange survey of the number of shareholders in this country. This revealed that some 8½ million people—one adult in five—owned shares, about three times the number in 1979.
A similar survey has been carried out this year. Despite all the stories of people taking quick profits on privatisation shares, and despite the stock market collapse, the results show that the number of individual shareholders has risen further over the past 12 months, to very nearly 9 million. This illustrates in a quite remarkable fashion how wider share ownership is now taking root.
I have two proposals to encourage share ownership still further to announce today.
First, personal equity plans are off to a successful start. Over a quarter of a million people took out PEPs in 1987 and subscribed nearly £½billion between them. To give further encouragement to this form of investment, I propose to increase the annual limit from £2,400 to £3,000. The new higher limit will apply to all plans taken out this year.
Second, measures to encourage employee share ownership have featured in seven out of the last eight Budgets. As a result, the number of approved all-employee share schemes has risen from 30 in 1979 to over 1,400 today, involving well over 10,000 companies, and providing shares and options for well over 1½ million employees.
Following extensive consultation, including the publication of draft clauses, I now propose to relax the provisions of section 79 of the Finance Act 1972. This will make it easier for companies to provide shares to their employees outside the approved schemes without giving rise to an undue charge to tax. This will he of particular benefit to subsidiary companies and their employees.
In previous Budgets I have already substantially reformed the taxation of capital, with the replacement of capital transfer tax by inheritance tax. But I believe this process can and should be taken further. Last year I reduced the number of inheritance tax rates from seven to four. This year I propose to simplify the tax still further by levying it at a flat rate of 40 per cent.
At the same time, I propose to raise the threshold from £90,000 to £110,000. The increase in the threshold will reduce the number of estates liable to tax by a quarter, allowing many more people to inherit the family home free of tax. And the flat rate of 40 per cent. means that for the family business enjoying 50 per cent. business relief the effective rate of tax can never exceed 20 per cent.—one of the lowest inheritance tax rates in the industrialised world.
The cost of these changes will be £100 million in 1988–89.
Lastly, capital gains tax. Strictly speaking, this should not be a tax on the original capital at all. Nor is it, so far as gains which have arisen since 1982 are concerned, thanks to the indexation provisions introduced by my predecessor in 1982 and extended in my 1985 Budget. But for gains that arose before 1982 the tax falls largely on purely paper profits resulting from the rampant inflation of the 1970s. In other words, it bites deeply, and capriciously, into the capital itself.
This has long been recognised as manifestly unjust. Indeed, from the time I first entered the House I have argued that capital gains tax should fall only on real gains and not on paper gains. I have therefore looked hard to see if the indexation provisions could be applied right back to the inception of the tax in 1965. Unfortunately, they cannot. The necessary information is in many cases no longer available.
Accordingly, I have decided to bring the base date for the tax forward from 1965 to 1982. That is to say, for all disposals on or after 6 April, that part of any capital gain which arose before April 1982 will be exempt from tax altogether for individuals and companies alike.
This Budget thus ends once and for all the injustice of taxing purely inflationary gains. This will benefit the economy by unlocking assets which have been virtually sterilised because of the penal tax that would have arisen on any sale. And it will help many small business men and farmers in particular.
At present, the first £6,600 a year of capital gain is tax free. The relatively high level of this threshold stems from the substantial increase my predecessor made in 1982 explicitly as rough and ready partial compensation for the continued taxation of pre-1982 paper gains. Now that I have taken pre-1982 gains out of tax altogether, I propose to reduce the capital gains tax threshold to £5,000. It should also be borne in mind that, with the introduction of independent taxation in 1990, a husband and wife will each have their own threshold for capital gains tax as well as for income tax.
Rebasing the tax so as to produce a fully indexed system makes it possible to bring the taxation of gains closer to that of income. In principle, there is little economic difference between income and capital gains, and many people effectively have the option of choosing to a significant extent which to receive. And in so far as there is a difference, it is by no means clear why one should be taxed more heavily than the other. Taxing them at different rates distorts investment decisions and inevitably creates a major tax avoidance industry.
Moreover, at present, with capital gains taxed at 30 per cent. for everybody, higher rate taxpayers face a lower—sometimes much lower—rate of tax on gains than on investment income, while basic rate taxpayers face a higher rate of tax on gains than on income. This contrast is hard to justify.
I therefore propose a fundamental reform. Subject to the new base date, capital gains will continue to be worked out as now, with the present exemptions and reliefs. But the indexed gain will be taxed at the income tax rate that would apply if it were the taxpayer's marginal slice of income. In other words, I propose in future to apply the same rate of tax to income and capital gains alike.
These changes will not take effect until 6 April.
Taxing capital gains at income tax rates makes for greater neutrality in the tax system. It is what we now do for companies. And it is also the practice in the United States, with the big difference that there they have neither indexation relief nor a separate capital gains tax threshold.
The changes I have announced represent a thoroughgoing reform of capital gains tax which will benefit the economy and eradicate a major injustice. They will sharply reduce the damaging effects of the tax, while ensuring that capital gains remain properly taxed and the yield of income tax adequately protected. They are expected to cost a little over £200 million in 1989–90.