The cuts in capital gains tax for most investments are set to make a major difference to tax and investment planning.
Just to recap, George Osborne announced in his March Budget the rates of CGT would be reduced by 8 per cent after 5 April for the tax year 2016/17. Most gains that have previously been charged at 28 per cent will be subject to the rate of 20 per cent, which will apply to the taxable disposals of higher or additional rate taxpayers.
Other taxpayers and non-taxpayers will only have to pay 10 per cent CGT on their taxable gains – down from 18 per cent. The new rate of CGT for trusts and estates will generally be 20 per cent as well.
Readers with long memories will recall in the 1980s Nigel Lawson took the view there was no logical reason why the tax on capital gains should not be the same as the tax on income – so he plonked a 40 per cent tax rate on both income and gains. Way back, more elderly readers will be dimly aware capital gains were taxed at the relatively low flat rate of 30 per cent and until the early 1960s they were not taxed at all.
The wheel has now gone (nearly) full circle and Osborne has decided to bring the rates down again, even though most gains are real and hardly at all now boosted by inflation.
Back when CGT rates were nil or at least very low, investors were driven to seek capital gains rather than income. In the 1970s and earlier, income tax rates were stratospheric, so the incentive was even greater. And the drive to focus on capital gains will be bolstered further this year with the new larger differentials opening up between the taxes on income and gains.
Not all capital gains will be accorded the new lower rates of CGT. Capital gains from residential property will continue to be taxed at the old rates of 18 per cent for basic rate, starting rate and zero rate taxpayers and 28 per cent for higher and additional rate taxpayers. It was yet another twist in the knife for buy-to-let investors and the owners of second homes.
But remember, these rate changes are set against the background of a continuing freeze on the annual exempt amount of £11,100.
So what will be the consequences of the changes for investment planning?
In theory at least, the cut in CGT rates should make investors more willing to incur tax bills on their gains to optimise their portfolios. Recommendations to switch and rebalance portfolios once investors have reached their annual exemption often come up against clients’ reluctance to incur tax costs. People naturally weigh the certainty of the tax cost against the imponderability of the further future gains.
Two behavioural finance biases come into play. There is prospect theory – we all hate losses roughly twice as much as we like profits. And there may be variation of this bias in which we dislike the certainty of immediate losses even more than twice as much as we savour the prospect of uncertain future gains.
The other behavioural bias is status quo affect (sic). We like what we already own more than we like assets that we do not yet possess. Both these biases can make it especially painful to pay a tax bill in order to achieve a better designed portfolio.
So it will be interesting to see whether lowering the pain threshold by cutting the tax costs will turn out to make investors more prepared in practice to switch their investments around. Logically it should. In reality, it might not.
One of the side effects of lowering taxes generally is tax wrappers can look less attractive in relative terms.
Someone might argue an Isa is relatively less attractive than it was in comparison with holding funds in a general account, especially with the first £5,000 of dividend income now free of tax.
The £11,100 exempt amount covers most people’s gains and then 10 per cent is not much to pay if the gain exceeds this tax-free limit. And that is true, but it omits some crucial factors.
First and foremost, Isas are still completely free of UK taxes on income and gains, and they do not need to be reported to HMRC. So investors can be confident they won’t have to pay tax on them. It is all a lot simpler. But also potential gains have a habit of a building up and creating unexpected and unwelcome lumpy taxable surprises.
More concerning are the threats to the relative attractions of life assurance bonds. These have the characteristic of eventually turning capital gains into income. So as capital gains have now become even more attractive than income in tax terms, the comparative tax position of bonds for individuals have become less beneficial for capital gains.
Confusingly, in recent years, life assurance bonds have accrued some additional relative advantages for income tax planning.
So as tax becomes even more complicated and confusing, the role of advisers becomes ever more important and valuable. But you have to keep up to date to be able to add value.
Danby Bloch is chairman at Helm Godfrey