Low capital gains tax is not a sensible way to support entrepreneurs

First, raising tax revenues to sustain the government spending needed to restore core public services and launch new programmes to deliver Labour’s five missions. Second, these additional revenues must be contributed by those with the broadest shoulders following over a decade of stagnant living standards for working households. This means ensuring that the lucky few who can generate income from wealth are taxed at the same rate as the rest of the population whose income comes from work.

Equalising capital gains tax (CGT) with the income tax schedule is one way to meet the chancellor’s challenge – sensible reforms on this basis can raise £14 billion. It could also slow growing regional inequalities created by the tax system. However, opponents of this reform frequently cite concerns about the impact on entrepreneurship and investment – activities that are especially vital for the growth and clean energy missions. Vested interests often drive this discourse, but it is essential to engage in a positive debate about encouraging innovative entrepreneurship.

Here, we gather evidence from existing research and insights from interviews with six successful entrepreneurs who support higher taxes on wealth. Our interviewees do not represent the whole range of views of UK entrepreneurs, but they do provide valuable insights into the impact of capital gains tax and government policy on successfully growing a business.

Lower rates of capital gains tax are a poorly targeted way to encourage entrepreneurship

Capital gains – the increased value of an asset when its sold – currently receive a substantial tax advantage relative to income from work. This disproportionately benefits the wealthiest in society but even after setting fairness arguments aside, there is scant evidence that it is effective at encouraging entrepreneurial behaviour.

Entrepreneurship as a concept is loosely defined and holds different meanings for different people. In most schools of economic thought, entrepreneurs have a unique and specific role in driving economic progress. They take risks, drive innovation, introduce or develop new technologies and are a source of competitive pressure for established firms. When successful, these activities generate positive spillovers for the wider economy through higher productivity, more jobs and better products – outcomes that are key to the government’s growth mission.

Successful entrepreneurs can reap the rewards by selling on their business – the cash received for selling the business counts as a capital gain. The tax advantage on gains is often justified by claiming it encourages entrepreneurship, as selling a business is taxed less than earning the same amount through employment. However, there are several problems with this view.

Firstl CGT matters very little at the crucial early stages of entrepreneurship – it only matters at the end for those who have been successful. When it comes to the startup and growth phases of business, issues around financing, management and logistics are far more relevant than the eventual return founders might make on selling the business. One interviewee who has experience starting up and selling multiple businesses over the years summarised it well:

Even specific CGT carve outs for entrepreneurs have been ineffective at influencing entrepreneurs’ behaviour. Business Asset Disposal Relief (previously known as Entrepreneur’s Relief) provides a generous 10 per cent CGT rate for entrepreneurs, compared to 20 per cent for other assets and 28 per cent for property. A HMRC-commissioned study found that only 16 per cent of people who expected to qualify for the relief upon sale of their business said that it influenced their business decisions.

Second, low CGT rates are poor value for money – they equally reward passive asset ownership and active entrepreneurship. Outside of business assets, gains are made on physical property or stocks and shares that are not the result of any innovative or productive activity on the part of the asset owner (see figure 2). For example, UK house prices have appreciated by around 54 per cent since 2014. Someone who owned a property portfolio since then could do nothing with their assets and sell them today for a significant gain. A gain of £1 million made passively over 10 years generates a tax bill half the size of someone who earned £100,000 a year over the same decade. The current system unfairly rewards those who already own assets over those who contribute productively to the economy through work. This also creates significant 'deadweight' costs to the Treasury – even if low CGT rates encourage some entrepreneurial activity, they also benefit wealthy households simply for being wealthy.

Capital gains related to unlisted shares are most likely to be related to entrepreneurial effort although even within this category, it is probable that some amounts of these gains are made through passive asset ownership. Based on the publicly available data we can say that at most half of all gains are made through entrepreneurship. This means at least half of all gains are not the result of innovative, risky economic activities but rather generated through passive asset ownership.

Third, unequal tax on income and capital gains encourages employees to act as ‘businesses’, creating labour market distortions. Low CGT rates distort behaviour in the labour market since workers can legally avoid income taxes and national insurance by self-incorporating. There has been an explosion of single-employee businesses over the past decade, particularly in high-earning sectors such as professional services or IT. These businesses are not ‘entrepreneurial’ – research by the IFS shows that they do little to no capital investment, instead retaining profits within a corporate entity to generate enormous tax savings. Ultimately, this encourages individuals to spend significant amounts of time and income on the bureaucracy of self-employment rather than working productively as an employee. This distortion can only be remedied by full equalisation between capital gains and income tax.

There are at least 32 policy initiatives already supporting business investment, innovation and entrepreneurship at the national level – government should focus on improving these

One interviewee highlighted that a higher tax bill could mean that some entrepreneurs-turned-investors are discouraged from reinvesting their gains. However, institutional investors (who are exempt from CGT), rather than individuals are the primary source of capital in our economy. Any disincentives created for individual investors can also be mitigated by providing a ‘rate of return allowance’ that ensures only real gains are taxed.

However, research by Katie Smith and Helen Miller of the IFS concluded that targeted policy instruments are more effective at encouraging investment into and by small businesses than a general tax advantage on capital gains. Through our research we have identified at least 32 unique policy initiatives that are designed to support businesses with financing, innovation and business growth.

One of the most challenging aspects of starting a new business is financing – new and innovative enterprises are highly risky by nature. Government policy already recognises this, with several currently operational schemes that supports financing for new, innovative businesses. Notably, the Treasury has recently extended the Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCTs) for another 10 years – these schemes provide tax breaks and partial loss relief targeted to equity investments in startups. On the lending side, the British Business Bank (BBB) offers several loan schemes for small business growth. When it is operational, the National Wealth Fund will also provide financing support to businesses, targeted to strategic industries.

The UK also has more generous support for private sector research and development (R&D) activity than any other OECD country. R&D tax credits and some BBB financing schemes provide general support, whilst Innovate UK operates several direct grant funding schemes for priority innovation areas.

The new ‘full expensing’ capital allowances regime has simplified and reduced the upfront costs of business investment, whilst small businesses across several industries qualify for relief on their business rates. UK Export finance provides advisory and financial support for British exporters. Help to Grow schemes provide support for improving management practices and digital technology adoption for small businesses.

The menu of existing business support policies should be the first port of call for those who wish to encourage entrepreneurship, not low CGT rates. These schemes can be adapted or expanded to target specific types of business or specific activities. This approach will be particularly useful to a mission-oriented government that should seek to align business support with activities that facilitate mission delivery.

Businesses also benefit from broader public services and investment

Entrepreneurs do not operate in a vacuum. They are part of the large and complex system known as the economy. Government provides many useful functions within this system that business leaders benefit from.

The government’s role in providing a healthy and well-educated workforce was recognised by most interviewees, summed up in the following quote:

Health is crucial to the UK economy’s vitality. According to the IPPR’s Commission on Health and Prosperity, poor health imposes significant costs on both employees and employers. Sickness-related lost earnings are estimated to cost the UK GDP £43 billion, while businesses have faced a £30 billion increase in costs related to employee sickness since 2018. Therefore, government investment in health and healthcare is essential not only for improving the nation’s overall health but also yields significant benefits to businesses.

Another interviewee highlighted the role of foundational public investment in generating opportunities to create their first successful business:

Individual tax policies, like low rates of CGT, also do not work in a vacuum. After over a decade of austerity, then the unprecedented twin shocks of the pandemic and Russian invasion of Ukraine, the public sector is on its knees. It is simply not sustainable to keep the tax advantage open when reforms could raise £14 billion. A better funded and better functioning public sector, that invests in modern technology and infrastructure, will unlock opportunities for entrepreneurship.

Conclusion

Entrepreneurship and investment are vital to generating sustainable growth for the UK, but low capital gains tax is not an effective way at encouraging these activities. Instead, government and business must work together to make the most of the targeted support that is already on offer. Policy support for entrepreneurs, and businesses in general, can and should be tailored towards delivering the government’s five missions.

Closing the tax advantage on capital gains means that the system becomes more efficient whilst raising revenues to adequately fund the public services and investment that business across the country rely on.