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Honest startups versus City bastards - the CGT conundrum

And how Alistair Darling didn't exactly solve it

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Analysis Why the Chancellor of the Exchequer, Alistair Darling, had to propose altering capital gains tax (CGT) back in the autumn is pretty simple to explain. There was a certain amount of vociferous shouting (led by the Guardianistas, of course) that the sight of private equity barons paying less tax than their cleaners was a moral outrage that must be stopped. Few stopped to think that the very idea was itself absurd: a lower rate of tax, possibly, but they certainly weren't paying less tax either in total or as a portion of their total earnings. No matter, a band wagon was rolling and something must be done.

The original problem was that Gordon Brown had brought in "taper relief". Without going into the sort of details that only an accountant could love, the idea was that if you invested long term in the future of a business you would pay a lower rate of CGT on your profits than if you'd made the same amount spivving around with shares on the Stock Exchange. Again, without going into the details that only an economist could love, this was and is generally thought to be a good idea.

For decades the structural analysis (at least since the Wilson Report in 1979, if not a century earlier) of the UK economy has been that investment horizons are too short term. We want to get people investing in businesses, investing for the long term, rather than speculating in cottage cheese futures or whatever. Thus if we offer a special lower tax rate for those who do the investing rather than the speculating then we'll get more of what we want, that longer term investing. Give Gordon Brown his due here, he did the right thing to get what he wanted, even if the actual rate of 10 per cent struck many as very low indeed.

However, as so often, there were unintended consequences. The tax change didn't invent the private equity business but it did coincide with it. So the people who came to be seen as the major beneficiaries were not the hard toiling entrepreneurs struggling to build up a business over the decades but those bastards in the City who were buying everything up with borrowed money. Which is what led to series after series of articles decrying private equity and the importance of the publicly owned firm. This was of course our dread Guardianista infiltration: the irony of which never seemed to be appreciated by the writers of the jeremiads. (The Guardian is ultimately owned by the Scott Trust, a private organisation which owns itself and thus has no outside shareholders at all, let alone any amongst the public. That it was deliberately set up to protect The Guardian from the effects of inheritance tax is also ignored by its writers when they opine on that subject.)

But politics is politics and when Osborne and the Tories floated a mischievous plan to reform CGT, Darling was panicked into doing something. His suggestion was that taper relief should be abolished and to compensate, the CGT rate itself would come down to 18 per cent. This of course is where the fun started: everything from the observation that this reduced the taxes on retiring MPs when they sold their second homes (the mortgages of which were financed tax free through their expenses) to screams of 80 per cent tax rises on those worthy entrepreneurs. Both of which are true of course.

But the real problem faced in trying to reform this part of the tax system is that it's very difficult indeed to separate out those hard working entrepreneurs from those private equity folks. What the latter are doing is something called "carried interest" in US speak. When they do a deal they keep some of the equity for themselves. This again comes in two parts: they really put some money in and buy shares and they also take some for their "management" over the life of the investment. This might more accurately be called payment for services rendered and thus be defined as income and taxed as such: if it weren't for the fact that just about every start up company and VC funding round works the same way, but for our hard working entrepreneurs.

As many of the assembled readers of this techie newspaper will know, no founding management retains equity in a new company because of the startling shade of their baby blues, nor the cash (usually a £10 note or some such) they put in. No, you get to keep 5, 10, 40 per cent of the company because you're going to sweat blood and weep bitter tears making it work over the next five years. Your shares you get because of the labour you're going to put in. So there's the real problem: how can we bash the City bastards without insisting that everyone pay income tax on whatever they earn out of starting a business? Which would mean, of course, that very few people would bother to do so?

This is the circle that Darling has tried to square with his announcement of last week. The new rate for CGT of 18 per cdent stays, but we get a reintroduction of taper relief at 10 per cent. The trick is though that you can only collect £1 million over a lifetime at that new "entrepreneurs' relief" rate, anything over that paying the full 18 per cent whack. We're still not managing to distinguish between the entrepreneur and the private equity wide boy, for that entrepreneurs' relief will still be open to the latter for reasons explained above. But, as was probably the intention all along, we've been able to distinguish between rich bastards making even more money and the hoi polloi making enough to buy a house in London.

Actually, it's not a bad compromise and shows the value of having Darling as Chancellor. Having someone who doesn't know what they're doing in that position isn't ideal, of course, but if they know that they don't know they are at least amenable to advice and reason: a refreshing change from the office's last incumbent when he started fiddling with taxation for contractors and small companies.

It isn't all good news though: "Mr Darling will also tax any inflationary gains in the value of existing assets such as restaurants and hotels." That's simply insane. It's the introduction of huge tax rises through the miracle of fiscal drag: but that's another subject that only accountants or economists could love. ®

Tim Worstall knows more about rare metals than most might think wise, and writes for himself at timworstall.com, and for The Business and the Adam Smith Institute, among others.

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