ChainWhat it assumes · how to break it
Start
The government raises capital gains tax on shares and business assets, taxing gains at rates closer to income tax.
1
As a result, the post-tax return on investing in shares and building up businesses falls.
rate of return
rate of return
Assumes: Investors pay capital gains tax on their returns.
But: Shares held in tax-free accounts such as ISAs and pensions are not subject to capital gains tax.
2
This means savers and business angels have less incentive to put money into risky ventures, so the supply of finance for new and growing firms falls.
incentives · cost of capital
incentives · cost of capital
Best link to attack
Assumes: The investors who supply finance are sensitive to UK capital gains tax.
Assumes: The investors who supply finance are sensitive to UK capital gains tax.
But: Pension funds and overseas investors, who own a large share of UK-listed companies, do not pay UK capital gains tax, so their incentive is unchanged.
3
Consequently, business investment and innovation are lower, so the capital stock grows more slowly.
investment · capital stock
investment · capital stock
Assumes: Investment depends mainly on post-tax returns.
But: Investment is driven largely by expected demand, interest rates and business confidence.
4
Therefore, productive capacity grows more slowly, LRAS shifts right by less and long-run growth falls.
LRAS · productive capacity
LRAS · productive capacity
Assumes: Lost private investment is not replaced.
But: If the revenue funds infrastructure or skills, public investment may raise LRAS by more than private investment falls.
End
Investment and productive capacity grow more slowly, so long-run growth may be lower.
Evaluation chain
- E1However, the effect on investment depends on whether the people who supply finance actually pay capital gains tax.
- E2Because pension funds and overseas investors own a large share of UK-listed shares and do not pay UK capital gains tax, the cost of capital for most large firms barely changes.
- E3As a result, business investment continues to depend mainly on expected demand, interest rates and confidence.
- E4So the effect on long-run growth is small overall and larger mainly for start-ups that rely on individual investors.
Another way to attack it: The lock-in effect works against growth too, since owners hold on to assets they would otherwise sell. However, a higher tax on gains from property rather than shares could move saving towards productive business investment.
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Questions this answers
- Assess the impact of higher capital gains tax on investment and growth.
- Discuss whether taxing wealth more heavily would harm the economy.
- Evaluate the conflict between reducing wealth inequality and promoting growth.
Diagram
AD/AS diagram: lower investment means AD rises less in the short run and LRAS shifts right by less in the long run.
Reverse and related
Cut in capital gains tax → higher post-tax return on risky investment → more finance for new firms, though most of the gain goes to the wealthy.