On Britain’s Bubbling Capital Gains Tax Debate

How does one plug a £20 billion hole in the next fiscal year’s UK budget without raising income tax, national insurance contributions (NIC) or value-added tax (VAT)—or raising taxes at all on “working people”?^[i] This is the question likely plaguing new Chancellor of the Exchequer Rachel Reeves after her team purportedly identified a roughly £20 billion gap between projected public spending and tax revenues next year.^[ii] In an interview last week, she didn’t rule out a capital gains tax hike—putting the topic front and centre.^[iii] Several analysts we follow are now pencilling this into the Autumn Statement, and commentators we follow are warning it will hollow out the UK’s stock market. Yet we think the history of UK capital gains tax changes demonstrates otherwise as we will show.

First, we think it is important to note a capital gains tax hike is entirely speculation at this point. We know Reeves didn’t rule it out, and we know Labour’s manifesto pledged not to raise income taxes, NIC or VAT.^[iv] Same with taxes on “working people,” too—and whilst we encounter many “working people” who own stocks, we find politicians often ignore that and act as if only the world’s wealthiest invest.^[v] So we can see why commentators we follow are running with this idea.

But the Autumn Statement is slated for 30 October, over two and a half months away. Plenty can change between now and then. Tax revenue could come in higher than expected, altering the deficit projections and easing the alleged need for changes. Reeves could also be floating a trial balloon to get the market’s and the public’s reaction—a time-honoured tactic we have seen across both main political parties. Former Prime Minister (PM) Rishi Sunak was legendary for this as both PM and Chancellor.^[vi] So were his predecessors at Nos. 10 and 11 Downing Street. Loose comments in an interview are hardly a policy blueprint, in our view, never mind actual legislation.

Still, it is possible. Currently, the UK’s tax rate on financial asset capital gains (e.g., stocks) is 10% or 20%, depending on whether the investor is a Basic or Higher/Additional Rate taxpayer. Some commentators we follow speculate Reeves could end preferential rates entirely, matching them to income tax rates (20% for Basic Rate, 40% for Higher Rate and 45% for Additional Rate). Analysts we follow cite what we think are some obvious drawbacks to this—not least of all, that capital gains aren’t indexed to inflation (broadly rising prices across the economy), raising the risk that higher rates turn a nominal gain into a post-tax, inflation-adjusted loss. They warn this will sap the incentive to invest, leaving households and UK stock markets poorer for it. Yet from April 1998, the UK went a decade with capital gains tax rates matching income tax rates and with no inflation adjustment—just a preferential rate for ultra-long holding periods. But the UK stock market didn’t implode. It participated in global cycles.^[vii]

The UK’s capital gains tax rate history is short but telling, in our view. Until 1965, there was no capital gains tax. But financial historians note this led to a lot of accounting trickery and asset shifting, leading the government to introduce a 30% capital gains tax that April.^[viii] This predates the MSCI UK and MSCI World Indexes’ starting points.^[ix] But other measures show UK stocks rising a bit in the year up to the change and jumping the year afterward, beating US stocks in the aftermath.^[x] It doesn’t seem to us that going from no taxes to 30% and no inflation adjustment made the UK suddenly uninvestible.

Exhibit 1 shows the full history after this: a description of each capital gains tax change, along with trailing and forward one-year returns for the MSCI UK Index, the US-orientated S&P 500 Index and MSCI World Index. As you will see, it is all over the map. Indexing gains to inflation didn’t make UK stocks suddenly outperform in April 1982. Matching capital gains rates to income tax rates in 1988 didn’t make UK stocks suffer. Nor did scrapping the inflation adjustment in 1998. UK stocks’ returns the year after that are weak relative to the S&P 500, but they traded in line with the rest of Europe and in our view, those weak returns are tied more to the deep correction accompanying 1998’s Russian Ruble Crisis than anything local.^[xi] And on the flipside, slashing the capital gains rate to a flat 18% in 2008 didn’t prevent UK stocks from falling hard in the bear market (prolonged, fundamentally driven broad equity market decline of -20% or worse) accompanying the global financial crisis.^[xii]

Exhibit 1: A Brief History of UK Capital Gains Taxes and Returns

Source: UK Parliament and FactSet, as of 12/8/2024. MSCI UK price returns in GBP, S&P 500 price returns in USD and MSCI World price returns in GBP.

Yes, a capital gains tax is a tax on investing, and we generally agree with the principle that the more you tax something, the less you get of it—in theory and all else equal. But theory isn’t reality, and we find all else is rarely equal. Taxes are but one variable affecting people’s investment decisions, based on our research. Anticipated profits are another, tied to a host of factors, most of them global, in our view.

Hence, what we think it is helpful to point out when assessing taxes’ and politics’ market impact: Global usually swamps local. Global markets are highly correlated.^[xiii] You can see it in US and UK stocks’ parallel movements, even when their political backdrops diverge.^[xiv] You can see it in Europe, Australasia and North America moving from bull market (a long period of generally rising equity prices) to bear market and back again despite their disparate taxes, politics, trade policies, industry makeups and all the rest.^[xv]

The UK is a value-heavy market with big exposure to Financials, Energy, Materials, Consumer Staples and Health Care.^[xvi] It has precious little Tech (or Tech-like industries in other sectors).^[xvii] In our view, this sector and style makeup will probably have a much larger influence on returns than tax tweaks, just as our research finds it has for decades. In our experience, not many find index composition as exciting (or enraging) as taxes, so it doesn’t get as many headlines, but from a pure return standpoint, we think it is far more meaningful.