Budget preview: what to expect on capital gains tax, inheritance tax and dividend tax

There is the potential for major changes to be made to the tax system at the Budget on 30 October, many of which could impact personal finances. We consider three areas that could be in the firing line.

Capital gains tax (CGT)

Having ruled out increases to some other taxes, capital gains tax (CGT) might appear like an obvious place for the government to make changes and generate more tax revenue.

The most radical option is equalising CGT rates with income tax – which would represent a huge tax increase for investors.

The Institute for Fiscal Studies has called for reforms to go further – and for an end to the exemption on death – arguing that the current system actually discourages productive investment.

The CGT allowance has been slashed in the past two years as former chancellor Jeremy Hunt sought to balance the books, but that doesn’t rule out further tax increases.

However, it may not be the cash cow that many think it is. The government’s own figures show that a big increase in CGT rates could backfire and actually lead to lost revenue for the government. For example, raising both the lower and higher CGT rates by 10 percentage points, to 20% and 30% for non-property gains, would result in a total loss of £2.05 billion for the Exchequer by 2027/28. That’s because while the rates are higher, investors would be expected to change their behaviour to mitigate paying the tax.

Capital gains tax being wiped out on death also creates an incentive in some cases to hold onto assets so they are taxed as part of the estate under inheritance tax (IHT), potentially paying less or no tax. But if the government scrapped this tax break, there would likely need to be some allowance made to account for inflation. Otherwise, people who have owned investments for a long time would be severely punished.

One option is to raise the rate of CGT for higher rate taxpayers to 28% from April 2025. This would be relatively simple to implement and puts it back to the higher rate introduced by George Osborne in 2010. It also narrows the gap between income and investment gains, but not to the extent of taxing them equally at rates of up to 45%. Waiting until April 2025 rather than implementing a hike on Budget Day could also bring forward sales investors were already considering.

It would also be a logical second step to the changes already in progress. Private equity fund managers receive a share of the funds’ profits as carried interest in a personal capacity. Carried interest is taxed under the CGT regime at 28%, rather than as salary income, but the government has already set the wheels in motion to treat and tax it as income, despite calls that it could dent the competitiveness of the UK private equity industry.

An alternative would be to get rid of some of the CGT tax breaks for businesses, where business owners selling their company benefit from a lower rate of CGT. Raising this rate from 10% up to 20% to equalise it with standard CGT rates is estimated to generate £710 million for the government by 2027/28 – but it’s clearly not a move that will be popular with entrepreneurs.

Inheritance tax (IHT)

Often cited as the UK’s most hated tax, despite only being paid by a small proportion of the population, the chancellor could set her sights on raising money through IHT. At 40% it’s already one of the highest tax rates, so it’s unlikely we’d see a headline rate increase. What’s more likely if Ms Reeves did want to change this tax is cutting allowances or whittling away certain reliefs to increase the amount some estates pay.

A couple leaving their main residence to their children could potentially shelter a £1 million estate from inheritance tax, thanks to both the nil-rate band and the residence-nil-rate band – but either of these could be cut. Another option is taking a red pen to the reliefs given to businesses or to gifting rules – although these aren’t overly generous anyway.

Tax relief on AIM shares

Abolishing tax relief on owning certain AIM-quoted shares could be high up the list of ‘easy wins’ for Rachel Reeves, writes AJ Bell Investment Analyst, Dan Coatsworth.

The Institute for Fiscal Studies said in April that abolishing IHT relief on qualifying AIM stocks would raise £1.1 billion in the 2024-25 tax year, rising to £1.6 billion in 2029-30. There is an argument to say the system is outdated and hard to defend.

Business property relief legislation came into force in 1976 for family firms passed down through generations so that inheritance tax bills wouldn’t put a privately-owned business into liquidation. It was subsequently expanded to include holdings in businesses quoted on London’s AIM stock market following concerns that such investments were harder to sell quickly than shares on London’s Main Market. While AIM stocks are typically smaller in size versus ones in the FTSE 350 index, it’s fair to say that liquidity has improved since the junior market launched in 1995.

Scrapping the tax relief on AIM stocks could backfire. Principally, it goes against the government’s efforts to support UK business growth. Without the tax benefit, investors might rethink why they are holding certain AIM stocks, leading to a sell-off in small caps just at the point where investors are starting to show more interest in the UK market. That could pull down valuations and accelerate UK takeovers if more companies are trading cheaply.

Dividend tax

The previous government has already cut dividend tax allowance to the bone, going from £5,000 to the current £500. The big question is whether Labour is prepared to go any deeper.

HMRC is expected to collect almost £18 billion from dividend tax in the current tax year so it is already a meaningful source of revenue. While slashing the allowance, perhaps to £250, cannot be ruled out, the new government would be incredibly unpopular with investors if it reduced the dividend allowance any further.

Another option would be to raise the rate of dividend taxation, although there’s only so much room for manoeuvre with tax rates on dividends already close to matching income tax rates for higher and additional rate taxpayers.

The government will likely tread carefully here. Labour wants to encourage investment into the UK stock market and create a more vibrant place for British businesses to access growth capital. Therefore, taking even more of investors’ returns as tax could mean shooting itself in the foot.