The hunt is on for extra tax revenues. First came the announcement of an NHS funding boost, back in June. Now, the Chancellor has the harder task of working out where he will find the more than £20 billion required. Some is likely to come from higher borrowing, and better than expected public finance figures this year will help. But to make the figures add up the real question is likely to be not whether taxes should rise, but which ones. And that’s before any consideration of other pressures for increased spending on, say, social care, defence, prisons or Universal Credit.

Hard choices are coming in the years ahead, whether on corporation tax, fuel duty, income tax or other big revenue sources – even if they might be ducked in the upcoming Budget by a government that lacks a majority. But alongside the usual major tax options, it’s worth looking at the £155 billion a year of big ‘tax expenditures’: tax breaks that are aiming to achieve economic or social purposes and that could alternatively be delivered through government spending.

We’ve often said that these reliefs need more scrutiny and debate – just like departmental spending receives, to ensure policy delivers value for money as far as possible. Some reliefs may be quite defensible. Others may be suboptimal but at least have some clear positive impact. But the subject of this analysis – Entrepreneurs’ Relief (ER) – is of very little merit at all. 10 years on from its introduction, perhaps now is a good time to check what this relief achieves, at what cost, and who benefits. None of the answers are flattering.

What is it?

ER is a tax relief that aims to encourage people to start or join growing companies, by lowering the rate of capital gains tax (CGT) they pay when selling the company.

At present, the top CGT tax rate (except for residential property) is 20 per cent, with a basic rate of 10 per cent and an annual tax-free allowance of around £12,000. So if you buy an asset (be it a company or a painting) for £1 million and then sell it for £6 million, you may well pay almost £1 million of CGT on the increase (leaving a £4 million return). ER allows people to pay only a 10 per cent tax rate if they dispose of all or part of a company in which they own at least 5 per cent of shares and voting rights (and have done for at least a year). External investors with smaller stakes can now benefit in some circumstances too.

The relief is limited to gains of £10 million (over a lifetime), up from £1 million when first introduced in April 2008. As it results in a 10p difference in rates, in terms of tax saved there is a maximum benefit of £1 million per person. However, couples may be able to structure their activities so as to benefit twice over. That is a lot of tax relief.

Figure 1: The Entrepreneurs’ Relief limit was dramatically increased in 2010-11 and 2011-12, but its value has also changed as a result of shifting CGT rates

Source: IFS Fiscal Facts. Note the limit was briefly £2 million between April 6 2010 and June 22 2010.

How much does it cost?

HMRC estimates that the relief cost £2.7 billion in 2017-18 (and the cost was higher until 2016-17 when the standard CGT rates were cut, lowering the value of the relief by reducing the tax that was due in the first place). In ‘Brexit bus’ terms, that’s over £50 million a week. Combining figures from numerous publications, the total cost over the relief’s first 10 years has been £22 billion.

As the National Audit Office has previously noted, these costs have been around three times as high as initially predicted when the relief was approved by parliament (as shown in Figure 2), as more people have taken advantage of it than expected. And policy changes have also greatly increased the cost. When introduced by Alistair Darling – following criticism of other CGT reforms he had introduced – it was predicted to cost only £200 million a year. So, overall, the relief now costs over 10 times what was originally intended.

Figure 2: The relief always cost more than expected, and has grown dramatically

Source: NAO and HMRC. The original projections line includes “HMRC’s published forecasts of the original cost of the relief and four subsequent extensions” (NAO).

To put the £2.7 billion cost in perspective, Figure 3 shows parts of public spending, taxes and benefits with similar costs. And, no, you’re not misreading it: the government does ‘spend’ more each year on ER than on intelligence (MI5, MI6 and GCHQ) or the foreign office.

Figure 3: The cost of different policies and spending items in 2017-18

It should be clear that serious scrutiny is justified simply due to the amount of money involved. For comparison, how much has been written about trying to reduce the cost of Winter Fuel Payments or about the ‘bedroom tax’? How much effort went into reducing spending at the foreign office, BBC or HMRC? How much of academic researchers’ time goes into grant applications, rankings and impact assessments to try and ensure money is well-spent? We should not be spending £3 billion a year on ER without having at least some analysis and conversation.

And on the face of it, one must be sceptical that ER provides value for money. Does it really deliver greater benefits (specifically, four times more) than the Medical Research Council, which receives around £700 million a year to fund research on cancer, dementia and other health advances? Is it really as valuable to society as the intelligence services, or Carer’s Allowance or Statutory Maternity Pay? Is it as valuable as other tax reliefs like Gift Aid for charities or R&D tax credits for businesses? Is it really preferable to giving every household a £100 (per year) tax cut, or other major tax cuts?

Who benefits?

There is little information to go on regarding ER’s impacts (and note that household income surveys don’t even ask about capital gains). But HMRC stats do show that 52,000 people claimed ER in 2015-16 (excluding trusts). Given the estimated cost of the relief in that year (and with some adjustment for trusts), this gives an average gain of £75,000 per person. Unsurprisingly, 82 per cent of those who’ve benefited have been male, with a typical age of 57, while a narrow majority of CGT revenue comes from London and the South East.

12 per cent of ER claimants made claims on gains of over £1 million. But this small group accounted for a massive 69 per cent of the gains on which ER was claimed. If we assume (slightly conservatively) that everyone faced the same CGT rate (rather than the smallest gains attracting the basic rate or zero tax), this implies that £2.7 billion out of £4.2 billion in that year (69 per cent) went to just 6,000 people. This gives an average gain for those lucky few of nearly half a million (£450,000) each.

Like the total cost of the policy, this figure is very likely to have fallen since 2015-16 as the top CGT rate has been cut. But even if the average gain of the biggest relief claims had fallen in line with the overall cost of ER, the luckiest 6,000 may have saved £290,000 each on average in 2017-18. Undoubtedly, some will have benefited from the maximum of £1 million each.

What does it achieve?

The government often does not explicitly say what a tax relief is intended to achieve, or how it is expected to achieve it, except in the broadest terms. After all, that might allow a detailed assessment against that goal, and ER has evolved more out of a series of political expediencies than out of a grand design.

Insofar as there is a theory behind the existence of ER it must be that there are some profit-motivated individuals who might not risk starting or entering a company if they thought they would face a 20 per cent tax if very successful, but that a 10 per cent rate would change their mind, and that these companies will produce innovations and competition, or otherwise raise productivity, in ways that would not have otherwise happened, ultimately improving living standards.

Some limited government research sheds doubt on the likelihood of that chain of events happening very often. A survey of some of those who’ve benefited from ER finds that only 16 per cent were aware of the relief when they made their investment, and half of that sub-group said it has no influence on them (see Figure 4). To be fair, many may have made their investment before the relief was created in 2008, but this raises the question of why £22 billion has been spent giving retiring businessmen tax cuts that they weren’t expecting when they originally invested? And even at the point of disposal, only 16 per cent said their decision – e.g. the timing or nature of the disposal – was influenced by the relief.

Figure 4: Even when disposing of assets, few beneficiaries of ER were aware of and influenced by it

Source: Capital Gains Tax Entrepreneurs’ Relief: Behaviours and Motivations, May 2017

Another government-commissioned report gives a very small number of case studies. There are some positive examples, such as a claimant who had turned around a failing furniture business, motivated by the relief. But, in keeping with Figure 4, most were retiring business owners – such as a partner in a dental practice – who were going to sell regardless, and for whom ER was just a welcome bonus suggested by their accountant. One also noted that they had been able to maximise the gains by transferring shares to additional family members.

Indeed, perhaps the biggest impact of ER is to distort business decisions. Not least, this includes very strong incentives to incorporate and (for those with the means) not to take income as dividends or salary.

Might there be any broader evidence to suggest ER’s cumulative cost of £22 billion has been money well spent? It should be noted that the number of people incorporating has risen dramatically since 2012, as Figure 5 shows. The biggest driver of this is likely the other, shorter-term, tax advantages that incorporation brings compared to other self-employment and employment, but it is plausible that the potential to take advantage of ER may have played some role too. But, in any case, there is no evidence to suggest that this rise in incorporation has delivered any results, however, other than a well-known hit to the Exchequer. Indeed, while the number of incorporated self-employed has doubled over the past six years, the number of self-employed people who are employers has actually shrunk.

Figure 5: Incorporation has become increasingly common, but being an employer has not

Source: RF analysis of LFS

Proving the economic impact of policies is always going to be ferociously difficult. But defenders of ER (if any) should try to show at least some evidence of impact or potential mechanisms for impact, in order to justify the very significant cost and complexity it adds.

Even with the goal of generally boosting ‘entrepreneurship’, concentrating the spending among a small group of 6,000 people a year may not be the best approach. For comparison, almost 5 million people are self-employed. And, looking to an even wider distribution, back in May the Intergenerational Commission proposed a use-limited £10,000 universal inheritance for everyone when they turn 25, in part to help young people start their own businesses. Whatever you think of that policy, it’s striking that a £4,000 per person universal inheritance would be no more costly than ER. It’s certainly arguable that ER comes at the wrong stage in a business’s life and that supporting large numbers of young people when they’re starting up a business might do more for entrepreneurship than giving very large sums to a small number of retiring people.

Finally, even if ER were considered worthwhile overall, it might be that a £10 million limit is not worthwhile compared to a lower limit. Even the scant research done on some of those who’ve actually claimed ER found that if anything the limit was considered generous: “Most claimants felt that anyone who reached this limit did not need the 10% relief rate, and felt that the lifetime limit would not drive business behaviour.” Returning to the original limit of £1 million, for example, could substantially reduce the cost to the Exchequer.

In looking for tax revenues to provide promised extra cash for the NHS – where the question is likely to be “what is the least bad tax rise” – the Chancellor needs to take a long, hard look at ER: quite likely the worst tax relief in the UK.