The indexation allowance was introduced in 1982 by then-chancellor Geoffrey Howe who was concerned about investors paying capital gains tax on price increases resulting from the rampant inflation of the 1970s.
However, the allowance only took into account inflation after 1982, effectively penalising those who had bought assets before that date.
Nigel Lawson, chancellor to Margaret Thatcher, addressed this problem in his 1988 Budget by rebasing the cost of all assets held in 1982 so that any gains arising prior to that year were not charged. At the same time, he aligned capital gains tax rates with income tax.
Announcing the measures, Mr Lawson said: “This Budget thus ends once and for all the injustice of taxing purely inflationary gains.”
But the 1988 Budget did not bring an end to taxes on inflationary gains.
This is because in 1998 chancellor Gordon Brown replaced indexation with taper relief. This meant investors paid lower rates of capital gains tax the longer they held on to an asset. However the indexation allowance was still available for investors who had acquired assets before 1998.
Then in 2008, Mr Darling scrapped both taper relief and indexation relief, reintroducing a flat rate of capital gains tax.
Shaun Moore, of Quilter, said: “The capital gains tax indexation allowance was abolished in 2008 as part of government efforts to simplify the tax system as it was viewed as highly complex and had proven less necessary in times of low inflation.
“Since then, further steps have been taken to simplify the tax system which is a positive, but capital gains tax has become significantly more punitive in the process.”
For example, an investor who held £100,000 in 2008 would have made a gain of £55,797 based on average inflation of 3pc per year, according to Quilter.
This investor would now face a capital gains tax bill of £11,159 – tax that would not be due if the indexation allowance still existed. The calculation assumes the investor has already used their tax-free allowance elsewhere.
Meanwhile someone who had invested £100,000 in 1998, after indexation was frozen, would be worse off by £17,000.