1. CAPITAL GAINS TAX IN SA: SELECTED ISSUES
NATIONAL TREASURY: TAX POLICY CHIEF DIRECTORATE
2. CAPITAL GAINS TAX - FISCAL FRAMEWORK
- Systematic structural adjustment programme continues: real GDP growth improved to an average 2.3% per year for 1995 to 1999.
- Macroeconomic and fiscal challenge remains to increase growth & employment opportunities.
- Fiscal restraint: deficit before borrowing approximately 2% for 1999/00 - can be ascribed to impressive revenue collection performance & strong advances in tax policy reform
3. RATIONALE FOR TAXING CAPITAL GAINS - Distorted composition of national tax revenue indicates inequity.
- Introduction of CGT will address fundamental structural weakness in SA tax system, by minimising tax arbitrage opportunities over time … increased attention by authorities on possible avoidance practices in the corporate sector.
- Base broadening will enable across the board rate reductions.
3.1 International trends & practice in taxing on the basis of the comprehensive income concept - Majority of tax jurisdictions accept soundness of ‘comprehensive income’ concept (Haig-Simons), meaning that the total sum of all revenue streams (the ability to consume plus net wealth accumulated) over tax period should be included in the income tax base as it constitutes increases in the purchasing power of a taxpayer.
- Both developed and developing countries have introduced CGT systems.
- AFRICA - 14 out of 43 jurisdictions have decided against CGT or data on CGT is unavailable, 68% of countries have CGT provisions.
- ASIA & ASIAN PACIFIC REGION: 21 out of 46 countries have no CGT provisions.
- AMERICAS: only 2 countries out of 19 jurisdictions in that region have excluded CGT provisions from their respective income tax acts.
- CARIBBEAN & MIDDLE EAST: 12 out of 22 jurisdictions no CGT legislation.
- EUROPE: 31 countries tax capital gains
4. CAPITAL GAINS TAX & EQUITY - Tax reform and tax policy informed by 3 central tenets of tax design: equity, efficiency (intersectoral neutrality) & simplicity.
- Proposed CGT legislation contributes to progressivity of income tax system, thereby underpinning vertical equity principle.
- Given high income inequality in SA (Gini coefficient of 0.61) inclusion of capital gains is absolutely necessary; tax liability will be concentrated within ranks of high-income earners - underpins progressivity of ITA
4.1 Capital gains and economic efficiency - Excluding capital gains from income tax fundamental structural weakness which triggers tax avoidance & misallocation of productive investment resources.
- CGT will improve allocation of investment funds by switching from risk-adverse, low pre-tax RoR property investments into high-risk, high pre-tax RoR income producing investments.
4.2 Capital gains tax & simplicity - Capital gains tax is difficult to justify on the grounds of simplicity but - - "simplicity has not been the outcome of a lack of capital gains tax in New Zealand." - As in SA, the income tax in New Zealand has become complicated due to the endless process of including anti-avoidance measures as taxpayers seek to recharacterise ordinary revenue streams into untaxed capital gains.
4.3 The capital vs revenue distinctions - could more certainty be created? - Capital gains should ideally be taxed in full as rand of gain is equal to any other rand of economic gain or accretion in revenue.
- Preferential treatment of capital gains erodes the redistributive impact of progressive income tax system.
- Preferential treatment of capital gains is primary reason for complexities in any income tax system as intricate anti-avoidance rules need to be drafted.
- Jurisdictions cannot prevent the conversion of ordinary income into capital gains as a capital gain is only what the law says it is. Hence, investigate possibilities of new definitions and rough justice rules that categorize certain transactions as ordinary revenue if it constitutes the main activity of a business sector?
- Non-taxation of capital gains compromises taxpayer morale.
- Preferential treatment of capital gains leads to inappropriate uneconomic activity.
- Full taxation of capital gains would underpin the income tax system’s counter cyclical effects.
5. STRUCTURE OF PROPOSED CGT - It is sub-optimal from the perspective of arresting tax avoidance … capital gains should be taxed fully (full inclusion rate) as other forms of income or profits.
- Well-advised and wealthy taxpayers will continue to exploit existing tax arbitrage opportunities.
- It will trigger a constant design of new anti-avoidance measures, adding to complexity of the current draft legislation -- this is an unavoidable trade-off which most jurisdictions have to make.
- National Treasury reiterates its policy preference for minimal use of tax incentives & overall reductions of income tax rates as it reduces distortions and fraudulent tax practices.
6. CGT & ECONOMIC ACTIVITY - International experience suggests that the introduction of CGT will not impact negatively on economic growth … most economies with robust growth performances tax indeed capital gains.
6.1 CGT and saving - In an environment absent of any CGT legislation, national savings in SA declined from 27,1 per cent of GDP from 1979-84 to 16,1 per cent of GDP for 1994-98.
- International evidence indicates that introduction of CGT should not aggravate this trend.
- OECD studies point to the fact that effect of taxation on household saving is ambiguous due to offsetting income and substitution effects.
- Len Burman, former US Treasury Assistant Secretary: Tax Policy states that - ‘changes in the taxation of capital gains are likely to have little effect on private savings’
6.2 CGT, investments & economic growth - Impact of CGT on investments & economic growth must be analysed in 3 steps:
- effect of CGT on cost of capital (RoR an investment project must generate to attract investment funds)
- elasticity of investment spending with respect to changes in the cost of capital
- effect of investment on economic growth
- User cost of capital has 2 components:
- depreciation rate of tangible capital assets
- financial opportunity costs of investment, measuring financial return foregone by sinking money into project rather than investing it in money or capital market.
- CGT affects only financial cost of capital, which is also influenced by real interest rates, inflation rates, tax rates on interest & dividends, tax depreciation rules, investment allowances & basic corp. tax rate
- The effect of CGT on investments is therefore a problem of multiple elasticities - the change in the cost of capital resulting from CGT, the change in investment resulting from changes in the cost of capital and the change in output resulting from the change in investments.
- The product of multiple elasticities (three numbers smaller than 1) will result in another small number much less than 1 indicating a small overall sensitivity to the CGT introduction.
6.3 CGT and risk-taking - Does CGT limit risk-taking & entrepreneurship?
- CGT lowers after tax RoR for high risk investment projects BUT by allowing deductions for capital losses, loss potential of a risky investment can be reduced, making these investments more attractive.
- Ultimate effect of CGT on risk-taking depends on:
- risk profile of investment
- degree of risk aversion by investor
- extent of investor’s portfolio diversification for offsetting capital losses against other taxable gains
7. CGT: INFLATION INDEXING
IMPACT OF INFLATION ON TAX SYSTEMS
- General effects
- Impact of inflation on personal income tax
- Impact of inflation on corporate income tax.
- Impact of inflation on the CGT
METHODS OF ADJUSTING FOR INFLATION
- Global adjustment method
- Partial adjustment method
- Ad hoc adjustment method
- Applying a lower rate of tax
- Applying a partial exclusion - Fixed percentage exclusion
- Variable exclusion
ADVANTAGES OF INFLATION INDEXING
- Consistent effective tax rates
- Distortion of investment incentives
- Argument on taxation of inflationary gains
- Both indexation & exclusion create tax arbitrage on various assets: Growth vs dividend-paying assets
- Indexation more efficient than exclusion in discriminating against dividend-paying assets
DRAWBACKS OF INDEXING CGT
- Creation of anomalies and distortions between gains and other forms of income
- Indexing with a ‘loss-limitation rule’ amounts to partial indexing
- ‘Loss-limitation rules’ enacted to offsets revenue losses on the Treasury
- Capital gains vs other forms of income (horizontal equity)
- Capital gains accrue disproportionately to wealthier members of society (vertical equity). Also, consider SA’s high income inequality
- Administrative complexity
- An asset that is built over time would involve extensive calculations
- Australia & UK’s decision to move away from indexing motivated by need to withdraw complicating features in the tax system
- What index to use for inflation adjustment
- Macroeconomic - inflationary expectations
Interaction of inclusion rate, inflation rate, holding period (deferral benefit!) and pre-tax real return on individual’s effective tax rate
[Table not included]
Summarising the discussion of the effective CGT tax rate as impacted upon by inflation - Effective tax rate depends on real RoR, inflation rate and holding period for which asset is held.
- Given low proposed inclusion rate, only moderate real RoR are required at moderate inflation of 5%.
- Effective tax rate falls as holding period increases.
- Realisation basis of taxation confers significant deferral benefits to taxpayers.
Survey of 40 countries: Do they have CGT? Do they index?
- 10 out of 31 developing countries were found to have some form of inflation indexation in their respective CGT regimes.
- Argentina & Brazil have since removed indexation as have the UK, Spain and Australia.
- Majorityof countries that indexed CGT have experienced excessive inflation - the average for Brazil & Argentina between 1970 and 1999 was 612% & 317 % respectively.
- SA’s average 1970-99 CPI is 11.4%, for 1993-99 it is 7.9% .
CGT inflation indexation - Conclusions - At moderate rate of inflation, defensible real RoR, low inclusion rates the deferral benefits due to the realisation basis of taxation are huge, thereby adequately compensating for effects of inflation.
- SA’s inflation rate continues to fall, positive inflation outlook underpinned by explicit inflation targets implemented by SARB.
- Internationally, countries abandon inflation indexation.
- Inflation indexation although conceptually simple, very difficult to administer with high administrative & compliance costs.
- Indexing only CGT and not the rest of tax system creates unintended consequences, distorts the economy and compromises horizontal and vertical equity principles.
- Adjusting for inflation only necessary if anticipated inflation reaches levels in excess of 20 %
CGT and its interaction with capital transfer taxes - CGT is tax on income and is an integral part of the income tax act
- Other taxes on wealth are net wealth taxes and capital transfer taxes include gross asset taxes as a minimum income tax, including taxes on immovable property.
- Other capital transfer taxes are so-called accession taxes in the form of inheritance taxes, estate duties, gift taxes, stamp and transfer duties.
- No inherent logic that would suggest that one should either have a CGT and none of the other - capital transfer taxes constitute useful tax handles which need to be exploited & affordability concerns
CGT & interaction with capital transfer taxes - revenue importance [Table not included]