To Tax Capital Gains Or Not to Tax Capital Gains

Taxing the slings and arrows of outrageous fortune,

The public discussion on a capital gains tax (CGT) has quickly descended into ignorance, hysteria and self-interest. Is there any point in trying to make an analytic contribution? I guess this columnist would be pointless if he did not try.

Practically capital gains taxation occurs when one sells the relevant asset – such as real estate, financial investments or interests in a business – to someone else. Realised capital gain refers to profits that result from a sale where the sale price exceeds the purchase price; the gain is the difference between a lower purchase and a higher selling price. Conversely, a capital loss arises if the proceeds from the sale of a capital asset are less than the purchase price.

There is, then, a real sense that the buyer paying the capital gain in the purchased asset is making an offsetting capital loss. (So you may make a capital gain from selling your house, but you then make a capital loss by buying the next one.)

Investors buy into these capital losses because, presumably, they think they are going to get a good return from their purchase. (The new house suits their purposes better, or perhaps they plan to flick it on to another muggins.)

In effect, sellers are bringing forward some of the expected return of the asset as a lump sum payment to themselves. Since the return has not yet occurred (and, for simplification, assuming they consume their gains) they are accessing savings from future returns. From this perspective, capital gains are a kind of Ponzi scheme in which early investors (those who make the capital gain) benefit from later investment (those who make the capital loss).

 As shocking as the last sentence may seem to some, the view that the financial system is a kind of Ponzi scheme is held by many orthodox economists. However, most see that often the result is the benefit of innovative investment and increased economic prosperity. However, their analysis does not say capital gains always give a benefit to the economy as a whole.

One issue that hovers behind this is that if capital gains – even the good ones – involve a Ponzi Scheme, is it possible that the process will continue in perpetuity – unlike the standard fraudulent one? I am cautious. Insofar as the capital gains are a response to inflation, I suppose they can go on as long as prices generally rise. But they wont always. For instance, we may be going into a period of housing price stagnation (or even decline). Insofar as capital gains arise from economic growth, it is possible they will, in aggregate, come to an end when economic growth (as measured in the market) does.

Should we tax capital gains? One argument is that a CGT would reduce financial instability and the potential viciousness of the Minsky cycle, discouraging and softening the later speculative and Ponzi stages which depend upon capital gains. (You could see how the current housing boom could have been muted had there been a CGT, even were it confined to second properties. The benefit would be that houses would now be more affordable.)

However, a greater concern has been that without a CGT different investments are taxed at different rates and that will distort investment to less-productive activities. (Everyone may be building bigger houses than they need because that gives bigger capital gains; in which case the diversion of construction resources will mean fewer houses built for living in.)

This concern is significant enough for a number of conservative economic institutions – including the New Zealand Treasury, the Reserve Bank of New Zealand, the IMF and the OECD – to advocate a CGT or, more precisely, to argue that all investment income should be taxed the same, irrespective of whether it comes from capital gains or from profits, interest and dividends.

I am not sure they would support the exact proposal from the Tax Working Group (TWG). Some capital gains arise from inflation and it is not obvious that the inflation component should be taxed. Mind you, exempt capital gains for inflation and you should also exempt interest and tax it on the real rate. (Perhaps the easy way to do this would be to deduct the RBNZ target inflation rate of 2 percent p,a. from interest earnings and tax only the residual.)

However, to tax only the real return on investment income would reduce the net revenue and there would be less available for cutting income tax rates across the board. Even so, we would probably get some efficiency gains from better quality investment while discouraging the speculative phase of the Minsky cycle.

Thus far the discussion has been on the efficiency of a CGT and has said little about equity, which seems to have been the TWG’s primary focus. The argument is that some people pay tax on their investment income and others do not. Moreover, it is those on higher incomes who are the main beneficiaries of the absence of a capital gains tax. That seems hardly fair.

The TWG set out how the additional revenue from a CGT could be used to reduce income tax rates generally. (As directed by the government terms of reference; you might prefer that all or some is spent upon struggling public services.) An important consequence is that it shifts the tax burden from labour to capital.

If you listen to the hysteria on CGT carefully and ignore the blatant self-interest/greed – alright, alright that is almost impossible – the concern is this change of balance, or rather that the tax rate is going up on returns on capital (most do not mention the recommended cuts in income tax rates). This is something we should talk about, but not hysterically or surreptitiously; it is hardly discussed in the TWG report.

What worries me is that it is difficult to assess the full impact of a CGT. I am not too concerned at the effect on second housing and land banking if the government takes offsetting measures to redirect the resources into adding family homes. A CGT on shares could be justified by the enormous reduction that the Rogernomes gave to taxation on dividends. But the farming industry and small businesses have been built around capital gains. I favour weaning them off the addiction, but I want to do it without destroying the sectors.

Indeed there is an interesting way to think about the TWG report strategy, harking back to the 1980s neoliberal era of Rogernomics. Policy was then crashed through and damn the consequences. That time the disruption set back the economy for a long period. The difference this time is that the proposal has the reverse distributional impact. Instead of taking from labour incomes and giving to investment incomes – from the poor to the rich – the TWG’s proposals operate the other way around. Those that benefited from Rogernomics are using exactly the same arguments today as they did then. Recall their promised overall economic benefits from the last round of changes never turned up. Will the detriments they failed to predict last time, occur this time?

Apologies for this being a rather difficult column – if a better explanation turns up I will draw attention to it. In truth the analysis is difficult, which is why it is much more exciting to be ignorant, to be hysterical and to focus on self-interest.