Capital Gains Tax Bleg

By Seamus Hogan 18/09/2014

When I first started writing posts on capital gains taxes three years ago, starting with this post and this one, they were sort of a bleg. I have never understood the rationale for CGT, as the arguments that are usually put seem to involve shifting definitions, or incomplete partial-equilibrium analysis. So I wrote those two posts to explain why I thought the arguments in favour don’t add up, hoping that someone could counter with a coherent argument. With a CGT defended within the context of a coherent model, it should be possible to phrase the debate in terms of differences in either values or empirical beliefs about the economy. Three years on, I have seen a lot of public discussion of capital gains taxes, but still don’t understand what is the model from which proponents draw their conclusions.

But now I have a different bleg. I would like to know how actual CGTs that have been implemented elsewhere (or the ones proposed by opposition parties in New Zealand) would deal with a particular issue. This issue is easiest explained with a series of examples:

  1. Imagine that you are a householder with a portfolio of $2,000 of shares in a single company that is earning a 5% rate of return on its capital. At the start of a new year, you decide that you want to save some more, so you buy $100 in a different company using money you have earned in the previous year but not spent. You now have a portfolio of $2,100. This increase in the value of your portfolio would not be classified as a capital gain. It simply represents increased savings.
  2. Now imagine that instead of putting the $100 into a different company, you bought $100 of freshly issued shares in the same company that you already have a shareholding of $2,000.  That still doesn’t count as a capital gain, right? The company uses the money from its new share issue to buy some capital equipment, which will also earn a 5% rate of return, but what they do with the money is irrelevant.
  3. Now, imagine that in the previous year, you were paid a dividend of $100 by the company in which you own $2,000 of shares, and you bought $100 of freshly issued shared by the same company. Again, this makes no difference. The fact that your purchase of new shares was in exactly the same amount as your dividend payment, is irrelevant; the additional $100 was paid for out of your total income and was available for buying shares because of a choice not to use it on consumption. 
  4. Now make one more change. Instead of paying out $100 in dividends and then issuing $100 of new shares, the company simply retains the profit, pays a dividend of $0, and uses the money to pay for the new capital, as above. The company has increased its ownership of capital equipment by 5%, and so the value of the existing shares will increase by 5%. So now our shareholder sees that his shareholding portfolio has increased from $2,000 to $2,100, just as in all the previous cases, except in this case he hasn’t bought any new shares; he has seen what looks like a capital gain of 5%. Except, it is not really a capital gain; the reinvestment of profits by the company instead of paying out a dividend is a form of saving that is imposed on its shareholders.  

In the absence of taxes, the only difference between example 3 and 4 is in the default position. In 3, the shareholder receives the dividend and needs to make a decision to buy new shares to turn that dividend into saving. In 4, the default is that the dividend is saved, and the shareholder would need to sell $100 of shares to convert that saving into consumption.

But what if we add capital gains taxation. Wouldn’t a CGT induce a difference between example 3 and example 4, adding additional taxation in the latter but not the former. And wouldn’t this induce a distortion in which the tax system created an incentive for firms to pay out all their profits as dividends and then raise new capital rather than retaining profits for investment? What I would like to know is how to other countries deal with this distortion in their CGTs (if at all), and how would the opposition parties in New Zealand plan to deal with it.

It is also interesting to note that currently in New Zealand, there is a slight tax distortion that favours retained income over dividend payout (as the corporate income tax rate is lower than the top rate of income tax). At the time the rate was lowered from .33 to .30 in 2008, the then Labour government said this was a deliberate distortion as a kind of nudge to encourage retained earnings and hence make saving the default. Does Labour now think that we should be changing the nudge to consumption by moving the tax advantage the other way?

0 Responses to “Capital Gains Tax Bleg”

  • This is quite a distortion. You wrote :
    “In the absence of taxes,…”
    “But what if we add capital gains taxation.”
    “And wouldn’t this induce a distortion in which the tax system”

    Dividends are already taxed. People pay tax on it based on their income – ie their is already a distortion in the tax system. Introduction of a CGT is an attempt to lessen that distortion. Currently, there is tax paid on option 3 so a dividend of $100 would only buy about $70 worth of shares. In option 4, the price goes up. If you sold $100 worth for consumption, you would be $30 better off than in option 3. That is the sort of distortion being talked about.

    Note that capital gains on shares are already taxable if the person is a share trader.

  • Brent,

    You would be right if we didn’t have full imputation of corporate income tax. Make the CIT 30% in your example. $100 of corporate profit results in $30 of CIT, and then $70 paid out as dividends in option 3. There is no additional income tax paid on that income, as the CIT is imputed as the income tax already paid. In option 4, the same $30 is paid as CIT and then $70 not $100 is the increase in the value of shares. There is no distortion to remove. Now in New Zealand, the CIT is 28% and the income tax rate could be as high as 33%, so there is a 5 percentage point difference between the two options and that distortion could be removed by having a 5% CGT, but having a CGT at the full income-tax rate would create a far greater distortion. In any event, a far easier way of removing it would be to bring the CIT and the top rate of income tax back into line. And, of course, if the reason for having the lower rate of CIT in the first place is to encourage retained earnings (Labour’s motivation in 2008), then even a very low 5% CGT would be counterproductive to that objective

  • I should add that if we did not have imputation, it wouldn’t immediately follow that we should have a CGT. In the absence of a CGT, there is a distortion in which debt finance, retained earnings and share buybacks are favoured over dividend payouts, due to the double taxation of dividend income (once as corporate profits and once as dividend income). Adding a CGT means that reinvested profits and share buybacks are now also subject to double-taxation, removing the distortion between those two mechanisms and dividend payouts, but increasing the distortion between them and debt finance, and increasing the distortion favouring consumption over savings. That is, even in a country without imputation, it is not clear that a CGT would be desirable.