There has been a good deal of argument about whether capital gains tax (CGT) is good for South Africa. Many people opposing the tax have argued that South Africa is going against the worldwide trend, that CGT will undermine the economy, tax the lowerto-middle-income groups and will undermine savings. In the current Parliamentary hearings on the implementation
a Canadian tax expert, Professor Niel Brooks, debunked all these arguments. This is an edited version of his presentation.
There is a compelling case for taxing capital gains that has been made over and over again by tax reform commissions and tax policy analysts around the world over the past 50 years.
Income tax systems that do not include capital gains in the definition of income are widely perceived as being inadequate. Taxing capital gains not only enhances the fairness of an income tax system, but also increases the efficiency with which resources are allocated in the economy and thus raises the average standard of taxation.
The argument that "capital gains taxes are being discredited around the world" is dead wrong.
Elementary fairness is the most compelling reason for taxing capital gains. People with the same means should be treated the same way by the government.
In tax law, the notion that two individuals with the same ability to pay should pay the same amount of tax provides the ethical justification for a tax on income. Without substantial adherence to this moral imperative the legitimacy of the government to implement a tax on income is impaired.
For example, an individual who makes R30 000 in capital gains has the same ability to pay as an individual who receives R30000 of interest income or one who earns R30000 from a business or as an employee. They should all pay the same amount of tax.
In Canada recent research shows taxpayers earning over 250000 Canadian dollars (R1,25 million) constituted less than 0.3 percent of taxpayers but reported over 40 percent of all taxable capital gains in 1996. People earning over 100000 Canadian dollars represented less than two percent of taxpayers but reported all taxable capital gains.
In countries where income and wealth are distributed less equally than in Canada, capital gains would be even more concentrated among the very rich.
Although some low and middle-income individuals realise capital gains, the average amount reported by them is trivial compared to the amount reported by large income taxpayers.
Most low- and middle- income individuals who make capital gains hold small amounts of mutual funds or other investments.
Many tax analysts, particularly those who believe a free and neutral marketplace fosters a dynamic economy, argue that the strongest case for taxing capital gains is not based on fairness, but on economic efficiency.
The economic efficiency case for taxing capital gains is straightforward. It rests on the most fundamental assumption underlying a market economy. To ensure the efficient allocation of resources, and to spur economic growth, market forces should be left to direct financial capital to where it will earn its highest rate of return. If capital gains are not taxed, capital will flow to those assets and sectors in the economy where tax-free gains can be realised, and away from investments with a higher before-tax rate of return. Such distortions reduce the efficiency of the economy and will lower average standards of living and reduce the potential for economic growth.
Some commentators think that if capital gains are subject to tax, this will reduce the rate of return to private savings and therefore reduce the overall rate of personal savings in the economy. Both parts of this argument are flawed.
Capital gains represent only a part of the return to personal savings. The return on savings also comes from interest income and dividends. Any tax concession designed to increase personal savings should be available to the returns from all forms of savings.
This argument for not taxing capital gains assumes that an after-tax increase in the rate of return on saving will increase savings. There is evidence that the rate of savings is relatively insensitive to the rate of return on savings.
When people make a decision to save, this is generally based on their needs. After making the decision to save, they then look where they can earn the highest rate of return. That is, the rate of return they can earn generally does not influence their decision to save. The rate of return on savings, that is the interest rate, varies considerably over time and varies from country to country, yet, the rate of savings over time and between countries bears no relationship to variations in interest rates.
In the United States over the past 25 years, each time the capital gain rate of tax has been cut, the period following has seen a reduction in the rate of household savings.
There is no doubt that if South Africa is concerned about the rate of national savings, taxing capital gains and using the revenues to pay down the budget deficit and public debt would be much more effective than leaving capital gains untaxed.