Virtually all economists agree that capital formation is essential for economic growth and job creation by increasing the pool of risk capital available for new entrepreneurial startups. Capital includes machinery, equipment, plants, computers and physical tools that workers use on the job in order to enhance productivity and generate more output.
Capital also increasingly applies to intangibles like patents, inventions, computer software and information technology, which are more important than ever for the production of goods and services in the modern economy. Almost everything you own and use for personal or investment purposes is capital asset. Examples include a home, moveable and immovable property and stocks or bonds held as investments.
A capital gains tax is the tax when you sell a capital asset. Capital gain is the income derived from the sale of investment capital. This capital investment can be a home, plot of land, farm, purchase of stocks or bonds and other assets. Capital gain is the difference between the money received from selling the asset and the price paid for it.
The capital gains tax is different from almost all other forms of taxation in that it is a voluntary tax. Since the tax is paid only when an asset is sold, taxpayers can legally avoid payment by holding on to their assets – a phenomenon known as the "lock-in effect".
No single tax issue has been the cause of more controversy than the capital gains tax. Tax rates on investment income have steadily climbed over the years with short-term capital gains tax rates or long-term gains; those held for a longer period. Tax rates on dividends, estates and high-income wages and salaries have also climbed with negative repercussions for the economy.
There is another large inequity in the capital gains tax. It represents a form of double taxation on capital formation. A government can choose to tax either the value of an asset or its yield, but it should not tax both. Capital gains are literally the appreciation of the value of an existing asset. Any appreciation reflects merely an increase in the after-tax rate of return on the asset. The taxes implicit in the asset's after-tax earnings are already reflected in the asset price or the change in price. Any additional tax is strictly double taxation.
One of the least fair features of the capital gains tax is that it taxes gains that may be attributable only to price changes, not real gains. This is because the capital gains tax is not indexed for inflation. The lack of indexing can have major distortion effects on what an individual pays in capital gains tax. In fact, in some cases, the effective tax on inflation overwhelmingly exceeds any tax on real inflation-adjusted capital gain.
That is why many tax analysts argue that the most equitable rate of tax on capital gains is zero – a strong case to abolish the capital gains tax from the tax code.
There are many unfair features embedded in tax treatment of capital gains. One is that individuals are permitted to deduct only a portion of the capital losses incurred per year, whereas they must pay taxes on all the gains, introducing an unfriendly bias in the tax code against risk taking.
When taxpayers undertake risky investments, the government taxes fully any gain that they realise if the investment has a positive return, but the government allows only a partial tax deduction against the earned income if taxpayers incur a capital loss.
Capital gain is also a double tax on corporate earnings. For example, corporations are taxed at the corporate level through the corporate income tax, but then shareholders have to pay a tax on the future value of those distributed earnings reflected in the share price through the capital gains tax. Thus, both the future income stream and the capitalisation of the future income stream are taxed.
Having a "lock-in effect", a high capital gains tax is avoided by delaying the sale of an asset. Therefore, eliminating the tax will lead to what is called an "unlocking effect" on asset sales. This "unlocking effect", in a well-functioning capital market, will want investors to sell their "old" assets to free up money so they can provide seed capital for potentially higher-returning assets – a pro-growth initiative.
Given that the impact of the capital gains tax on total federal revenue collection vis-a-vis corporate income taxes, individual income taxes, sales taxes, excise taxes, etc is minimal, it is nevertheless a high cost of monitoring to the tax collector and a high cost of compliance to the taxpayer. It also coincides with low-economic growth and below-average capital investment.
Abolishing the capital gains tax would deliver an immediate boost to the economy in addition to long-term benefits. It would also increase incentives for more capital investment in existing firms, promote entrepreneurship, business creation, competitiveness, new jobs and higher wages, benefitting all income groups and last but not the least – raising stock market valuation in real terms!
The writer is a philanthropist and an economist based in Belgium
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