Capital gains tax, high interest rates and uncertainty

Inflation is mainly due to supply side constraints.

BRISTOL: This is how the story goes! With capital gains tax in place, profitability will decrease and therefore much needed investment from both within and abroad will not flow into the capital market. Instead it may even force existing investors to withdraw their investments from the country’s stock exchange.

With capital outflow, growth will decrease and much needed jobs will not be created leaving the country worse-off as a whole. As such restrictions on capital flows will affect investors’ confidence in the national economy; chances of future investment will decrease hence putting country’s future growth at stake as well.

With capital flows taking such an important role, one may ask what else can be done to increase such inflows? Ask any IMF official and the answer will be to increase interest rates. It serves two purposes. Firstly, an increase in interest rates decreases domestic demand and therefore inflation by making it more attractive for people to save more. Secondly, it increases the rate of return for foreign investors who are now more likely to take the required risk and bring their money into the domestic economy which also helps in stabilising the exchange rate. Makes sense, right?

Such free inflow of capital (money) is as good for short term stability as it is for instability, with close to no benefit for long term growth of country’s GDP. Capital flows are pro-cyclical. Investors enter the market during the high growth periods to make quick money and leave when the situation deteriorates. To be more precise, ‘hot money’ enters the economy when it is least needed therefore exacerbating the inflationary pressure and leaves when it is most needed hence pushing the economy further into recession.

When the East Asia crisis hit Thailand – which had liberalised its capital market as per IMF’s advice, a complete reversal of investors’ sentiment resulted in huge outflows which amounted to 7.9% of GDP in 1997, 12.3% in 1998 and 7% in the first half of 1999. The only country to stand up to the dictates of the IMF during the East Asia crisis was Malaysia. Their policies of putting breaks to the free flow of capital (or speculative capital which is a consequence of such a policy) and not increasing the interest rates paid off as Malaysia experienced the shorter and shallower downturn relative to other countries.

Interest rates are a useful tool to control inflation, given that the reason for inflation is excess demand. However, inflation in Pakistan has been largely due to global commodity prices and supply side constraints in both agriculture (floods) and manufacturing (energy shortages). With growth rates for last couple of years already at low levels, it is unlikely that excess demand is the cause for double digit inflation.

In developing countries where equity markets are by and large underdeveloped, businesses rely on loans to expand and run themselves. In Pakistan not even a fraction of businesses are listed on the stock exchange. Under an environment with high interest rates, likelihood of default increases for businesses as they are now required to pay huge amounts to their creditors (banks).

Apart from low growth rate, uncertainty at both political and security front makes it even more difficult to attract both local and international investors to Pakistan. In the case of East Asia, high interest rates, free capital flows and everything which the IMF says did not succeed in achieving the desired results.

Two main things which come out of this discussion are imposition of capital gains tax and lowering of interest rates. In addition corporate tax should also be lowered to compensate domestic businesses for the uncertainty. While capital gains tax will bring much needed stability to the capital markets, low interest rates and decrease in corporate tax will provide much needed breathing space to businesses so they can increase their production and expand further thereby overcoming the supply side constraints to some extent. The magnitude of the change is an empirical question and should better be left to those who have access to the data.

The writer is currently an MSc (Economics and Econometrics) student at the University of Bristol and has previously worked at the Planning Commission (Pakistan)

Published in The Express Tribune, April 23^rd, 2012.