Why a capital gains tax is a very, very bad idea

All taxes are economically damaging but the capital gains tax is easily the worst of the lot.

Taxes on capital gains doubly tax savings and investment, they are brutally unfair, they are complicated and costly to administer, they are easy to avoid, they raise very little money, they choke the economy and harshly penalise entrepreneurship and innovation.

Capital gains taxes double-tax income

The value of say a business is simply the net present value of its expected income stream. The income stream is taxed and so the capital value of the business is after tax. This is a key point.

Cut the tax rate and the business will be worth more. That shows that the capital value of productive assets is always after-tax. Let’s show a simple case.

A business generates $100 a year. The going discount rate is 10 percent. The value of the business is $1,000. That’s if there’s no tax.

Introduce a tax of, say, 30 percent, and the business now yields only $70 a year. The business is worth only $700. The tax liability is capitalised into the value of the business.

Now let’s say I buy the business and fix it up. I double its income to $200. In the absence of any tax the business is now worth $2,000 and I can sell the business and pocket a $1,000 capital gain. However, if there’s an income tax of 30 percent the increase in the business’s value is from $700 to $1,400. My capital gain is now only $700.

My gain is not tax free even though I appear to pay no tax on my gain.

That’s because the capital value reflects the extra tax the extra income the business generates.

A capital gains tax of 30 percent reduces my gain from $700 to $490. I am doubly taxed.

Capital gains aren’t tax free and a capital gains tax doubly tax savings and investment.

Capital gains tax is brutally unfair

There are plenty of ways a capital gains tax is unfair. Imagine a young widow with children whose husband poured his heart and soul into his business. Following his death the young widow has no choice but to sell the business. She has no income and no other assets.

The business was a start up. It generates $200 a year. After tax, that’s $140. The business sells for $1,400 upon which capital gains tax has to be paid at say 30 percent.

She nets $980. In the absence of any tax she would net $2,000.

The widow is taxed at 51 percent. That’s brutal.

Capital gains tax complicated and costly

Capital gains taxes for practical and political reasons are invariably riddled with exemptions and exceptions making them devilishly complicated to administer and to comply with.

We see that with Phil Goff’s proposal with exemption and exceptions already and having to be sent off to an 'expert panel' to be worked out.

The big complication is determining the true capital gain net of inflation after netting out the purchase price and the cost of maintenance and investment in the asset over the years.  It’s hard to do financially let alone in terms of writing and then administering tax law. 

It will be a great tax for tax lawyers, tax accountants, tax consultants and tax bureaucrats. But bad for everyone else.

Interestingly, but not surprisingly, Phil Goff’s proposal is not to net out inflation. That makes the tax somewhat simpler, but means New Zealanders will be taxed on their nominal gains.

The government-induced inflation rate over which you have no control will determine your tax liability. It’s not a trivial amount.

BERL who provide Phil Goff with his analysis estimate the return on New Zealand shares at 2.6% with inflation at 2%. The bulk of the tax to be raised is on nominal gains, not real gains.

Capital gains tax easy to avoid

The decision to pay a capital gains tax is entirely up to the taxpayer.

It’s the easiest tax to avoid because you just don’t sell your asset.

Besides high-priced consultants will always outwit the complex and complicated law that will always have to be amended and reviewed in the vain attempt to keep up with perfectly legal tax minimisation.

Capital gains tax raises little money

Capital gains taxes don’t raise much money. BERL assume no change in behaviour as a result of a 15 percent tax on the nominal gains in many trades.That’s a heroic assumption.

But even accepting that, they estimate that by 2028 Phil Goff’s capital gains tax will raise $3.7 billion. That’s a lot of money.

In its first year, it only raises $17.5 million – leaving Phil Goff a big hole in his budget.

But Treasury’s Long-Term Fiscal Model estimates the total tax in 2028 as $120 billion.

Phil Goff’s capital gains tax fully matured raises a measly extra 3 percent in tax assuming no change in the number of trades and with the tax taxing nominal gains not real gains.

Capital gains tax chokes the economy

The heart of a vibrant, prospering society is wealth-creating trades that shift productive resources to ever higher valued uses.

A capital gains tax chokes those trades and bungs up the economy. That’s the big problem with a capital gains tax.

Imagine you can an increase the value of a productive asset by ten percent. That’s a big gain that the economy can ill-afford to miss out on.

In the absence of a capital gains tax you would easily make an offer to the present owner in which both of you are better off through the trade and the economy gets a ten percent gain.

That gain won’t happen with a capital gains tax.

The tax at 15 per cent proposed by Labour more than wipes out the gains from trade and the wealth-creating trade does not proceed.

Multiply that result a million times over and the incredible wealth-sapping effect of a capital-gains tax is obvious.

Phil Goff’s capital gains tax will lock up New Zealand resources in low-valued uses. It’s an incredibly damaging tax.

Capital gains tax harshly penalise entrepreneurship and innovation. Entrepreneurship and innovation are key to a dynamic and prosperous economy.

The incentive to entrepreneurship and innovation are capital gains. The capital gains tax is a double tax on entrepreneurship and innovation.

Politicians like Phil Goff talk up the need for entrepreneurship and innovation but their policies invariably hobble and hinder them, and there’s no greater disincentive than a capital gains tax.

But what about economists backing a capital gains tax?

Back in the day economic text books used to back a capital gains tax because it was argued capital gains are income and that the absence of a capital gains tax is itself distortionary. The latter point is the important point. It derives from a note Nobel Prize winning economist Paul Samuelson wrote in the 1960s.

It showed that a true capital gains tax was neutral alongside a comprehensive income tax. The trick is in the assumptions.

The model assumes perfect information, no entrepreneurship or innovation, a closed economy so that critically the income tax drops the cost of capital rather than grosses it up, and that the capital gains tax is an accruals tax payable every year on gains with all losses netted out.

I wrote to Prof Paul Samuelson about his conclusion and he readily accepted it didn’t apply to an open economy like New Zealand in which the income tax rate here grosses up the cost of capital.

I suspect the New Zealand Treasury now accept that point.

There is a section of the New Zealand population that are always up for taxing the rich and the successful. That’s who Phil Goff is targeting.

It’s certainly not about improving the economy.

The promise of a capital gains tax also allows Phil Goff to bluff and bluster through how he is going to pay for his spending promises which is where he hopes to win his votes.

The great thing about political promises is that the numbers don’t have to add up.

That’s because as H. L. Mencken observed an election is an advance auction in stolen goods.

This was first published 15 July 2011 on interest.co.nz.