ECONOMIC POLICY RESEARCH INSTITUTE (EPRI)
An Economic Appraisal of Arguments For and Against
South Africa’s Proposed Capital Gains Tax Legislation

8 January 2001
Dr. Michael Samson
Director of Research, Economic Policy Research Institute
Visiting Associate Professor of Economics, Williams Center for Development Economics
Mr. Jason Stanley
Oxford University

Mr. Kenneth MacQuene
Executive co-Director and Senior Researcher, Economic Policy Research Institute

Ms. Ingrid van Niekerk
Executive co-Director and Senior Researcher, Economic Policy Research Institute

EPRI acknowledges that this policy report was made possible through support provided by USAID under the terms of grant no. JCNAT98-954-01-00. The opinions expressed herein are those of the authors and do not necessarily reflect the views of the United States Agency for International Development.


An Economic Appraisal of Arguments For and Against
South Africa’s Proposed Capital Gains Tax Legislation


EXECUTIVE SUMMARY


This submission summarises research by the Economic Policy Research Institute concerning the proposed tax on capital gains. The report critically appraises arguments for and against the proposed law. On balance, the research supports the implementation of the capital gains tax (CGT) as proposed by the National Treasury.

ARGUMENTS PRESENTED FOR THE PROPOSED LAW

(1) The CGT will reduce distortions in the tax system.
CRITIQUE:
The absence of a capital gains tax creates significant distortions in South Africa’s tax structure, leading to an erosion of the tax base and wasted resources that could otherwise promote economic growth and job creation. The proposed legislation will provide some measure of correction to these distortions, but will not eliminate them completely because only a fraction of the capital gains are subject to tax.

(2) The CGT will provide a more equitable tax structure.
CRITIQUE:
A rand earned through the sale of a capital asset bestows the same economic power as does a rand gained through employment, and the dictates of equity suggest they should be taxed similarly. Furthermore, the wealthy benefit from a disproportionate share of capital gains, so the absence of a CGT skews the burden of taxation onto lower income individuals. The proposed legislation will move towards a more equitable tax structure. However, since only a proportion of capital gains are subject to tax, those fortunate enough to enjoy capital gains will continue to benefit from preferential tax treatment.

ARGUMENTS PRESENTED AGAINST THE PROPOSED LAW

(1) The CGT will not provide significant tax revenue.
CRITIQUE:
There is no substantial evidence that the capital gains tax will not provide a significant source of revenue. Estimates from cross-country comparisons are of limited value because of substantial differences between South Africa’s current circumstances and the context of these studies. First, elements of the proposed capital gains tax law effectively close loopholes that undermined revenue gains in the comparison countries. Second, since the proposed legislation reduces the incentives for converting other income into capital gains, the tax revenue resulting from the new law will be greater than the directly measured tax on capital gains. The resulting tax revenue will include not only capital gains taxes but also incremental taxes on the broadened tax base, revenue that was not calculated in the comparison studies. Also, the significant increases in income from capital gains over the past few years make older studies less reliable.

(2) The CGT will undermine investment and economic growth.
CRITIQUE:
Economic evidence concerning the impact of a capital gains tax on investment and growth is ambiguous. Numerous studies contradict the notion that a capital gains tax undermines incentives for savings and investment.

(3) There is not sufficient time for implementation on April 1.
CRITIQUE:
The National Treasury has provided more time for preparation for the new tax than is generally provided in other countries. Even with implementation on 1 April 2001, individuals and companies have more than a year to deal with the consequences of the proposed legislation.

(4) Indexation of capital gains complicates the tax system.
CRITIQUE:
The notion that indexation complicates the tax system presumes that indexation is a necessary aspect of a capital gains tax. Most countries with a capital gains tax do not adjust capital gains for inflation, and some of those who do are moving away from this practice. Furthermore, indexation undermines the efficiency and equity of the tax structure.

(5) A capital gains tax "locks" taxpayers into investments.
CRITIQUE:
A capital gains tax does tend to undermine the free movement of capital by creating incentives to hold onto appreciating investments. However, this same principle also tends to foster a choice towards savings rather than consumption, which can promote economic growth and job creation.

(6) The CGT will undermine our international competitiveness.

CRITIQUE: The capital gains tax is a generally accepted form of taxation in nearly all industrialised countries. The proposed effective tax rates are substantially lower than international norms. Furthermore, by promoting equity and financing social development, the capital gains tax can foster improved labour and capital productivity that enhances South Africa’s international competitiveness.

Conclusion
On balance, the proposed legislation evenly weighs the advantages and disadvantages of the capital gains tax and arrives at a policy reform that improves South Africa’s tax structure and economic prospects. Given the politically volatile nature of the reform, many people will undoubtedly find fault will many aspects of the legislation. Nevertheless, the proposed tax is well crafted to achieve important policy objectives furthering social equity, economic growth and job creation.

TABLE OF CONTENTS
Executive Summary

Main body of submission

Introduction
Arguments presented for the proposed law:
(1) The CGT will reduce distortions in the tax system
(2) The CGT will provide a more equitable tax structure

Arguments presented against the proposed law:
(1) The CGT will not provide significant tax revenue
(2) The CGT will undermine investment and economic growth
(3) There is not sufficient time for implementation on April 1
(4) Indexation of capital gains complicates the tax system
(5) A capital gains tax "locks" taxpayers into investments
(6) The CGT will undermine our international competitiveness

CONCLUSION
TABLE OF FIGURES
Capital Gains Tax Revenue in the United States
International Comparison of Capital Gains Tax Rates

INTRODUCTION
This submission summarises research by the Economic Policy Research Institute concerning the proposed tax on capital gains. The report critically appraises arguments for and against the proposed law. On balance, the research supports the implementation of the capital gains tax (CGT) as proposed by the National Treasury. The following discussion analyses each of the arguments in further detail.

ARGUMENTS PRESENTED FOR THE PROPOSED LAW
(1) The tax will reduce distortions in the tax system
The South African Revenue Service supports the proposed law by arguing that "the absence of a CGT creates many distortions in the economy, by encouraging taxpayers to convert otherwise taxable income into tax-free capital gains. The South African Revenue Service has observed that sophisticated taxpayers have engaged in these conversion transactions, thereby eroding the corporate and individual income tax bases. This erosion reduces the efficiency and equity of the overall tax system. A CGT is, therefore, a critical element of any income tax system as it protects the integrity of the personal and corporate income tax bases and can materially assist in improving tax morality."

This reasoning provides one of the strongest arguments for the CGT. The artificial conversion of income to capital gains not only erodes the tax base, but it also absorbs productive economic resources that could be more efficiently employed in raising real economic growth. Nevertheless, the proposed tax law only partially reduces the incentives to convert income to capital gains, because it only taxes a portion of the capital gains. For natural persons, only 25% of the capital gains are subject to tax, while for legal persons, only 50% of the capital gains are subject to tax. Therefore, substantial distortions in the tax system will remain. Nevertheless, the proposed tax law significantly reduces the incentive for efficiency-distorting income conversion.

(2) The tax will provide a more equitable tax structure.
Internationally, tax jurisprudence recognises the importance of taxing capital gains in order to treat different sources of income equitably. Likewise, the Katz Commission has recognised the importance of a capital gains tax not only for actually improving equity but also for supporting the perception of fairness. Capital gains accrue primarily to the wealthy, who by definition are the primary holders of assets that yield capital gains. In the United States, the Deputy Assistant Secretary for Tax Analysis at the U.S. Department of the Treasury has quantified the skewed accumulation of capital gains to the wealthy.

Leonard Burman employs a ten-year panel data set (1979 to 1988), demonstrating that the 3% of taxpayers whose real incomes (in 1993 dollars) exceed $100,000 received nearly three-quarters of the capital gains. A more recent cross-section of a single year’s tax returns reveals about the same degree of concentration. Given South Africa’s substantially more skewed distribution of income and wealth, it is likely that the incidence of capital gains in South Africa is even more concentrated in the hands of the wealthy.

While taxing capital gains will improve the equity associated with South Africa’s tax structure, the fact that only a portion of capital gains are subject to tax undermines the horizontal and vertical equity of the tax structure. Furthermore, capital gains benefit from a much higher exclusion than either interest or dividends.

ARGUMENTS PRESENTED AGAINST THE PROPOSED LAW
(1) The tax will not provide significant revenue.
Critics of the capital gains tax have suggested that the proposed tax will not provide significant revenue. The Katz Commission suggests that revenue from a capital gains tax in South Africa might not be great enough to offset added administrative costs. Part of the basis for this stems from dated international studies that document a relatively low contribution to overall revenue from capital gains taxes. The applicability of these studies to South Africa’s situation is limited.

The actual revenue increase that South Africa will realise is likely to be higher for several reasons. First, the amount of revenue measured by these studies is the direct collection of taxes on capital gains. This is only part of the revenue improvement. Because a CGT reduces the incentive to convert other sources of income into tax-favoured capital gains, much of the improvement in tax collection accrues through a broadened tax base above and beyond capital gains. Second, the proposed legislation allows for constructive realisation of the capital gains on the death of the asset holder. This provision prevents the capital gains basis from being stepped up with the resulting tax revenue loss. Third, the broadened expansion of equity ownership and rising valuations have dramatically raised the value of capital gains over the past several years, limiting the usefulness of studies more than a few years old. For instance, in the United States, the ratio of net capital gains in adjusted gross income to total adjusted gross income doubled from 3.6% in 1990 to 7.3% in 1997. The volatility of capital gains and the recent upward trend is documented in the graph on the next page. This demonstrates the degree to which earlier studies underestimate current potential for capital gains taxation, as well as the complexity of predicting revenue from a capital gains tax.


CAPITAL GAINS TAX REVENUE IN THE UNITED STATES (1974-1997)


(2) The tax will undermine investment and economic growth.
A major South African law firm raises a critical question embroiled in the debate around the capital gains tax: "What is the effect of CGT, Inflation and STC going to do to investor confidence in the new South Africa?" The conventional wisdom can be summarised: "An oft-stated dictum of journalists and politicians is that [preferential treatment for capital gains] will increase economic growth by encouraging investment in new firms." For instance, a proponent of preferential treatment for capital gains claims that "because the [capital gains] tax restricts capital formation, its burden falls on new business start-ups."

A large body of theoretical and empirical evidence, however, refutes this conventional wisdom. While Chief Economist of the World Bank, Joseph Stiglitz argued: "In the United States, preferential treatment of capital gains has been defended on the grounds that it encourages risk taking and entrepreneurship, of the kind associated with the knowledge economy. But most of the tax preferences go not to this kind of entrepreneurship, but, for instance, to speculative real estate lending. I referred earlier to the importance of a change in culture. A tax system that rewards the returns to speculative real estate in the same way that it rewards real innovation is not supporting the culture of innovation." His arguments are rooted not only in empirical observations of the American economy but also theoretical modeling that calls into question the desirability of employing preferential treatment of capital gains to promote risk-taking.

The Deputy Assistant Secretary for Tax Analysis at the U.S. Department of the Treasury, Leonard Burman, concludes that the preferential treatment of capital gains undermines economic growth. Numerous theoretical and empirical studies corroborate this finding. A recent theoretical development of a supply side model demonstrates significant positive growth effects stemming from capital taxes. Another study that focused on fiscal constraints similar to those South Africa faces concluded that increases in capital taxes reduced interest rates and raised capital investment. A study analysing open economy characteristics and trade deficits found that increases in capital taxation might increase wages and social welfare. A simulation model built to distinguish the differential impact of capital gains taxation on new and established firms demonstrates that beneficial treatment of capital gains can actually reduce new firm investment. The study "contradicts the widely held view that a capital gains tax cut would be a well-targeted approach for encouraging new firm capital formation."

(3) There is not sufficient time for implementation on April 1.
Many critics of the current legislation question the feasibility of implementing the proposed legislation before the indicated deadline. A major South African law firm raises the question: "Won't implementation be delayed?" and answers it: "Not likely! Remember, SARS only has to get the legislation through parliament by April 2001. Thereafter SARS has a period of approximately 18 months to get ready to process the first tax returns affected by CGT. Taxpayers need to plan now!" The National Treasury provided substantially more notice for this proposed legislation than is generally available internationally when changes to capital gains taxation are implemented. South African companies have demonstrated a strong technical capacity to deal with substantial changes to financial systems--the success last year in dealing with Y2K provides a good example. No compelling argument exists to delay implementation of the legislation.

(4) Indexation of capital gains complicates the tax system.
A frequent argument raised against the capital gains tax is that since a large part of the capital gains are due to inflation, fairness requires that the value of the capital asset be indexed to a representative price index so that the inflation component can be exempted from tax. In line with this argument, the law firm Cliffe Dekker Fuller Moore Inc. points out that "South Africa has experienced high inflation rates for the last twenty years. Although there has been a substantial decline in inflation rates in recent years, inflation is by no means a thing of the past. Government has set its own inflation target of 3 to 6 percent. Even if these targets are achieved the inflation rate will still be well above that of most first world countries." In addition, they point out that "the cost of collection of CGT is very high." The process of indexing capital gains for inflation increases administrative complexity and raises collection costs.

This argument, however, presumes that it is desirable to index capital gains for inflation. In fact, the vast majority of countries that tax capital gains do so without indexation for capital gains. Furthermore, there has been a shift away from indexation in those countries that follow the practice. Recently, Australia eliminated indexation for inflation.

(5) A capital gains tax "locks" taxpayers into investments.
A capital gains tax distorts the economy by "locking" taxpayers into investments because they seek to avoid the realisation of capital gains taxes triggered upon disposal of assets. The Katz Commission notes that the ‘lock-in’ effects of a realisation-based capital gains tax may have negative effects on free-market capital flows. Nevertheless, this may also have positive benefits for the economy. A simulation model that accounts for household portfolio choice finds that "eliminating the 'lock-in' effect through a revenue-neutral move to accrual taxation causes national saving to decline, as households face a lower tax on present consumption from appreciated assets and, by reallocating existing wealth more efficiently, need to save less for future contingencies." A capital gains tax is actually associated with higher national savings.

(6) The tax will undermine our international competitiveness.

Opponents of a capital gains tax frequently argue that the tax will undermine international competitiveness by reducing incentives for investments that will yield capital gains. Nevertheless, many of South Africa’s trading partners tax capital gains at a much higher rate than the rates in the proposed legislation. The table below compares capital gains taxes in 24 countries.

International Comparison of Capital Gains Tax Rates



The average capital gains tax rate in the sample is 19.4% for short-term capital gains and 15.9% for long term capital gains. South Africa’s proposed maximum capital gains tax rate for individuals compares very favourably at 10.5%. Likewise, South Africa’s proposed maximum tax rate on legal persons--at 15%--compares very favourably to the average in the sample--22.8% for short-term gains and 19.6% for long-term gains.
The issue of international competitiveness raises a very important question. Is a country more competitive if it exempts capital gains from taxation yet fails to support the conditions necessary for asset value growth? A rational investor prefers a taxed capital gain to a capital loss. Given South Africa’s social backlogs, the returns to socially investing the capital gains tax revenue may yield not only important social returns, but also nurture labour and capital productivity and reinforce the conditions for even greater capital gains in the future.

CONCLUSION

The law firm Cliffe Dekker Fuller Moore Inc. puts the issue of the capital gains tax into a political economy perspective: "CGT will work for the ANC. The debate is not really about ‘Can it work?’ but rather ‘How can we stop the rates increasing?’" The debate over the capital gains tax is largely political. Once it is accepted that the capital gains tax will work, attention can be focused on how best to employ this policy reform to achieve South Africa’s pressing social objectives.

A recent study by international economists argues that while globalisation can promote higher rates of economic growth, "there is no guarantee that capital mobility makes everyone better off.... risk-averse capitalists unambiguously benefit from international capital mobility. Risk-averse workers lose..." From a fiscal perspective, "tax competition is generally expected to drive tax rates down to inefficiently low levels...." The net effect of these two forces is that "capital market liberalisation calls for more redistribution while making this redistribution difficult." International tax co-ordination can help to resolve this dilemma.

South Africa’s adoption of a capital gains tax moves the country’s tax structure closer to international best practice. It serves to better co-ordinate South Africa’s tax system with international standards, improving the management of globalisation in the interests of the country’s social and economic objectives.

On balance, the proposed legislation evenly weighs the advantages and disadvantages of the capital gains tax and arrives at a policy reform that improves South Africa’s tax structure and economic prospects. Given the politically volatile nature of the reform, many people will undoubtedly find fault with many aspects of the legislation. Nevertheless, the proposed tax is well crafted to achieve important policy objectives furthering social equity, economic growth and job creation.