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Should There Be A Capital Gains Tax?

Capital Gains Tax (CGT) is a very emotive subject. Left leaning people believe that not having CGT is unfair because self centered people are allowed to use certain types of investment to earn money without paying tax, while others have to work to pay all the tax. Right learning people tend to see those left learning people as lazy brats with Tall Poppy syndrome who don’t work or save hard enough to invest.

There’s probably some truth in each side… and now that I’ve riled everyone up, lets accept that looking at CGT from an emotional perspective is the wrong approach.

Once we’ve calmed down and removed our emotion from the subject, lets look at another approach in deciding whether we should have a CGT. Let’s first consider what tax is for.

Why Do We Have Tax?

Tax is used to correct flaws in Capitalism. Without tax, pure Capitalism would be unjust and result in a less successful society by all measures. People would be unable to get things that should be available to all, such as education and medical care. Inaccessibility of such things is bad for society overall – workers are less efficient because they’re unwell, under-educated and society as a whole would ironically be less happy without tax.

But tax also has a negative effect, which is why we should tax as little as possible to achieve the governments goals. That said, that same negative effect can be a good thing as another purpose of tax is to dissuade the populace from things that have negative effects if left untethered. For example, a tax can be good on cigarettes (reducing consumption) or petrol (which causes people to think more if they need to make the journey; reducing the damage to the environment).

Do We Need A CGT?

Given the purpose of tax, we should try to take the emotion out of our discussion about whether we should have a CGT, and instead ask ourselves if we need a CGT. Lets look at the benefits and disadvantages of a CGT on investing in shares and property.

Remember: The purpose of tax is not to redistribute wealth (with the exception of Communist societies). The purpose of tax is not to take money*, it’s to put money into area’s where it’s needed to fix the failings of pure Capitalism (we don’t do pure Capitalism in NZ). If increased tax is required, money should be taken from places where tax will cause the least harm to society.

*The exception to this rule is where the aim of taxation is to adjust demand for something who’s restriction of demand does not consider the negative effects on society, like tobacco or petrol.

Do We Need A CGT On Investing In Shares?

The Advantages Of Taxing Shares

There is no advantage of specifically taxing shares over other things, because remember that the purpose of tax is not to redistribute wealth and we’re not aiming to damage the stock market by tempering demand.

The only advantage of taxing shares is that tax revenue would increase.

The Disadvantage Of Taxing Shares

Since there are different types of shares and different types of investors in shares, we’ll have to identify the differences so we can analyse the impact to each.

Firstly the IRD defines two types of investors in the stock market, Share Traders and Investors. Share Traders already effectively pay CGT as they pay tax on their share trading income at the end of the financial year, at the normal income tax rate. Investors do not pay tax on the sale of their businesses / shares. See this article for more information on the differences between investors and traders.

To add to the confusion, there are multiple types of investors within the group broadly classed as “Investors” by the IRD. Business owners own shares in their privately owned company, and then there are Angel Investors / VCs who buy shares in a company not listed on the stock market – which is implicitly a long hold due to the lack of liquidity.

The Disadvantage Of Taxing Stock Market Traders

Essentially traders play the stock market and have no loyalty to the companies they own. If the company needs additional capital, a trader will likely be gone well before the subject is even risen (this is a bit of an assumption – a trader may indeed find the offer of a capital raise attractive as an investment in itself). Therefore it’s arguable that Traders bring little benefit to the companies they own, except perhaps helping to push the price of stocks upwards, which is good for the economy as investors get better returns and this helps Joe Public (think: Kiwisaver, etc.). Some may argue that this doesn’t really help anyone because it doesn’t contribute to GDP.

While Traders don’t really bring benefit to the economy through their trading activity, they are wealthy entities, and a CGT could cause them to leave the country (to set up an entity, such as a business or trust, as a tax resident elsewhere). This would be highly probable as they already pay tax at typically 33%, an extra ~30% CGT would be too much. When I talk about that being too much, I’m not referring to it being unfair, because tax is nothing to do with what’s fair – just what people will accept. The net effect of increasing tax to traders would be a movement of money out of the country, which would be a bad thing.

The Disadvantage Of Taxing Stock Market Investors

Like traders, investors will be less likely to partake in investing if the risks are higher (as the ROI will be lower). This means that it will be harder and more expensive and more risky for companies to raise capital. This is obviously bad for the economy.

If the taxes for being a trader are the same as being an investor, all investors would be traders. This is also bad, for the reasons mentioned above in the section about taxing traders. We want to incentivize traders to be investors, if anything.

Additionally, as investors hold stocks for longer, a CGT would to some effect end up being a tax on inflation – effectively causing a loss in real terms. So investors would be less likely to sell, which is economically inefficient as money is not free to move around in the “free market” as is required for capitalism to be successful.

The Disadvantage Of Taxing Business Owners

Again, this would be a tax on inflation, disincentivising sales. This is bad for the well being of business owners because they would have to work longer before retiring (remember much of NZ is made of small businesses / sole traders). This is bad for young people trying to make their way up the chain or even enter the workplace in the case of industries dominated by sole traders, which is not good for the well being of the country and stifles innovation.

Do We Need A CGT On Property?

A CGT on property implemented on peoples homes would be catastrophic. It would mean that as home prices went up with inflation, after people sell their home, they wouldn’t be able to afford a new one. This would cause geographic inelasticity of labour as people wouldn’t be able to leave the place they live to work elsewhere, even at the prospect of a very large pay rise. The would obviously damage the economy and push up house prices due to supply shortage.

A CGT on investment property would have different consequences. We have seen in the last year that policies aimed to help renters at the cost of landlords have decreased the number of landlords in the market (myself included) which has caused an increase in the price of renting. It follows that a CGT on investment properties would increase the cost of renting.

Looking into the LINZ ownership data, I can see that most people who have their name on one title, also have their name on another title. From this we can conclude what we already annocdotally know: there are a lot of mum and dad property investors out there, and this is what most people put their retirement savings into. A CGT on investment property would damage peoples retirement savings, having the effects described to retirees and the economy in the above section on taxing business owners.

Other Considerations

More types of tax decreases the efficiency of an economy, creating more administration an associated costs, such as Accountancy and Tax Lawyers.

As mentioned before, CGT is also a tax on inflation. Imagine if you buy an asset that is worth $100, each year inflation goes up 3% and the value of that asset with it. At the end of 10 years, if you sold the asset, you wouldn’t be able to buy an equivalent asset. Selling would always be at a loss, which is bad when that’s what your savings are invested in. This would make the population poorer, taking a slice of peoples savings, not take a slice of their profits.

While people might feel that it’s unfair that there are ways of making money that aren’t taxed, those people should remember that later in their life, they will be in the position to make such gains, so if your motivation of wanting a CGT is still based on a perception of justice, you may want to do the sums and see how retirement looks after a CGT on popular retirement investments.

Summary

There are a lot of disadvantages of introducing CGT on property and share investments, and the only advantage that I can see is adding more money into the governments coffers. It seems to me that the first question is not “Should we have a Capital Gains Tax?”, but “Should we have extra taxes?”.

After deciding whether we want extra taxes, we should then look at all the different things that can be taxed, and analyse the impact (disadvantages and advantages) of each type of tax, rather than running to CGT because it seems the fairest – remember, tax is nothing to do with what’s fair, it’s what causes the least harm to the population and economy.

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