E-Letter To Business Day Re: Capital gains tax will not boost equity

Your article, "Capital gains tax will not boost equity," hits the nail on the head. For over 2 years now I have warned against the dangers of the imposition of a capital gains tax in South Africa. Your argument compliments the core of my articulations regarding the matter.

I think you succinctly, with the help of Reuven Brennner's quote, blow a whole in the most traditional of reasons offered, internationally, as to why a capital gains tax should be instituted, when you wrote:

What has been lacking in the debate is a realistic assessment of government's underlying principles. Tax equity is driven by such concepts as "fairness" between taxpayers, "progressivity of the tax burden" and so on. These are certainly meritorious concepts, but does capital gains tax realise them?

Research from the US and Canada has refuted the long-held belief that capital gains taxes promote tax equity. In the US 54,5% percent of the capital gains tax burden is paid by families earning less than 100 000 a year. In Canada it is estimated that more than half of all capital gains taxes were paid by families with incomes of less than 50 000 a year.

One reason for this is that the majority of middle- and lower-income earners realise a once-off capital gain, which pushes them into a higher tax bracket for that year. This "bunching effect" tends to nullify the ability of the tax to promote horizontal equity. And the fact that the burden of capital gains tax falls on low- and middle-income earners undermines the progressivity of the tax system.

The following quote by academic Reuven Brenner is appropriate in this regard: "Capital is mobile and difficult to tax - it flows away from places with strict constraints and high taxes to locations where it can freely circulate and grow.

"This is why capital gains tax revenues are low: the tax burden effectively falls on the most immobile factors. Thus the popular claim that capital gains tax is a tax on the rich is misleading. The tax is effectively paid by those who cannot move their capital."

Good point. Here is my Wall St. Journal op-ed written last spring on the subject of a capital gains tax in South Africa:

The Flight to Europe From Johannesburg

By Cedric Muhammad, publisher of BlackElectorate.com and a specialist in African politics and economics

April 2, 2001

Will the last investor leaving South Africa please turn off the lights?

The people who create new assets and new jobs are fleeing the once-vibrant South African economy more than a decade after the end of Apartheid gave that nation a ray of hope. A proposed new tax on capital gains, as well as galloping inflation and falling exchange rates, are driving them away.

Company executives recognize that investors are increasingly wary of South African stocks. So nearly every major publicly traded South African company -- including the venerable De Beers Consolidated Mines Ltd. -- has moved its primary listings to London, New York or elsewhere from the Johannesburg Stock Exchange in the past few years. They have little choice. If they are to preserve their firms' access to foreign capital, they know they will have to delist in South Africa and list elsewhere. Any individual investors left on the Johannesburg Stock Exchange may soon follow their lead.

Blame the South African government. South Africa has a poor monetary policy that has led to inflation and a weakening exchange rate. This is compounded by South African Finance Minister Trevor Manuel's plans to levy a capital-gains tax for the first time ever.

The lack of such a tax was a source of considerable comparative advantage. For years, foreign investors have been attracted to countries like South Africa, Argentina, Belgium, the Netherlands, New Zealand and Singapore because of the exemption of personal capital gains from taxation. Now South Africa will lose that vital selling point.

It is not only the growing specter of the capital-gains tax that worries investors, but the manner in which the government of President Thabo Mbeki has allowed it to hang over the country -- like an uncertain storm cloud. Indeed, the imposition of the tax, once scheduled for April, has already been delayed once. It may be delayed again.

The tax, now slated for October, is a headache. It is both complex and vague on certain key points. Individuals are taxed on 25% of capital gains at their marginal income-tax rate after exclusions, while businesses are taxed on 50% of capital gains at the relevant statutory rate. Got that? The tax will apply to stocks, bonds, real estate and other investments.

The capital-gains tax further increases the growing tax burden on an ailing economy. The South African government already claims 20% of gross domestic product, up from 9% of GDP in 1970.

And for all of the South African government's talk about the need for the tax, by its own estimates, the government doesn't expect to collect very much revenue. The South African Revenue Service forecasts that the tax will bring a little more than 1% of all government tax revenue.

Worse still, the new capital-gains tax is not indexed for inflation. Capital gains above the $10,000 exemption will be vulnerable to the ravages of inflation, which the South Africa Reserve Bank estimates will be as much as 6% this year. And that is if the central bank is lucky. The central bank's inflation target is 6% -- among the highest in the developed world. Inflation could easily top the target.

Meanwhile, South Africa's currency is weakening against the dollar. In the past year, the Rand has fallen to eight per $1 from six Rand in January 2000. This deterioration in purchasing power has yet to fully pervade the South African economy. When it does, it will further erode capital gains, on top of the tax the government intends to apply.

Already capital-gains tax anxiety is beginning to grip the Western Cape, where real-estate investments would be punished by the tax, due to the lack of inflation indexing. Many of those who are currently holding their primary residences in trusts, companies or closed corporations, will find themselves taxed on their supposed capital gains -- even though the "gains" are almost entirely caused by the inflation and the Rand's decreasing purchasing power rather than a real increase in value. Indeed, the real-estate market is quite weak in South Africa these days. Since the capital-gains tax is not indexed for inflation, property owners will be forced to pay taxes on a nominal appreciation in the value of their homes, and not on a capital gain.

One of the most depressing aspects of the promise to implement the capital-gains tax is the rationale used to defend it. "Capital-gains income falls within the generally accepted definition of income and, as such, should be treated no differently from other income in a comprehensive income tax system," Mr. Manuel argues.

Capital gains are indeed income in their final incarnation, but Mr. Manuel ignores that any economy, and certainly South Africa's, depends on capital formation. Businessmen will not risk their capital unless they can expect to be rewarded at a rate above that which is offered by an alternative investment. Mr. Manuel's insistence in looking at capital as income avoids this important consideration -- one that is especially important in a country with as much poverty and unemployment as South Africa.

Why? Because investments are most often made in enterprises that lack collateral, it is in the long-term interests of economic development and growth in South Africa that disincentives to capital formation not be created. The number of "equity chances" in untested enterprises will increase only when the amount of available capital increases. Of course, it is those on the bottom who need investment the most.

South Africa's policy makers should be rewarding and encouraging capital formation and risk taking, especially among the country's black population, and not adding a new barrier on top of the legacy of apartheid. Without a capital-gains tax, total investment would grow and boost the chances that the number of entrepreneurs will grow. In time, South Africa would have a strong black middle class. Instead, the nation is heading in the opposite direction. South African blacks would benefit most if the government dropped it capital-gains tax proposal. After all, blacks currently rely the most on their labor while having the smallest claims on capital.

The coming tax is even causing many companies to intensify and quicken the pace of their restructuring efforts. Under the new law, share distributions that are part of corporate restructurings will no longer be exempt from taxation. Hurriedly, these companies move toward decisions they would not otherwise make in such a short time span, thanks to the capital-gains tax.

A capital-gains-tax storm cloud is present in South Africa. If investors decide not to get out of town they had better carry an umbrella.

When it rains it pours.

-- From The Wall Street Journal Europe

Used With Permission From The Dow Jones Reprint Service

Cedric Muhammad

Tuesday, December 31, 2002

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