Wednesday 3 August 2011

A Diatribe Against Capital Gains Taxes-Part II.

I noted yesterday that the main argument put by proponents of capital gains taxes is that they are needed to encourage savings into productive investments rather than into chasing capital gains. This sounds plausible on the surface, but I’m not sure that those making that argument have fully stated their implicit assumptions.

The first thing to note that “investment for capital gains” is not unproductive investment, it isn’t investment at all, at least not in the economics sense of the word investment—the creation of capital goods for the purpose of producing a flow of newly produced goods and services in the future. One can imagine government policy designed to improve the quality of investment, such as by creating a legal environment under which investors have confidence that they will be able to retain the returns on that investment, or more simply by removing policies that subsidise uneconomic uses of resources. But when a saver “invests” (in the household sense of the word) for capital gains by purchasing an existing physical or financial asset expected to increase in value, he is not diverting resources into the production of an unproductive asset, he is simply changing ownership of the existing stock. The best that can be said about a link to real investment is that if real investment in New Zealand is an increasing function of New Zealand savings (i.e. that firms here do not face a perfectly elastic international supply of lending) and if the pursuit of capital gains results in a reduction in the New Zealand savings rate, then the quantity not quality of real investment could be reduced by the absence of a capital gains tax.

But how reasonable is that assumption that the pursuit of capital gains results in a reduction in savings? For savings to have been reduced it must be the case that consumption has increased. How does that happen? Consider a saver who has to choose between lending to an investor or purchasing an existing asset. Whichever he chooses, he has devoted the same amount of his income to the savings, and so his consumption is not affected. If, however, he chooses to purchase an existing asset, he will need to induce its current owner to sell. What that owner does with the income from selling (i.e. whether he consumes or saves) is what determines whether the transaction has led to an overall increase in consumption. Now typically, when someone sells an asset, it is because they are seeking to earn the true return (consumption) from a previous decision to save, but that doesn’t mean that the pursuit of capital gains has induced an increase in consumption. We need to ask why the marginal asset seller was induced to sell as a result of a saver’s decision to seek capital gains rather than lend directly to investors. Presumably, the marginal seller was induced to sell because the additional demand increased the asset’s price, which would mean that the change in the observed price has changed his assessment of the asset’s value.

This is getting complicated, but when you put it all together, this is what it seems to me must be the story you have to tell if you believe that the absence of a capital gains tax is harming productive investment:
  1. there are some canny savers out there who know which assets are going to appreciate in value; 
  2. some of the owners of those assets are not so canny and believe that their assets are worth less than they actually are based on the current price;
  3. in the process of bidding for those assets, the canny investors push up their price, inducing some of the non-canny owners to save;
  4. when the non-canny owners sell at higher prices, they discover that their portfolios are more valueable than they thought;
  5. as a result of this higher perceived permanent income, they increase their consumption;
  6. as a result, the total flow of savings in the economy is reduced;
  7. investing firms are not able to replace this reduced flow of savings from off shore;
  8. even though the increased consumption in point 5. is the result of non-canny asset owners receiving better information about their true wealth, this change of behaviour is a bad thing;
  9. somehow a capital gains tax will act to prevent this better information getting through to uncanny asset holders, even though anything less than a 100% capital gains tax would provide an incentive for canny investors to exploit undervalued assets! 
There has got to be a better justification for capital gains taxes than this. Is there an economist advocate for such taxes out there who can enlighten me?


  1. if you introduce a cgt as Labour says to stop people speculating in houses(a problem 3 years too late) surely following the same logic it will stop them investing in anything that has a cgt attached, productive or other.
    NZ has a brilliantly simple tax system and apparently the only reason cgt became policy is because the PR man told Labour they needed some outrageous game changer.

  2. Here is my thought experiment:

    Suppose H wants to improve his business by adding a customer service database. He is a mediocre programmer, but his friend, S, is pretty good. H can hire S for $100 to build the database, or do it himself. Also, assume a 30% tax on labour and no CGT.

    - H hires S if she can add $100 of value to the business. She can, he does. S receives $70 in the hand.

    - H does it himself, let's say adding $80 of value to the business. He sells the business and receives the whole $80.

    Efficiency problem: if you can DIY and build capital value, you'll do less valuable work at the margin w/o a CGT.

    Equity problem: S does $100 of work and receives $70. H does $80 of work and receives $80.

  3. Bill's thought experiment is fraught with simplicities , eg H does it himself, adding $80 of value.
    That's speculative, but generally the added value is sold at a multiple of earnings, and since the CRM creates better value, the added value at exit is not $80.

    The problem these days is that too many with vested interests in managing tax returns prefer complicated taxes, the more the better. What we need is a simple tax system, not mechanisms to create pools of money for politicians and bureaucrats ala Len Brown to dip into to bribe gullible, short term thinking impaired voters. Less money for bureaucrats means more real capital formation, more REAL jobs, not more chair polishers and paper shufflers, unionists, academics thinking up new ways to get funding for the next fashionable topic.

    Long live New Zealand without an additional tax.