Wednesday, 17 September 2014

Capital Gains Tax Bleg

When I first started writing posts on capital gains taxes three years ago, starting with this post and this one, they were sort of a bleg. I have never understood the rationale for CGT, as the arguments that are usually put seem to involve shifting definitions, or incomplete partial-equilibrium analysis. So I wrote those two posts to explain why I thought the arguments in favour don't add up, hoping that someone could counter with a coherent argument. With a CGT defended within the context of a coherent model, it should be possible to phrase the debate in terms of differences in either values or empirical beliefs about the economy. Three years on, I have seen a lot of public discussion of capital gains taxes, but still don't understand what is the model from which proponents draw their conclusions.

But now I have a different bleg. I would like to know how actual CGTs that have been implemented elsewhere (or the ones proposed by opposition parties in New Zealand) would deal with a particular issue. This issue is easiest explained with a series of examples:

  1. Imagine that you are a householder with a portfolio of $2,000 of shares in a single company that is earning a 5% rate of return on its capital. At the start of a new year, you decide that you want to save some more, so you buy $100 in a different company using money you have earned in the previous year but not spent. You now have a portfolio of $2,100. This increase in the value of your portfolio would not be classified as a capital gain. It simply represents increased savings.
  2. Now imagine that instead of putting the $100 into a different company, you bought $100 of freshly issued shares in the same company that you already have a shareholding of $2,000.  That still doesn't count as a capital gain, right? The company uses the money from its new share issue to buy some capital equipment, which will also earn a 5% rate of return, but what they do with the money is irrelevant.
  3. Now, imagine that in the previous year, you were paid a dividend of $100 by the company in which you own $2,000 of shares, and you bought $100 of freshly issued shared by the same company. Again, this makes no difference. The fact that your purchase of new shares was in exactly the same amount as your dividend payment, is irrelevant; the additional $100 was paid for out of your total income and was available for buying shares because of a choice not to use it on consumption. 
  4. Now make one more change. Instead of paying out $100 in dividends and then issuing $100 of new shares, the company simply retains the profit, pays a dividend of $0, and uses the money to pay for the new capital, as above. The company has increased its ownership of capital equipment by 5%, and so the value of the existing shares will increase by 5%. So now our shareholder sees that his shareholding portfolio has increased from $2,000 to $2,100, just as in all the previous cases, except in this case he hasn't bought any new shares; he has seen what looks like a capital gain of 5%. Except, it is not really a capital gain; the reinvestment of profits by the company instead of paying out a dividend is a form of saving that is imposed on its shareholders.  

In the absence of taxes, the only difference between example 3 and 4 is in the default position. In 3, the shareholder receives the dividend and needs to make a decision to buy new shares to turn that dividend into saving. In 4, the default is that the dividend is saved, and the shareholder would need to sell $100 of shares to convert that saving into consumption.

But what if we add capital gains taxation. Wouldn't a CGT induce a difference between example 3 and example 4, adding additional taxation in the latter but not the former. And wouldn't this induce a distortion in which the tax system created an incentive for firms to pay out all their profits as dividends and then raise new capital rather than retaining profits for investment? What I would like to know is how to other countries deal with this distortion in their CGTs (if at all), and how would the opposition parties in New Zealand plan to deal with it.

It is also interesting to note that currently in New Zealand, there is a slight tax distortion that favours retained income over dividend payout (as the corporate income tax rate is lower than the top rate of income tax). At the time the rate was lowered from .33 to .30 in 2008, the then Labour government said this was a deliberate distortion as a kind of nudge to encourage retained earnings and hence make saving the default. Does Labour now think that we should be changing the nudge to consumption by moving the tax advantage the other way?

16 comments:

  1. Not a tax lawyer but have paid Australian CGT a few times. My recollection is that there is an adjustment for inflation but not for dividends, so dividends do reduce the taxable capital gain. The story is further complicated by the fact that there is a 50% discount on your marginal tax rate for CGT for assets held >1yr and there is full dividend imputation.


    The net impact of all the rules seems to be that the ASX is dominated by firms paying high franked dividends. Share buybacks are also popular (presumably because CGT is still lower than income tax). If anything is getting squeezed it appears to be capital investment.


    Two personal observations: the beginning of the current house price boom in Australia seemed to come soon after Howard introduced the CGT discount. And CGT is a massive pain to comply with. Very complex, and "feels" arbitrary and distorting having to factor it into decisions.

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  2. The dividend imputation is good (removing a bias in favour of debt versus equity), but the CGT seems to be having the effect I surmised: discouraging retained earnings as a form of equity finance.

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  3. Yes it seems so. But what do you think about share buybacks? It seems these should not be favoured. Let's say a NZ CEO is running a company with a high ROE. If he grows the business, he pays 28% tax, but if he does buyback it's tax free?

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  4. There are two issues, I think. One is should we see share buybacks rather than retained earnings. A high ROE company without much growth potential could well seek to pay out more to shareholders and buybacks are one way. The second issue is buybacks versus dividend payouts. In a sensible tax system where the corporate income tax was the same as the marginal personal income tax rate, full inputation and no CGT, there should be no reason for a company to favour buybacks over dividend payouts (suggesting perhaps some aspect of insider information about company value). But without a sensible system, buybacks may well reflect tax arbitrage.

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  5. Depends on the CGT. If income and gains are taxed at the same rate It could be that in example 3, the dividend is taxed and in example 4, the gain is taxed.

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  6. I can't speak for other countries except Australia. Here, in 3 you pay tax on the dividend (because it is income) before you are able to buy new shares with the revenue. In 4 if you sell your shares that are now worth $2100 because the company reinvested earnings instead of paying dividends, your $100 capital gain counts as personal income and is taxed. The net effect in both cases is that the $100 of income earned by the company is taxed after inclusion into the income of owning households. https://www.ato.gov.au/General/Capital-gains-tax/

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  7. I've had this same thought but in the context of: Why on earth do companies in NZ currently pay dividends? Number 4 holds, but imagine Number 5 where, instead of a dividend, the company uses those retained earnings in a share buyback. The pool of shares shrinks, and their value rises proportionately to the hypothetical dividend amount, allowing the value of the dividend to be passed on to shareholders without being taxed as income.
    Why is this not more widespread?

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  8. I should say that with NZ's imputation regime the tax differential would be small, but present nonetheless.

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  9. In a country with no imputation of corporate income tax, this would be correct: the CGT would imply the same tax whether the company retained the earnings or paid them out as dividends. Of course, that would mean broadening the double taxation that occurs when a company is taxed on its profits and then the shareholders taxed on their earnings of those profits. In NZ with imputation, there isn't this double taxation, and so we have (essentially) the same tax on retained earnings as we do on dividend payouts. The only caveat is that retained earnings are taxed at the CIT of 28% and dividends taxed at the (typically) marginal tax rate of 31%. In theory, a 3% CGT, would remove that difference. Any CGT higher than that, would push the distortion the other way.

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  10. ckmurray. But my understanding is that Australia has full inputation, and so the tax on dividends that you pay in 3 is net of the implicit tax already paid as corporate income tax, which (if the CIT is the same as the income tax rate) would imply no additional tax on dividends. Similarly, the CIT is paid before earnings are retained and reinvested, and so are similarly taxed. A CGT then would imply additional taxation, unless there was some way of applying the same imputation to the reinvested-earnings-generated capital gain. As I can't see any way of distinguishing between a capital gain that is the result of a a changing world in general and that that is the result of reinvested earnings, I can't see how imputation could stop the double taxation from having a CGT.

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  11. I think that is the answer. The 3 percentage point difference is not enough to outweigh the transactions costs of doing a share buyback rather than dividend payout, I think.

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  12. I've got no comment on the equivalence of the options above, but I would point out there's a rich literature in the Chartered Financial Analyst content (levels 2 and 3 I think) on solving the problem from the businesses point of view, on whether it is optimal for shareholders for the business to pay dividends, retain & hoard earnings, reinvest, or buyback shares depending on CGT and dividend tax treatments in different countries.


    If I'm remembering correctly, I believe the recent trend for an increasing amount of buybacks is in large part due to the way dividends are taxed: since paying dividends and buying stock is financially equivalent, it's cheaper on an after tax basis to buyback stock than pay dividends to shareholders.

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  13. It think this is because of the points discussed by Ben and me above: The fact that the company tax rate is 5 percentage points lower than the top rate of income tax (I said 3 above, but I was mis-remembering what the top income tax rate is), means that stock buybacks are cheaper, but the difference is small.

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  14. buybacks are often used to allow overseas investors to obtain some benefit as they cant use imputation credits.

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  15. Good point.


    Is that a decision of NZ or of overseas countries? If I earn income in Canada as a non-resident, 15% is deducted at source by Canada, and then I pay my NZ marginal tax rate less 15% in NZ. Why wouldn't other countries treat imputation in the same way as a deduction at source?

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  16. As is often the case with tax, I went looking for a simple answer and found tax speak! So i really can't answer. Maybe someone like Greg D, who I think Eric knows could answer?

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