Amaresh Bagchi: Taxing capital gains: Unending debate

The tax treatment of capital gains is indeed a "vexed issue", as Finance Minister Chidambaram put it in his Budget speech this year. "Probably no income tax issue has been as much debated as the taxation of capital gains," says Michael Graetz, a renowned law professor at Yale and former US Treasury official, in his delightful book on the income tax in the US. And the debate still goes on.

The reason simply is that in principle no rational system of income tax can afford to leave capital gains out of the tax base. If income is to serve as a good index of the ability to pay, which is the raison d' etre for having income as the tax base, taxable income must include all ingredients of economic power defined as the sum of net accretion to wealth and consumption occurring over a given period.

Since much of economic power accrues to asset owners in the form of rise in asset values, a tax system that fails to tax capital gains remains gravely deficient and creates a strong bias in favour of the rich.

Not taxing capital gains also offends efficiency in that it discriminates in favour of activities like speculation, which beget large gains quickly, as against risk taking in ordinary business. Besides, the concept of capital gains has its origin in the practice of measuring income periodically on a calendar-year basis, which is arbitrary, and which only "accountants and some aboriginals regard as fundamental", as Nobel Laureate Paul Samuelson once remarked.

If the accounting period is taken to be sufficiently small, all incomes would accrue as capital gains, while with a sufficiently long accounting period all capital gains would turn out to be ordinary income.

Keeping capital gains out of the tax base also creates opportunities for tax avoidance by converting ordinary income into capital gains. One has only to go through the cases that went up to the Privy Council and the Supreme Court to have an idea of the efforts that went into claiming receipts that clearly contained large elements of gains as "capital", to avoid taxation. The terms "share stripping" and "bond washing" were mothered by the lure of tax saving, by converting regular incomes like dividend into capital gains.

The problem, however, has been that measuring income comprehensively to include increments in capital values is problematic unless the assets in question are put to actual sale. Notional valuation opens up room for subjectivity and arbitrariness.

Hence, income tax systems all over the world proceed on the basis of what is called "realised" income and subject capital gains to taxation as and when they are realised.

Since under a system of progressive taxation this results in taxing the gains accruing over several years as one year's income, taxing gains bunched over more than a year""which is the usual period of accounting""gives rise to inequity.

Another problem has been that when asset values appreciate simply because of inflation, the gains to asset owners may be illusory. Sifting "real" from "illusory" gains presents problems, but it can be taken care of through devices like the indexation of the cost of acquisition of the asset.

To alleviate the burden of progressive taxation caused by bunching, long-term capital gains are often taxed at a preferential rate, while short-term gains, that is gains from assets held for less than a year, are taxed as ordinary income.

Another method followed in the UK is to allow "tapering", that is taking only a fraction of the realised gain depending on the period of holding, starting with 100 per cent for assets held for not more than a year. If a lower rate is to be applied to long-term gains, as has been the practice in the Indian income tax, what should be the appropriate rate? There is no straightforward answer.

In the US, capital gains were taxed at a rate of 25 per cent, when the top rate on other income went up to 91 per cent. However, when the celebrated Reagan reforms of 1986 brought down the top rate of income tax sharply and the average rate did not go beyond 28 per cent, capital gains were treated as ordinary income; but when the top rates went up later, the rate for capital gains remained unchanged. For all his Republican fervour for a soft treatment of capital gains, President George Bush could not get Congress to cut the capital gains tax.

At what rate of the capital gains tax the revenue for the government is maximised has also been the subject of some debate. While one cannot say for certain what the precise revenue-maximising tax rate could be, US evidence suggests that it probably lies between 19 per cent and 28 per cent.

Given this background, the system of capital gains taxation prevailing in India in recent years, that is treating short-term gains as ordinary income and taxing long-term gains at 20 per cent after indexation, has not been too bad. The lower rate of 10 per cent for taxing gains from equity was an unjustifiable aberration.

In fact, taxing the gains of foreign institutional investors at a concessional rate does not stand to reason, because they can get the tax rebated against the tax payable in their home country. Moreover, higher tax would discourage speculative investment and help avoid volatility in the capital market.

A softer treatment of capital gains is sometimes advocated on the grounds that it will increase savings and investment and spur economic growth.

A comprehensive survey of the empirical studies on the question in the US by George Zodrow, a well-known economist, however, shows that the effects of capital gains tax cuts on savings, investment, and growth are uncertain. The survey concludes: "It is rather unlikely that such a cut will result in a significant increase in economic growth."

It cannot be denied, however, that the capital gains tax can lead to a "locked-in" effect because the tax can be deferred by simply holding on to the appreciated asset.

At the same time, it should be realised that an unduly soft treatment of capital gains can lead to excessive volatility in the capital market. Locked-in effects can be taken care of through provisions for tax-free rollover, as is allowed for residential houses.

In any case, exempting long-term gains from only listed equities, as is now proposed, offends not only fairness but also efficiency by discriminating against the unorganised corporate sector and unincorporated enterprises""the small and medium sector""where the bulk of our economic activities take place.

In sum, there is no good reason to exempt long-term capital gains from taxation, and that too selectively for gains from listed equities, or for taxing short-term gains at a rate lower than applicable to other incomes, as has been proposed now. It will grievously damage the income tax base and offend both equity and efficiency.

Can the transaction tax be a substitute for a tax on capital gains? The answer plainly is "no". For all its "neatness" and "transparency", it is distortionary and pays no heed to equity. At best, it can help to recover part of the cost of running bourses, but can in no way replace the income tax any more than a sales tax can.

(The writer is emeritus professor, National Institute of Public Finance and Policy)