Capital gains taxes: some thoughts

It is a day for repeating some material from old posts. I haven’t yet read any more than a few news reports on the Tax Working Group’s report.  But I have debated capital gains taxes for years.   This was a post on the topic from 2017.  Here was the gist of my comments.   My bottom-line is that capital gains taxes aren’t the worst thing in the world, but mostly are a distraction from what should be the real issues.

Anyway, here are some of the points I make:

  • in a well-functioning efficient market, there are typically no real (ie inflation adjusted) expected capital gains.    An individual participant might expect an asset price to rise for some reason, but that participant will be balanced by others expecting it to fall.  If it were not so then, typically, the price would already have adjusted.  In well-functioning markets, there aren’t free lunches.    It also means that, on average, capital losses will be pretty common too, and thus a tax system that treated capital gains and losses symmetrically wouldn’t raise much money on average over time.   A CGT is no magic money tree.   And there is no strong efficiency argument for taxing windfalls.
  • if you thought, for some reason, that people were inefficiently reluctant to take risk, there might be some argument for a properly symmetrical CGT.  In such a system, the government would take, say, a third of your gains, but would also remit a third of your losses (the overall risks being pooled by the state).    The variance of an individual’s private after-tax returns would be reduced, and they might be more willing to take risk.   But, in fact, no CGT system I’m aware of is properly symmetrical –  there are typically tough restrictions on claiming refunds in respect of capital losses (one might only be able to do so by offsetting them against future gains).  There are some reasonable base-protection arguments for these restrictions, but they undermine the case for a CGT itself.
  • All real world CGTs are based on realised gains (and losses to an extent).   That makes it not a pure CGT, but in significant part a turnover tax –  if you never trade, you never pay (“never” isn’t literal, but tax deferred for decades discounts to a very small present value).    And that creates lock-in problems, where people are very reluctant to sell, even if their circumstances change or if a new potential owner could make much more of the asset, for fear of crystallising a CGT liability.  In other words, introducing a CGT introduces a new inefficiency to asset markets, making it less likely that over time assets will be owned by the parties best able to utilise them.
  • Basing a CGT on realised gains will also, over time, bias the ownership of assets subject to CGT to those most able to avoid realising the gains.  A long-lived pension fund, or even a very wealthy family, will typically be better able to  count on not having to sell than, say, an individual starting out with one or two rental properties, or some other small business, where changed circumstances (eg a recesssion or a divorce) might compel early liquidation.  Large funds are also typically better able to take advantage of loss-offsetting provisions.  The democratisation of finance and asset holding it certainly isn’t.
  • CGTs in many countries exclude “the family home” altogether.  In other countries, they provide “rollover relief”, enabling any tax liability to be deferred.  Most advocates of a CGT here seem to favour the exclusion of the family home, even though unleveraged owners of family homes already have the most favourable tax treatment in our system.  Again, a CGT applied to investment properties but not owner-occupied ones would simply trade one (possible) distortion for another.
  • In practice, most of the arguments made for a CGT in New Zealand have to do with the housing market.   But, on the one hand, all major (and minor?) parties claim that they have the fix for the housing market (various combinations of RMA reform, infrastructure reforms, changes to immigration, restrictions on foreign ownership, state building programmes or whatever).  If they are right, there is no reason to expect significant systematic real capital gains in houses.  If anything, real house prices should be falling –  a long way, for a long time.    Of course, prices in some localities might still rise at some point, if unexpected new opportunities appear.  But “unexpected” is the operative word.   Enthusiasm for a CGT, at least at a political level, seems to involve a concession that the parties don’t believe, or aren’t really serious about their housing reform policies.
  • Oh, and no one I’m aware of anywhere argues that a realisation-based CGT applied to (a minority of) housing has made any very material difference to the level of house prices, or indeed to cycles in house prices.
  • In general, capital gains taxes amount to double-taxation.    Think of a business or a farm.  If the owner makes a success of the business, or product selling prices improve, expected profits will increase.  If and when those profits are achieved, they would, in the normal course of affairs, be subject to income tax.  The value of the business is the discounted value of the expected future profits.  It will rise when the expected profits rise.  Tax that gain and you will be taxing twice the same increase in profits –  only with a CGT you tax it before it has even happened.   Of course, at least in principle, there is a double deduction for losses, but as noted above utilising losses (whether of income, or capital) is a lot more difficult.    If you think that New Zealand has had less business investment than might, in some sense, have been desirable,  you might want to be cautious about applauding a new tax that would fall heavily on those who took business risks and succeeded.
  • Perhaps double taxation of expected business profits doesn’t bother you.  But trying reasoning by analogy with wages.   If the market value of your particular skills has gone up, your wages would be expected to rise.  When they do you will pay taxes on those higher wages.  But by the logic of a CGT, we should capitalise the value of your expected future labour income and tax your on both that “capital gain” and on the later actual earnings.  Fortunately, we abolished slavery long ago, but in principle the two cases aren’t much different: if there is a case for a CGT on the value of a business, it isn’t obvious why one shouldn’t have one on the value of a person’s human capital.
  • (I should note here, for the purists, that there are other concepts of double-taxation often referred to in tax literature, none of which invalidate the point I’m making here.)
  • Real world CGTs also tend to complicate fiscal management?  Why?   Because CGT revenue tends to peak when asset markets and the economy are doing well, and when other government revenue sources are performing well.  CGT revenue doesn’t increase a little as the economy improves and asset markets increase, it increases multiplicatively.  And then dries up almost completely.  Think of a simple example in which real asset prices had been increasing at 1 per cent per annum, and then some shock boost asset prices by 10 per cent.  CGT revenue might easily rise by 100 per cent in that year (setting aside issues around the timing of realisations).  And then in a period of falling asset prices there will be almost no CGT revenue at all.   Strongly pro-cyclical revenue sources create serious fiscal management problems, because in the good times they create a pot of money that invites politicians to (compete to) spend it.  If asset booms run for several years, politicians start to treat the revenue gains as permanent, and increase spending accordingly. And if/when asset markets correct –  often associated with recession and downturns in other revenue sources-  the drying up of CGT revenue increases the pressure on the budget in already tough times.     It is easy to talk about ringfencing such revenue (mentally, if not legally) but such devices rarely seem to work.

None of this means that I think there is no case for changes in elements of our tax system as they affect housing.  The ability for business borrowers to deduct the full amount of nominal interest, even though a significant portion of that interest is simply compensation for inflation (rather than a real cost), is a systematic bias.  It doesn’t really benefit new buyers of investment properties (the benefit is, in principle, already priced into the market) but it is a systematic distortion for which there is no good economic justification   Inflation-indexing key elements of our tax system is highly desirable –  at least if we can’t prudently lower the medium-term inflation target –  and might be a good topic for a tax working group.  In the process, it would also ease the tax burden on people reliant on fixed interest earnings (much of which is also just inflation compensation, not a real income).

Of course, at the same time it would be desirable to look again at a couple of systematic distortions that work against owners of investment properties.  Houses are normal goods and (physically) depreciate.  And yet depreciation is no longer deductible.  Perhaps there was a half-defensible case for that when prices were rising seemingly inexorably –  but even then most of the increase was in land value, not in value of the structures on the land –  but there is no justification if land reform and (eg) new state building is going to fix the housing market.    Similarly, when the PIE system was introduced a decade or so ago, it gave systematic tax advantages to entities with 20 or more unrelated investors.  Most New Zealand rental properties historically haven’t been held in such entities.  There is no good economic justification for this distinction, which in practice both puts residential investment at a relative tax disadvantage as a saving option, and creates a bias towards institutional vehicles for holding such assets.  Institutional vehicles have their own fundamental advantages –  greater opportunities for diversification and liquidity –  but it isn’t obvious why the tax system should be skewing people towards such vehicles rather than self–managed options.  As noted above, any CGT will only reinforce that bias.  Funds managers, and associated lawyers and accountants, would welcome that. It isn’t obvious why New Zealand savers should do so.

And in all this in a country where we systematically over-tax capital income already.  I commend to readers a comment on yesterday’s tax post by Andrew Coleman, of Otago University (and formerly Treasury).  As Andrew noted:

Somehow, New Zealand’s policy advising community decided it would restrict most of its attention to the ways income tax could be perfected rather than question whether income taxes (which are particularly distortionary when applied to capital incomes) should be replaced by other taxes. It is almost as if we have the Stockholm Tax Syndrome – fallen in love with a system that abuses us.

A broad-based capital gains tax would just reinforce that problem.

2019 again. I hope the TWG report has dealt substantively with these sorts of points.  But I’m not optimistic.


40 thoughts on “Capital gains taxes: some thoughts

  1. There is a inherent double taxation in capital gains tax. The current value of a business is usually the present value of the anticipated future net cashflow of the business after tax which is then discounted further for a key person risk.

    The owner on sale gives away the future net after tax cashflow from the business. It is rather disgusting of communist Grant Robertson, communist Stuart Nash, communist Jacinda Ardern, communist Winston Peters and communist James Shaw to even consider what is double taxation.


    • The Tax Working Group is a disgrace. The lack of consideration of inflation index calculations or the consideration of the sacrifice of the future after tax net cashflow on sale is just negligent and lazy. It is unbelievable the degree of lack of professional duty of care to ensure that these issues are considered and the public actually pays for such nonsense reports.


  2. Michael,

    You claim CGT is double taxation, but for housing owner occupiers the (non-cash) benefit of the house is untaxed. This was a criticism that Gareth Morgan made when he campaigned for TOP during the previous election. Have you written a post on this topic? That would be interesting to discuss.



  3. Hi Michael,

    Interesting post. A major source of variation in asset values is changes in discount rates (as opposed to changes to expectations around the distribution of future cash-flows). Would you consider taxing of discount rate-driven capital gains to be double taxation? You’d need a slightly different explanation: if discount rates fall (ceteris paribus), the present value of your future tax payments increases, even without a capital gains tax.


    • Generally not, altho I think you overstate the importance of changing discount rates (which generally change for a reason, often having to do with changes in the income earning potential of the economy.


  4. Despite all these theoretical problems, CGT is used successfully and without controversy by the vast majority of OECD countries. Thus, I think it’s extremely unlikely that the sky will fall if it’s implemented in New Zealand.

    Sadly, I think it’s many years too late to save “the New Zealand Way” as I understood it, rather than the way National is presenting it, which would have been completely unacceptable a generation or two ago. CGT can go some way towards restoring fairness to our economy though, which I think is more important than the small monetary gains that will accrue.


    • The 5 year Bright line test at 33% tax is already a CGT at one of the highest penal rates in the entire world. It is just nonsense to even suggest NZ does not already have a CGT on property. The current CGT under consideration is to extend CGT on all businesses, on all shares ownership also at one of the highest penal rates in the world at 33%.

      Liked by 1 person

      • Even in property, CGT longer than 5 years and as principle loans start to be paid down, the double taxation impact increases. Rental income becomes increasingly net cash flow positive with tax being paid on the rent. The maximum term of a loan is 30 years which means that the rental income is fully taxed as loans get fully repaid. CGT on the all the capital profit on sale is therefore double taxation because the capital gain is the value provided by the purchaser for the owner to sacrifice the future rental income after tax cashflow.

        Nothing at all fair to owners of equity to pay tax twice. It is plain day light robbery of the kind that Stalin would be proud of. Everytime I listen to Grant Robertson and his hard core communist attitude, I think of Stalin.


  5. I see China has blocked Australian coal imports.

    Ouch, the Lucky Country is already in the midst of a collapsing house price bubble.

    China is pouring fuel on that fire!

    NZ will follow Aussie.

    Our un-affordable housing problem is about to fix itself. Aussie and NZ dodged a bullet during the GFC. Now it is our turn to watch the property bubble implode.

    This time round there is no coordinated global QE reinflating the bubble(s). The opposite in fact – accelerating international conflict. Aussie and NZ are going to be left to grapple with imploding housing bubble all on our lonesome.


  6. Listened to a farmer last night passionately opposing the GST for all the reasons you could possibly give. He was 30 years old and had purchased his farm 4 years previously. Not bad for a 26 year old to be able to buy a farm at that age. The kicker was because he had purchased at the top of the market his farm value was now down below his purchase price. So he is making a loss. No CGT payable on that loss. Yet to listen to him he was parroting all the propaganda you can possibly hear. It is a co-ordinated stooge program


    • His Farm business is making a profit, therefore he is bleating about the CGT on the eventual sale of his profitable Farming business. CGT does not just apply to land but also to his business.


  7. You spent a lot of words dealing with the non-existent hypothetical
    Fact is we are not dealing with a “well-functioning efficient market”

    quote “In general, capital gains taxes amount to double-taxation. Think of a business or a farm”

    The complaint from the small business community is “we slaved our arses off to build the business up and the government wants to steal it.

    The reality of non-perfect-functioning market is most proprietors build the business up by either not taking out realistic fullsome wages, but leaving the unpaid wages in the business thus avoiding PAYE tax. All th3ey are doing is postponing the day of the tax-man calling

    Then there is the reality of 45% inflation which is not attributable to the proprietors working their arses off


    • Iconoclast, you are wrong. You must have heard of Income tax, which is paid on Taxable profit?

      Revenue less cost = Taxable Profit.

      If an owner reduce wages to himself = lower cost, which equals to higher taxable profit ie more tax paid.

      Therefore surplus cash re-invested in the business is already income tax paid. There is no deferment of tax on reinvesting in your own business.


      • That is code for income-sharing, and usually the retention of cash in the business is to cover personal expenses. A personal experience was a business proprietor (friend) who paid out of his business the cost of Pauanui Golf Club membership, paid for $900 radar-detectors for self and staff, painting of his Pauanui Bach, plus the costs of owning a couple of poodles as guard dogs. Food etc. No holding back. The lot.


      • If you are aware that your friend is a cheating fraud then you can lodge his name and the offense with IRD hotline on the IRD website. Most business people are honest in their approach and pay their taxes in accordance with the law.

        Liked by 1 person

    • The thing about farms is a lot of them rely on capital gains on the sale of the farm to the owners’ children, and the day-to-day productivity being very low


      • In farming the productivity is very high because productivity does not measure the number of animals or the amount of land or water resources. It measures the number of people or the number of working hours.


    • The truth is that the political drive in NZ is mostly about rental properties and to the extent there is an issue it could be fixed almost overnight by freeing up the land market, and also by allowing purchasers to deduct only real interest expenses (not the full nominal expenses). There would still be individual people who ended up doing well out of owning residential property, but there would be roughy as many who end with sub-par returns.

      On other businesses, there are always issues around the tax treatment of closely-held companies. Most just never make that much money (there isn’t a big asset to sell at 65 or thereabouts).

      In principle I have no particular problem with taxing windfalls (so long as there is full offsets for windfalls losses), if “fairness” is the concern. But a well-designed system will not only generate little income, it will do it in a highly procyclical way, and involve non-trivial compliance costs. I’m not convinced it is worth it, but as I noted in the post I don’t think a CGT is the worst thing in the world.

      Liked by 1 person

  8. And in all this in a country where we systematically over-tax capital income already.

    This is not something I’ve given much thought to, outside of the imputation tax debates that have been going for a while now.

    Given that the key to productivity increases is to employ more capital than labour, including perhaps replacing labour with capital, and your many references to New Zealand’s lousy productivity record, could it be that this over-taxed capital income is one of the main factors here?

    I’d like to see an article from you that goes into a little more detail as to exactly how NZ over-taxes capital income already, and what that might mean for capital investment and deployment.


    • I largely agree, altho something on residential rentals might still be a possibility – even though the symptoms that generate the angst could be fixed more convincingly more directly (free up land use, and allow interest deductions only for real interest).


      • We are already seeing rental property investments fall quite dramatically. This has certainly put upward pressure on rents due to lack of available rentals which is what most long term property investors are looking for.

        At the moment there is no capital gains to be made in the housing market anyway as the Auckland property market is flat and falling.


      • The removal of the foreign buyer with a foreign buyer ban and also assisted by China’s fund transfer restrictions have drained the Chinese housewives emotional auction buying nightmare. The property market is now operating at a more rational basis with proper fundamentals based on rental cashflow and the Unitary Plan’s higher flexibility with the multiunit site potentials.

        Push too much harder and you could be back to 2008 where even though property prices were low, no one was buying except for long term property investors looking for rents. Emotional homeowners would not buy in a falling market. They would prefer to rent trying to time the market.


  9. I actually think the solution to the double taxation problem is to get rid of company tax altogether.

    CGT is definitely not the solution to the housing problem, no one thing can be, but I’d say it’s in the top ten things that need to be done to fix housing prices.


    • The 5 year Bright Line Test is a CGT at one of the highest penal rates in the world at 33%. It has not done much to prices. Another CGT on top of a existing CGT is just rather over the top punishment for property investors? Talk about a Stalinist approach to wealth theft, perhaps, comrade Grant Stalin Robertson?


  10. No sign a CGT has “fixed” house prices anywhere else is there?

    Simply getting rid of company tax would bring its own problems – you’d need something like a compulsory distributions provisions or else the incentive is to keep earnings in the company, never distributing them (unless you were suggesting getting rid of dividends taxation as well?).


    • Yes, a wealth tax on highly liquid assets (cash basically) of companies when they exceed a certain ratio of revenue might be necessary. However what’s the point of hoarding cash in a company if you can’t ever spend it? (Genuine question by the way.)


  11. Michael, shouldn’t real assets (including equities, real estate etc) grow roughly in-line with the economy’s real growth over a long period of time?

    If there were no positive expected real return, then why would anyone buy equities or real estate and not bonds, offering a positive real return? Real bond yields will tend to be driven by real variables including the potential growth rate of the economy. And equities and real estate should offer some risk premium in excess of bonds as well.

    So my premise would be that real estate should have some ex ante positive real return (at least in NZs case with a neutral real OCR in positive territory and OK potential growth). In that case, I’m not sure you have this symmetrical problem around losses and gains. Over time you’d expect systematic gains to accrue (although not at all times for sure). I don’t have the data off the top of my head, but I’m pretty sure US equities and real estate have generated positive annual real returns over a very long period of time.

    Any thoughts?


  12. Nick

    It sounds a bit as though you are conflating positive returns and capital gains. There is no question that there is a significant equity risk premium (and of course, real bond yields are positive – and in equilibrium related to the long-term growth potential of the economy). Land has a natural productive potential. But none of those should give rise to capital gains (or losses) – only shocks that change prospective returns (or discount rates).And those shocks can be negative or positive.

    Of course, in a system without dividend imputation there is typically an incentive not to pay very much in dividends, and in that world share prices will (I think) tend to rise over time – the return comes in capital gain rather than dividends. But that isn’t the NZ system.

    As for land, have a look at Robert Shiller’s long-term series, Little or no change in real house prices (repeat sales measure) over 100 years (until eg land use restrictions start putting an artificial upward bias). Those houses still had positive returns tho – actual or imputed rents.

    Of course if you don’t inflation index, there won’t be a symmetry between expected gains and losses for CGT purposes. I’m less outraged by the lack of indexation proposed (than some critics) because a realisations basis means that the CGT is typically a very deferred tax, much less in PV terms than a tax on unrealised gains (the theoretical “ideal” and practically inconceivable).


  13. “in a well-functioning efficient market, there are typically no real (ie inflation adjusted) expected capital gains.” ???

    The long term compounded growth rate on the US stockmarket indexs over the long term is some 6-7% nominal, which still leaves a substantial real return.

    Yes, the indices are self selecting in that weak performing companies drop out and stronger companies enter the indices, but the real return is there and can be captured by index following funds.

    Perhaps the US stockmarket is not a well-functioning and efficient market? It could be that the competition laws are far too weak and allow too many monopolies.


    • You can’t just look at a capital gain and consider that a real return. You also have to factor in that the owner has to sacrifice the future net after tax cashflow that is inherent in that capital gain when he sells. The purchaser established the value of the future net after tax cashflow he is buying to establish a purchase price.


  14. Hi Michael
    The CGT proposal looks difficult politicall, and questionable as to whether it would have any impact on prices or revenue. But I’ve thought since coming to NZ 9 years ago that something does need to be done to put the brakes on land and house prices and encourage investment in the ‘productive economy’, much like the slogans the government has. I’ve wondered if something couldn’t be done to steer the ‘new money’ banks create when lending into different sectors and away from land and house purchases. Whilst supply and demand obviously impacts prices, so does the supply of money into different sectors. QA doesn’t impact on supply in the economy or real demand, but it fuels demand. Does anyone know how much ‘new money’ has been put into the NZ housing market over the last 20 years? Would it be possible to say to banks new money available for new builds and first home buyers and business investment, but not for second homes?


    • Lending for housing (outstanding) was $54bn in Dec 98 and $258bn in Dec 18.

      I guess i tend to see the lending (and associated deposit creation) as largely an endogenous response to the population and land use restriction pressures that have driven house prices sky high. Take away the ability to borrow and you don’t change those factors; mostly what will change is who owns the houses (more will be owned by cashed-up people, institutional investors etc).

      The biggest problem here re lack of much (outward-focused) business investment doesn’t seem to be lack of access to finance so much as lack of lots of profitable opportunities. I’ve argued that the combination of our very remote location and our persistently overvalued real exchange rate exchange much of that.


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