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South African Journal of Economic and Management Sciences

versão On-line ISSN 2222-3436
versão impressa ISSN 1015-8812

S. Afr. j. econ. manag. sci. vol.14 no.4 Pretoria Jan. 2011

 

Does capital gains tax add to or detract from the fairness of the South African tax system?

 

 

Warren Maroun; Magda Turner; Kurt Sartorius

School of Accountancy, University of the Witwatersrand

 

 


ABSTRACT

This research adds to the existing body of knowledge on the perceived impact of capital gains tax (CGT) on the fairness of the South Africa tax system. Building on the largely qualitative work done by Vivian (2006) and Smith (1776), the research makes use of an extensive literature review followed by a correspondence analysis to complement the existing body of research in this area. The literature review discusses the fairness criteria advanced by Smith (1776) (Smith's tax canon) and the identified 'unfairness characteristics' of CGT. The correspondence analysis only tests the theories advanced in the literature review and reveals that there are potential sources of unfairness inherent in the Eighth Schedule to the Income Tax Act No. 58 of 1962 (the Eighth Schedule). These include the possibility that CGT gives rise to double tax and imposes a high burden on taxpayers' ability to bear the tax load. The findings are relevant in practical terms in that they may have policy implications for subsequent revisions to the Eight Schedule. Theoretical contributions are made by exploring the perceived fairness of CGT using the theory of tax fairness advanced by Smith (1776).

Key words: fairness, inflation, 'bunching', lock-in, equity, correspondence analysis
JEL: E30, H20


 

 

1 Introduction

The introduction of CGT has been cited as a key source of unfairness in the South African tax system. In particular, the tax has been denounced as a tool of political expediency, as well as a destroyer of initiatives because it places an undue burden on taxpayers. CGT has also been cited as an attack on the capital base of South Africa's economic reform and growth (Voster, 2000; Meyerowitz, Emsile & Davis, 2001a; Conda, 2006; Dyl, 1977; Roberts, 2006; Stein 2000). Smith's (1776:V.II.II) first canon of taxation suggests that four attributes can contribute to an unfair tax system: firstly, if the 'seed' of a taxpayer's income is taxed, in addition to the "fruits", a tax is being levied on both income and capital, resulting in double tax and an erosion of a taxpayer's ability to generate taxable income (Vivian, 2006:83). Secondly, only amounts earned under the protection of the state should be taxed (Vivian, 2006:84) implying that a source-based system of taxation is superior to the current residencebased system. Thirdly, a taxpayer needs to have the ability to bear a tax's burden and not merely the ability to pay it (Smith 1776; Vivian, 2006:84). A balance is necessary between the state's inexorable pursuit of revenue and the citizen's right to survive (Vivian, 2006:84-85 & Montesquieu, 1748: XIII.1). Finally, a progressive system of tax may be less desirable than a proportional one (Vivian, 2006).

Despite a considerable body of literature on CGT from a positive economic and technical perspective, scant research has been done on the perceived fairness of CGT. What little has been written has tended to be informal, lacking in empirical analysis and not rooted in a theoretical approach. Little effort has been made to elicit the opinions of CGT practitioners or to contrast emerging perceptions from multiple sources and to consider the relevance of economic theories such as Smith's (1776) theory of tax fairness.

The objective of this paper is to explore the perceived 'fairness' of CGT, in order to contribute to a better understanding of the impact of CGT, as well as to configure the Eighth Schedule and the fairness criteria advanced by the tax canons of Smith (1776). Using a detailed analysis of the relevant literature, coupled with a correspondence analysis, based on the perceptions of a sample of tax experts, the paper will investigate the fairness of CGT in relation to several concerns. First is the issue of taxation of capital and absence of inflation adjustment. Secondly, whether CGT exacerbates the problem of taxing capital gains at an artificially high rate by virtue of the sliding tax scales (the 'bunching problem') and artificially discouraging realisation of capital gains (lock-in problem). Third, whether CGT is inconsistent with the notion of concentrating the tax burden on the rich and taxing taxpayers in similar economic conditions equally (vertical and horizontal equity respectively). Finally, the paper will question whether CGT promotes anti-avoidance behaviour (structuring of transactions with an aim of avoiding a CGT charge) and whether the burden of administering this tax is cost effective.

An outline of the remainder of the paper is structured as follows: Section 2 discusses unfairness criteria with a view to the development of a questionnaire for tax experts. Section 3 outlines the data and method used to test the research questions. Section 4 develops the results, as well as a series of discussions. Finally, Section 5 concludes the study and makes some recommendations.

 

2 The unfairness of capital gains tax (CGT)

The unfairness of CGT was evaluated from a double tax perspective, from the 'bunching' or lock-in effect, whether it affected vertical and horizontal equity and whether inflation contributed to the unfairness of this tax. Finally, CGT is discussed with respect to its impact on tax avoidance, as well as the cost of its administration.

2.1 Double tax

The fruits of the taxpayer's efforts may be taxed but not the seed of those fruits (Smith, 1776). In other words, the 'fruits' or income of the taxpayer may be taxed but not the 'seed', 'tree' or capital receipts of the taxpayer (Stiglingh, Koekemoer & Wilcock, 2011; Vivian, 2006). A failure to comply carries two interrelated disadvantages: firstly, the tax may erode the assets used to generate income and pay taxes; secondly, the effect of taxing capital may be a double tax (Vivian, 2006:83; Ricardo, 1817). The result is economic ruin: the ability of a taxpayer to bear the tax burden is impaired, as are the funds used to maintain labour and generate wealth (Ricardo, 1817:63). Empirical evidence would suggest countries adopting CGT generally reported lower per capita income due to capital erosion (Dyl, 1977; Stein, 2000; Stein, 2001; PwC, 2000). This evidence would support Ricardo's (1817) contention which regards capital as 'the seed corn of the nation from which income is earned' and a part of the foundation of a taxpayer's ability to generate income. When 'capital is [reduced a taxpayer's] economic foundation and his ability to generate income is diminished' (Stein, 2000:12).

The taxation of inheritances may result in a similar problem (Smith, 1776; Ricardo, 1817). In this context, the provisions of para 40 of the Eighth Schedule that deals with the CGT of any disposal to or from a deceased estate may be relevant. Upon death, a deceased person is deemed to have disposed of his or her assets for an amount equal to the market value of those assets at the date of the person's death and such deemed disposal is subject to taxation in the form of CGT (Para 20 & 40 of the Eighth Schedule). This may force the deceased estate to realise certain assets to settle the CGT charge and detract from the recipient's inheritance (Stiglingh et al. 2011:855; Moore & Silva: 1995:87). In this way, a form of double tax arises which impairs the capital base of the nation (Ricardo, 1817). Capital gains are also the product of improvements in respective companies' post-tax cash flows rendering CGT as a form of double tax. Stein G (2001) negates the South African Revenue Service's (SARS) view that CGT is a fair charge on wealth realization by implying that CGT is a further tax on the selling prices of shares that already reflect the accumulated profits of a company. (Stein, 2000:102).

2.2 The 'bunching' and lock-in problem

Second, only amounts earned under the protection of the state should be taxed (Vivian, 2006: 84). This could imply that a sourcebased system of taxation is superior to the current residence-based system. Smith (1776) requires a tax to allow for only a fair remuneration for state-sponsored services with a tax representing only a fair quid pro quo (Vivian, 2006:82-83). Per Conda (2006), however, CGT has resulted in a 'locking in' of capital gains. Simply, CGT may 'lock-in' or discourage the realization of capital assets at the most efficient times. The result: assets may not be disposed of at the most efficient times or to the most effective users. The lock-in effect frustrates tax collection and the state's capacity to execute social-upliftment projects to the detriment of the poor (Conda, 2006). Secondly, the lock-in could result in a lower CGT rate stimulating realizations and improve state revenue (Auten & Cordes, 1991). Paradoxically, it may be possible to generate higher revenue, and offer improved state services, with a lower CGT rate (Dyl, 1977; Moore & Kerepen, 2001:5-6; Leonard, Randolph B & Randolph W, 2002; Roberts, 2006:1). This potential is magnified when one considers that relief offered under the rating formula is not available to minimise the negative impact of an excessively high CGT rate.

Nonetheless, these findings have been refuted by Brooks (2001) and SARS (2010; 2000) who assert that the conclusions are idealistic in that they rely on the assumption of perfect market efficiency to direct capital resources with optimal efficiency. In contrast, the absence of CGT would arguably lead to investment decisions motivated by tax avoidance rather than maximisation of society's utility. Indeed, such selfishness would necessitate a compensatory tax rate increase (SARS, 2010; Brooks, 2001:2; SARS, 2000). There is no guarantee that market forces alone will produce a socially fair result (SARS, 2000; Congress of South African Trade Unions (COSATU), 2001).

2.3 Vertical and horizontal equity

Third, the taxpayer needs to have the ability to bear a tax's burden and not merely the ability to pay it (Smith, 1776; Vivian, 2006:84). A balance is necessary between the state's 'inexorable' pursuit of revenue and the citizen's right to survive (Vivian, 2006:84-85; Montesquieu, 1748:XIII.1). In other words, equity theory is relevant. Taxpayers in equal positions should have equal tax commitments (horizontal equity) while wealthier taxpayers ought to shoulder a larger tax load (vertical equity) (Farrar, 2011; Vivian, 2006). The Katz Commission (1997) and Institute for Fiscal Studies in England (1978) maintained that CGT is instrumental in entrenching the ideals of horizontal and vertical equity in the tax system.

Equity has been achieved by ensuring that vast amounts of capital are not left untaxed in the hands of a wealthy minority and by taking cognizance of the need for the wealthy to spare the poor an undue tax burden (Katz Commission, 1997:46; Meade, 1978:12; Stiglitz, 1976; SARS, 2000). The need to remedy the legacy of Apartheid has made these views particularly valid (COSATU, 2001; Ensor (e), 2001:11). In this context, the Carter Commission (1966), Musgrave (1968) and SARS (2000) endorse CGT as being aligned with the notion of allowing taxpayers to bear the tax load in proportion to their ability to do so.

It has, however, been argued that vertical equity penalises the economically efficient to the detriment of the tax base. Mandatory charity may also be counter philanthropic (Coetzee, 1998:5; Voster, 2000; Farrar, 2011). CGT's ability to redistribute wealth and achieve vertical equity becomes tantamount to the state '[turning] the strong into the weak; the healthy into the sick and the wise into the stupid to make them equal' (Voster, 2000: 125). The lock-in effect aggravates the situation by paradoxically forcing the lower income worker who is forced to sell off an inheritance due to an inability, not experienced by the wealthy, to defer a capital gain (Groves & Curran, 1974; Voster, 2000; Moore & Kerpen, 2001; Moore & Silva, 1995 ). In this way, equity may be dismissed as lacking pragmatism. Indeed, the quantification of households' abilities to pay taxes may be too difficult to be a feasible justification for CGT (Coetzee, 1998:10-12).

2.4 Issue of inflation adjustments

The absence of inflation adjustment serves only to aggravate the 'bunching' and lock-in problem (Staszczuk, 2001:10; Cordes, 2000:3). While inflation indexing may be possible, it could prove 'horribly administratively complex' and too costly a solution (Croome, 2007; Olivier, 2007; Krever, 2001). Indeed most OECD countries made no provision for inflation adjustment in CGT calculations, except under hyperinflationary conditions (Ensor, 2000:1). The fact that the exemptions and exclusions are in place and that inflation impacts on all aspect of life may suggest that detailed inflation adjustments are not required (Krever, 2001; Ensor, 2000:1).

2.5 The anti-avoidance potential and administrative requirements

CGT's potential to discourage the concealment of wealth realization as capital gains has been part of the arguments in favour of CGT in several countries (Moore & Silva, 1995; Wood, 2001:13; Cameron, 2001). SARS maintains that CGT 'protects the integrity of ... the tax base and...materially assists in improving tax morality' (SARS, 2000). By protecting the tax base, it is also argued that this may lead to the future alleviation of the burden created by other taxes (SARS, 2010; Friedland, 2001; Wood, 2001:113.).

Critics, however, challenged CGT's antiavoidance potential. Paradoxically, in the context of globalisation, tightening the tax net has led to ever more creative tax avoidance schemes (Thomas, 2001:17; Honiball: 2007, pers. comm., 16 November). This shortcoming is complemented by CGT's alleged complexity (Croome, 2007; Olivier, 2007) and administration burden such as the need for complex pre 1 October 2001 valuations and maintenance of detailed schedules in support of capital gains and losses (Wood, 2001:114; Meyerowitz et al. (b,c & d), 2001:82).

 

3 Data and method

This paper adopted an inductive approach to explore the fairness criteria of CGT. A survey questionnaire was developed on the basis of a literature review, as well as the opinions of a sample of tax academics and tax practitioners. The reliability of the questions was then subject to a number of pilot tests (Leedy & Ormrod, 2001) and further amendments made or additional questions added. In essence, the population surveyed consisted of registered taxpayers with an understanding of the Eighth Schedule. A purposeful selection technique was applied to this population with a view to selecting only tax experts (tax partners) from several audit firms, SARS officials and academics specialising in tax. A sample size of 60 experts was, therefore, relied upon (Creswell, 2009) because of a limitation of tax experts.

Purposeful selection using small sample sizes enhances the quality of the research findings by ensuring that only participants knowledgeable of the Eighth Schedule are engaged (Creswell, 2009; Brennan & Kelly, 2007; Blaxter, Hughes and Tight, 2003). Further, the research takes on an interpretive style. The aim is to shed light on the perceived fairness of CGT from the perspectives of informed practitioners. As such, the study is grounded in a social constructivist outlook (Creswell, 2009). The intention is neither to 'quantify tax fairness' nor to generalise the findings. In a similar ontologically inspired study, O'Dwyer, Owen and Unerman (2011), for example, employ purposeful selection techniques using detailed interviews to successfully explore the perceptions of informed participants on auditor legitimisation strategies.

Statistical modelling and testing of hypotheses are dispensed with. Tax 'fairness', by its very nature is subjective making a predominantly positive research approach inappropriate. Validity and reliability of the findings no longer refer to the scope of the results and statistical precision but to the depiction of perceptions in a clear and concise fashion (Creswell, 2009; Ahrens & Chapman, 2006; Neuendorf, 2002:114-115; Parker & Roffey, 1997).

As a result, the research method is a correspondence analysis. It captures a range of perceptions from relatively small sample sizes (Bendixen, 1996), aggregating the data and presenting it in a simple form. It is well suited for exploratory research, overcoming the potential risk of more interpretive inspired research becoming cumbersome (Creswell, 2009; Bendixen, 1996). As a final check, the choice and use of the correspondence analysis was reviewed by an independent statistician who confirmed the appropriateness of the chosen method and it