4.1 INTRODUCTION
4.1.1 At the request of the Minister of Land Affairs, the Commission was requested by the Minister of Finance to include in its terms of reference the entire question of a land tax.
4.1.2 It was decided by the Commission to appoint a specialist Sub-Committee, under the Chairmanship of one of the Commission's members, Professor Dennis Davis, to investigate this issue. The reasons for the appointment of such a specialist sub-committee included the following.
(a) The issues involved, although relating primarily to taxation, also included other matters. It was thus considered that an appropriate approach to this matter would be that the Commission, which is responsible for investigating the total tax structure of South Africa, retain responsibility for the recommendations on Land Tax, but that a Sub-Committee appointed by it, under the Chairmanship of one of its members, investigate this matter in the first instance on behalf of the Commission.
(b) Secondly, since there are many parties who have an interest in the question, it was important, as a matter of substance and process, that they should all be given an opportunity to participate in the evaluation and consideration of a land tax. Since interested parties could obviously not all be members of the Commission, the obvious solution was to appoint a representative Sub-Committee.
4.1.3 The Sub-Committee has functioned extremely well and has presented a report to the Commission which the Commission finds to be of great value and entirely acceptable.
4.1.4 Accordingly the Commission supports the recommendations in the Report of the Sub-Committee.
4.1.5 In doing so, the Commission places on record its great appreciation for the efforts and dedication of the Sub-Committee and in particular of its Chairman.
4.1.6 A copy of the Sub-Committee's Report is attached to this Report as Appendix B.
4.2.1 The Commission believes that there is no reason in principle why a rural land tax should not be given serious consideration. There is sufficient international experience with the implementation of such a tax, and its implementation will not represent a new tax in South Africa.
4.2.2 The Commission's Sub-Committee has investigated the possibility of a national tax on agricultural land. The Sub-Committee's findings on this matter are as follows.
(a) A national land tax that has as its primary target the taxation of agricultural land is not a viable possibility for South Africa at present for the following reasons:
(b) The weight of the evidence from South Africa and abroad is that a national land tax has, at best, a negligible effect on a land reform programme. Even if evidence of significant positive effects were to be uncovered, this would still have to be weighed against the cost of implementation of a land tax. There is compelling evidence to suggest that the social costs of a national land tax would be high in South Africa (as, for example, poor subsistence farmers would be subject to the same tax as commercial farmers).
4.2.3 In the light of the foregoing considerations, the Commission does not recommend a national land tax in the short to medium term.
4.2.4 However, the Commission believes that there is sufficient evidence to justify the possible implementation of a rural land tax at local government level. The reasons in support of this view are as follows:
4.3 RECOMMENDATION
4.3.1 The Commission proposes that further investigation be undertaken to ascertain the merits of a local level land tax and to ensure that, if introduced, the implementation of such a tax should not have undesirable distorting effects. The issues which, in particular, require further investigation include the following:
5.1 INTRODUCTION
5.1.1 The Regional Services Councils Act 109 of 1985 introduced two levies payable to a Regional Services Council. In broad terms one of the levies, the Regional Services Levy, was introduced as a levy on remuneration paid or payable by an employer to his employees and in the case of the self-employed (or partner) on his or her drawings from an enterprise or partnership. The other levy, a Regional Establishment Levy, was imposed on an enterprise on the selling price (turnover) of the sale of goods or fixed property, a gross rental derived from the letting of property or the gross charges, fees and commission derived from the rendering of any trade, business or professional service or the gross profit earned by financial enterprise including interest and dividends.
5.1.2 The commencement date of these levies differed from council to council. In regard to those which were established by 1987 the commencement date was 1 August 1987, from which date the levies would be paid in respect of each month by the 20th day of succeeding months. In the province of Kwazulu-Natal, Joint Services Boards which became operational in 1991 correspond to the Regional Services Councils elsewhere.
5.1.3 The levies were introduced in the wake of considerable dissatisfaction which was expressed by organised commerce against the levies. A number of appeals were made to the Government not to introduce the levies or to postpone their implementation until the report and recommendations of the Margo Commission had been carefully studied.
5.1.4 When the levies were introduced at a rate of 0,25 per cent for the services levy and 0,1 per cent for the establishment levy, it was expected that the annual yield in South Africa's major metropolitan areas would be approximately R800 million, R250 million coming from the services levy and the balance from the establishment levy.
5.1.5 As an illustration of the resistance to these levies, reference is made to research conducted by Assocom in which it was found that the cost-raising effect of the levies was that for every R1 raised the business community would incur a further 80 cents to collect the levy. Furthermore, Assocom suggested that there would be the creation of "a new legion of bureaucrats to administer and collect the levies which meant that at the maximum rate currently proposed they are certain to cost the country more to collect than they will yield by way of tax revenue".
5.1.6 Whatever the merits of these arguments, the Regional Services Councils were bodies of questionable legitimacy in that they were introduced into South Africa at a time of considerable political and social crisis. For this reason their introduction and the levies which were implemented as a consequence thereof could hardly have taken account of the dramatic constitutional changes which have taken place in the past two years. Accordingly the appropriateness of these levies in the new South Africa is a matter which must now be carefully canvassed.
5.2 IMPACT OF CHANGED CIRCUMSTANCES
5.2.1 The present change in the structure of local government and the replacement of Regional Services Councils by local and metropolitan councils has just commenced pursuant to the local government elections of 1 November 1995.
5.2.2 Furthermore, it is possible that the provinces might consider that Regional Service Council levies should become a source of provincial revenue. Hence their constitutional power of levying taxes is relevant. In terms of section 156(1) of the Constitution of the Republic of South Africa, Act 200 of 1993, a provincial legislature shall be competent to raise taxes, levies and duties other than income tax or value-added or other sales tax and to impose surcharges on taxes, provided that:
(a) it is authorised to do so by an Act of Parliament passed after recommendations of the Financial and Fiscal Commission on the draft text of any such Act have been submitted to and considered by Parliament; and
(b) there is no discrimination against non-residents of that province who are South African citizens.
5.2.3 Accordingly the Financial and Fiscal Commission will need to be consulted about the future of Regional Services Council levies and the particular status of such levies within the new framework of government in South Africa. In particular, there is a Constitutional problem in that the establishment levy is a form of sales tax and thus falls outside of the taxation powers of provinces. As the services levy is a form of payroll tax which could be classified as an income tax, the same difficulty could be raised.
5.3 DIFFICULTIES IN THE IMPLEMENTATION OF REGIONAL SERVICES COUNCIL LEVIES
5.3.1 In its investigations the Commission heard evidence regarding a number of difficulties with the implementation of Regional Services Council levies, including:
(a) uneven levels of payment and enforcement of levies in the country;
(b) alleged use of private contractors to enforce the payment of Regional Service Council levies including the use of questionable means of collection; and
(c) the practice on the part of certain enterprises of paying the levy in only one area for all employees thereby reducing the potential for revenue in other areas where employees of the enterprise actually work, which leads to an inequitable distribution of revenue amongst councils.
5.4 REVENUE POTENTIAL
5.4.1 Whatever the merits of the tax and the level of compliance, the levies have assumed an increased importance as a source of revenue. The following represents the collections of Regional Services Council levies during the Income Tax Year 1994/1995 broken down into what were then the four provinces of South Africa :
R million
Cape 434,3
Transvaal 1 018,7
Orange Free State 78,0
Natal 269,6
5.4.2 Accordingly levies have raised over R1,8 billion in the last tax year and hence represent a considerable amount of revenue for possible use by second or third tier levels of government.
5.5 CONCLUSIONS
5.5.1 In the light of the constitutional uncertainty regarding the replacement of Regional Services Councils, the criticisms which were levelled against the introduction of levies in 1987 and the evidence cited above, the Commission is of the view that the matter of Regional Services Council levies should be investigated as a priority by the Financial and Fiscal Commission. With a view to ensuring that any continuation of such levies fits within the holistic framework for taxation recommended by the Commission, the Financial and Fiscal Commission should liaise with the Commission in this regard. This investigation is of particular importance in that:
(a) the establishment levy in the form of a turnover tax impacts on the balance between direct and indirect taxation and at higher rates would adversely affect the system of value-added tax; and
(b) the establishment levy, as a turnover tax, has a cascading effect, thereby increasing the base for the levy but impacting differentially on final prices of goods and services;
(c) if the Commission's recommendations regarding group taxation (Chapter 10) were to be extended to RSC levies, the cascading effects would be reduced with the consequential diminution of the tax base; and
(d) a flat rate services levy impacts on the overall burden of income tax and accordingly any such tax needs to be considered in relation to other taxes on income.
5.6 RECOMMENDATION
5.6.1 The Commission recommends that Regional Services Council levies be investigated as a matter of priority by the Financial and Fiscal Commission who should liaise with the Commission in this matter, particularly with a view to ensuring that any continuation of such levies fits within the holistic framework for taxation as recommended by the Commission. [paras. 5.2.3; 5.5.1]
6.1 INTRODUCTION
6.1.1 In much of the relevant literature the taxation of capital gains is discussed within the context of personal income tax, although questions regarding taxation of the corporate sector also arise. A key issue is whether capital income should be included in the base of the personal income tax. According to the comprehensive definition of income (the so-called "Schanz-Haig-Simons" concept) personal income is given by the market value of consumption plus the net change in the value of assets or property rights during the period in question. In so far as capital gains either increase the net value of an individual's assets, or allow a higher level of consumption, the comprehensive definition implies that capital gains should be regarded as income and taxed as such.
6.1.2 As only real capital gains should be included in income, a suitable index to deflate nominal gains in an inflationary environment is needed if capital gains are to be taxed.
6.1.3 Any discussion of capital gains taxation must also consider the position of wealth taxation in a country's tax system. On the direct tax side, the taxation of income together with capital gains addresses the question of taxing personal and corporate income flows. On the indirect tax side one looks at taxing expenditure flows. Thirdly, taxation could also be levied on the basis of a stocks concept, i.e. wealth.
6.1.4 Two approaches can be distinguished regarding the latter. One is based on the benefit approach, for example when the owner of property is taxed to reflect the benefits received from the State in the form of protection, infrastructure, and so forth. Such property or land taxes are of the impersonal or in rem type. Alternatively such taxes may be imposed on the combined property holdings of the taxpayer, i.e. his net worth or net wealth, in which case they are in the nature of a personal tax. In this case the tax is based on the ability to pay principle.
6.1.5 These levies and taxes are often collectively called "capital taxation", but can be sub-divided into three groups:
(a) Annual capital taxes, which are fiscal levies on net assets (net wealth/worth taxes);
(b) Inheritance or estate duties and gift taxes, also known as "capital transfer taxes";
(c) Capital gains taxes on the increase in value of assets such as shares and real estate. Strictly speaking, a capital gains tax targets the appreciation of wealth under an income tax regime and should therefore not be regarded as a separate tax instrument. Hence, a capital gains tax is not a wealth tax, but is a broadening of the income tax base to include provision for the taxation of the appreciation of asset values.
6.1.6 Net worth can be defined broadly, including intangible qualities such as knowledge or skills. For the purposes of taxation this is impractical and net worth must be defined as some aggregate of assets which can be reliably valued, less total liabilities (or indebtedness). Taxing net wealth as a supplementary tax on capital income is not required if capital income already attracts tax under a comprehensive income tax which includes capital gains. A net wealth tax may be useful in those cases where it can supplement incomplete coverage of capital income under an income tax regime. This is particularly relevant in the case of South Africa. Since South Africa at present does not tax capital income under the Income Tax Act, horizontal equity considerations may, in the view of some people, necessitate the imposition of either a capital gains or a net wealth tax, or alternatively the definition of a more comprehensive base for the personal income tax.
6.1.7 This, in essence, is the issue to be considered.
6.2 DEFECTS OF THE PRESENT APPROACH IN SOUTH AFRICA
6.2.1 The South African income tax system distinguishes between capital and income flows in three main areas:
(a) section 1 of the Income Tax Act determines that receipts or accruals of a capital nature generally are not subject to tax;
(b) in terms of section 11(a) of the Income Tax Act, which defines general deductions allowed for in the determination of taxable income, expenditures and losses actually incurred in the Republic in the production of income are allowed as deductions provided such expenditure and losses are not of a capital nature; and
(c) section 9B provides that under certain conditions the proceeds of the sale of listed shares held for a period of at least five years may be regarded as of a capital nature.
6.2.2 As outlined in section 6.1 above, the comprehensive approach to taxing income is to use an income base defined to include all income accretions to the taxpayer's economic power to consume goods and services between two points of time. This concept of income is obviously much broader than that under the current income tax legislation in the Republic. According to the comprehensive income approach no distinction should be made between different causes which increase economic power, so that the tax regime should be indifferent whether the gains result from work (salary or wages), investment income, gifts, capital gains or other windfalls.
6.2.3 The main arguments for the comprehensive income tax approach were eloquently summed up in the 1966 Report of the Canadian Carter Commission:
Adoption of the comprehensive tax base requires the taxation of not only income from property, but also capital gains on the disposition of property. Almost everyone is familiar, at least in a general way, with the difference between income and capital, even though the words seem to be incapable of precise definition. Capital is the source of income. By levying a tax on income, the distinction between the two concepts takes on great significance, for if the courts find a particular gain to be capital the transaction is not now taxable. There is an enormous incentive for the taxpayer to try to transform income gains into (untaxable) capital gains (tax arbitrage). However, it is impossible to draw an unambiguous distinction between capital gains and income gains and the attempt to do so necessarily results in great uncertainty for the taxpayer because a particular transaction may or may not be found by the courts to fall on one side of the line or the other. . . After the most careful and exhaustive consideration of this complex question, we have arrived at the conclusion that the present distinction between kinds of gain is inconsistent with our concept of what we believe income is for purposes of determining the individual's capacity to pay real tax . . . A dollar gained through the sale of a share, bond or piece of real property bestows exactly the same economic power as a dollar gained through employment or operating a business . . . To tax the gain on the disposal of property more lightly than other kinds of gains or not at all would be grossly unfair . . .These radical reforms are advocated because (horizontal) equity can be achieved in no other way, because in our opinion there would be no adverse economic effects through their adoption when combined with our other proposed changes, and because they would simplify the tax system and reduce uncertainty.
6.2.4 Based on the Carter Commission's recommendations, Canada amended its tax laws with effect from 1971, effectively including 75 per cent of realised post-1971 capital gains in the income base at the general income tax rates.
6.2.5 Before proceeding further with the analysis, it is necessary to point out that there are two separate enquiries to be made:
(a) first, is a particular gain of a capital nature; and
(b) secondly, if so, should that gain be taxed?
Significant errors can be made if these two enquiries are blurred.
6.2.6 In South Africa, for the purpose of the first enquiry, the distinction between capital and revenue is largely determined in accordance with principles that have been established by our courts. Although the tests are based on subjective principles, the criteria for applying these principles have been well established by numerous judicial decisions over many years. Admittedly, the subjectivity undermines certainty and accordingly endeavours have been made to promote certainty by the introduction of safe-harbour approaches to the Income Tax Act. The insertion of section 9B illustrates this endeavour.
6.2.7 It must be pointed out that, in the absence of a comprehensive income tax which taxes capital gains and current revenue at the same rate, the problem of distinguishing between capital and revenue cannot be avoided. Certainty is not achieved simply by the introduction of a capital gains tax. The justification for the imposition of a capital gains tax must therefore be sought in other considerations which are dealt with in greater detail later in this Chapter.
6.2.8 The greatest disadvantages of a capital gains tax lie in its complexity. This gives rise to difficulties of administration and high costs of compliance. It is also recognised that the yield of a capital gains tax is low. Each of these issues is dealt with at length in this Chapter.
6.2.9 As was pointed out by the Margo Commission, an apparent justification for the imposition of a capital gains tax was given in the following passage in the report of the O'Brien Commission in Ireland:
... a major reason for charging capital gains to tax is to prevent avoidance of income tax by switching income gains into a form in which they are regarded as capital gains. This is not only necessary for reasons of equity, as not all taxpayers are able to effect this kind of switch; it is also necessary for reasons of efficiency to prevent investment distortion. Furthermore, in so far as the presence of a capital gains tax deters such switches, it will serve to protect the yield of income tax. Thus, even on the narrow criterion of revenue yield, its contribution will be more than is apparent from looking at the yield of capital gains tax in isolation.
6.2.10 On the other hand, note must be taken of the considerable administrative costs associated with the introduction and maintenance of a capital gains tax. In this regard, whatever its merits, the Commission recognises that the revenue administration in South Africa does not at present have the capacity to administer a capital gains tax. Thus, Inland Revenue has been restructured in line with the Commission's recommendations as set out in the 1994 Interim Report, there cannot be any realistic possibility of its introduction.
6.3 KEY ISSUES IN THE DESIGN OF A CAPITAL GAINS TAX SYSTEM
6.3.1 Some developed countries have imposed "capital taxation" for more than seventy years. Likewise, their capital gains tax regimes have survived many tax reforms during these last decades. Worldwide, the current debates regarding the taxation of capital gains focus largely on aspects relating to the equitable distribution of the tax burden, revenue effects, impacts on savings and on the economic competitiveness of the relevant tax jurisdiction. Of particular importance is the question of the benefits which accrue to certain taxpayers from the preferential tax treatment of capital gains. These aspects need to be considered in relation to a number of questions relating to the design of a capital gains tax system. Some are identified and discussed below.
Separate or Integrated Taxation
6.3.2 If capital gains are not included in the income base and, accordingly, taxed at regular income tax rates as gains are realised, a separate tax with a separate rate structure can be imposed.
6.3.3 In the United States capital gains have been subject to a separate preferential capital gains tax since 1921 in the case of individuals and since 1942 in the case of corporations, save for a short period in the 1980s when capital gains and ordinary income were taxed on the same basis. Germany also has a long history of capital gains taxation. In Germany the 1920 "Erzbergersche Fiscal Reform" imposed a capital gains tax (Kapitalertragsteuer), initially as a separate tax, but since 1925 as part of the income tax system.
Realisation versus Accrual Basis
6.3.4 One of the most crucial questions is when to recognise changes in net worth. An annual net worth calculation would entail a complete balance sheet estimate at market prices for each taxpayer. This would make the administration of the tax extremely burdensome and expensive.
6.3.5 Because of the practical problems, most tax jurisdictions levy a capital gains tax only when an asset is sold or transferred, or on realisation of the gains to be taxed. At the date of the asset's disposal its capital gain is assessed, being the difference between (a) the original purchase value plus value enhancement expenditures (including interest costs) and (b) the sale value. This represents its change in net worth, which could be a loss or a gain. Unless there is a separate capital gains system, the gains are added to other taxable income. This rather straightforward method reduces some of the more troublesome accounting problems, but nonetheless requires that the costs of assets and expenditures which enhance value be recorded.
6.3.6 On the realisation basis, tax is deferred from the accrual date until the realisation date. This deferral reduces the present value of the tax liability, making it worthwhile to hold on to assets rather than to trade them. This "lock-in" effect depends on the expected change in capital values and the rate of taxation. It can detrimentally interfere with the mobility and optimal use of capital.
6.3.7 From the point of view of the fiscus an additional problem with the realisation basis is that capital gains go untaxed if assets are held until death and passed from one generation to the next. Heirs may be able to realise the gains with little or no tax liability. The same applies to gifts where capital gains transferred through gifts are taxed only if the asset is sold at a later stage. These effects mean that increases in the value of stocks and real estate in the hands of wealthy families may never attract tax under the income tax regime.
6.3.8 The Canadian tax authorities have addressed this problem by enacting a "constructive realisation" provision that allows them to tax unrealised gains at death when the assets are transferred to heirs (with an averaging provision to spread the gains over a number of years). Such a provision minimises the incentive to hold assets indefinitely for tax reasons.
6.3.9 Another problem with the realisation basis occurs when an asset, for example, real estate, is held for a long period of time and appreciates substantially in relation to the owner's other income. A substantial capital gain could be realised at the time of sale. This "bunching" problem, in the context of a progressive income tax schedule, means that the marginal tax rate applicable to the realised gain might significantly exceed the marginal rates which would have applied during the intervening years when the capital gains actually accrued. Unless there is a device for averaging incomes over several years, tax on realisation thus unfairly disadvantages those whose incomes are usually taxed below the maximum marginal rate. In the absence of an income averaging system, a preferential tax rate structure for capital gains relative to income provides a second best option for alleviating this inequity.
6.3.10 The main problem of the alternative accrual method is the possibility of the forced liquidation of assets in order to pay the tax. This is the "liquidity" problem. Another major drawback is the difficulty of attaching a true value to gains without having recourse to the price that could have been realised on sale. Even if a taxpayer could borrow against the collateral of the assets to pay the tax due, the vexed question of an appropriate valuation would remain unresolved. Disputes and litigation regarding assessed values would occur frequently. Consequently, the taxation of capital gains on the realisation basis has distinct administrative advantages.
Effective Date
6.3.11 Countries that decide to introduce a capital gains tax must exercise utmost caution with the announcement of the introduction of a tax prior to the date when the tax is to take effect. If an announcement on the introduction of capital gains tax is made before the revenue authorities are actually in a position to promulgate necessary legislation, taxpayers will devise a multitude of avoidance schemes. Taxpayers could, for example, artificially inflate the base values of their assets in advance of the implementation date of the tax, or advance the realisation date of assets.
6.3.12 A "benchmark date" has to be promulgated on which all assets to be included in the tax base are valued. This value is then taken to be the initial "cost" when, in due course, the gains realised come to be calculated.
Timing Problems
6.3.13 Most jurisdictions that tax capital gains as part of their income tax system provide for its preferential treatment in order to minimize inequities that might arise if there is no income averaging procedure. Capital gains tax laws typically distinguish between assets held for different time periods, with the objective of penalizing speculative gains. As a rule, the longer the period the asset has been held, the lower the tax rate. Short-term gains, which are often of a speculative nature, are taxed more heavily.
6.3.14 In Belgium, for instance, the cut-off period is five years. Realised gains on assets held for less than five years are taxed as ordinary income whereas gains on assets held for more than five years are taxed at a flat rate of 16,5 per cent. This is an administratively attractive method of compensating for the inflation element in nominal gains on assets which are held for an extended period. Similar approximations for indexing for inflation are also in force in Denmark, Finland, Germany, Ireland, Japan, Spain and Switzerland, where reduced percentages of the gains are taxable as the period over which assets are held increases.
6.3.15 Unfortunately, the differentiation between short- and long-term gains has a detrimental effect on the optimal functioning of the capital markets, as these measures increase the "lock-in" effect referred to in paragraph 6.3.6 above.
Symmetrical Treatment of Capital Gains and Losses
6.3.16 Most tax authorities recognise that capital losses and gains should be treated symmetrically. The overriding principle is to include in income the net change in a taxpayer's net worth.
6.3.17 In a regime where capital gains are separately taxed, capital losses should as a matter of principle be offset against capital gains only. However, unless there are capital gains against which to offset capital losses, the taxpayer would bear the entire capital loss. This necessitates a provision mandating the carrying forward of capital losses, to be offset against future capital gains.
6.3.18 Where capital gains are not separately taxed and assessed only on realisation, taxpayers can plan the timing of their sales to absorb capital losses promptly as they occur, and to postpone gains for as long as possible. Because of these avoidance tactics, tax jurisdictions differentiate between capital losses and gains and put limits on losses allowed against other forms of income. In the United States, where capital gains are taxed on a preferential basis, only $3000 of capital losses in excess of realised capital gains are deductible. Legislation against so-called "wash sales" has been promulgated.
Types of Assets Included
6.3.19 The design of an administratively workable capital gains tax regime requires the specification of the assets to be taxed or to be exempted, either under the regular income tax law or under special capital gains tax provisions.
6.3.20 There are clearly sound economic arguments for a broad definition, allowing exemption only of a strictly limited set of assets.
6.3.21 Under the United States tax code the main assets subject to capital gains tax are corporate stocks or equities, privately owned businesses, private residences and real estate held for investment purposes. The US Revenue Act of 1921 defined capital assets as property acquired for profit or investment whether or not connected with the trade or business, and which was held for two years or more. The Revenue Act of 1938 excluded all depreciable business property from the definition of capital assets, thereby allowing the losses on this kind of property to be deducted in full by both individuals and corporations. The American tax system experienced yet another major tax overhaul with the Tax Reform Act of 1986, which redefined capital assets as any property held by the taxpayer except certain excluded classes such as:
(a) inventory, stock-in-trade or property held primarily for the sale to customers in the ordinary course of the taxpayer's trade or business;
(b) depreciable or real property used in the taxpayer's trade or business;
(c) specified literary or artistic property;
(d) business accounts or notes receivable; and
(e) certain US publications.
6.3.22 In many countries which operate a capital gains tax, capital gains are included in the tax base in order to tax speculative profits generated in, especially, the real estate markets. However, the administrative problems of taxing capital gains realised in real estate are immense, due largely to the problem of aggregating costs of acquisitions and improvements effected over long periods. The scope for avoidance devices is correspondingly wide. If property gains are taxed strictly, real estate can be transferred into assets which are treated more favourably.
6.3.23 In sum, whereas ideally all forms of material wealth should be in the base of a capital gains tax, in practice it is possible to include only those assets whose value can be determined with comparative ease on a benchmark date. Collectors' items (for example, art, jewellery, books), land and private company shares are obvious examples of assets that are, in varying degrees, difficult to value. Only marketable securities are relatively free of valuation problems.
Rate Structure
6.3.24 The 24 OECD member countries distinguish between the corporate sector and individuals. In the majority of cases, realised capital gains in the corporate sector are added to taxable income and taxed at the applicable corporate tax rates. The capital gains tax rates pertaining to individual taxpayers vary more widely.
6.3.25 In designing an appropriate rate structure, the following main approaches can be distinguished:
(a) a flat rate on all taxpayers (e.g. Zimbabwe);
(b) different rate structures for companies and individuals (e.g. UK, Belgium, Sweden, Spain);
(c) different rates depending on the long- or short-term nature of capital gains (e.g. Belgium, Denmark, France, Greece, Japan); and
(d) different rates dependent on the type of asset involved (e.g. Finland, France, Greece, Norway).
6.3.26 Some tax authorities tax capital gains as ordinary income at the normal income tax rates. This approach makes it immaterial to the taxpayer, in the absence of indexation of the capital gain, whether a gain is of an income or a capital nature.
6.3.27 An approach in which the tax authorities specify a certain percentage of capital gains to be subject to income tax (75 per cent in Canada and 60 per cent in Finland, for example) increases the opportunities for tax arbitrage. Such a step creates a differential between income and capital which could be exploited by taxpayers in claiming income gains as being capital in nature.
Indexation
6.3.28 Inflation complicates the measurement and taxation of capital gains. Any gains which fail to match the general increase in the price level are illusory; only real capital gains add materially to net wealth or consumption power. The adjustment of nominal gains to compensate for the effects of inflation is crucial to any equitable system of income taxation, especially one based on the principle of a comprehensive income tax base. However, the partial indexation of capital gains while adjustments for inflation are not reflected in the rest of the country's tax statutes must be regarded as an inequitable and inappropriate solution.
6.3.29 In the case of individuals, two main alternative approaches can be followed.
(a) Capital gains tax can be assessed on an inflation-adjusted basis. After an appropriate deflator has been selected, the mechanism to exclude the portion of capital gains that is due to inflation is relatively simple. However, the indexation option remains problematic, especially if interest income is not indexed but capital gains are. This opens the way to tax arbitrage.
(b) Alternatively, a procedure can be adopted which indirectly compensates for inflation. One approach, used in the United States, is the exclusion of a fraction of nominal gains from the tax base. These exclusion provisions can either over- or under-adjust for inflation but are easy to administer.
6.3.30 No inflation corrections are needed for current income flows in the form of wages and salaries, since they bestow the taxpayer purchasing power over resources at the prices of the period during which they are earned. However, there remain problems with regard to the valuation of inventories and the depreciation of capital assets. Holders of assets that do not appreciate with general price increases in the economy (for example, cash balances, government bonds and book debts) should be allowed to deduct real capital losses from their taxable income.
6.3.31 The taxation of "real gains only" and the process of selecting an appropriate price deflator complicates capital gains tax law and administration. The choice of a price deflator is itself problematic and cannot be entirely neutral between taxpayers.
(a) The most commonly used deflator in South Africa, the Consumer Price Index (CPI), is heavily influenced by food price fluctuations, which do not reflect price trends in the values of capital assets. Countries such as Argentina, France, Israel and Sweden have used the CPI to adjust capital gains for inflation because of their acceptance of the Schanz-Haig-Simons definition of income (see section 6.1 above) and the suitability of the CPI in relation to the purchasing power of income. However, the wide appeal of this approach is more a reflection of its convenience than of any underlying principle.
(b) The Production Price Index (PPI) is an attractive alternative, since it measures price movements of a representative basket of more than 1000 capital and intermediate goods as reported by approximately 150 manufacturing establishments, government departments and agricultural control boards. The advantages of the PPI are numerous: it is an explicit price index, it is measured monthly, it is available promptly, it is not revised, and a long time series is available.
(c) An index specifically designed for capital gains taxation is also possible. A 1992 assessment of the potential for capital gains taxation in South Africa proposed a "Business Prices Index" which would exclude price movements in food and mortgage interest rates but include factors such as business interest rates and stock exchange movements.
(d) Consideration could also be given to the use of various indices for different types of assets. On administrative grounds, however, this option should be resisted.
6.3.32 Tanzi, in a discussion of inflation accounting and the taxation of the capital gains of business enterprises, concludes that under inflationary conditions there is, even in theory, no single and objective measure of income which is widely acceptable to economists, accountants, tax experts and taxpayers. Tanzi concludes that there are the following (imperfect) alternatives for the assessment of capital gains:
(a) unadjusted historical costs;
(b) historical costs adjusted with the CPI;
(c) historical costs adjusted with some broader index reflecting not only consumer goods but also investment and, perhaps, government goods;
(d) historical costs adjusted with a general price index for capital goods;
(e) historical costs adjusted in line with indices related to specific categories of capital goods and other inputs; and
(f) replacement costs for each individual asset or specific type of input.
6.3.33 A choice among these alternatives which satisfies all interested parties is unlikely. Tax reform in practice, however, need not be based on full indexation of capital gains. It can be argued, for example, that indexation should only apply to assets held longer than some reasonable period. An unqualified indexation system can indeed be regarded as discriminatory, since different assets are affected in divergent ways by inflation. All assets, moreover, and not just capital assets, are "taxed" by inflation.
6.3.34 Problems such as the following can occur in an indexed capital gains tax regime:
(a) given an indexing regime for capital gains, holders of monetary assets and earners of fixed incomes would be disadvantaged;
(b) individual and corporate owners of depreciable capital assets will remain uncompensated for inflation since these assets yield illusory income flows in ordinary use (as most tax jurisdictions limit depreciation write-offs to historical costs only);
(c) debtors gain when inflation erodes the real value of debt, whereas creditors who lose as a result of inflation remain uncompensated.
Main Exemptions
6.3.35 In many countries (including the United Kingdom, Norway and France) annual "exonerations" exempt gains below a threshold amount. There is much to be said for granting individuals a small annual exemption of, say, R15 000, since from an administrative point of view this relieves the revenue authorities of the burden of collecting minor amounts.
6.3.36 Exonerations specifically aimed at small businesses in order to stimulate their growth can be considered. Gains which arise when a small entrepreneur retires or disposes of a firm, business assets or shares in a family company could be exempted partially or in full, in order to prevent the erosion of capital accumulation in the family business sector by a capital gains tax regime. A once-off or life-time maximum relief of, say, R1 million could be attached to this provision, although at some cost in terms of horizontal equity.
Roll-over Relief
6.3.37 In many countries the corporate sector can offset accrued capital gains (after the sale of land, industrial buildings, fixed assets with a long useful economic life and shares in corporations) against the acquisition price of new assets within a certain period of time (usually 2 to 3 years). The rationale behind such a policy is one of equity and reasonableness. In the absence of such "roll-over" relief, obsolete assets would tend to be locked in for a prolonged time much to the detriment of the competitiveness of the industrial base.
6.3.38 Insufficient or inappropriate provision for roll-over relief interferes with the continuity and integrity of capital formation by the business sector. On the other hand, the definition of business assets must be formulated carefully to limit tax avoidance. Relief should be granted in respect of those assets which can be used for purposes of trade or which are able to generate income flows, restricted, for example, to "non-wasting assets" such as land and industrial buildings, goodwill, and shares in subsidiary trading companies.
6.3.39 Where dwelling houses are included in the tax base, roll-over relief enables a home-owner to defer liability for tax on any gain made on selling a house if the proceeds, or a percentage of the proceeds, are reinvested in a new home within a fixed period of time. Similar relief is often offered to businesses wishing to relocate a plant or to substitute one method of manufacture for another; and to those exchanging assets for shares in a company. In all these cases the new assets are deemed to have acquired the tax bases of the assets they have replaced. Roll-over relief is important because it removes the tax incentive to retain ownership of assets beyond their useful or preferred life. Experience has shown this to be an essential part of any capital gains tax system, although the yield of the tax may be considerably reduced by such provisions.
6.4 THE MAIN ARGUMENTS FOR AND AGAINST THE INTRODUCTION OF A CAPITAL GAINS TAX
Arguments in Favour
6.4.1 Limiting tax arbitrage: If capital gains go untaxed, or are taxed less heavily than other forms of income, there is an incentive for the taxpayer to switch income into capital gains. A few examples of such "income switching" suffice:
(a) If the owner of a business does not take out the annual yield from his business as income, but reinvests it in his business, the asset value will increase by the compounded yield. This could eventually be disposed of in the form of long-term realised gains with a lower effective tax burden.
(b) Rather than paying dividends out of after-tax corporate profits, profits can be retained and, unless gains are taxed on accrual basis, capital gains accrue on which taxes can be deferred until realisation.
(c) In the case of death and the absence of constructive realisation of the gain the taxation of these accrued gains can be even further deferred.
6.4.2 Tax equity: The maxim of horizontal equity dictates that people with equal economic power should bear equal tax burdens, while vertical equity requires that wealthier people should bear proportionately greater tax burdens. Since capital gains also contribute to ability-to-pay, the failure to tax capital gains undermines both vertical and horizontal equity. The absence of capital gains taxation interferes particularly with the progressive incidence of the income tax across the income distribution, as ownership of capital is highly concentrated amongst higher income groups. These problems are aggravated by income switching.
6.4.3 Comprehensive income taxation: An acceptance of the comprehensive income concept requires that capital gains be subjected to the same tax treatment as any other income, since income should be defined to include all accretions to the taxpayer's power to consume.
6.4.4 Protection of the income tax base: The failure to tax capital gains or preferential treatment of capital gains erodes the income tax base, thereby contributing to the need for higher rates of tax on the restricted base.
6.4.5 Redistributive goals: The preferential treatment of capital gains undermines the contribution of the tax system to redistributive goals of government.
6.4.6 Taxpayer morale and tax ethics: In so far as the absence of taxation of significant sources of income concentrated in the hands of the rich is perceived as unfair, the introduction of an effective capital gains tax might be beneficial to taxpayer morale and tax ethics.
6.4.7 Simplification of the income tax: The full taxation of capital gains, if not indexed, makes an income tax system less complex.
6.4.8 Symmetrical income tax treatment of distributed and undistributed corporate profits: Company shares are usually the principal source of capital gains, and retained corporate earnings a major contributing factor. If profits of companies were to be taxed in the hands of shareholders only when distributed as dividends, retained profits of companies would escape personal income tax and the corporate sector would retain most of its profits in the form of retained earnings. In the combined corporate and personal income tax regime, the failure to tax capital gains will again lead to a less heavy tax burden on retained than on distributed earnings. In a combined tax regime without double taxation of distributed profits, however, this argument for capital gains tax falls away.
Arguments Against the Introduction of a Capital Gains Tax
6.4.9 Low revenue yields: It is often argued that the net yield from taxing capital gains is low and might not exceed the administrative costs. The yield tends to be low because realisation is deferred, and because real gains (adjusted for inflation) in asset values, taking an overall view of the economy, are largely offset by real losses. Even in a context of rapid economic growth, capital formation consists at least as much in investment in new assets as in growth in the value of existing assets, which is the base a capital gains tax seeks to tap. The exceptions to this rule, arising, for example, from the pressure of population growth on land values, or of urbanization on residential house prices, or from increased demand for antiques and art works, frequently involve assets which are difficult to assess and tax. In the important case of rising share prices due to the retention of company earnings, which may be encouraged by the double taxation of dividends in the income tax system, the presence of capital gains tax leads to changes in corporate financing policies. Under the present South African income tax regime, the response of companies to a capital gains tax would be to declare all distributable income as dividend, either in cash or in scrip. If scrip were chosen, the rise in share values would convert to a rise in the number of shares in issue, and there would be no capital gains to tax.
6.4.10 Administrative burden: Due to the complex nature of assessing real capital gains, the administrative burden and collection costs are high. High administration costs are universally experienced in the collection of capital gains tax and highly expert tax officials are needed. This is because:
(a) if the base is comprehensive, including assets other than listed securities, an immense number of individual assets have to be valued (often some years after the "benchmark" date) to determine "cost" or "initial value", and track has to be kept of the costs of improvements;
(b) each transaction has to be assessed individually - not each taxpayer, as in income tax; and
(c) simplifying procedures such as standard deductions at source (which oil the wheels of an income tax system) are impractical.
6.4.11 Effects on saving and investment: High tax rates on long-term capital gains can inhibit savings and the acquisition of capital assets like plant and equipment. It can be argued that the taxation of capital gains impacts negatively on risk-taking, especially when the tax schedule is highly progressive.
6.4.12 Effects on the Stock Exchange: It is argued that capital gains taxation aggravates fluctuations on the stock exchange. The argument, which relies heavily on the "lock-in" effect, is that behaviour of investors is highly sensitive to expectations regarding adjustments to capital gains tax rates. An impending rate reduction would induce delays in share sales and large scale selling when the rate was reduced, for example.
6.4.13 Illusory gains: Most capital gains are illusory because they merely reflect inflation.
6.4.14 Impracticality of taxing unrealised gains: As it is impractical to tax unrealised gains, it can be argued that it is preferable not to tax capital gains at all.
6.4.15 Need for preferential treatment of long-held assets: A gain realised in a particular year might represent the appreciation of an asset over many years. In the context of a progressive income tax, full taxation of capital gains would then be excessive, resulting in the need for preferential treatment of assets held for long periods.
6.4.16 Problem of pyramiding: Among the problems of capital gains taxation, the one that is furthest from solution is the prevention of pyramiding. Assume company A (which is owned by company B) makes a gain which is subject to 30 per cent tax. It retains the balance. If B sells A, the price is likely to reflect the value of the 70 per cent retained. This will attract tax of 30 per cent x 70 per cent = 21 per cent in B's hands. Total tax paid is now 51 per cent. If B is owned by C and C is owned by D and so forth, simple algebra shows that the total tax eventually exhausts the original gain. In practice the response has been from the business community rather than the tax authorities. Long chains of subsidiaries tend to disappear from economies in which capital gains are taxed in the hands of companies.
6.4.17 Avoidance problems: The wealthy are able to hold assets for long periods, borrowing against them if necessary, and realisations of capital gains can often be timed to coincide with off-setting losses. Whereas capital gains tax is primarily intended to promote equity, this purpose is confounded, in practice, by the potential for avoidance at the disposal of the wealthy.
6.4.18 Complexity: The complexity of a capital gains tax makes its introduction unattractive.
6.4.19 Compliance cost: The cost of compliance is also high.
6.5 REVENUE POTENTIAL
6.5.1 The availability of reliable statistics on revenue from capital gains tax in other countries is limited. Revenue from capital gains tax is, almost without exception, added to the other revenues from income tax. The Government Finance Statistics Yearbook published by the International Monetary Fund provides just one global figure for taxes on income, which includes salaries and wages, profits or dividends, income from real property and other capital gains. Therefore it is "not possible to generalise about the revenue contribution of capital gains tax because in many countries the receipts are not separate from income tax ..."
6.5.2 In the United States, for the period 1980 to 1985 the fiscus collected an average of US$15,8 billion per annum in revenue attributable to taxes on long-term capital gains. This constituted an average 0,46 per cent of GNP. Pechman estimates total capital gains tax revenues (long- and short-term) for fiscal year 1988 as approximately US$43 billion, including tax on capital gains realised on the "constructive basis". For the other OECD countries comparable figures on capital gains tax receipts are not available, except for the United Kingdom, where this tax generates proceeds equivalent to 0,4 per cent of GDP.
6.5.3 Generally speaking, the IMF Fiscal Affairs Department is of the opinion that the direct revenue potential of the capital gains tax remains limited and could at best generate additional tax revenue to the extent of 0,1 to 0,3 per cent of a country's GDP. In the case of South Africa, with an expected 1995/96 GDP of approximately R500 billion, this would imply additional revenue ranging from R500 million to R1,5 billion. The net gain to the fiscus would be considerably reduced by high costs of administration.
6.6 CONCLUSION
6.6.1 It will be seen, both from the contentions for and against a capital gains tax in section 6.4 and the analysis of an appropriate design in section 6.3 above, that a capital gains tax is highly complex both in administration and compliance.
6.6.2 Having regard to the problems of tax administration in South Africa, implementation of a capital gains tax cannot be recommended at this stage. It should not be inferred, however, that but for the lack of administrative capacity the Commission would have been in favour of a recommendation to introduce a capital gains tax in South Africa. Its low potential yield reinforces this conclusion.
6.6.3 Thus the Commission does not consider it desirable to make a recommendation at this stage in favour of the introduction of a capital gains tax in South Africa.
6.6.4 The Commission considered it desirable to analyze the topic as part of its holistic evaluation of the tax structure of South Africa. However, it deliberately refrains from making any recommendation with regard to the merits of the tax and its suitability for South Africa. These are issues that can be revisited when the restructuring of the tax administration has been completed in line with the recommendations in its first Interim Report. The Commission therefore makes the recommendation set out in paragraph 6.7.2 below.
6.6.5 The Commission considers it necessary to draw attention to the fact that paragraph 12(1) of the First Schedule to the Income Tax Act permits the deduction from current income of expenditure on certain farm improvements. When in due course the property is sold there is no attempt to recoup or "claw back" this previously allowed expenditure for tax purposes. Although in the Report of the Margo Commission attention was drawn to this fact, no legislative amendments have materialized to date. The Commission will consider this matter further when it embarks upon its investigation of taxation of the agricultural industry.
6.7 RECOMMENDATIONS
6.7.1 The Commission recommends that, by reason of the lack of capacity on the part of the tax administration, there should not be a capital gains tax in South Africa at this stage. When the restructuring of the tax administration has been completed in line with the Commission's recommendations in its first Report, the contentions for and against the possible introduction of this tax and its suitability for South Africa should be revisited and cognisance should be taken of the considerations set out in this Chapter. [paras. 6.6.2; 6.6.4]
6.7.2 If at any time in the future it is decided that a capital gains tax should be implemented in South Africa, then the date on which the tax is introduced should be designated as the "benchmark date" and all assets owned by taxpayers at that date should have a value assigned, being the market value on that date. This recommendation is necessary in the opinion of the Commission to promote certainty and thereby to allay concerns on the part of prospective investors, both local and foreign. [paras. 6.3.11-12]