The Disadvantages Of Capital Gains Tax
CGT decreases employment, stifles innovation, technology and growth
With all the hui going on recently about Capital Gains Tax (CGT) I’ve been intending to write a balanced article on the advantages and disadvantages of CGT for a while. An important tenet of this publication is that I present factual information and a balanced, open-minded perspective, so writing a list of both advantages and disadvantages is in keeping. However, I’ve previously written about this exact subject on another website and didn’t want to rehash the same article. Additionally, I think that the advantages of CGT are clear: The government gets more tax and it seems fair that there’s an untapped source of money that people wealthy enough to invest could be paying tax on.
In my former writings I had covered this subject from the perspective of fairness and the counter position that tax is always bad (but necessary) and should be minimized as much as possible. Also the aim of tax is not just to collect money but provide balance in the failings of the free market (that’s economist talk for “Capitalism”), so it might be that there’s nothing to fix here (some people earning money that isn’t taxed isn’t something that needs fixed - that’s a good thing! An example of something that needs fixed is tobacco or petrol, which is taxed to discourage its use or to tax users of an expensive service such as roads, in a way that's proportionate to its use).
In this article, however, I will talk about CGT from the perspective of the damage it could do. Of course there are a number of things that could be taxed with CGT, but since there’s already a CGT on houses (called the Brightline Test), I will assume that they’re talking about the sale of shares in companies.
The Problem With CGT On Shares
So what’s the problem with taxing the sale of shares? Well, imagine that you’re a company and you’ve worked out that if you can raise some money at the cost of diluting your shareholding, then you can hire some people, buy some plant (machinery) and expand your company, making existing shareholders richer despite the dilution of your shareholding. In other words, even though you’ll own a smaller piece of the company, that company and your piece of it will be worth more money.
However, this is pivotal on how much your company is worth because if the company isn’t worth much, you’ll end up getting more diluted (having to sell a greater percentage of the company) to get the same amount of money. If you get too diluted in the fund raising, the extra value of your company after the growth might not increase the value of your (now smaller) shareholding. Therefore if the valuation of your company isn’t big enough, it won’t be worth doing a capital raise.
Why is this information relevant? Well, because Capital Gains Tax reduces company valuations for capital raises. Let me explain…
When an investor buys shares, they work out how much those shares are worth. Without going into valuing a company here, lets just say that the value is directly related to how much money the company will earn them. In other words, if a company has $1m in profit after tax, then a shareholder that wants 5% return on their investment might value that company at $20m (because $1m is 5% of $20m). It’s a bit more complicated than that, but lets say that when an investor buys into a fund raise, it’s a long term investment and the price for early investors has a consideration for the exit price built into the investment case because you’re probably going to get forced to sell at some point anyway. Given this, if there’s a Capital Gains Tax, that $20m company is now worth only $12.2m for investors paying the top tax bracket (assuming that’s what the CGT will be set at).
This is a big problem because it means that it will no longer be worth doing fund raising for growth for many companies. Instead they will likely trundle along for an extra few years to raise the money themselves through organic growth. This will have the negative affect of making New Zealand companies less competitive because they can’t grow fast enough to seize market opportunities and therefore more likely to fail. It will also mean less employment, less efficiencies, less productivity and stifle innovation and technology. This will prevent NZ from competing alongside other first world economies.
Another Disadvantage Of CGT
Another article I’ve written on my other website is about how almost anyone can invest their savings to become rich using compounding interest based on the average return on the NZX stock market. This is my other problem with CGT, because when you factor this into the financial models for the average Joe, suddenly CGT prevents them from being able to become rich from investing their savings, creating a glass ceiling between the middle class and rich.
Therefore a CGT aimed at taxing the rich (out of envy, let’s be honest) will actually prevent average earners from becoming rich… While the rich, will (let’s be honest) still be rich. From an envy tax perspective, people are kicking themselves with a CGT on shares and removing their own opportunities and opportunities of their families. You’re also delaying your own retirement.
This Is All Right Wing Propaganda!
You might disagree (or perhaps not appreciate/understand) what I’ve written here and it would be easy for someone who is pro-CGT to dismiss my arguments as right leaning views (leave a comment, we can discuss it).
However let me assure you that I write from an experienced position of representation of the above information. To that end, these are my credentials:
I am a single, average wage earner who has (until very recent years) been on a standard 5-figure salary (I’ve recently broken through to an extremely low 6-figure salary). During which time I’ve used investing to put myself in a position where I now have a net worth of 7 figures. I help other people in the same situation achieve the same through information shared in my various websites (for no profit to myself). I have also helped a number of NZ companies raise money and have seen each go on to use that money to employ more people, buy plant (machinery), improve efficiencies and grow into new (often foreign) markets. I am responsible for enabling companies to raise money that (as a direct result) have gone on to have a significant, positive ecological impact on the world - not through any virtue of my own beliefs or good values, rather as an example of a normal side effect of improving efficiencies through capital raising.
Finally, I would love to hear your counter arguments or other opinions on the subject. I’m keen to discuss this more because there’s a lot to discuss - this is a complicated subject and the talk from politicians, the media and the recent IRD report don’t go into enough detail for an intelligent analysis of the subject.