Taxing capital income vs. taxing labour income

Financial Express, 20 August 2009

The direct tax code is an outstanding piece of work in many respects. Long-standing distortions and inefficiencies have been addressed. There are two areas where certain difficulties are visible. The first concerns capital gains and the second concerns treatment of cross-border financial activities. In this article, I focus on the first.

In the long run, growth and poverty reduction require capital deepening

Taxation of capital income has long been seen as something that stands symmetrically alongside taxation of labour income. It is often felt that the capital gains tax should be similar to the income tax on wage income. However, both need to be seen in a unified perspective: one of fostering high GDP growth in the long run.

A central source of high GDP growth in the long run in a poor country like India is growth of capital stock. A poor country has to save and invest, to build up the capital stock. This `deepening of capital' increases the productivity of labour and underpins the expansion of labour income.

Fairly modest changes in the annual savings rate translate into an elevated trajectory of per capita income over long periods of time. Conversely, if we spend five years at a lower investment rate (e.g. owing to a period of hostile tax policy), then this permanently depresses the future trajectory of capital and thus per capita GDP.

Taxation of capital income hinders capital deepening

The question that should be posed of tax policy is: How can the tax code be structured to foster a high rate of savings and investment? Once seen in this perspective, taxation of capital income is shown in poor light. Many projects which have a positive NPV in a world without taxation are tipped into the zone of negative NPV once some of the winnings are paid to the government (at future dates) as taxation of capital income. Hence, the introduction of taxation of capital income leads to fewer projects being undertaken. It reduces the pace of capital deepening in the economy, and reduces the long-term growth of the country.

Going beyond the individual perspective, the behaviour of corporations also changes when there is a capital gains tax. Without a capital gains tax, corporations are neutral between paying dividends or reinvesting post-tax profits. The rule that is prescribed to companies is: If you have internal projects that will yield a return on equity that is higher than investing in the market index, then reinvest everything, else payout everything.

When capital gains are taxed, firms have an incentive to payout more dividends. This reduces the savings of corporations and hinders their capital deepening.

Solving this problem

A unified and symmetric solution to the treatment of labour and capital income is the EET system of taxation. The key insight here is to encourage and support saving and reinvestment. So when a person takes labour or capital income and puts it into investments, this part should be tax-exempt. Further, when securities are sold and reinvested, the capital income should also be tax-exempt. This gives strong incentives for capital deepening in the economy. It is when the person liquidates assets and brings money into consumption that two taxes should come into play: the long-term capital gains tax that is paid on money that comes out of an EET system, and the GST that is paid on consumption goods purchased.

This approach requires scaling up the EET system to go from the present vision, of a few lakh rupees per person in the context of long-term savings, to cover all financial activities of citizens. Systems like the NSDL's Tax Information Network can be designed to track a comprehensive portfolio of each individual, whereby sale of assets and reinvestment is tax exempt, but exit from the EET track is subject to the long-term capital gains tax.

Tax policy: an arena for class struggle?

Too often, tax policy is unfortunately seen as a conflict between rich and poor. Taxing the rich is popular. But we need to see that it is good for everyone when the capital stock of the economy grows. Building up the capital stock drives up labour productivity and the general wage level in the economy. The rich should be encouraged to have a high savings rate and reinvest their capital income. As argued above, when the rich sell their securities and buy (say) a designer shirt, they should suffer two taxes: the long-term capital gains tax (on money taken out of an EET system) and the GST on the price of the shirt.

Through this, in effect, we implement a consumption tax. It is often felt that one of the functions of a tax system is to reduce income inequality. This also happens here, since the poor would only pay the GST on their consumption, while the rich would also pay income tax on their consumption.

In summary, in India, there is a misplaced notion of symmetry between taxation of labour income and taxation of capital income. However, we need to see that for India to become a developed country, what is needed is a torrid pace of capital formation. When the rich save and invest, the capital stock of the country goes up, and there are spillovers of benefits to workers who get higher wages because they are more productive thanks to capital deepening. Hence, the tax system should give out strong incentives to save and to reinvest capital income. This can be achieved by scaling up the EET framework and building some IT systems surrounding it.

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