Capital gains is no different from other incomes

The case for concessions on long term capital gains is that it would encourage saving and investment and make the economy perform better in the long run. There is however, not a great deal of evidence that reducing tax rates on long-term capital gains has made much difference in saving or investment. In case of real estate, as is evidenced by developments in many Indian cities (witness Hyderabad), massive investments have been made in just amassing land, without any productive economic activity. Increasingly greater proportion of investments and effort in the equity markets is going towards speculative trading activity, rather than adding to the productive capacity of the economy.

My contention is that capital gains on assets - land, buildings, shares and bonds, financial market related investments etc - are determined more by factors outsde the control of human beings and hence need to be differentiated from gains and incomes from entrepreneurship and individual or collective effort. The recent spate of asset booms across the world, sparked off by "irrational exuberance" in real estate and equity markets, have opened up the debate on capital gains taxation. The buccaneering role of the hedge fund managers and private equity firms and the benefits showered on them have made the debate livelier still.

The proponents of capital gains taxation argue that any capital gains tax exemption is unfair in so far as it treats wealth and effort differently. Let us examine the two major sources of capital gains today - real estate and the financial markets. It is unargubaly true that chance and randomness dictates fortunes in both these markets. A Black Swan event does not discriminate between types of investors, and can either make fortunes for even small investors or wipe off the entire investment of even the most "intelligent" investors. More than any personal effort, it is lady luck and also the privilege by way of access to better information and the systems to analyze it, that gives our superstar investors their higher capital gains. And this too is fleeting and suspect.

The real estate market is even more a game of luck and chance. Generally, land value appreciation has little to do with the developments on the land and any efforts of the land owner. It is almost exclusively dependent on developments around the land, like development of new civic infrastructure, or new capital investment in any economic or commercial activity in its vicinity. The land owner appropriates a disproportionately large share of the land value appreciation as an unearned increment.

Any system of taxation has to be seen as being fair and rewarding effort. By this yardstick, a large share of capital gains taxation is surely not very fair. With the economy firmly enscocned in the "Age of Asset Bubbles", the time may have come to have a re-look at the principles underlying concessions on capital gains taxation. This assumes even greater importance in light of ever increasing evidence that the taxation policies in vogue today have contributed in no small measure towards increasing inequality.

Update
John Kay writing in the FT, The capital gains tax change will not deter enterprise,argues against tax breaks on capital gains.

"Studies of entrepreneurs – and their own accounts – suggest they may be really different. Establishing a business is hard work and the people who succeed are fired by enthusiasm for business in general and their own, in particular. The capital gains tax on an eventual sale is rarely at the front of their minds.

There is a large difference, in motivation and in achievement, between the originator of a new or differentiated product or service and the supporter – whether venture capitalist or office fitter. The interest of the latter is in the money the business will make rather than in the business activity itself. Both the entrepreneur and the supporter are necessary, but the first is the unique dynamic of the capitalist economy and the second the product of a competitive market. Where the first is found, the second will follow."