By Bellwether - ECONOMYNEXT
Sri Lanka has announced plans to charge capital gains tax and the proposal to tax shares has created uncertainty among investors and analysts, but care should be taken not to make it another retrospective tax.
It may be acceptable to charge capital gains tax, especially since it is the stock market analysts who have amplified an anti-people doctrine that Sri Lanka should charge more taxes from the people to raise a questionable tax to gross domestic product ratio, rather than push the rulers to cut spending.
This is good lesson to all pundits who push for a higher tax-to-GDP ratio and 'progressive taxation.'
Without doubt capital gains tax is the best 'progressive tax' available.
But the new tax should not further undermine the people's right to a predictable legal framework by imposing capital gains taxes retrospectively, which this administration did with the 'ill gotten gains' tax and other deadly one-off taxes.
Rule of Law
Until 2016 there was no taxation on capital gains. This was the law and understood as such.
If a tax is imposed it should only be imposed on capital gains made from this year onwards and not retrospectively on capital gains made during the time such gains were tax free.
Capital gains taxes are charged in this way.
Someone buys an asset for say 100 rupees. Then sells it later for 120 rupees. He makes a 20 rupee capital gain. If the capital gains tax is 10 percent he will have to pay 2 rupees for the upkeep of the state and rulers.
The taxpayer can also off-set any capital losses against the gains made. If he or she sells shares bought at 100 rupees for 50 rupees, the 50 rupee capital loss can be offset against any gains made.
There can be further refinements to say that shares or houses bought and sold within a small period is only taxed. Shares or houses bought and sold after several years, say 5 years, 10 years or 20 years will be exempt.
It is usual to exempt the first family home from capital gains taxes especially and any property that has been held for a long time, say 10 years, 20 year or 30 years. It is also the practice to reduce capital gains tax rate over time. An asset held for 10 years is taxed at 10 percent but an asset held for 20 years is taxed at 5 percent.
In any case the principle should be not to tax any capital gains made before the tax was imposed.
The simplest solution would be to say that capital gains on any asset including shares bought before say 2016 will be exempt, at whatever date they are sold. This will ensure that only capital gains made from this year onwards is taxed.
Now that the market has fallen, there will be capital gains when it rises in 2017.
However even if the government wants to capture capital gains made on all shares from this year onwards, transitional provisions would be needed to avoid retrospective taxes.
For example say someone bought shares in a bank for 50 rupees in 2005 and it is worth 300 rupees today. If capital gains tax is enacted today, and next week he sells the stock for 310 rupees, his capital gain should not be considered to be 260 rupees. It should only be 10 rupees.
Since there was no ongoing capital gains tax regime, a deemed starting valuation date can be given to accumulate capital gains or losses.
This can be the date the tax is signed into law or any other suitable date in the future.
However a further complication arises because there was no ongoing capital gains regime in the recent past and the stock market has fallen since the new regime came to power.
Suppose capital gains tax is imposed from April 31, 2016 onwards. Someone then sells shares of a manufacturing company which had a market price of 150 (the deemed purchase price) on April 31, for 160 rupee in June.
He would then be deemed to have made a capital gain of 10 rupees.
However in actual fact he had bought the shares in January 2015, for 200 rupees, before the stock market started to go down.
The investor would then be in the unfortunate position of being forced pay tax on a stock which he had made a loss of 40 rupees (bought at 200 rupees last year and sold at 160 rupees though the deemed purchase price is 150 rupees on April 31).
Therefore transitional provisions must be available to either pay capital gains tax on the shares on a deemed starting date or the purchase price, whichever is higher. The gains on all shares would far outweigh the losses made last year.
But such measures however are more complex than charging taxes only on new shares or property bought from the date of the law or this year, and are best avoided.
To encourage smaller investors and perhaps help out pensioners who play the market, a certain amount of capital gains such as 500,000 to million rupees, can be made tax free.
In 2004, Prime Minister Ranil Wickremesinghe tried and failed to push through a capital gains tax.
Prime Minister Wickremesinghe's 2001-2004 administration probably saw the economic policy that most benefited the weakest and poorest in society and least benefited the state, the ruling class and their unionized acolytes since budgets implemented by then Finance Minister M D H Jayewardene.
In 2004, the administration cut spending, strengthened the rupee, brought inflation down to near zero and then gave a 10 percent salary hike to state workers, protecting the poorest and weakest in society from inflation and currency depreciation as well as the state workers themselves.
It is to his credit that inflation was brought down while the Federal Reserve was firing the mother of all liquidity bubbles and sending oil prices up. The bubble only ended in 2008.
For his pains, an ungrateful public, kicked the administration out of power, misled by the Janatha Vimukthi Peramuna and Sri Lanka Freedom Party, which banked on the 'money illusion' to mislead the public by promising subsidies and state jobs to special interest groups.
The JVP, with its typical unconcern for the poor and deceptively false doctrine, made the fuel price formula, which was what allowed inflation to be low and the rupee strong, a weapon to hit at prudent economic policies that helped all citizens.
This time the new administration gave a massive salary hike to state workers and printed money willy-nilly to pay the salaries and busted the currency to 145 rupees to the US dollar from 131, much like the so-called 'Rata Perata' economic policies did in 2004 by printing money to give fuel subsidies.
By the end 2004, just before the tsunami came and domestic credit fell allowing the currency to stabilize, it may be recalled that the rupee was down to 105 to the dollar from around 95 and inflation was near 20 percent.
But even more damagingly, this administration has undermined the rule of law and taxation principles dating back to South Asia's Gupta Empire by imposing retrospective as well as large one-off taxes that threatened to bankrupt several companies (Sri Lanka's fiscal tyranny by midnight gazette, retrospective taxes must end).
By violating taxation principles and rule of law, the rulers will discourage investments, which in turn will hurt new jobs and productivity gains, keeping people poor.
Retrospective taxation and one-off taxes, which is similar to expropriation, should be avoided in all true free countries with just rule of law