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Lithuania: Capital Gains Tax Becomes Debatable Issue

Washington, 31 July 1998 (RFE/RL) -- Lithuanian President Valdas Adamkus last week vetoed a proposed tax on capital gains, calling it a short-sighted step unfavorable to the Lithuanian economy.

But in the west, aside from Belgium, Hong Kong, and the Netherlands, every nation taxes capital gains.

As the countries in transition begin to weigh the various forms of taxes normally imposed in market economies, the question of whether to tax capital gains increasingly will be debated.

In it's simplest form, if a person sells a piece of property or a share of stock for more than he or she originally paid for it, the difference between the buying and selling price -- the increase in value -- is considered a capital gain.

Capital in this case is the classic definition -- any wealth, whether held as property, real estate, stocks, bonds or virtually anything which is used, or capable of being used, to create more wealth.

When the United States was young, it did not tax capital gains. The Supreme Court in 1872 ruled that an advance in the value of property between acquisition and sale could not be taxed. That prohibition did not last long, however, and by 1913 when a tax on incomes was first imposed nationally, capital gains were included in the income to be taxed.

The Economic Policy Institute (EPI), Washington-based policy study organization, says that's only fair because the gains made by workers through their labor are also taxed. If it's acceptable to impose a tax on the wages or income of workers, it should also be acceptable to impose a tax on the income of capitalists.

After all, they argue, both capital and labor are necessary for the success of all industry and the contributors of both should share equally in the growth and improvements, as well as pay taxes on them.

Taking a different view is the American Council for Capital Formation, an organization of investors and bankers, which argues that taxing capital gains is actually double taxation of savings.

The council says that's unfair because the money is taxed first by the income tax when the money is earned and again whenever interest and dividends are received or when capital gains are realized when the investment is sold.

"Taxes on income that is saved raise the capital cost of new productive investment," argues the council, "thus dampening investment."

The council stresses that favorable tax treatment of capital gains is especially important in encouraging the start-up of new but risky enterprises, requiring entrepreneurs who provide significant dynamism and growth to an economy.

While most western countries tax capital gains, the rates vary widely. The United Kingdom taxes gains on non-business assets held by individual investors for 10 years at 23 percent, and for people who build their businesses or put their own money into them, the capital gains tax rate falls to 10 percent. However, for capital held for only a short time, London imposes a 40 percent tax.

In Ireland, the tax on all capital gains is 40 percent. In Japan, capital gains are taxed at 20 percent, whether held long or short term. Alternatively, capital gains in Japan can be taxed at a simple one percent of the sale price.

The United States used to tax capital gains at up to 40 percent, but in 1996 cut that to two levels -- 32 percent or 28 percent depending on a persons' other income. In some cases, for capital held long term, the rate falls to 15 percent.

One of the arguments against capital gains is that, without indexing or adjusting for inflation, it charges people for the inflation which reduced the value of the investment. One thousand dollars in 1975 would be three thousand dollars now because of inflation alone.

William Wilson, Vice President of Comerica Bank in Detroit, gives an example. Stock bought for $10,000 20 years ago, which earned an average return of 10 percent per year, would be worth $68,000 today. If sold, it would face a capital gains tax of nearly $17,000. However, most of that growth was actually inflation, says Wilson, so adjusted for the real value of the money, the investor earned only $3,000 for the entire 20 years -- a horrible return.

Many countries do index their taxes on capital gains so that only the real increase in value -- not the inflation -- is taxed.

But even then, argues the American Farm Bureau, the tax is unfair because people like farmers and ranchers are in a capital intensive business -- using land -- and they get hit the hardest.

Even with indexing for inflation, the farmer's organization argues, there should be a minimum exclusion of the first $500,000 from land sales and everything over that taxed at a maximum of 15 percent.

Homeowners in America recently won such an exemption when they sell their primary homes after three years, a move that real estate economists say will assist many middle income people.

One of the political arguments against cutting capital gains taxes has been that this only benefits the rich while reducing government revenues used to help middle income earners and the poor.

However, Congressman David Drier (R-California) says that more than 50 percent of all capital gains in the U.S. are realized by people with incomes of less than $50,000 per year, considered middle income. Even more, he says, since 63 million Americans now own mutual funds, capital gains taxes are hitting working people harder.

Proponents argue that cutting these taxes would reduce the cost of capital, improve labor productivity, encourage risky enterprises and greatly encourage domestic savings.

They argue that since much of the reward to entrepreneurial activity comes in the form of capital gains, lower or no taxes on capital gains would be a potent stimulus to productive economic activity.

However, the Jerome Levy Economics Institute at Bard College in New York, says a study it sponsored shows that there is "little theoretical or empirical" evidence that lowering or eliminating the capital gains tax would have a "substantial effect on economic growth or level of economic activity."

The study found that the long-term economic impact of cutting the capital gains tax would be no greater than the impact of roughly two months of normal economic growth and that it would take years to realize even this small benefit.

The International Monetary Fund (IMF) and the World Bank, which frequently advise nations in transition on adopting appropriate tax codes, say they have no official policy on capital gains taxes.

"Capital gains are income just like any other income," says the IMF's chief tax expert, Emil Sunely. However, he says, fund and bank advisors believe it is most important to put tax systems in place which are mostly automatic -- primarily collecting through withholding by employers, banks and other institutions.

And since capital gains taxes are usually collected through tax returns which must be filed by individuals -- something the advisors argue against, says Sunely -- it's an area better left to be dealt with later in the transition process.