CAPITAL GAINS TAXES

1-2. Introduction & Old Provisions

Tax on capital gains have numerous issue, several issue is this taxation
lead to high revenue to some countries (e.g: US, UK, France)
But the application some problem arise, i.e extreme complication on
administration, fairness (ability to pay & wherewithal to pay),
economic efficiency.
In 1977, US has enacted tax reform theres several reform which to
consider are relevan to comprehensive income taxation (tax base)
4 (four) issues related to the change are exclusion and alternative
rate, deferral, limited step-up in basis, limits on the deduction of
capital losses
 Exclusion and Alternative Rate
Several special treatment on taxation of capital gains
exclusion on 50 % of net income form capital gains (excess of net
long-term capital gains over net short-term)
Alternative 25 % rate of first $ 50, 000 on income of capital gains
These treatment only for people up to marginal tax rate level
excess 50%
After 1977 US has changed the definition of holding periode on capital
from long term to short term only for 1 years, after that these special
treatment no longer given
Deferral
Tax payer have to report on capital gains & losses when realized, but
on the comprehensive tax base recognized at the time accrued
Several effect on recognition of income realize principle, i.e:
Deferred tax and gain an interest free loan from government, but
also deferred tax saving on capital losses.
Income averaging effect
Bunching effect (i.e excess burden/unfair burden of taxation)
Interest free loan resulting in the 1/3 exemption calculation of taxable
income on increase of capital gains due to increase value of assets
Step up in Bases
Transferor of assets (gift) will not report any earnings, and the
recipient will seek over capital losses by the transferor (adjustment)
Tax reform act 1976 enacted carry over of basis at death as general
provisions on transfer of inheritance/gift
Before the tax reform theres several clause which allowing such
transfer are not to be taxed permanently.
Several clause also appear such an exemption if the basis value of
assets lower than $ 60,000,-
Limits on the Deduction of Capital Losses
After the tax reform under the principle of comprehensive tax base, the
capital losses are allowed to be deduct against ordinary income
(before the reform the deduct only available maximum of $ 3,000 which
can carry forward until death)
The transferee of assets must used base valued assets when the property is
transferred
Under the principle of step-down in basis at death, the transferee of gift
cant carry over the capital losses incurred by the transferor.
Although, for the transfer of inheritance assets the transferee (heirs) allow
to carry over such capital losses.
3. Treatment of capital gains and losses under
principle of comprehensive tax base
Under comprehensive base principle
Step down in basis at death (recognized losses gains accrued)
Exclusion on transfer tax on the value asset of $ 60,000, -
Adopted unlimited deduction capital losses on ordinary income
Impossible to value capital gains & losses at the principle of accrued (non
marketable asset) transfer to realize principle
In realization principle theres insentif for tax payer to deferred gains,
therefore 2 alternative solutions
Constructive realization theory
Deferral charge
 Constructive realization: step up in & down value asset when transfer are
recognized as transferee gains & losses.
Administratif superiority is that taxpayer must asses the asset at the time of transfer, so
theres no administratif burden when asses taxable income
In this principle tax burdens are more lower then the accrued principle (e.g lower
marginal tax rate at the end year taxpayer will die)
However, this principle could lead to bunching effect, but can be muted by the
alternative income averaging
Problems on the principle of wherewithal to tax, i.e force people o sells the asset when
the gains are realized or apply for installments
Another alternative: deferral charge, i.e has several advantage
Reduce the insentif to deferred gains in the long term
Eliminate complexity of administration (i.e to asses aset when transferred)
Eliminate problems on principle of wherewithal to tax
Adopted Carry over losses principle & full deduction to ordinary income
4. Income and Distribution Effect
Under principle of full taxation on capital gains & losses theres substansial
revenue to treasury on burden of taxpayer from high brackets
Eliminate exclusion & alternative rate, and enacted new deferral charge
principle will stepped up revenue to 11.9 billion comes from people earning
over $ 100,000,-
Also shifting burden of taxation to the transferee of assets i.e sells the asset
to acquire another asset
Theres harmful effect on the principle of exclusion & alternative rate i.e
reduce accumulation of capital, productivity of labor, and salary of
workforce, so the tax incidence more directed to the workers
 5. Complexity
Theres several complexity on the principle of exclusion & alternative rate,
eliminate this principle will make simplification, i.e
Tax reforms: reduce the tax law pages, reduce compliance cost & admin
burden
Record keeping: reduce record keeping in the burden of taxpayer when
give unlimited deduction of capital loss against ordinary income
Economic decisions: reduce consideration of taxation impact when
decide some economic decisions
Tax law: provide broad access for the public and lawmakers it self (i.e
easy to understand )
6. Horizontal Equity
One of the tax policy goals are to give horizontal equity (fairness ), and the
principle of full taxation on capital gains & losses nearly accomplish the goal
Inflation effect: i.e reduce taxation on illusory capital gains and simplify
the administration to adjust inflation rate
Bunching effect: i.e reduce progression impact on earning spike, with
principle of prorate, income averaging, reduction effective tax rate to
reflect ability to pay principle

Although several disadvantage i.e to give loophole for taxpayer who willing to
avoid the lax legally
 7. Economic Efficiency
Another goals of the tax policy if to reduce economic distortion, while this principle also
nearly accomplish the goal
Effect on deferral charge: i.e reduce the lock-in effect & averaging behavior impact
from capital gains (i.e reduce net return expect)
Effect on unlimited deduction of capital losses: i.e more fair because reducing tax-
loss selling in the last year and reduce averaging behavior
Effect on economic efficiency: reduce on productivity investment purpose (retained
gain), distort allocation of new investment, reduce household welfare by providing
them low quality portfolio.
Effect on saving: effect on income, effect on wealth, dan effect on the rate of return,
dan lock-in effect.
Corporate saving
Previous principle give incentive for people to retained earnings, while the afterward
principle will reduce the behavior (i.e deferral charge & full capital loss deduction).
Meanwhile also encourage people to allocate earning for a more productive sector
Effect on allocation of capital
Capital gains on corporate stock: previous principle induce people to buy
more corporate stock, while decrease cost of new investment and R&D
cost and increase net wealth to corporate
But these phenomena give extremely inefficient (earning retention ->
deferral charge) & inequity impact (double taxation -> fiscally transparent)

Capital gains on land: increase price of land and net revenue expected but
these benefit only for those who already in the high tax brackets

Effect on risk taking

Previous principle encourage people tax take more risk in new investment
but produce some inefficient & unfair conditions.
While the afterward principle also encourage more risk taking with more
little problems on efficient & equity issue
Conclusion
Principle of full taxation of capital gains are more efficient & equity
Eliminating retention behavior which is distort capital allocation
Full deduction losses will still give an incentive to encourage
people tax take more risk
Fiscally transparent policy (i.e tax integration) will reduce inequity
issue on corporate taxation or lowering progressivity impact to
people on high tax brackets
TAXABLE OF BUSINESS INCOME
 1 2 Introduction & Income Definition
Income definitions according to Haigh Simmons states that income
consists of consumptions plus/minus changes in net wealth over
particular periode of time
But in practice theres several difficult to apply this theory according to
business income taxation
Lead to theory adjustment (Freed M. 1890, Lawrence 1892, etc.) i.e
change in net worth or proprietorship, adjusted for proprietors
contributions or withdrawals.
Haigh-Simmons: also accrual change in net worth, plus distribution and
less net contribution of capital
C + S = Y = W (wages) + I (interest) + R (rent) + P (profit) + T (transfer) + G
(grants), where C is consumption, S is saving, and Y is income
3. Perfect Market & Degree Of Certainty
Difficult in applying the definition of income is to the change in net
worth / wealth according to market value
Perfect market & certainty serves as a must to count the change in
net worth accurately
a. Under perfect market & certainty, theres no difficult to count the
income accurately according to the market fair value (symmetric
information of market fair value)
e.g : count the depreciation asset based on real useful life, financial asset &
liabilities, intangible assets (R&D, ad, IP rights, etc.)
b. Under competitive market & uncertainty: unforeseen capital gains
& losses (interest rates, risks, technology, productivity etc.)
4. Imperfect Market
Several difficult lies on the implementation of income definition
under imperfect market (i.e fair value market, value gap converging
asset to cash/equivalent)
Accuracy on measuring business income? (asymmetric information on
market value when transaction occurred)
Need of adjustment & principle of realization (on cash transfer) when
valuing gains & losses according to fair value market (need final
adjustment on book value market fair value)
Solutions: measure value on the basis of realization
principle/deferred gains & losses until it realize.
5. CURRENT TAX LAW DIVERGENCE FROM INCOME
IN ECONOMIC CONCEPTION & DEFINITION
Diverging on the conception of income definition according to Haigh Simmons concept
(accrued net wealth changes to realization net wealth changes) to give more efficient
& fair tax on business income
Special rate tax (i.e special tax rate treatment)
Direct tax base reduction (i.e reducing effective tax rate)
Subsidies of factor input (i.e tax incentive)
Deferment of tax (i.e deferred tax)
Expensing capital outlay (i.e capitalization on some expense)
Five-year amortization (i.e depreciate to some facility)
Accelerated depreciation (i.e to accelerate capital return)
Direct postponement of tax (i.e to delayed tax to reinvested on productive
capital)
Objective on this policy are subsidize & give special tax rate (to increase capital net
wealth on corporation ) not to deviate from the original principle income definition
6. Seriousness of Divergence of Realized from
Accrued Income
Theres several critical divergence issue on change conception from
accrued income to realized income.
Theres no taxation until capital gains & losses are realized.
i.e lead to permanent non taxation on capital gains & losses accrued in
some periode
But its worth to consider this serious divergence to offset asymmetric
information on imperfect market & uncertainty and in the ease of
administration burden and compliance
This will lead to more efficient (allocation investment distortion) and equity
(ability to pay & wherewithal to tax) of business income taxation