The Taxation of Capital Gains: Reply

Abstract

I welcome the opportunity to amplify the purpose and details of my proposal. My purpose was to develop a simple approximative procedure for avoiding the taxation of inflationary gains and removing the lock-in effect. In the interests of brevity, I did not consider what marginal tax rate would be used nor whether the interest rate used to accumulate the tax liabilities ought to be on a before-tax or on an after-tax basis. Dr Shibata has suggested that separate marginal tax rates ought to be used for each year during which the asset is held, and that, if interest on money borrowed to pay taxes were tax-deductible, one ought to put the interest rate on an after-tax basis. If both marginal tax rates and the after-tax borrowing rates were given separate values for each year within the asset holder's period, the calculation formulae for my procedure would become more complicated, and the relevant taxable amount could no longer be read from a simple two-dimensional table. Dr Shibata is right to emphasize that whether or not his amendments to my procedure are worth making depends on the differences they would make to the amount of tax payable. These differences ought to be looked at in relation to the greater costs of calculation using his amended version of my proposal. In general, I would suppose that any tax system which was attempting to treat capital gains equivalently to other forms of income would also embody good income averaging procedures. If so, then there would be little inter-temporal variation in marginal tax rates to worry about. If there were not good income-averaging provisions, taxpayers would schedule their asset sales in order to help average out income fluctuations if the entire gain were put into taxable income of the year of sale. In order to avoid this undesirable trading purely for tax reasons, I would recommend that the marginal rate applicable to realized gains (as calculated by my procedure) should be the individual's average marginal rate over the holding period, or over a specified number of past years. This is very much a second-best procedure, however, as it would be much simpler and more appropriate to have good averaging provisions for all sorts of income. I agree with Dr Shibata that the interest rate assumed in my procedure should be on an after-tax basis if interest on money borrowed to pay taxes were tax-deductible. The arbitrary interest rate would just be equal to the assumed typical market rate times one minus a typical marginal tax rate. Whether it is worthwhile making Shibata's amendment making year-to-year changes in the marginal tax rate used in defining the after-tax borrowing rate depends, as before, on how good are the income-averaging provisions. Even though Dr Shibata's amendments would be unnecessary in a tax system with good income-averaging provisions, it is worthwhile to consider