Shorting the Budget – Why taxing short-term capital gains at progressive rates is wrong?
The Portuguese Budget Law includes a proposal for taxing short-term capital gains at progressive rates as from 2023 onwards. In a recent newspaper article, tax experts considered this rule induces complexity, raises limited revenues, is incorrect from a technical point of view, is unfair and even potentially unconstitutional. Despite such shortcomings, as the government has majority in the Parliament few expect this measure not to approved. The following is a short note on why this proposal is flawed and should be corrected.
What is being proposed?
For income earned as from 1 January 2023, the positive balance between capital gains and losses arising from the transfer/disposal of shares and other type of securities shall be included and taxed at progressive rates, whenever, cumulatively:
the shares/securities in question have been held for a period of less than 365 days;
the taxable income, including the balance of said capital gains and losses, is equal to or greater than €75,009 (highest tax bracket).
In Portugal, the top progressive rate is 48% and an additional solidarity surtax is also levied at 2.5% on the annual taxable income between €80.000 and €250.000 and 5% on the annual taxable income exceeding €250.000. For a short-term capital gain of €300.000 this measure may represent an increase of almost 20% of the tax payable.
Long term capital gains will remain taxable at flat 28% rate and losses may be carried forward for 5 years when the option to tax at progressive rates is exercised or mandatory.
What are the arguments in favour for this measure?
One expert mentions that it is a fair proposal to tax speculative gains at a higher and harsher rate. Naturally, such view reflects a political vision or ideals that should preferably be absent of a tax system, which should be judged on the technical aspects. There is in fact a technical reason why capital income is generally taxed at lower rates than labour income, but the Government choose to ignore it.
Others raise that taxing capital income at progressive rates is an effective way to redistribute income and having that in mind the Government allocated the revenue of this particular provision to the Social Security Financial Stabilization Fund that currently manages €20 billion. Portugal combines large cash transfers to households with a very significant progressivity on active labour income and therefore I fail to understand the redistributive impact of this measure. Let’s not forget that those reporting more than €100k represent only 1.7% of taxpayers but contribute 22% to the total amount of personal income tax paid.
What are the arguments against this measure?
From an economic standpoint, by sacrificing consumption today, savings in the form of capital income are a way of generating future income and hence there is a clear case for preferential tax treatment.
In the Portuguese case, the case of PPRs (individual saving funds) were an excellent example of positive individual response to tax incentives. This measure of taxing at progressive rates savings invested in shares/securities may have the opposite effect on households. It will simply enhance a ‘lock-in’ effect, where there is an incentive to hold securities or shield the accrued gain from tax. This measure will also enhance, the search for type of financial instruments that will be safeguarded from this treatment, such as distribution type funds, life insurance bonds or Lombard loans or even crypto related holdings. One may argue it may also induce taxpayers to implement tax loss harvesting strategies.
From a technical standpoint, a progressive rate structure in capital gains is wrong tax policy. The effective tax of capital gains on shares should not be determined simply by the tax paid by the individual. Let’s not forget that profits are taxed at the corporate level (in Portugal at progressive rates of 21% plus municipal and state surtaxes) and therefore there is no more margin to go beyond the 28% flat tax rate in place.
There is “economic double taxation” of dividends and retained profits. The economic double taxation of dividends is composed of the taxable corporate profit as well as taxable personal income when the dividend is then distributed. The economic double taxation of retained profit is more subtle: it is constituted by the taxable corporate income and the induced proportionate appreciation of outstanding shares. This appreciation is subsequently taxed through personal capital gains tax when the shares are disposed.
See this example to compare a case of an individual selling shares in 3 situations: (i) long term gain from selling shares of a company with 70% dividend payout in the same year of sale; (ii) long term gain from selling shares of a company with full retained profit (no dividends); (iii) short term gain from selling shares of a company with full retained profit (no dividends).
In the example, we see that a strategy of investing on a dividend pay-out equity and disposing the share is comparable to investing on an accumulation type of shares (combined corporate and personal tax rate @53%). If one adds a progressive element to the capital gains, the combined tax rate increases exponentially illustrating the lack of neutrality of such a measure.
One should add that this measure catches off-guard some cases that are clearly not-speculative. For example:
An employee vested and exercised a particular stock option programme and shares were transferred at a certain exercise date and taxed as employment income. If the employee later disposes within a window of less than 365 days any appreciation between the vesting price and sale value will be again taxed at progressive rates (instead of the flat 28% rate). The proposal should carve-out these situations by taking into account the date when those options were first granted to the employee (regardless of the exercise date).
A person receives the shares as a donation or inheritance. If that person later disposes within a window of less than 365 days from donation date or acquisition date for inheritance purposes, any appreciation between the deemed acquisition value and sale value will be again taxed at progressive rates (instead of the flat 28% rate). No carve-out exists. The case of the donation is further fuelled if combined with a new measure provided by the Budget proposal that sets the acquisition value of donated securities as the value under the Stamp Tax Code up to two years prior to the donation.
Let’s give a numerical example to illustrate the exponential effect. Assume a daughter receives a portfolio of quoted shares in 2023 from her father that at the time of the donation are valued €1m. Assume the daughter monetizes the portfolio still in 2023 for €1.2m. If the value of the quoted shares in the prior 2 years were for example €500k, the daughter will pay more tax than the actual gains (effective tax rate of 181% over €200k appreciation). This capital gains tax is effectively a tax (through the back door) on the donation that otherwise should benefit from an exemption for transfers within the direct family members.
Tax policy principles indicate that there should be: (i) neutrality over the level and timing of capital income; and (ii) neutrality between different types of capital income assets. The government proposal simply breaches those principles and proposes a rule contrary to EU Law as regards gains generated from foreing based investment funds. One could add other arguments against progressive taxation on gains, such asymmetries between recognition of tax losses arising from short-term or long-term positions, complexification and the fact that adding progressivity should entail revisiting the cost base and specially deduction of interest expenses (for leveraged transactions).
What about comparative tax law?
On the progressivity point, the table below identifies a trend in key EU countries to tax passive income (such as capital gains or dividends) at a flat tax rate. Only Denmark taxes at progressive rates up to 42% and Portugal is not Denmark. On the speculative and non-speculative point, the only examples found in other countries is when tax systems want to favour certain tax treatment on long-term holding and not the other way round.
In conclusion, it is clear from a tax policy and EU benchmark perspective that any quick-fix changes to the current capital gains rules are countertrend and possibly even counterproductive in tax revenue terms.
What to conclude then?
We should ask ourselves if tax policy should be influencing whether one person decides to save or trade in bonds, shares, financial products, or even invest in real estate and what is deemed speculative or not. Capital gains are return to savings (already taxed) in just the same way as dividends. There is no basis for segregating speculative income for two reasons: (i) tax law should not attempt to distinguish what under financial planning has no clear dividing line; (ii) unnecessarily penalizing via taxation certain types of income only induces taxpayers to alter their behaviour. The key point for savings income is not the tax rate but rather on the tax base and equalizing tax treatment across diferent asset classes. Once again, the tax system is going the wrong way and this is why “shorting” the budget is the right position.
Tiago Cassiano Neves
25 April 2022