• News
• 2024-08-20

Understanding Capital Gains Tax

Tax regulation plays a crucial role in guiding residents' expectations, and the "locking-in" effect of long-term capital gains may itself contribute to the cultivation of patient capital.

The "Decision of the Central Committee of the Communist Party of China on Further Comprehensively Deepening Reforms and Promoting Chinese-style Modernization" (hereinafter referred to as the "Decision") proposes to "improve the direct tax system, refine the personal income tax system that combines comprehensive and categorized elements, and standardize tax policies on business income, capital income, and property income." How should we understand the tax policy on capital income within personal income tax?

Current Policy Status

The 2018 personal income tax reform mainly revised labor income and established comprehensive income, while largely retaining the settings of the previous personal income tax law for capital and property income. After the 2018 personal income tax reform, labor factor income still dominates the composition of personal income tax revenue. In 2022, it only slightly decreased compared to 2017, with property income increasing and asset income remaining unchanged.

We categorize and summarize comprehensive income as the scale of personal income tax paid by residents for income obtained through labor. Compared to 2017, the proportion in 2022 slightly decreased by 6.3 percentage points, but it still accounts for a high 65.6%, with payroll tax absolutely dominant in personal income tax. The increase in proportion mainly comes from property income (interest, dividends, bonus income, and property rental income), which increased by 4.8 percentage points in 2022 compared to 2017, while the proportion of capital income (property transfer income) remained unchanged.

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The "Decision" proposes to "regulate the order of income distribution, standardize the mechanism of wealth accumulation, and increase the property income of urban and rural residents through multiple channels." This requirement actually implies the direction of personal income tax reform. At the same time, the "Decision" also proposes to "standardize tax policies on business income, capital income, and property income," which is also coordinated with the changes in residents' income structure and internal changes in personal income tax.

The rapid development of China's economy has led to the continuous growth of financial assets, and with the prosperity of the capital market, personal income tax also needs to adapt to the development situation and continuously enrich itself. However, in the past development process, in response to the continuous emergence of new types of capital market development, personal income tax has been more standardized in the form of patches.

According to the type of transferred assets, the part of personal income tax related to capital income (property transfer) can be divided into four categories: securities, real estate gains, tangible asset gains, and intangible asset gains. The transfer of personal secondary market is temporarily exempt from personal income tax, but the transfer of restricted shares requires the calculation of taxable income according to scale, and personal income tax is paid at a tax rate of 20%. In the provisions for capital gains tax, the part that residents need to pay when trading real estate actually changes according to the needs of national macro-control.

In the large structure of personal income tax revenue, emphasis is placed on payroll contributions, and in the small structure of property transfer income, emphasis is placed on restricted shares, house transfers, and equity transfers. However, the role and effect on income distribution are relatively limited.

Taxation remains an important part of building a new income distribution system. The "Decision" proposes to "improve the income distribution system. Construct a coordinated system of primary distribution, redistribution, and the third distribution, increase the proportion of residents' income in the national income distribution, and increase the proportion of labor remuneration in the primary distribution. Improve the determination, reasonable growth, and payment guarantee mechanism of workers' wages, and improve the policy system of distribution according to factors. Improve the redistribution adjustment mechanisms of taxation, social security, and transfer payments. Support the development of public welfare and charity."Some International Experiences

Capital gains tax in OECD economies plays a role in raising revenue and guiding income distribution. According to incomplete statistics, there are 31 OECD economies that have imposed capital gains tax, of which 27 combine it with the personal income tax, and 4 levy it separately. In terms of setting capital gains tax rates, the highest marginal tax rates are generally lower than the highest marginal rates for personal income tax, with an average highest marginal rate of 25.4%.

In terms of scale, some economies have strong tax collection capabilities for capital gains, making capital gains tax an important supplement to fiscal revenue. OECD data shows that there are three countries with a large scale of capital gains tax, namely Sweden, South Korea, and the United States, with proportions of GDP accounted for by capital gains tax in 2021 being 2.0%, 1.8%, and 1.7%, respectively. Additionally, there are three countries where capital gains tax revenue remains at a high level; the UK, Ireland, and Israel had capital gains tax scales accounting for 0.5%, 0.4%, and 0.4% of GDP in 2021, respectively.

Differentiating between long-term and short-term capital gains tax to create a "lock-in" effect. To encourage long-term investment, many countries adopt different tax treatments for long-term and short-term capital gains, with most countries using a single time limit for judgment, such as the United States using one year as the standard for distinguishing between short-term and long-term.

The difference in taxation of long-term and short-term capital gains has a clear effect on guiding residents to hold assets for a long period. According to data disclosed by the Internal Revenue Service in 2015, 37.8% of the total annual resident asset transactions were long-term capital transactions, and among the transactions that generated profits, the long-term proportion was 85.8%. The proportions of long-term transactions in stocks, bonds, real estate, and derivatives were 84.6%, 85.4%, 95.9%, and 85.2%, respectively.

The offset of capital losses reflects the shared responsibility between the government and residents in the face of risks, which is conducive to encouraging residents to continue investing. Looking at the types of loss offsets, they are roughly divided into allowing offsets against the same type of gains, capital gains, ordinary gains, and other offsets. The carryforward of capital losses is also another major risk-sharing mechanism.

Optimizing Income Distribution

Looking at the distribution of capital gains tax in the income structure in the United States, capital gains tax helps to optimize the income distribution structure. According to data from the Internal Revenue Service in 2021, residents with an annual taxable income of less than $50,000 paid no long-term capital gains tax, and as taxable income increased rapidly, the proportion of long-term capital gains in personal income tax began to rise synchronously. Residents with an annual taxable income of more than $10 million have paid long-term capital gains tax that accounts for 43.9% of their personal income tax payments.

Improving the direct tax system helps China's secondary distribution to be effective. The most direct part of improving the direct tax system may be further optimizing the personal income tax structure and adjusting the personal income tax revenue brought by labor and capital elements. The 2018 personal income tax reform was just the first step, and subsequent personal income tax reforms may still be the core content of direct tax reforms. Similarly, regulating the wealth accumulation mechanism also requires a capital gains tax.

Since the reform and opening up, the economy has developed rapidly, and a large amount of wealth has accumulated in the residential sector. According to international experience, wealth inequality may be more pronounced than income inequality, and regulating the wealth accumulation mechanism can also help residents feel a stronger sense of gain in the process of economic development.The current means of data governance are rich and also conducive to the tax system better playing the role of direct taxes in regulation. On July 19th, the State Taxation Administration expressed in a meeting to convey, study, and implement the spirit of the third plenary session of the 20th Party Congress, "Continuously deepen the rule of law in taxation, data-driven taxation, and strict taxation, continuously create an efficient tax system, and promote the practice of modernization in the Chinese style with high quality." The meeting's renewed emphasis on data-driven taxation also highlights the current tax authorities' approach to strengthening collection and management through digital systems. The difficulty in the reform of personal income tax lies in how to effectively clarify the scale and types of residents' income. The strengthening of this digital means will also pave the way for future reforms of personal income tax.

The "Decision" points out, "Encourage and standardize the development of angel investment, venture capital, private equity, better play the role of government investment funds, and develop patient capital." Patient capital is of great significance to the current development of the capital market. How to create patient capital through institutional design has actually become the focus of subsequent reforms. Tax regulation is crucial for guiding residents' expectations, and the "locking" effect of long-term capital gains may help cultivate patient capital.

From the national experience, differentiated tax policies for long-term and short-term capital gains may help improve capital market expectations and enhance residents' holdings of long-term investments. This institutional design provides a reference for the further improvement and development of our subsequent personal income tax. In addition, the standardization of capital gains-related taxes can better guide expectations.

The current clauses related to capital gains are set in a decentralized manner, which originates from the gradual development of China's capital market in the past. Drawing on the reform process of comprehensive income in personal income tax, the standardization and unification within capital gains may also be a future development direction.