China Leads the Way to Lower Capital Gains Taxes

December 14, 2005

As lawmakers on Capitol Hill debate whether to hike the U.S. tax rate on capital gains income, the Chinese government is moving in the opposite direction, exempting both foreign and domestic investors from capital gains tax in an attempt to boost the attractiveness of its equity markets. From Bloomberg:

China will exempt foreign investors in the nation’s local-currency securities from paying capital- gains tax, the latest attempt to revive stock markets that have lost more than half their value in the past four years.

“This is good news for foreign investors as it removes all ambiguity on the issue of capital gains tax,” said Sean Hu, who helps manage $400 million at Martin Currie Investment Management Ltd. in Shanghai. “This was a grey area in the past. It may encourage more investment.”…

“The tax relief would attract more foreign investors to invest in China’s stock market, and leave them with more money to buy domestic shares,” said Yan Ji, who helps manage the equivalent of $720 million at domestic asset manager First Trust Fund Management Co. in Shanghai.

The ruling places foreign investors on an equal footing with domestic institutions, which are exempt from capital gains and business tax, Yuen said. “Any other outcome would have an adverse impact on the further development of the QFII regime.” (Full story here.)

Currently Congress is debating whether or not to extend the current 15 percent tax rate on capital gains and dividends, both of which are set to expire in 2008.

So what’s the argument for keeping the lower rates? Many have focused on the distribution of the tax relief the cuts provide, and whether it’s fair or not. But to economists concerned with growing the economic pie—rather than slicing it more carefully—there are two much stronger arguments.

One is the simple argument of Chinese lawmakers: taxing investment less leads to more investment, which makes workers more productive and raises wages.

However, a more subtle argument for extending the 2003 dividend tax cuts is that they get the U.S. one step closer to a consumption-based tax system in which capital would be exempted from tax altogether—a system nearly all economists agree would dramatically improve U.S. economic performance, allowing U.S. lawmakers to fight over the division of a much larger economic pie.

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