The Hedgehog and The Fox: Is there a case for a capital gains tax?

This article first appeared in Forum, The Edge Malaysia Weekly, on January 11, 2021 - January 17, 2021.
The Hedgehog and The Fox: Is there a case for a capital gains tax?
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Among the long list of enquiries into inequality that emerged in the last decade, Walter Scheidel’s The Great Leveler stands out for its startling evidence that plague and pandemic will play themselves out to narrow the gap between the haves and the have-nots.

Whether it was the Black Death that struck Europe in the 14th century or the Irish famine of the 19th century, the twin effect of the human catastrophe — ­depleting wealth for the rich and a rise in wages for the workers as a result of the massive loss of life and labour shortage — would eventually balance the economic scale.

This had been the outcome throughout the history of mankind — until Covid-19. Instead of levelling it, the coronavirus, as evidenced by anecdotes and quantitative data, has widened the economic gap. Medical breakthroughs and an effective public health policy mean that we no longer experience a plague or pandemic of catastrophic proportions that would have the natural effect of levelling the economy the way it did in previous centuries.

Such a scenario is indeed a blessing but herein lies the importance of active government intervention to contain the social crisis that may have been aggravated by the pandemic.

A lower Goods and Services Tax rate, as recently envisioned by the Minister of Finance, is certainly a welcome option, but the Inland Revenue Board’s proposal for a capital gains tax is an option worth drawing attention to. While it seems to have been lost under the pile of comments and debates on the 2021 national budget, the suggestion is no less important and deserves serious consideration.

At a mere 12.5% of gross domestic product (GDP), Malaysia’s tax base is among the lowest in the world. By comparison, the average of the Organisation for Economic Cooperation and Development countries is about 15%, while the comparable economies by GDP per capita, Turkey and South Africa, record tax collections of 17% and 26% respectively.

But the argument in favour of a capital gains tax is not just that the small tax base constrains the government’s fiscal space. The tax serves as a potent policy tool to rein in corporate behaviour that exacerbates the widening inequality.

Granted, shareholders and investors are entitled to the long-term returns for their risk-taking ventures, earned through the genuine rise in share value and dividends. But as The Edge reported at the end of last year, we have seen a disproportionate amount being spent by the companies to buy back their own shares.

By the end of 2020, almost RM2 billion had been spent by some of the companies for this purpose. The most notable ones were probably the glove makers, one of which spent almost 70% of its profits to repurchase its own shares. Some loss-making entities jumped on the bandwagon too, digging deeper into their retained earnings to reward their shareholders.

No doubt, share buybacks — a fairly recent invention of corporate America courtesy of the Reagan administration — is an available legal mechanism to maintain share value or return excess cash to shareholders. But it may also be abused to arbitrarily reward shareholders at the expense of economic equity.

As recent sanctions and raids on the glove factories show, it appears none of the windfall profits delivered any value to the workers, including foreign workers. We would have expected the profits and retained earnings to have been partly spent on improving the well-being of the thousands of people who contribute their fair share towards the sterling performance of the companies. Instead, they were used only to further advance the fortune of a select few.

The increase in net worth through share value, dividends and now, share buybacks, would most certainly put more people on the billionaires list, but they have no productive or consumption value that would add to economic growth, let alone close the economic gap.

While a tax on capital gains might not stop entirely the practice of buying back shares for the shareholders’ own benefit, it would at least provide the government with a source of revenue to further its economic programmes.

Critics would argue that a tax would drive investors away from our financial market. But as someone who invests and is linked, in one way or another, to the fund management  business, I can say with confidence that the capital gains tax is the least of all factors under consideration when it comes to investment decisions.

What matters to fund managers is the health of the economy, the fundamentals of the target counters and the quality of their earnings. All these combined bring vigour to the world of finance and securities trading.

That is the reason why the Kuala Lumpur benchmark index gained only 3.5% last year, paling in comparison to Vietnam’s VNINDEX, which rose 14% despite having a tax on gains from the disposal of securities.

The lacklustre performance is not because of the existence of a tax or otherwise, but because 58% of all Bursa Malaysia counters are penny stocks. For the four years since 2016, the amount raised in Malaysia through IPOs by a total of 78 companies was a mere US$2.6 billion, trailing far behind Thailand and Vietnam, whose 130 and 156 companies raised US$10.2 billion and US$5.3 billion respectively when they went public. It is the lack of depth and choices that drives investors and fund managers away.

Thus, in analysing which tax might or might not work, the focus should not be on its impact on investor sentiment towards our financial market, but on how to have companies with quality earnings and strong balance sheets in our market. The value of direct investments that create jobs and strengthen the real economy matters more than the size of capital flow on the stock market.

After all, it is the strength of the real economy that gives vibrancy to the financial market, not the absence of a capital gains tax.

Nazim Rahman works in private equity

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