Korea Capital Market Institute

While capital gains taxes are imposed comprehensively on bonds and real estate in Korea, they are imposed on stocks selectively based on the listing status and the investor type. This selective taxation system might undermine tax fairness and distort the resource allocation, consequently lowering the overall market efficiency. The reason for this selective tax benefits on capital gains is to facilitate the Korean stock market. However, given the current level of stock market development both in qualitative and quantitative measures, it is arguable to maintain the current selective tax benefit for non-controlling investors trading in stock exchanges.
When the government plans to expand the taxation base for capital gains on stocks, the most important thing to evaluate is its impact on the stock market and tax revenue. Requiring non-controlling investors to pay taxes on capital gains realized by trading in a stock exchange can cause overall stock prices to fall. In addition, market liquidity can dry up to a certain degree. These undesirable effects imply that the actual tax revenue may not increase as much as the government expects. If capital losses are offset or transaction tax is removed along with the capital gains tax, the negative impact on the stock market will be alleviated. However, it can also lower the tax revenue at the same time.
This study examines the market environment for the general taxation on capital gains of stocks and its impact on the Korean stock market. It uses economic models and quantitative analysis to estimate the changes in tax revenue and also to compare the consequences of taxation on capital gains of stocks with the consequences of taxation on stock transactions.
General taxation on capital gains of stocks may cause paradigm shifts in asset allocation, stock price, and trading volume. If tax burdens differ according to asset category, the overall asset allocation will be determined by the after-tax rate of return. If the progressive tax rates apply to interest income but not to gains on capital assets, investors in high tax brackets will prefer capital assets to interest-bearing assets. In the same context, investors in low tax brackets will prefer interest-bearing assets. This can undermine efficiency in asset allocation.
The capital gains tax on stocks may change stock prices and trading volume through capitalization effect and lock-in effect. Due to the capitalization effect, stock buyers require a higher rate of return as compensation for the future tax burden on the capital gains. As a result, a hike in the capital gains tax rate shifts the demand curve for stocks downward, which results in a fall in stock prices and trading volume. The more the interest rate changes, the stronger the effect.
Owing to the lock-in effect, stock sellers require higher prices of stocks in return for the current tax burden on capital gains. Hence, a rise in the capital gains tax rate moves the supply curve for stocks upward, which brings about a rise in stock prices and a fall in trading volume. The more the interest rate changes or the bigger the size of the capital gains, the stronger the effect. While the capitalization effect comes from the expectation of future capital gains, the lock-in effect is based on the current realized capital gains. This implies that the former is likely to take place before the tax rate change and the latter after the change.
When we compare the capital gains tax with the transaction tax by economic model, we do not reach any solid conclusion on which tax system works more efficiently. With regard to the firms' capital accumulation, both taxation schemes diminish the incentives for capital accumulation. In terms of stock prices, the transaction tax clearly drives down the prices, while the impact of the capital gains tax on the price varies depending on the timing and size of dividend payments. Because the transaction tax does not affect the size of capital gains, the stock prices fall regardless of the timing of dividend payments. However, the capital gains tax has a more negative impact on the stock prices of venture start-ups whose dividend payments are expected far off in the future than on the stock prices of seasoned  companies whose dividend payments are expected in the near future. As for the government's tax revenue, the capital gains tax is likely to result in lower revenue, while the impact of the transaction tax on the revenue differs according to the level of the tax rate. Theoretically, the increase in the capital gains tax rate would reduce the size of overall dividend payments and tax revenue by lowering optimal capital accumulation. The higher transaction tax rate would result in both effects of an increase and decrease in tax revenue. The increase in the effective tax rate would drive up tax revenue, while the decrease in capital accumulation would cut tax revenue.
Assuming that the capital gains tax replaces the current transaction tax, we find that tax revenue may not grow. Based on the holding period model, we selected 5 representative companies listed in KRX to estimate tax revenue for 5 years from 2007 to 2011. Assuming the tax rates on long-term (typically longer than 1 year) investment and on short-term investment are the same, we find that the capital gains tax rate should be at least 7.37% in order to collect as much tax revenue as the current transaction tax does if the capital losses cannot be offset against the capital gains. If full capital losses can be offset, the capital gains tax rate should go up to 17.02%.
Assuming that long-term stock holdings get a favorable tax rate (half of the short-term rate), we find that the capital gains tax rate should be 8.33% for the short-term rate without rules for  offsetting in order to reach the current tax revenue level under the transaction tax system. With full offsetting rules, the short-term rate climbs to 23.2%. The volatility in capital gains tax revenue is greater with full offsetting rules than without them and always exceeds that of the transaction tax.
Tax revenue drops even more if trading volume shrinks due to the capitalization effect and the lock-in effect. Assuming that the short-term rate is twice as high as the long-term rate and the capital losses are fully offset, a 1% drop in trading volume calls for an additional 0.26% increase in the short-term capital gains tax rate to recover the tax revenue losses.
Considering the current capital gains tax rate, the adoption of a favorable tax rate on long-term holdings and offsetting rules, and the total replacement of the transaction tax with the capital gains tax, we conclude that the general application of the capital gains tax will not achieve tax revenue enhancement. The higher the capital gains tax rate, the larger the capitalization effect and lock-in effect. A decline in trading volume even reduces tax revenue. Ironically, this implies that a rise in the tax rate can result in a tax revenue fall. It is important to recognize that the general capital gains tax system is likely to have a more sizable market impact because the overall dividend yields for companies listed in KRX are relatively low.
The full-scale introduction of the capital gains tax system, as a policy goal, should be clearly set for the sake of enhancing tax fairness and not for raising tax revenue. This is because, as this study finds, the capital gains tax is not an efficient policy tool for increasing tax revenue. To minimize any undesirable market impact, it is necessary to take a stepwise approach to the full-scale introduction of the capital gains tax system. Gradual increases in the tax rate and the taxation scope is advisable. Removal of the transaction tax is also necessary since it will diminish the negative market impact on prices and liquidity. It is reasonable to allow the offsetting of capital losses as it prevents the after-tax rate of return from falling too much. For smooth transition to the full-scale taxation on capital gains of stocks, separate taxation can be better than the taxation of total income. Also, favorable tax rates on long-term stock holdings should be considered.