Korea Capital Market Institute

In Korea, the issue of taxing capital gains from financial investment products has been persistently discussed. Given the taxation principle, “Tax is applicable where there is income”, and in terms of the fair tax treatment of financial investment instruments, the legislative trend of taxing capital gains on stocks has faced no serious social opposition. However, capital market participants and tax policy makers share very little common ground to determine the timing and methods of taxation on capital gains from securities transactions. Another controversy is whether the current securities transaction tax should be replaced by the capital gains tax or not.

Despite the recent move for tax hikes on the rich for the sake of equitable taxation, the U.S. has kept favorable tax rates on long-term capital gains from stocks. This can be justified by the following policy considerations. First, the bunching effect is in play. Preferential tax rates are necessary because adding long-term capital gains to ordinary income and taxing the gains at a progressive ordinary income tax rate would lead to excessive tax burden at the timing of asset disposal. Second, inflation during the long holding period reduces the actual capital gains (the inflation effect), which necessitates tax benefits to compensate the reduction. Third, a higher rate of tax on capital gains is highly likely to delay the timing of realizing the gains (the lock-in effect). Consequently, it may discourage stock market activities and undermine efficient asset allocation. Fourth, taxing dividend income and capital gains can be regarded as double taxation because a corporate entity is subject to corporate income tax. Hence, it is fair for capital gains tax on stocks to come with lower tax rates.

The U.S. capital gains tax system exhibits the following features as compared to the Korean system for capital gains tax on stocks. First, the U.S. system enhances tax neutrality by integrating the long-term capital gains and qualified dividend income as adjusted net capital gains. Second, a progressive tax rate is applied to long-term capital gains and the weakness in tax fairness is supplemented by policy tools such as the alternative minimum tax, etc. Third, a favorable tax rate is used for long-term capital gains to prevent a contraction in capital market activities. Fourth, by setting the principle of substantial taxation, it has paved the way for fair treatment of various but similar financial instruments and prevented abusive tax avoidance transactions associated with short sales, straddles, and structured financial instruments.

In Korea, recent tax law revisions regarding the capital gains tax on financial investment products lack important tax policy considerations of economic growth, tax fairness, and neutrality. Those revisions merely focus on increasing tax revenue and regulating capital market speculation. Korean legislators and policy makers should take as an example the legislative intention and historical experience of the U.S. capital gains tax, rather than the law itself. They are required to take systematic and principled approaches to the establishment of the capital gains tax system in Korea. Any tax reform that comes without sufficient considerations of progressive tax rate application, fair treatment of financial investment instruments, and the principle of substantial taxation would only worsen economic polarization and impede capital market efficiency and functions.

In Korea, legislative discussions on the capital gains tax on financial investment products should take place from the perspective of how to advance the taxation system, rather than how to increase tax revenue. To advance the taxation system, the Korean government should steer relevant legislative efforts in the direction that enhances tax fairness and neutrality. For enhancing tax fairness, it is important to establish the ability-to-pay principle by applying a progressive tax rate on capital gains from securities transactions. For improving tax neutrality, it is worth considering a balanced taxation on capital gains and dividend income and a symmetric treatment of capital gains and losses. Also, the Korean government should set up the principle of substantial taxation to eradicate abusive tax avoidance transactions in the capital market. Given the enormous time and costs necessary to induce the system of capital gains tax on stocks to make a soft landing in the Korean capital market, it is desirable to use a phased approach. More specifically, it is recommended that the current securities transaction tax be phased out to be repealed ultimately before the capital gains tax fully kicks in.

Lastly, Korean tax policy makers should recognize that the overall introduction of capital gains tax on stocks will contribute to higher efficiency in tax incentive policies for venture startups. Taxing capital gains on stocks will enhance readiness to design a variety of tax incentives for facilitating a venture ecosystem. By subjecting capital gains from the QSBS (Qualified Small Business Stock) to tax deductions and tax-free rollovers, the U.S. has improved the effectiveness of its startup incubation policies. This implies the necessity of having continuous discussions on the overall introduction of capital gains tax on stocks in connection with the issue of how to design diverse tax benefits for promoting venture startups and the venture ecosystem.