Profits from Sales of Securities: Changes to Taxation May Significantly Reduce Returns

The current discussion on the constitutionality of speculation tax, has reignited the debate on the taxation of private capital gains. It is now being considered whether a comprehensive retention tax on interest, dividends and capital gains should be introduced. The Mannheim Centre for European Economic Research (ZEW) has analysed this scenario in a recent study.

As the recent study carried out by the Centre for European Economic Research (ZEW) shows, extending taxation on private capital gains would significantly decrease rates of return for financial products with high shares of securities and long saving periods, such as retirement schemes. As securities constitute only a small proportion of the wealth of the majority of the German population, however, the financial losses experienced as a result of such a change would remain fairly moderate.

In the current German system, investors must pay income tax on profits gained from  the purchase of securities for only one year following the purchase. As soon as the speculative period ends, tax must no longer be paid. In a recent study, ZEW has analysed how abolishing the speculation period and introducing a permanent flat-rate tax of 15 per cent would affect capital gains.  In addition, the effects of introducing a 25 per cent flat-rate tax on interest and of a 25 per cent flat-rate tax on capital gains were also analysed.

The ZEW study was supported by the Citibank Foundation and was based on asset projections from 2003. This data was gathered in 1998 as part of the income and consumption sample testing programme. The study shows that in the case of short-range resale of securities, households with high marginal tax rates would particularly benefit from a flat-rate speculation tax. The reason for this is that the flat-rate tax rate would be applied only to their capital gains, not to their high income tax rate.

Returns, however, would decrease in the long run. Private portfolios consist of significant shares in life insurance schemes and stock shares, the  majority of German investors would not therefore be significantly affected. Changing taxation on capital gains would nevertheless cause great losses in the returns for retirement planning by stock-oriented investment saving schemes. Given a final withholding tax of 15 per cent on capital gains, a sample calculation shows that the returns gained from an annual saving contribution of 1,000 euros over a 35-year period would decrease by more than 20,000 euros. The sample is based on average returns of shares and pensions from 1993 to 2002.

Introducing a flat-rate withholding tax on capital gains would essentially have the opposite effect. It would lower the tax burden on capital gains, but would not compensate for the effects of reforming increment value tax. Because of a progressive income tax rate, households with a high income would benefit the most from flat capital income taxes.

The analysis is available for download online  ZEW documentation no. 03-08

Contact

Dr. Peter Westerheide, E-mail: westerheide@zew.de