New study: The effect of capital gains tax on the pricing of financial assets
The findings show that the tax increases that took place in Israel had an impact on the composition of the public’s asset portfolio
- Various taxes on alternative financial assets have a tremendous impact on the worthwhileness of investing in those assets, thereby affecting the development of asset prices.
- The findings show that the tax increases that took place in Israel had an impact on the composition of the public’s asset portfolio, reducing direct holdings of financial assets and savings plans and significantly increasing the volume of holdings of demand deposits and SROs.
- An examination of total tax revenue from capital gains on financial assets does not find a positive correlation between the statutory tax rate and actual revenue.
A new study conducted by Dr. Roi Stein of the Bank of Israel Research Department examined how the method of capital gains taxation in Israel affects the pricing of financial assets and the public’s financial asset portfolio. The main characteristic of the method involves separating two tax tracks—those for nominal assets (those not indexed to the CPI), and for real assets (those indexed to the CPI). This two-track method was gradually applied from 2003, following the Rabinovich Committee’s report, as a result of which individuals were charged capital gains tax for the first time. Taxation on real channels (indexed bonds, stocks, foreign exchange securities and options) was initially 15 percent, and taxation on nominal channels (unindexed bonds and deposits at banks) was 10 percent. The tax rates were increased twice since then. The tax on real channels is currently 25 percent, and the tax on nominal channels is currently 15 percent.
The two-track taxation method is unique to Israel, and is intended to reduce the particularly high effective tax revenue during periods of increasing inflation. Many countries use a uniform nominal tax, and in order to prevent an increase of the effective tax during periods of increasing inflation, some of them compensate investors for long-term holdings of financial investments by instituting a certain reduction of nominal tax.
The effect on the pricing of financial assets
Another question examined by the study concerns how the changes in the tax rates affect the composition and volume of the public’s financial assets portfolio, and as a result actual tax revenue. These factors must be examined since tax payments are not only a function of the tax rate itself, but also of the public’s holdings of taxable financial assets of the extent to which it is worthwhile to avoid tax payments.
The findings show that the tax increases in Israel had a sizeable effect on the composition of the public’s asset portfolio, reducing the public’s direct holdings of financial assets and savings plans, and significantly increasing the volume of holdings of demand deposits and SROs. The study also found a significant negative effect on the public’s total direct holdings of taxable financial assets. Moreover, the last increase in tax rates, at the beginning of 2012, accelerated the downward trend in the volume of the public’s direct holdings of such assets. It can therefore be concluded that the most recent increase in tax rates did not necessarily increase the government’s total tax revenue, because the worthwhileness of holding financial assets declined and the tax base narrowed.
An examination of the tax revenue on capital gains from savings plans shows that while the volume of revenue increased relative to the volume of the public’s holdings, it increased less than the tax increase. Moreover, an examination of total tax revenue on capital gains from financial assets does not find a positive correlation between the tax rates and the volume of revenue. These findings indicate that the current tax rates are at a point from which it is possible that an increase will reduce tax receipts. However, it is important to note that the revenue data in the study are not sufficiently detailed by type of asset, and it is therefore difficult to obtain firm conclusions from the empirical findings.
The deviation in the inflationary balance point as a result of the various tax rates on indexed and unindexed bonds*
* The red line indicates the interest rate aggregates at which there is no deviation in the balance point.