CapitalGainsTxnLecture

CapitalGainsTxnLecture - Capital Gains Taxation: Outline...

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1 Capital Gains Taxation: Outline The realization doctrine and its effects Examples of tax avoidance strategies Capital loss deductions Short sales “against the box” Solutions Vickrey taxation Retrospective taxation Generalized cash flow taxation
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2 Capital Gains and Losses Defn: Increases/decreases in the value of assets owned by taxpayers Recall that these are part of “income” under the Haig-Simons definition In practice, however, capital gains are tax- favored in 2 ways: lower tax rate taxes are only paid at the time the asset is sold (when the value is “realized”)
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3 Capital Gains and Losses What is the justification (if any) for this favorable treatment? Would reducing capital gains taxes increase revenue? Who benefits from favorable treatment of capital gains? Do lower capital gains taxes increase economic growth?
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6 Realization Doctrine The tax system generally does not tax changes in asset values until a “realization” event (typically a sale) What are the consequences of realization- based taxation? Lock-in: investors are better off holding their assets for longer periods, leading to suboptimal portfolio choice Opportunities for tax avoidance strategies
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7 Tax Avoidance Strategies (1) Capital gains and losses: arise from the “sale or exchange of a capital asset” e.g. the sale of shares contrast “ordinary income” (salary, interest, dividends etc.) Suppose that capital losses are fully deductible You have salary income of $100, on which you owe $35 of tax Corporation XYZ:
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8 Tax Avoidance Strategies (1) $ Time Now Year-end With prob ½, XYZ’s stock price ↑ by 10 cents/share $1.10 $1 $0.90 With prob ½, XYZ’s stock price ↓ by 10 cents/share
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9 Tax Avoidance Strategies (1) $ Time Now Year-end With prob ½, XYZ’s stock price ↑ by 10 cents/share $1.10 $1 $0.90 With prob ½, XYZ’s stock price ↓ by 10 cents/share Take a perfectly hedged position in XYZ’s stock: • Short sale: borrow 1000 shares in XYZ from a broker; sell the shares (for $1000) • Long position: use this $1000 to buy 1000 shares in XYZ
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10 Tax Avoidance Strategies (1) $ Time Now Year-end • Close the short position (i.e. buy 1000 shares in XYZ for $1100 and “return” the shares to the broker) → realized capital loss = $100 Do not realize the $1000 gain on your long position • Taxable income = Salary – Loss = 100 – 100 = 0 $1.10 $1 $0.90
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11 Tax Avoidance Strategies (1) $ Time Now Year-end $1.10 $1 $0.90 • Close the long position (i.e. sell the 1000 shares you own in XYZ for $900) → realized loss = $100 • Do not realize the $1000 gain on your short position • Taxable income = Salary – Loss = 100 – 100 = 0
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12 Tax Avoidance Strategies (1) In either case, Taxable income = 0 i.e. you can eliminate tax on your salary income Next year, you can buy or sell appropriately to reestablish your perfectly hedged position in XYZ
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13 Tax Avoidance Strategies (1) To prevent taxpayers from using this type of strategy, the US income tax system limits the deductibility of capital losses Capital losses are deductible against capital gains, but only up to $3000 against ordinary income
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This note was uploaded on 05/09/2008 for the course ECON 253 taught by Professor Damika during the Spring '08 term at UConn.

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CapitalGainsTxnLecture - Capital Gains Taxation: Outline...

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