The disaster that is unrealised capital gains tax

The idea of taxing unrealised capital gains is both beguiling in its apparent simplicity and profoundly dangerous in its practical consequences.  

While this is not policy in South Africa, it is understood that this notion has in recent times enjoyed serious consideration within the precincts of National Treasury. As with expropriation without compensation, the mere discussion of it may do huge harm to investor confidence. 

Let us be clear: the taxation of unrealised capital gains is a fiscal mirage. It seeks to extract revenue from bookkeeping entries rather than from real, crystallised economic value. As such, it violates both the spirit and the letter of sound tax policy and risks unleashing a cascade of economic distortions. 

At its core, the concept of unrealised gains refers to the paper appreciation of an asset. But such gains are both contingent and reversible. To tax them is to ascribe permanence to that which is provisional, and to treat as realised that which remains entirely theoretical. 

This is not just semantics; to be just, taxation must attach to real economic events – transactions in which real value has been transferred, risk undertaken and liquidity generated. To tax notional appreciation is to sever the link between tax liability and economic capacity, and thereby to undermine the very legitimacy of the tax system itself. 

Perhaps the most immediate consequence of such a policy is the imposition of tax liabilities in the absence of any corresponding liquidity. In other words, investors would be compelled to pay tax on gains they have not realised and may never realise. In practical terms, investors without a hoard of free cash would have to sell assets to meet tax impositions.  

These “fire sales” would likely depress asset values and could generate permanent distortions in capital markets. 

As a result, the state ends up cannibalising its own future revenue by engineering a regime of forced disposals, which would reduce the amount of genuine capital gains ultimately realised.  

Financial markets may become subject to new levels of artificial volatility where investors, rationally seeking to avoid punitive liabilities on phantom profits, begin to time their buying and selling, not in accordance with economic fundamentals or investment horizons, but in response to tax-year considerations and projected valuations. 

This distorts asset pricing and subverts the efficiency of the market. Capital is misdirected, not towards its most productive uses, but misallocated towards those assets most easily valued or least likely to attract taxable appreciation. The consequence is a degradation of investment quality and a misalignment of capital with national development priorities. 

An administrative nightmare

And then there are the deep administrative implications of such a regime. The annual valuation of illiquid, bespoke or complex assets, ranging from private equity holdings to intellectual property, to fine art and land, would require armies of auditors, assessors and litigators. These valuations may be subject to dispute, manipulation and contestation, further clogging an already strained revenue service. 

The revenue service would also have to take into account the costs of compliance, professional fees, appraisals and administrative overheads. This is deductible against income, thereby diminishing the net yield of the tax. In fiscal terms, this is a pyrrhic policy. 

In a globalised economy, capital is neither blind nor immobile. It moves towards friendly jurisdictions that exhibit stability, predictability, and respect for the sanctity of property and the logic of markets. The imposition of a tax on unrealised gains would place South Africa squarely in opposition to these principles. It would broadcast to the world a signal of fiscal caprice and of regulatory hostility to investment. 

The consequences would be immediate and far-reaching. It would see the withdrawal of foreign direct investment, the accelerated offshoring of domestic capital, and the further systematic erosion of the very tax base such a policy purports to enlarge. Investors do not respond well to expropriation, even when disguised as taxation. 

What’s more, any regime that seeks to tax unrealised gains runs the risk of imposing double taxation: once on the notional appreciation, and again upon realisation. This, too, would be an administrative nightmare and the burdens of proof, record-keeping and reconciliation would fall disproportionately on smaller investors and entrepreneurs. 

Sound tax policy rests on the cardinal principles of neutrality, equity, certainty and simplicity. The taxation of unrealised gains violates each of these: 

• Neutrality is destroyed when tax policy distorts investment behaviour. 
• Equity is undermined when taxpayers with no liquidity are asked to pay tax. 
• Certainty is obliterated when liability is based on subjective valuations. 
• Simplicity is sacrificed on the altar of administrative complexity. 

A tax system that violates these principles ceases to be a system of justice, and becomes a system of extortion and predation. 

South Africa does not suffer from a shortage of tax instruments. It suffers from a shortage of capital investment, investor confidence and growth. These cannot be conjured into existence through fiscal sleight of hand. They require a tax regime that respects capital, that honours real returns and that adheres to the foundational principles of sound economic policy. 

Temba A Nolutshungu is president of the Free Market Foundation.

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