Capital gains tax

A capital gains tax (CGT) is the tax on profits realised on the sale of a non-inventory asset. The most common capital gains are realised from the sale of stocks, bonds, precious metals, real estate, and property.

Not all countries impose a capital gains tax, and most have different rates of taxation for individuals compared to corporations. Countries that do not impose a capital gains tax include Bahrain, Barbados, Belize, the Cayman Islands, the Isle of Man, Jamaica, New Zealand, Sri Lanka, Singapore, and others. In some countries, such as New Zealand and Singapore, professional traders and those who trade frequently are taxed on such profits as a business income.

Capital gains taxes are payable on most valuable items or assets sold at a profit. Antiques, shares, precious metals and second homes could be all subject to the tax if the profit is large enough. This lower boundary of profit is set by the government, and if the profit is lower than this limit it is tax-free. The profit is in most cases the difference between the amount (or value) an asset is sold for and the amount it was bought for.

The tax rate on capital gains may depend on the seller's income. If any property or asset is sold at a loss, it is possible to offset it against annual gains. For equities, national and state legislation often has a large array of fiscal obligations that must be respected regarding capital gains.

The CGT can be considered a cost of selling which can be greater than, for example, transaction costs or provisions. The literature provides information that barriers for trading negatively affects the investors' willingness to trade, which in turn can change asset prices.

Companies with tax-sensitive customers are particularly reactive to capital gains tax and its change. CGT and changes to it affect trading and the stock market. Investors must be ready to react sensibly to these changes, taking into account the cumulative capital gains of their customers. They are sales must be delayed due to an unfavorable market conditions caused by capital gains tax. A study by Li Jin (2006) showed that great capital gains discourage selling. On the contrary to this fact, small capital gains stimulate the trade and investors are more likely to sell. "It is easy to show that to be willing to sell now the investor must believe that the stock price will go down permanently. Thus, a capital gains tax can create a potentially large barrier to selling. Of course, the foregoing calculation ignores the possibility that there might be another taxtiming option: Given capital gains tax rates fluctuate over time, it might be worthwhile to time the realization of capital gains and wait until a subsequent regime lowers the capital gains tax rate."

Because capital gains are taxed only upon realization, an individual who owns a security that has increased in value may be less likely to sell it. The seller knows that when sold, tax is levied on the positive difference of the price at which the security was bought and the price at sale. If the seller chooses not to sell, the tax is postponed to later date. Postponing allows more time for the security to grow in value and generate returns. If the seller delays the sale, though the absolute value of the tax is greater than if they had not delayed, the present discounted value of the tax is reduced; thus allowing the security to grow undoes the tax. Therefore, the seller has an incentive to hold the securities longer than they would have without capital gains tax. This distortion has been called the locked-in effect or lock-in effect.

Martin Feldstein, former chairman of the Council of Economic Advisers under President Reagan has claimed that the effect is so large that reducing the capital gains tax would lead individuals to sell securities that they previously had refused to sell, to such an extent that government revenues would actually increase.^{[citation needed]} 1994 estimates suggest that a permanent reduction in the capital gains tax rate would have little effect.