A critical analysis of inflation adjustment in the calculation of capital gains tax in South Africa

Abstract

Inflation is a widespread occurrence in the modern world. Even in very stable economies inflation has increased rapidly over the past 20 years. In South Africa rising food, fuel and power costs will ensure that inflation remains high for some time to come. The income tax system cannot afford to ignore the importance of inflation. Capital gains on assets accumulate over the period the asset was held. The inflationary component included in the capital gain will be bigger the longer the asset is held. Capital gains are taxed only when an asset is sold, thus on a realization and not on an accrual basis. Capital gains are taxed as part of normal income in South Africa. If the annual capital gains are allowed to accumulate over years it might push the taxpayer into a higher marginal tax rate because of the use of a progressive income-tax system. A number of countries used indexation to adjust capital gains for inflation. In some countries indexation has been frozen or abolished and in others it is still used extensively today. Before a system of indexation can be introduced in the taxing of capital gains, a number of key factors should be considered. The benefits derived from inflation adjustment should not be out-weighed by the administrative and compliance cost. In the research it is concluded that South African taxpayers enjoy some limited indirect inflation adjustment. If attention is just focused on the asset side, indexation will create a tax benefit for some taxpayers who will finance the purchase of assets with borrowed funds. The liability side cannot be ignored and therefore further research will be needed to determine if the inflationary interest component should also be disallowed as a deduction for taxpayers. Copyright