'Unearned income' targeted for filling fiscal gap left by welfare budget

By Kim Da-ye

A big change after the global financial crisis in 2008 was the hostility against “making money from money.”

Amid protests against financial industries across the world, Korea is poised to become heavily affected by this sentiment.

While relatively little profiteering by banking giants has been observed here, this is a presidential election year with interest in welfare peaking.

Politicians are seeking to boost welfare-related budgets and found easier targets to fill up the resultant huge fiscal hole than increase in taxes on wages or corporate taxes.

The method of choice is taxes on financial activities and so-called “unearned incomes.”

Tax reforms suggested by the ruling Saenuri Party encompass three major areas _ taxation on income from financial assets, on profit from selling stocks and on trading derivatives.

In Korea, people who make more than 40 million won of profit from financial assets including interests and dividend payments have to report such types of income. The amount will be added to the “composite income” which determines their final tax brackets. In other word, people who make 40 million won or less from their financial assets are waived from the possibility of paying a lot more tax.

The ruling party made a commitment during the general election campaign that that boundary will come down from 40 million won to 20 million won by 2015. As early as next year, that boundary could be revised down to 30 million won.

The conservative party also wants more of the “stock-rich” to pay taxes on profits made from buying and selling shares.

The existing law imposes such taxes on shareholders who own 3 percent or more of a KOSPI-listed firm’s equities, or stocks of a KOSPI-listed firm worth 10 billion won or more. For shareholders of KOSDAQ-listed companies, those limits are 5 percent or more and 5 billion won or over.

The ruling party pledge says that the limit for a shareholder of a KOSPI-listed firm will be revised down to 2 percent or more or 7 billion won or over; and that for a KOSDAQ-listed company’s shareholder to 3.5 percent or 3.5 billion won.

The current tax rates for a qualifying major shareholder are 10 percent on profits from trading stocks of small- and medium-sized enterprises; 20 percent on stocks of large corporations; and 30 percent on shares of large corporations that have been owned by the seller for less than a year.

The most contested change to the taxation system would be the introduction of transaction taxes on derivatives traded on the Seoul bourse.

The Saenuri Party advocates collecting 0.001 percent on the sales of derivatives as tax _ the opposition Democratic United Party wanted the rate at 0.01 percent.

The government is also interested in tax reform on financial income. The Ministry of Strategy and Finance created a new financial income taxation team within its tax department earlier this year.

The team confirmed that taxation on financial income, on profit from selling stocks and on trading derivatives is under review along with other types of levies for a broader reform of the taxation system.

An official at the team said that now is not the time to discuss the progress of or a government preference for a particular type of a tax. He neither denied nor confirmed a recent report that the government outsourced research on taxes on profits from stock trading to the Korea Institute of Public Finance.

“We won’t deal with each type of tax separately, but they will be part of our annual revision of the taxation system,” the official said.
The move to levy taxes on financial activities and profits is observed globally. European countries are debating if the eurozone should adopt financial transaction taxes for stocks, bonds and derivatives.

French President Nicolas Sarkozy said earlier this year that France will impose a 0.1 percent financial transaction tax, beginning in August, regardless of other countries’ decision to join the move.

For vs. against

The least popular revision to the tax system is taxation on those who make more than 20 million won a year in interest and dividends.
It will no longer be just the wealthy but also the middle class that have to report incomes from financial assets and get them taxed along with other types of income including that from labor and from running own businesses.

It is, however, drawing less debate and scrutiny from the industries than the other two are.

In the case of taxation of profits from trading stocks, the Saenuri Party’s proposal still targets major shareholders with a significant size of wealth in equities.

Doing so for an even broader spectrum of investors is likely to face much resistance, and the government, industry and regulators have been studying its pros and cons.

Kang Jong-man, a research fellow at the Korea Institute of Finance, is the latest expert to comment on the reforms. He wrote in his latest column favorably on the taxation of profits from speculative short-term trading.

Speculative short-term trading boosts liquidity in the markets and brings brokerage houses good revenues in fees, but could cause damage to retail investors and heighten the volatility of markets, he argues.

Kang said that for Korea’s stock market to improve in quality, taxation of profits from short-term trading could help encourage long-term investment and stabilize it.

In the short term, securities firms would suffer from shrinking revenues because many Korean institutions have been focusing on brokerage services without effectively diversifying their services, Kang said.

In the long run, however, they will be forced to develop better financial products that eventually contribute to a stable capital market, he said.

Kang acknowledged the method could temporarily deal a blow to the stock market, so the range of qualifying taxpayers should broaden gradually.

“For instance, investors who sold stocks worth 1 billion won may be taxed for stocks that they held for less than six months,” Kang said.
The more controversial part of the expansion of tax revenue is the introduction of transaction taxes on exchange-traded derivatives.
The revision of the Securities and Exchange Taxation Act was submitted by policymaker Lee Hye-hoon of the Saenuri Party back in August 2009.

It passed the National Assembly Finance Committee in December 2009 and the Judiciary Committee in March 2011, but failed to reach the plenary session of the 18th National Assembly that ends on May 29.

The purpose of the revision is taxing fairly and equally across securities, cooling down speculation in the derivatives market and boosting tax revenue.

Various interest groups, however, said that the losses caused by the revision could defeat the benefits.

The main argument from the opposition _ the industry _ is an inevitable contraction of the derivatives market.

Derivatives are usually traded without full payments for their value but with deposits that are just a small portion of the total value.
The tax rate suggested by the Saenuri Party at 0.001 percent may look minuscule, but it would boost transaction costs by 67 percent, according to the Korea Exchange (KRX).

In addition, arbitrage, a common method for trading derivatives, would no longer make a profit, driving out a significant portion of investors.

Arbitrage involves making profits from differences in the spot price of an asset and the price of the related derivatives. Because those differences tend to be tiny and last for a short period of time in an efficient market, the profit is accumulated through diminutive gains from high frequency trading.

A 0.001 tax rate could kill that small gain, taking away the purpose of arbitrage.

A survey by the Korea Financial Investment Association found that a majority of the respondents expect trade volume to decrease by over 30 percent.

The KRX is concerned that investors are likely to flock to overseas markets and replace Korean-developed derivatives with their foreign counterparts.

The Seoul bourse adds that a weak derivatives market would eventually lead to the shrinking of the stock market as derivatives are usually bought with underlying assets for hedging risks.

The other side of the story is the capital market that is already suffering from multiple sets of new regulations this election year.
The KRX’s derivatives division had been proud of being one of the most liquid markets in the world. The pride has turned to the stigma of being a highly speculative market.

The equity-linked warrant (ELW) market, for instance, has dramatically shrunk after new regulations restricted liquidity providers from actively making bids and asks.

What does it mean to savers and retail investors?

Kim, a 58-year-old retiree who used to work at a large conglomerate, makes more than 20 million won but less than 40 million won from his financial assets, mainly equity-linked securities.

“I would be happy to pay taxes if the government makes sure they collect them fairly and equally. They need to ensure certain professionals including doctors and lawyers all pay tax,” Kim said.

The retiree added that the government should consider the elderly who heavily depend on their savings instead of pensions.

Foreign investors’ solution for heavier taxation in the capital market and less profit could be simply moving to other markets while domestic retail investors, particularly pensioners who live off savings, would be directly affected by the change and left with few alternatives.

Such revisions to the taxation system will change the way people manage their money, and savvy retail investors have already begun restructuring their portfolios.

Investors are recommended to mix financial products that are exempt from taxation and those that could be separately taxed without being included in calculating general income tax.

For instance, a high-income earner may purchase bonds that mature in 10 years or longer and request to deduct withholding tax from profits from the bonds.

The profits from certain types of securities such as 10-year bonds do not need to be included in the investor’s financial income and therefore his general income. If the investor’s income level is on the border of the highest bracket, the separate taxation method could be advantageous.

Kim, however, finds assets qualifying for tax exemption unattractive because they often have to be held for 10 years or longer and their managers ask for fees.

“Most financial products exempt from taxation are life insurances, which involves fees. For now, I do not see much value in investing in them,” Kim said.