Alternative methods for adjusting realization based capital gains taxes

Capital gains taxation on a realization basis is known to give rise to a number of distortions and to several arbitrage opportunities that can result in a significant erosion in the tax base. Most countries tackle these problems through a series of "ad hoc" adjustments to "pure" realization based taxation, such as separate treatment of ordinary income and capital gains, reduced tax rates on long-term capital gains, limited loss offsets. The theoretical literature proposes several methods which may provide a more comprehensive solution along the lines suggested by Vickrey (1939) and Meade (1978). However no country, except Italy, have experimented any of these methods. This paper reviews the alternatives in order to evaluate them primarily on the basis of compliance and administrative costs and political feasibility. The analysis highlights that most of the difficulties in the implementation of any of the comprehensive solutions are related to the taxation of intermediate payments such as dividends. This issue has been relatively neglected by the existing literature. We show that no proposal may overcome all the objections raised in the literature and in the debate on the Italian experiment. Each method should be judged as a second best solution and evaluated with reference to a specific institutional and economic environment.