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A comprehensive regime for taxing capital gains has been a feature of Australia’s personal taxation system for over 30 years.  The rationale for the inclusion of capital gains in the income tax base is now well accepted, although there is less consensus about the extent to which gains should be taxed.

Under current policy, capital gains are treated in a highly preferential manner, at considerable fiscal cost and with negative implications for the equity, efficiency and simplicity of the tax system.  Since 1999, the main preferential policy is the capital gains tax (CGT) 50% discount. Half of the capital gain made by an individual is excluded from assessable income, subject to some conditions (a preference also applies to gains of trusts and superannuation funds).  This preference was introduced in 1999, replacing the former rule that taxed only real gains, indexing the cost base to inflation.

The Henry Tax Review in 2009 recommended (Recommendation 14) reducing the CGT discount from 50% to 40% but this was ruled out by the Labor Federal Government at the time.  The 2014 Murray report into the financial system considered (though stopped short of recommending) the removal of the CGT discount, and the government Re:Think Tax Discussion Paper issued in March 2015 posed the question: ‘To what extent is the rationale for the CGT discount, and the size of the discount, still appropriate?’

An alternative approach

We recommend removing the CGT 50% discount and, in its place, introducing a CGT-free threshold, usually referred to as an annual exempt amount (AEA).  Our modelling, discussed below, suggests that this would enhance the equity, efficiency and simplicity of the tax system and would also result in an overall revenue gain for the government.

What is an annual exempt amount?

The proposed AEA would allow individual taxpayers to qualify for a complete exemption from any CGT liability by meeting one of the following two criteria:

  • the net capital gain for the income year is equal to or less than the AEA. We model the fiscal implications for two possible AEAs, $10,000 or $1,000; or
  • the total capital proceeds from all relevant CGT events for the personal taxpayer in the income year are equal to or less than an amount which is twice the AEA.

The AEA would operate as a CGT-free threshold for those taxpayers with a net capital gain in excess of the threshold.  It will allow taxpayers with net capital gains above the AEA threshold to reduce their taxable capital gain by the amount of the AEA.  However, like the tax-free threshold for income tax, the CGT AEA is non-cumulative.  If an individual taxpayer is unable to use part or all of the AEA in a given tax year, it cannot be carried forward or backward to other years.

Why would an annual exempt amount be better than a CGT discount?

The case for the removal of the CGT 50% discount and its replacement with an AEA is based on the three traditional criteria of equity, efficiency and simplicity. 

Equity

The essential reason for introducing regimes for taxing capital gains is one of equity. The current CGT 50% discount savagely offends both horizontal and vertical tax equity.

For example, a share market or property investor with gains of A$1 million made over a 5 year period (ie A$200,000 per annum) would lose less than a quarter of the proceeds in tax as a result of the discount; in comparison an employee earning A$1 million over that same five year period (ie earning A$200,000 per annum) would lose nearly half in tax.  This different outcome for similarly situated taxpayers contradicts horizontal equity.

The current CGT 50% discount operates as a tax rate reduction and the most significant benefit is obtained by high-income taxpayers.  This is contrary to the principle of vertical equity that underpins our progressive income tax.  The existence of the CGT 50% discount can result in marginal tax rates which are merely theoretical, especially at higher levels of income.  This is because, as the proportion of discount capital gains included in assessable income increases, the effective marginal tax rate of the individual taxpayer decreases.

There are strong equity grounds for the introduction of an AEA.  In terms of horizontal equity, the exemption remains a fixed amount regardless of the size of the gain and so does not have the capacity to produce the anomalous horizontal equity outcomes that can emerge applying the CGT 50% discount.  The AEA is superior on vertical equity grounds because it caps the tax preference available to higher-income taxpayers.  An AEA of $10,000 will save taxpayers on the highest marginal tax rate of 49% a maximum of $4,900, in contrast to the open-ended benefit of the CGT 50% discount.  The larger the capital gain, the less effect the AEA will have on reducing tax liability, consistent with the basic premise of a progressive tax system. 

Efficiency

A tax system is usually described as economically efficient to the extent that it does not, of itself, alter individual taxpayer behaviour.  Removing the CGT 50% discount achieves increased efficiency because the deadweight costs associated with tax planning aimed at characterising income as capital gains are removed from the tax system.  It is well recognised that a large difference between the tax rate on ordinary income and capital gains encourages taxpayers to devise schemes to re-characterise the former as the latter (see Ingles (2009) and Evans (2002)).

An efficiency benefit of an AEA is that for lower income taxpayers with small capital gains, there is more of an incentive to realise these gains in comparison with the current CGT regime.  This is because in doing so there will be no CGT liability.

The introduction of an AEA, accompanied by the abolition of the CGT discount, is unlikely to have detrimental effects on overall efficiency. Although the reduced incentive for higher income taxpayers to realise capital gains is, prima facie, a distortion which would decrease efficiency, the removal of the incentive to convert income into preferentially taxed capital gains would be expected to increase efficiency. Such countervailing efficiency effects of a CGT rate increase were discussed by Auerbach (1988). 

Simplicity

A system that taxes capital gains like other forms of income at the same marginal rate has obvious simplicity benefits.  The CGT 50% discount, apparently simple in concept, can cause significant complications in practice.  CGT is a complex tax in other ways and imposes significant compliance costs on individual taxpayers.

One of the most effective ways of achieving some measure of simplicity is to minimise the number of taxpayers who are liable for CGT.  The replacement of the CGT 50% discount with an AEA in Australia would remove from the CGT net the majority of individual taxpayers who have a CGT liability under the current system (and derive small capital gains in any event).  Table 1 shows the high proportion of taxpayers who would no longer face a CGT liability at the two proposed levels of an AEA threshold.

 


Table 1          

Taxpayers removed from CGT regime as a result of introducing an AEA (2012-13)

  Annual Exempt Amount (A$)
10,000 1,000
Percentage of taxpayers removed from ‘CGT net’ 71% 43%

Source: Author modelling based on ATO Taxation Statistics 2012-13


 

The relative benefits of increased simplicity far exceed the relatively small cost of forgone tax revenue from these individuals with low gains, as we explain below.  This is because although the largest dollar amounts of capital gains accrue at higher levels of income, there are a higher number of taxpayers with taxable net capital gains of below $10,000 than with taxable net capital gains of $10,000 or more.

What are the revenue implications?

The tax revenue implications of replacing the CGT 50% discount with an AEA derive from four sources.

 First, there is a ‘first round’ or static revenue effect in the form of an annual revenue benefit for the government that will derive from the removal of the CGT 50% discount.  This measures the tax revenue currently foregone on an annual basis by the government as a result of excluding half of eligible capital gains from taxation.

Second, there is a ‘second round’ or dynamic revenue effect in the form of a revenue cost or benefit to the government as a result of behavioural responses by taxpayers to the change in the rate of taxation of capital gains on removal of the CGT 50% discount (effectively a doubling of the tax rate).

Third, there is a ‘first round’ or static revenue effect in the form of an annual revenue cost for the government from the introduction of an AEA.  This measures the tax revenue that will be foregone on an annual basis by the government as a result of excluding a certain amount of capital gains (dependent upon the level at which the AEA operates).

Fourth, there is a ‘second round’ or dynamic revenue effect in the form of a revenue cost or benefit to the government as a result of behavioural responses by taxpayers to the introduction of an AEA.

We calculated the revenue effects for the first three sources above with some degree of reliability, drawing on data from the ATO 2012-13 Taxation Statistics and other sources.  It was not possible to calculate precisely the fourth matter being the dynamic effects of the introduction of an AEA.  However, we suggest this does not prevent a conclusion being reached based upon the data available on the likely revenue effects of the reform package.

Table 2 below confirms that replacing the CGT 50% discount with an AEA results in an overall net revenue gain, from static and behavioural responses.  This conservative estimate, assuming a moderate behavioural response, is an overall revenue gain in 2012-13 of $1.162 billion where the AEA is set at $10,000 and an overall revenue gain of $1.647 billion where the AEA is set at $1,000.  The revenue cost of the AEA is a fraction of that of the CGT 50% discount and so the proposed reform is clearly more fiscally sustainable than the current CGT regime.

 


Table 2          

Summary of net revenue effects from the abolition of the CGT discount and the introduction of an annual exempt amount ($10,000 and $1,000): 2012-13

  Annual Exempt Amount (A$)
10,000 1,000
A$ billion
Government revenue benefit of removing the CGT discount  (static): (1) 3.29 3.29
Government revenue benefit of removing the CGT discount (dynamic): (2) 1.74 1.74
Government revenue cost of introducing an AEA (static): (3) (0.578) (0.093)
 Net increase in government revenue (static): (1)-(3) 2.712  3.197
 Net increase in government revenue (dynamic estimate of benefit of removing CGT discount, less the static estimate of cost of AEA introduction): (2)-(3)  1.162 1.674

Source: Author modelling, ATO Statistics 2012-13


 

An improvement to Australia’s CGT system

Our proposal to replace the CGT 50% discount and in its place to introduce an AEA could enhance the equity, efficiency and above all the simplicity of the regime for taxing individual capital gains in Australia. It could remove more than two thirds of existing individual taxpayers currently exposed to the ‘pain’ of the CGT regime, with the bonus for the government of a net revenue gain.

We estimate that the reform could contribute between $1.16 billion and $1.65 billion to Treasury coffers, depending upon whether a $10,000 or $1,000 AEA were adopted and upon assumptions about possible behavioural responses.  The additional revenue would provide some welcome relief to a government facing revenue deficits and financial constraints.

Ultimately, the decision as to whether to replace the CGT 50% discount with an AEA will likely depend, not on arguments about equity, efficiency and simplicity or on the fiscal outcome. While these will be important, reform will depend upon arguments based upon political ideology and upon the existence of a political champion prepared to drive through the change against vested sectional interests.

Opposition to such a reform is likely to originate from the wealthier sections of society who enjoy disproportionately higher benefits from the CGT 50% discount.  Nevertheless, the reform package may find such a political champion in the current political climate where reducing the budget deficit appears to be a priority of the government. This reform could lead to improved outcomes for the tax system and for Australia as a whole.

This article is based on Evans C, Minas J and Lim Y, 2015. Taxing personal capital gains in Australia: An alternative way forward, Australian Tax Forum. (2015) 30, 735-761.

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