It looks increasingly likely (though it is by no means certain) that Treasurer Jim Chalmers will make changes to the capital gains tax discount in the forthcoming Budget on May 12. At the moment individuals who have held an asset for at least 12 months receive the benefit of a 50 per cent reduction in the capital gains tax bill they would otherwise pay when they dispose of assets, such as shares, real estate, crypto or other forms of property.
Informed opinion suggests that this discount may be reduced in the Budget, perhaps to 33 per cent or 25 per cent, or that it might even be abolished entirely. At the same time, it is suggested that there may be some claw back on the very generous negative gearing benefits that – together with the discount – may have helped to turbo-charge speculative investment in property and produced inflationary pressure on housing prices.
Why was the discount introduced and did it work?
The capital gains tax discount was introduced over a quarter of a century ago by the then Treasurer, Peter Costello, with the aim of encouraging investment (particularly in shares), compensating for inflation, and improving international competitiveness. These were dubious aims and were never likely to be achieved. Instead, research over the last 25 years, which has included studies into who benefits most from the discount and examination of the very high costs of this generous tax break, demonstrates that the discount has produced outcomes that substantially diverge from the original policy intent. In summary, the evidence from this body of work demonstrates that the 50 per cent discount introduced in 1999 has produced significant inequities, inefficiencies and revenue losses, while failing to meet the principles of a well-designed tax system.
Why should it be wound back or abolished?
In a nutshell, those are the three reasons the discount must be wound back at a minimum, if not entirely abolished: it is unfair, inefficient and too costly. It is not fair that a high-wealth individual who sells a property for a $10m capital gain should receive a tax break of $5m, while an individual selling a few of Telstra shares for $1,000 capital gain gets only a $500 benefit. That outcome offends the principle of vertical equity (those with a greater ability to pay, should pay more); and – more tellingly – it offends the principle of inter-generational equity, given that those at the top end of the income and wealth scales are far more likely to be older and to make large capital gains compared to those who are younger and who make much lower, if any, capital gains.
And if vertical and inter-generational equity are not enough justification for reducing or abolishing the discount, there is also a problem with horizontal equity: the notion that those with equivalent levels of income from different sources should pay the same amount of tax. Way back in the 1960s a tax review in Canada came out with the famous line that “a buck is a buck is a buck”. So the dollar I earn from my employment or business is no different from the dollar I receive in bank interest or the dollar I receive from selling an asset – they should all be taxed the same. Yet at the moment we only tax 50 cents of the dollar I receive from selling my asset compared to the full dollar that is taxed for the other forms of income I receive. How is that fair?
The existence of the discount is also inefficient because it distorts the principle of neutrality. Individuals will be much more likely to invest in a safe asset such as an investment property rather than in other potentially productive and profitable endeavours (such as starting up a business) when they know they will only be taxed at half the rate that would otherwise apply. Add to that the benefits of negative gearing (100 per cent deductions against any other income, which is almost unique to Australia) and it is a no-brainer to invest in a property rather than engage in other activities. Moreover the combination of these two tax breaks tilts the housing market significantly in favour of investors over owners, particularly first-home owners.
And, finally, we come to cost. The discount is one of the biggest giveaways in the Budget. It costs us taxpayers between $20 and $24 billion each year, with the benefit of that generosity (paid for by all of us) enjoyed predominantly by the top wealth holders and income earners in the country. Just imagine what could be paid for in the way of hospitals, schools or national resilience if that $20 billion plus was not going out of the door to the select few.
What are the options for change?
Clearly a reduction in the amount of the discount – whether to 33 per cent or 25 per cent – is a step in the right direction. But all that does is tinker with the problem; it does not solve it. The better option would be to abolish the discount entirely and replace it with the system that prevailed before 1999 of inflation proofing the amount of the capital gain through a process of indexation of the cost base in line with a recognized measure of inflation like the Consumer Price Index. But arguably that is still more generous than needs to be the case; after all we don’t inflation-proof any other parts of the tax system so why should we give preferential treatment to capital gains? One other possible option might be to adopt the solution that prevails in many other countries and simply provide an annual exempt amount or tax-free threshold, on a ‘use it or lose it’ basis, specifically for capital gains. This exempt amount might be something like $10,000 per individual. So our billionaire making a $10m capital gain would pay tax on $9.99m while the person with just a $1,000 capital gain would have no tax to pay. The problems of inequity, inefficiency and the cost to the public purse are all simply resolved.
Are transitional measures needed?
One of the main problems that will arise if changes are made to the discount is the squealing that will inevitably occur if the government seeks to reduce or abolish it. Taxpayers, and particularly the well-heeled, are very vociferous when losing a long-enjoyed perk. Its immediate reduction or withdrawal might also cause unintended consequences if some limited grace period is offered before the change is to be introduced and the market is suddenly flooded with properties that investors are attempting to sell to take advantage of the 50 per cent discount while it still exists.
By the same token, if existing property investors are allowed to keep the full discount so long as they own the property (the so-called grandfathering approach) then they may decide never to sell, locking themselves into what may be an inappropriate investment. Neither outcome is desirable but some transitional messiness may be inevitable and worthwhile in order to remove an unfair, inefficient and costly aberration in the Australian tax system.
Perhaps the most sensible compromise may be to phase out the discount over a number of years, reducing it to 33 per cent in, say, July 2027, 25 per cent in July 2028, 10 per cent in July 2029 finally removing it completely in July 2030. In that way, the perverse outcomes of both market flood and asset lock-in are carefully neutralized as property investors make decisions over time based on rational economic drivers rather than allowing tax factors to determine the outcomes: the tax tail should never be allowed to wag the commercial dog.
This article has been adapted, with permission, from Chris Evans’ original piece “Tinkering with the capital gains tax discount isn’t enough. Here’s why it needs to go” in The Conversation
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