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Posted on 3 Nov 2015 by Gareth BrownIt’s great to see the Turnbull government embracing the idea of tax reform. It will likely cost me a few extra dollars each year, but ironing out some of the distortions and inequities in our tax system makes a lot of sense.
The public discourse on matters ranging from negative gearing to large superannuation balances has, for the most part, been well reasoned and intelligent. But discussions around the special treatment of long-term capital gains, which are important and should be on the table, inevitably miss an important point.
The talk around capital gains tax focuses on what’s seen as the “capital gains tax discount” introduced in 1999 by the Howard government. Read any media piece on the topic and you’d swear that everyone who has paid any capital gains tax since 1999 has only paid half what they would have in a pre-1999 system.
In conjunction with negative gearing, it is blamed for severely distorting the property landscape in Australia (not without some justification). Because most capital gains taxes are paid by well-off folk such as the Prime Minister and – to a lesser extent – me, it seems a logical topic for discussion.
My bone is that nobody seems to discuss the abolition, also in 1999, of the system of inflation indexing. In short, the old system used to tax capital gains at your full marginal tax rate, but it taxed real (after inflation) gains. The new system taxes capital gains at a lower rate, but it taxes nominal (pre-inflation) gains.
The public discussions suggest that the 1999 tax changes saved everyone 50 per cent on their capital gains tax bill. The only world in which that would be true was if inflation was zero. It’s not. According to the Reserve Bank’s inflation calculator, inflation has been running at an average of 3.0 per cent a year since 1999. An investment of $1,000 in 1999 would need to be worth $1,550 today just to maintain purchasing power in real terms.
Reality of 1999
The reality of the 1999 changes is this.
If you sell an asset that has appreciated more than twice as much as the inflation rate (the $1,000 you invested in 1999 has grown to $2,100 or more, versus $1,550 if it grew at the inflation rate), good on you for the smart investment and, by the way, you’ll pay less tax than you did under the pre-1999 system (but more than half, because inflation wasn’t zero over your holding period).
If you sell an asset that has appreciated at between one and two times the rate of inflation over its holding period, I’ve got bad news. You’ll pay more tax than you would have under the old system.
Oh, and if you sell an asset that has grown at less than the rate of inflation, guess what – you’re now paying capital gains tax where you would once have paid none – an infinite, and unfair, increase.
These changes introduced a new distortion – higher risk-higher return investment was preferenced over lower risk-lower return investment. It was the pensioner who positioned their portfolio with the humble aim of maintaining purchasing power in a way that incurs the lowest risk possible that really got sucker punched.
Raising long-term capital tax rates while reintroducing indexing would remove this distortion and make a fairer system. Go for it, I say. In my eyes, the person who invested $1,000 in 1999 and sold that assets for $1,550 this year has made zero real gain, and should pay no tax on it. Anything above that should be taxed fairly.
New distortions
Raising long-term capital tax rates without reintroducing indexing, however, would make the system less fair than either today’s or the pre-1999 system, and introduce new distortions.
Most systems around the world tax capital gains at a lower rate than income from work, and often lower than passive income such as bank interest, for a reason. That’s because pay on work done today is largely protected against inflation – in an inflationary environment your wage will go up. Long-term nominal capital gains, however, are partly a mirage – some or even all of the gain is not a genuine wealth-increasing profit but merely the maintenance of purchasing power in a world where inflation exists. Long-term capital gains discounts indirectly acknowledge this fact. Inflation indexing directly acknowledges it.
The potential distortions introduced by raising the capital gains tax rate without reintroducing indexing are large. For one, Australian company payout ratios – already high by international standard – will rise inextricably, as close as they can get to 100 per cent. How could it be any other way? Shareholders and their boards would be crazy not to preference the dollar earned and taxed fairly today over reinvesting that dollar for an uncertain gain and unfair taxation tomorrow.
Australia can make big bounds towards being more agile and innovative, and yes that volatility can be our friend if, as Malcolm Turnbull has noted, we are “smart enough to take advantage of it”. With the end of the resources boom we’re sure going to need it.
But we won’t get there without investment, without people prepared to put down capital with a long-term perspective for an uncertain payoff. That will require taxing capital gains at least fairly, if not preferentially. Discussions centred on raising the capital gain tax rate without recognising the need to reintroduce indexing, are a large step in the wrong direction.
First published as Think twice before changing CGT on afr.com.
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Great article, Gareth!! Like simple things explained simply 🙂
Agree totally.
Because we are currently in a low inflation environment everyone seems to have forgotten that inflation is real and will at some stage become a bigger issue again.
There was another change in 1999. The averaging provision was also done away with. This allowed the tax to be calculated as though the gain was spread over several years (recognising that capital gains can represent a large but very infrequent chunk of income).
Costello sold the changes on the basis of administrative simplicity – some gains (the discount – for individual non-trader taxpayers only) and some losses (loss of indexing and averaging) but simpler to administer. Probably too simple.
The current system introduces significant distortions (including for instance people putting off selling an asset until they have a low income year, or even taking a year off work when selling a very large asset such as a house).
However, the current debate risks (on the basis of some of the discussions going round) just swapping these for worse distortions. As you say – either leave it alone or address it properly and permanently.
Nice piece Gareth.
Capital gains on retained earnings are basically a form of double taxation already. You pay company tax on earnings, and then, if reinvested, investors are subject to capital gains on the reinvested earnings.
Drop the 50% discount and you’d want to pay out every cent from a company that you could.
Great article and in some ways sets the problem of tax reform in context.
My concern is that those that are paying capital gains tax are also not immediately compensated if they end up with capital losses that exceed capital gains. So a very bad event can mean you don’t recover the tax component of the loss either.
I must say I am more disturbed then you are about the whole tax debate: Often it seems to me that I have to accept that I must pay high taxes because I am more fortunate than most. Where is the reward for taking risk – Are we to end up where the incentive to take a calculated risk and reward is not worth it.
In addition I have two siblings – One will be dependent upon the state pension and the other not. The one who will be dependent upon the state pension has made life choices that have put them in this space – they have had more holidays (Probably 2 to 1 ratio) than the rest of us. They have borrowed to do this. We have not – yet we are to be punished because we saved.
I must say there are moments when I think this is going to lead to many going to live elsewhere – me included. I get the impression to succeed is sometimes seen as sleazy.
Why should capital gains be discounted for inflation if bank interest and company distributions are not? If indexation is added only to capitals gains, this itself will create another distortion.
I think you implied that some kind of discount on capital investment is required to motivate investment into the riskier sphere of productive enterprise (versus passive bank investment which is lower risk). Shouldn’t the potential higher return of the active investment into a business be reward enough to justify that risk? (And therefore the risk will be priced appropriately).
Even in the area of company earnings, there is presently a distortion between dividends and capital retention. If company earnings are distributed, they are taxed at the share-holder’s marginal tax rate (forget about the franking credits, they are just a pass-through mechanism), whereas by retaining earnings, the capital gain is currently discounted (and would still have an indexing discount under your proposal.)
Removing all tax distortions would see that risk priced correctly (and hopefully might curtail some of the over-ambitious growth aspirations of those companies which seem to regularly destroy shareholder value). Just pay the earnings out as a dividend (without the present tax penalty on dividends) and let the shareholder decided where to invest it next.
Thanks for the great article. Very thought provoking. Keep up the good work.
I’m not sure I follow your reasoning Franco. Distributions, bank interest and wages are current income, earned that year and taxed that year. I don’t see how you can index a current income. Capital gains is the product of, sometimes, multiple years and is thus more directly subject to erosion by inflation. I’d be happy to give up the discount as such, as long as the Government taxed real (after inflation) capital gains, not nominal capital gains. If anything, I’d say that the distortion today for corporate Australia is already to underinvest and overpay dividends (it surely has been for the banks). The idea of paying out 100% dividends and letting shareholders decide is one worth considering, though I fear shareholders and managements might become even more short-term focused and that’s probably not a good thing. It would also need a mechanism for clawing back past tax payments in instances where a new venture is a failure (currently offsettable against other capital gains, to a degree), else there would be a significant disincentive to ‘rolling the dice’ on any new ventures. Discouraging risk taking through the tax system would be a shame.
Brilliant post Gareth and as usual 110% correct, maybe more!
It follows on form your blog of a year or 2 ago about how the loss of indexation disadvantaged many and to further distort the matter by adding a higher capital gains tax could compound this.
Your blog last year made me review the family portfolio and I had a queasy feeling that Charlie Munger was right in referring to unrealised capital gains as a ‘tax free loan’ and to take advantage of them (i.e. the tax free loan).
Have now taken this to mean don’t take capital gains and indeed would probably have been better off if we hadn’t; should only have re-invested dividends into better options.
However, looking at the wider share-market and the general loss of confidence in it since the GFC (a recent update from Vanguard noted Aussie adults with direct shares has fallen from 40% to 30% in a decade), a major tax revamp of capital gains in shares and I presume property could have an un-intended severe impact.
It would be grand-fathered for currently held investments so the consequences will take a while to appreciate but perverse outcomes are likely. If it goes ahead it penalises investments and in this low inflation environment surely raises the chance of deflation or worse.
Franco makes a good point. To remove distortion, an inflation adjustment should be made against all forms of return on capital. If you invest $100 in an environment where inflation is 2 per cent, the first $2 of return shouldn’t be taxed, whether it comes in the form of capital gain, dividend, interest etc.
Wages are different because they are not a return on capital.
Another great article Gareth.
Can you clarify something for me, if I understand you correctly when they removed indexing but halved capital gains tax, that favored higher risk investments over lower risk ones. Does this mean the current system (compared to pre-1999) may be more likely to create bubbles (and therefore financial instability)?
Also would there be a valid argument that a capital loss, that can be carried forward to offset future discounted capital gains, should have its ability to discount those gains in a similar way? Interesting article, thanks.
I agree that inflation indexed is a fairer system, even though it will personally cost me heaps. Also agree with those who consider it should apply to return of fixed interest capital, but that isn’t going to happen.
May be wrong, but I don’t remember many (any?) financial institutions having much to say to when Howard changed the CGT. I suspect they had figured out how much tax they would save on their short to medium term schemes.
I’m also not sure quoting comparisons for shares held since 1999 is much use. I’m guessing that the average holding period is nothing like that. I know when I took issue with a LIC quoting pre-tax NTA because, “We are long term holders”, that looking back they did not have one share they had held ten years previous.
Hi Graeme. My recollection was that financial institutions generally were salivating over the switch from indexation to 50% discount. Just as individuals were salivating over unlimited tax free super and the generous transitional contribution rules. When it comes to tax, the Howard era was happy times for those with plenty of capital.
You neglect to mention that inflation is itself a form of taxation. It is, as Milton Freidman said, always and everywhere a monetary phenomenon. It represents the transfer of wealth from holders of nominal assets to central banks and their counterparties (which usually include governments).
The British pound sterling is so called because it was originally a note that was redeemable for a pound of sterling silver at the Bank of England. That’s 454 grams.
Despite the fact that the production of silver has become vastly more efficient over the past three centuries, and so silver probably hasn’t held its value particularly well in real terms, one pound sterling buys about one gram of silver today.
The fact of the matter is that as long as we have the illusion that fungible pieces of plastic, paper and computer data, hold real value, then the creators of that currency will continue to create more of it.
Western central bankers and Zimbabwean ones are both points along the same continuum. What one group does slowly, the other does fast, but they are both essentially doing the same thing.
The only reason that “inflation” wasn’t added to Benjamin Franklin’s famous “death and taxes” quote was that he never lived to see the death of the gold standard.
Hi Gareth, I will jump back into the conversation to clarify my view, although I think [email protected] has already done so, more succinctly than I ever could have:
I was suggesting that all earnings on invested capital , whether capital gains or income (dividend & interest), should be taxed at the same rate to remove distortions. Either we should tax all nominal earnings or we should tax all earnings as real (after inflation) earnings, by allowing a tax free discount for the portion of earnings which serves just to keep up with inflation. My view is to do it equal for all earnings whether they are “returned” to the investor as income or capital growth.
I am sure you are right that some of corporate Australia has a tendency to underinvest and pay out too great a proportion of earnings (e.g. Telstra?). In contrast, I think there are other businesses which have wasted earning by re-investing into overly risky expansions in a reckless quest for growth at any cost (e.g. mining acquisitions at the peak of the cycle, banking and retail expansions into off-shore markets (such as NAB & Billabong)).
You said that discouraging risk taking through the tax system would be a shame. I agree, but my view is that the present tax system, rather than offering a level-playing field where risk is priced efficiently, has today an active bias which positively encourages risk taking – this itself is a distortion. Replacing the present system of discounted capital gains with a system of indexed capitals gains just swaps the present distortion for a different (but similar) distortion. The penalty on paying out earnings would remain.
Thanks again for the very interesting blog!
Ineresting blodg but all of this is a worry as we are living in a world where the Government and the Banks are playing us for fools in the biggest Ponzi Scheme they can come up with.
I would be fearful of any more interference in the taxation system. We are already one of the most highly taxed countries in the world. Already small businesses pay the brunt in the amount of GST, -PAYG-, BAS they pay, in fact, some are having to pay more than they are capable of in a period of low income as the Tax Department assumes earnings based on “past figures”….provisional tax all over again.”Who is on their side?
If someone sells something and makes a profit, good on them, why should’nt they benefit from it (as long as they are not criminals)…not a “system”who figures they are entitled to their share.
If we did’nt have people who bludge their lives away, if we did’nt have those who commit crimes, if we did’nt have the political system and its three levels….we would’nt have to pay as much tax to support Centrelink payments, imprisonment costs, taxation etc…it just goes on and on and on.
You can blast me if you like!
The current treatment of capital gains provides more than a 50% discount due to the effect of compounding, especially for long term investors. On the top marginal rate, for an investment returning 6% per year, held for 10 years, if there was no discount for capital gains, the post-tax return is 12% more in total, because the returns are taxed once at the end, instead of every year.
This is one reason passive index tracking funds can be a good idea, because they so rarely have CGT events.
Not to mention to large tax advantage that comes for some people from being able to decide the year in which you sell the asset.
An aspect of CGT that rarely gets a mention is the sheer length of time you need to hang on to the records. CGT has been running since 1985. You need to keep contract notes and property transfer documents going back 30 years, and for houses, eg a holiday home, you need to keep receipts for everything you do to improve the house. There needs to be a time limit, eg twenty years, after which CGT no longer applies. The original cost base can carry over on assets when they are inherited, so you may need to keep records from when your ancestors bought property or shares. We could eventually have situations where great grandchildren were paying CGT in one year on 50% of the total gain in value of a beach house bought a century before.
The pre 1999 rules were well designed, and very fair. When the Hawke Government introduced it they looked at the experience of other jurisdictions. The two aspects that made it fair was that it only taxed real (i.e above inflation) gains and the averaging over 5 years provisions to account for one-off gains. It would make sense to return the taxing of capital gains to the pre 1999 method.