It’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.
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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