Everyone knows that inflation is a government-orchestrated swindle that takes purchasing power from savers and delivers it to the government and its preferred constituency, borrowers. Well, everyone should know this.
But under the current capital gains tax (CGT) rules, it’s a swindle of an even higher magnitude. Not only is inflation going to erode your wealth, but you’re going to collect a nice big tax bill for the pleasure.
Before 21 September 1999, capital gains were generally taxed at your top marginal tax rate (plus the Medicare levy). The Howard government introduced a 50% capital gain tax (CGT) discount for assets held longer than one year. So, if under the old system you were due to pay a 40% tax on capital gains, under the new system you’d only pay 20%. So far, so good.
But the bit that wasn’t trumpeted in the press release was that they also scrapped indexing. And it’s a biggie. Indexing adjusts for the debilitating effects of inflation on an investment. So under the old system, you got taxed on the real (inflation-adjusted) capital gain, whereas today you get taxed on the nominal gain.
I’m quite concerned about the likelihood of inflation as an after-effect of current initiatives aimed at the global financial crisis. I’m searching for good inflation hedges.
Assume I can find a conservative investment that pays little income but has a value that grows in line with the consumer price index (CPI), an official measure of inflation. If you trust the way the CPI is calculated – and I don’t – then it means one dollar invested in this structure would grow into an amount that buys what $1 buys today, whether we took our money out in two years or 20.
Let’s say that, happy to have my money protected against inflation, I placed $100,000 in this conservative investment for 20 years. And let’s say that, over the following 20 years, inflation averaged 5%. Come 2029, my money has compounded at 5% and the investment is worth $265,330.
If the old tax system was still in operation, the Australian Tax Office would recognise that $100,000 doesn’t buy what it used to. I’d be able to ‘index’ that money, and convert it into 2029 dollars. Following the indexing schedule, they’d say that $1 invested in 2009 equates to $2.6533 because of inflation (1 times 1.05^20). So I’d multiply my original nominal cost base of $100,000 to arrive at a real cost base of $265,330. The ATO would agree that I haven’t made any real capital gain, and I wouldn’t owe any capital gains tax on the investment. It makes sense considering the structure of the investment.
Under the current tax system, though, I’d have to declare a capital gain of $165,330 ($265,330 – $100,000). I then get the privilege of applying the capital gains tax ‘discount’, halving the gain to $82,665 because I’ve held the investment longer than one year. I would then pay tax on this gain at, say, 40% – so I’d owe the ATO $33,066. See the problem? My conservative investment, designed to keep up with inflation, doesn’t achieve its aim. On a post tax basis, my return falls to 4.3%, and in 2029 I cannot buy as much as I could have if I’d spent the money in 2009. Thanks for the tax cut!
If I can do substantially better than inflation, the current system is obviously better than the old. Assume I make an identical (but riskier) investment that successfully grows at twice inflation (a 10% nominal return). It would be worth $672,750 come 2029. Under the old system, I would have paid capital gains tax, at 40%, of $162,968 and achieved a post-tax rate of 8.5% per annum. Under the current system, paying an effective 20% tax rate but with no indexing, I’d pay $114,550 in capital gains tax, for an after tax return of 9.0%.
But the higher inflation gets, the harder it is to beat. Simply keeping up with inflation would be a commendable investing performance if prices start to skyrocket. Even those that don’t manage this feat and suffer a decline in their real spending power, though, will see their wealth further eroded thanks to a hefty bill from the tax office.