Bring back indexation to replace big CGT discount

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“The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state.”

Adam Smith, The Wealth of Nations, 1776

Everyone has a different idea of which taxes are fair. The ‘father of modern economics’, Adam Smith, thought tax should be paid according to what a taxpayer could afford. Without wading through an ethical debate, let’s focus mainly on one way Australia raises money to finance the operation of government: the Capital Gains Tax (CGT) on investments.

The realised gains on investments, which are what a CGT taxes, should fall within a comprehensive definition of income.

What is the logic of giving a generous 50% discount on CGT for assets held greater than 12 months, when other income is taxed at marginal personal rates? This has the knock-on effect of encouraging people to arrange their affairs to generate a CGT rather than income.

The current favourable treatment of CGT has become sacred ground, defended again recently by Prime Minister Malcolm Turnbull, as if it were a basic and long-standing tenet of our budget system.

The large discounts of today were only introduced in 1999, when market circumstances were different. It’s time to recognise that after 18 glorious years of CGT heaven, it is no longer appropriate.

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Look what’s happening in the current residential market

In a comprehensive study of CGT (in Economic Roundup, Issue 2, 2014), John Clark of the Tax Analysis Division of the Australian Treasury, wrote:

“The concessionary treatment of capital gains income is arguably the primary motivation for financial investment in negatively geared real estate, which aims to shift all of the investment return into the capital gain on the eventual sale of the asset.”

Only the hard-hearted would feel no sympathy for young families struggling to take the first step into their own home. A home is usually more than an investment. It represents a more secure future and roots into a community and lifestyle. Home ownership is part of our culture. Australia’s short-term rental leases make a precarious existence for tenants who are often uprooted with a few weeks’ notice. With both Sydney and Melbourne experiencing auction clearance rates over 80%, and last month CoreLogic claiming Sydney house prices hit an annual growth of 18.4%, frustration levels show no sign of easing.

What pushes the disappointment to anger for first home buyers is knowing they were beaten at auction by a property investor at a different stage of life, probably buying a second or third property, with confidence buoyed by tax breaks.

(Victoria has announced a range of measures to help first home buyers, such as a waiving of stamp duty and a Vancouver-style tax on empty properties at 1% of the capital value. The fear is that these will merely stimulate demand further in the residential market, while doing little to curb the enthusiasm of investors).

Briefly, what are the tax breaks?

Without going into great detail, the two main tax breaks that fuel investor property appetite are:

  1. Capital Gains Tax discount

Assets acquired since 20 September 1985 are subject to CGT unless specifically excluded, such as personal assets. A capital gain is the difference between the cost of the asset and the amount received on disposal. The realised gain forms part of taxable income in the year of sale. A loss can’t be claimed against other income but it can offset a capital gain and can be carried forward.

For assets held for 12 months or longer before the CGT event, there is a 50% discount for individuals and trusts, and a 33 1/3% discount for complying super funds. There is no CGT payable on a person’s main residence upon sale.

  1. Negative gearing

Where the rental income on a property is less than the interest and other expenses, the loss can reduce the investor’s taxable income (of course, the same applies in other investments including shares). Many people seem to believe that anything that reduces their tax bill is good. They talk about negative gearing as if it is an end in itself, when all it does is reduce the size of the loss. It’s still a loss.

An owner occupier who buys a family home does not have negative gearing, and mortgage payments are not tax deductible.

Why did we introduce such a generous CGT discount?

When the Hawke Keating Government introduced CGT in 1985, the rules allowed for the cost base of assets held for one year or more to be indexed by inflation when working out the gain. That is, the part of the realised gain due to the consumer price index (CPI) rises was not taxed. The 50% discount was introduced in 1999 by the Howard Costello Government. Let’s consider Australia’s inflation since 1970, as shown below.

CGT indexation

For much of the late 1980s, inflation was around 8%, and then in ‘the recession we had to have’ in 1991, it fell significantly and then rose again. By 1999, it was approaching 6%. It is now closer to 2%.

According to a paper from the Tax and Transfer Policy Institute of the Crawford School of Public Policy, Australian National University, “Somewhat surprisingly, the 50% CGT discount was introduced with little in the way of empirical evidence or modelling of the possible revenue effects.” One stated rationale for change was the old indexation method was too complicated to calculate, adding uncertainty and inefficiency to the tax system.

The rationale for returning to indexation

Economists like to measure purchasing power in ‘real’ terms, adjusted for inflation. GDP, for example, is best judged as ‘real GDP’ to determine actual economic growth. Realised capital gains should be considered in real terms, allowing for inflation over the holding period.

With inflation closer to 2%, and likely to stay low for many years, the 50% discount is extremely generous for assets realised after a relatively short period. The 50% discount is inherently arbitrary – what does 50% signify other than half? It does not appeal to the basic tenet of adjusting gains for inflation, it simply applies a number with no relationship to real returns or the length of time an asset is held (beyond the one year).

The CGT discount offends the principles of both vertical and horizontal equity, the very reasons to have a CGT in the first place. For example, a person in the top marginal tax bracket with a $1 million realised property gain will lose less than a quarter of the proceeds in tax, but would lose half in tax on other income. This breaks the principle of horizontal equity between gains. Also, as capital gains accrue to the highest income earners, it offends principles of vertical equity and the ability to pay according to our means in our progressive system. The CGT discount effectively lowers the marginal tax rate for high income earners.

Furthermore, the CGT discount pushes investment towards shares and property and away from regular income streams, such as from bonds.

As for the complexity identified in 1999, our improved accounting systems and ability to make adjustments ensure indexation is a straightforward calculation based on published statistics.

When CGT indexing was introduced, inflation was high at around 8%, and an asset held for say six years would have a 50% ‘discount’. Now inflation is around 2%, the 50% discount is inequitable.

Unlike some schemes designed to improve home ownership which simply act to increase the amount a first home buyer can afford to pay and therefore bid up prices, this CGT change would reduce investor demand and remove a speculative element from the market.

Although at high rates of inflation, it’s possible that an indexation system would be more favourable to investors than the 50% tax break, this is highly unlikely for many years.

Let’s remove this investor tax incentive and give our children a chance

There is no justification that someone can flip a property after a year and be taxed on only half the realised capital gain.

It’s also likely that knowing gains will be halved drives investor confidence, far more than the uncertain principle of ‘adjusted for inflation’. Most people will know that inflation over say five years is likely to be only about 10%, leaving 90% of the realised gain to be added to taxable income.

The capital gain discount regime which replaced the previous inflation indexed method is inherently arbitrary and has differing consequences depending on the rate of inflation and the length of time for which an asset subject to CGT is held. Let’s fix the calculations and level the playing field a little more!

(Note, there is a follow up discussion in the following week between Noel Whittaker and Chris, including extra background data).

 

Chris Cuffe is co-founder of Cuffelinks; Portfolio Manager of the charitable trust Third Link Growth Fund; Chairman of UniSuper; and Chairman of Australian Philanthropic Services. The views expressed are his own.

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21 Responses to Bring back indexation to replace big CGT discount

  1. Wealth21 March 9, 2017 at 1:46 PM #

    Some logical reasons for change – but do we have the political resolve for tax reform currently?

  2. Ray Greenshields March 9, 2017 at 1:48 PM #

    Totally agree Chris provided it is introduced prospectively, not retrospectively as was done with the super changes.

  3. Graeme March 9, 2017 at 2:08 PM #

    Couldn’t agree more, but then I was dead against the the introduction of the 50% discount method in 1999. The outcome was inevitable.

    I assume indexation would be applicable to equities as well, in which case there will be some interesting market gyrations as investors come to grips with the likelihood of it occurring.

    Why stop at property and equities? In the interest of fairness, a good case could be made for the indexation of interest returns as well.

  4. Ralph Greenham March 9, 2017 at 2:25 PM #

    I agree. Indexation of capital gains is totally reasonable. Good for first home buyers and for government revenue. Better than Victoria’s stamp duty plan which is likely to ultimately decrease housing affordability.

  5. Gen Y March 9, 2017 at 2:48 PM #

    Surely everyone without a vested interest agrees on this one. This is why it comes up in every tax review. Unfortunately the property lobby is powerful, and most of our politicians have their own vested interests with large property portfolios, nevermind the ‘wealth affect’ that applies with ever increasing property prices and the massive amounts of Stamp Duty the states are collecting.

    I was only a teenager at the time but wasn’t the argument for the 50% discount around it being too complex to calculate the using the indexation method? Surely an argument that is 15 years past its use by date, with tax lodgements done online now

  6. Tony Kench March 9, 2017 at 2:53 PM #

    Totally agree Chris. I really fear that as a society we get more segregation into those that have / have not with less prospect of bridging the gap. People with existing wealth are able to support their kids in getting a house round them whereas for those that don’t – kids are stuck in the rental grind in less well off suburbs.

    I would probably go back to the old system where the CGT can be averaged over a period (say 5 years) in working out what marginal rate to apply, as with large scale assets just the property gain could force otherwise less well off onto the top marginal rates.

  7. Richard Brannelly March 9, 2017 at 3:23 PM #

    At last some common sense on this very emotional issue that doesn’t simply focus on the self-interest of any one group. Howard and Costello should never have changed the old method in the first place and it is hard not to think the change was politically motivated. I think the change should be applied retrospectively as “investors” won’t be disadvantaged – only the “speculators”.

    • Tony Kench March 9, 2017 at 4:08 PM #

      Or let it work like the CGT relief about to apply in super funds. Let people write up the cost base to the value at date change

  8. Paul March 9, 2017 at 4:35 PM #

    Thanks Chris for this excellent article and very sensible recommendation. Great to see some rational debate on this matter.

    However, if we really want to ‘give our children a chance’ why not wind back the negative gearing concessions on housing as well. Negative gearing costs the Government significant revenue each year and favours investors over owner occupiers (who do not receive a tax deduction for their mortgage payments). In the interests of of an equitable society surely it is time to reform this also.

  9. Peter Gillies March 9, 2017 at 4:50 PM #

    This proposal would almost double the rate of CGT and produce a top rate of 48% (tempered by inflation indexation of the cost base). Review of other similar jurisdictions indicates that this would be one of the highest CGT rates in the developed world (other high taxing countries are Belgium, Denmark and France). The average CGT rate elsewhere is about 20-30%. In the UK it is a maximum of 18%, 15% in the US, and 26% in Japan. In Canada half of the capital gain is taxed. There is no CGT in the Netherlands, NZ or Switzerland. The relatively light taxation of capital gains in a range of countries indicates that there are sound policy reasons for taxing capital gains and income differently.

    It is predictable that an (almost) doubling of CGT in Australia would divert funds into owner occupied housing, given its tax exempt status.

  10. Aaron March 9, 2017 at 5:05 PM #

    The changes were made for simplicity, and while I agree that there is potential for improvement with the current 50% discount model, the maths in the article highlights that the indexation regime was complex and difficult to follow.
    In particular:
    “When CGT indexing was introduced, inflation was high at around 8%, and an asset held for say six years would have a 50% ‘discount’. Now inflation is around 2%, the 50% discount is inequitable.”
    is inaccurate.
    The 50% discount is on the nominal gain. In the old regime, only the real gain was taxed.
    Any inequity will depend on the actual gain on the asset (over time).
    The discount in the first place depends on the actual asset.
    An asset bought for 100 which sells for 200 in 6 years (12.2% p.a.) when the ‘inflation-adjusted’ value is 150 (6.9%p.a.) receives a 50% discount to the nominal gain which equates to the real gain. At other prices on sale, the discount varies.
    Consider an asset that increases by 10% in total over 10 years (roughly 1% p.a.). (This is better than a lot of international share funds 2000-2010). With the 50% discount means that 5% is taxed and the investor is being taxed for an asset that is losing real value (if inflation is 2% pa).
    The real question is whether there is a simple way to tax only the real capital gain.

  11. Nick March 9, 2017 at 7:44 PM #

    I fully agree with Chris that we should go back to the old indexed method of calculating CGT; that method was rational whilst providing some compensation for investment risk.

    However, I don’t agree with getting rid of negative gearing (I have never utilised it myself!) as I consider it perfectly legitimate to claim expenses against personal income for income producing investments. Of course, reverting to the old CGT rules will diminish the incentive for investors to buy real estate for favourable CGT treatment. But others in this forum suggesting interest on owner occupier home loans should be subject to negative gearing forget that the owner occupier home is CGT free. Yes, negative gearing could be applied to the owner occupier home, but consistency would require elimination of its CGT free nature as well. And the current 10% loan growth limit imposed on banks by APRA seems way too high. A reduction of this limit coupled with reverting to the old CGT rules seems to me to be a more effective means of reducing investor influence on the property market without throwing the negative gearing baby out with the bath water. If interest rates were to go up, and loan defaults and unemployment up with it, I predict negative gearing will be viewed in a different light.

  12. Bruce C March 9, 2017 at 7:57 PM #

    Why not remove inequity and tax capital gains without any indexation. This would then be on the same basis as say bank interest where the the total return is taxed each year i.e. the nominal and real return is taxed. There is the issue that a large gain is taxed in the one year and may have a higher tax rate applied due to marginal tax rates; arguably the ability to defer the tax and compound the gain compensates for the eventual higher tax rate.

  13. Marcus wigan March 10, 2017 at 12:34 AM #

    I agree wit Chris and his argument replicatesmy submission to the relevant inquiry around the time of its introduction. But the key to unlock this is the 10-20 years records required had to await all organisations having the capacity to supply data from de that period.stillnot done the n my experience

  14. Chris M March 10, 2017 at 6:31 AM #

    The principle should be that interest and capital gains are treated the same. As per Ken Henry’s comments recently.

    Their should be no indexation or any discount. If you do the calculation of over 10 years for bank interest taxed yearly, the closest final balance is when a capital gain is fully taxed with no discount or indexation.

    This would simplify the tax system, and make it symmetrical.

    If we take Labor’s policy of a 25% discount on CGT, then it also should apply to bank interest and income loss deductions for neg geared new properties.

    CGT on super should be just removed.

    Changes to CGT should be retrospective. Keep it simple.

    • Chris M March 10, 2017 at 6:33 AM #

      Sorry, the CGT “discount” on super should be just removed.

  15. Graeme Bennett March 10, 2017 at 9:52 AM #

    I really think you need to do a lot more work to convince policymakers Chris. You do not even mention competing tax regimes. One of the reasons for replacing indexation was the concern that our tech companies would set up in other jurisdictions with much more generous capital gains tax regimes. Suggesting the change was about simplification and not exploring other reasons will get you nowhere.

    You do not mention the lumpiness of capital gains, particularly on property but sometimes with longstanding equity holdings – a foreign investor taking over Australand for example. This will have investors moving up and down the tax scale pretty regularly, potentially getting caught out with insufficient funds to meet the next year’s tax. Should some smoothing be introduced so that the capital gain is allocated over a number of years? Otherwise investors will be reluctant to take profits with adverse impacts on the economy.

    You do not explore the impacts of negating negative gearing, not all of which is planned, nor taxing capital gains at a high rate. Sure there is a short term benefit for buyers trying to enter the market for the first time. What is the long term impact of chasing investors out of the property market? I can’t imagine developers would continue to build at the same rate if property prices were depressed. It doesn’t take much thought to connect the dots between a reduced pool of housing stock and the long term impact on prices for property buyers and renters.

    I think there is a case for looking at the CGT discount but always with an eye on competing tax regimes. Unfortunately most of the commentary on these topics is quite superficial and shortsighted. Not trying to be personal because I know that you do quite a lot for charity and support good works but there is an element of pulling the ladder up behind you here.

    Good luck
    Graeme

    • Vicki C March 10, 2017 at 4:08 PM #

      I think Chris has focused too much on the residential property sector. The CGT rules affect far more than that one sector.

      As an aside, if you invested in December 2000 (CPI 73.1) and still hold the asset, indexation passed the 50% mark in December 2016 (CPI 110.0). Longer term investors would now have a higher taxable capital gain under the 50% discount method than the old indexation method.

      Do we prefer longer-term investors or want to encourage short-termism?

      And what about capital losses – maybe we should be able to deduct them immediately?

      • Graeme Bennett March 10, 2017 at 5:58 PM #

        Residential housing is the topic of the day I suppose. Lots of young voters want to get a toehold in the property market. It will work against prices and the wealth effect will prove negative for the economy overall. Property-owning voters still outnumber the aspirants by a wide margin so you can understand the politicians wanting much stronger reasons before they write their final goodbyes to a career in politics.

        Interesting about the more than 50% discount available for such long-term investors. You need a mix of short and long term investors I believe. If taxes are too heavily applied landlords are more likely to sit on their properties until they are no longer of this earth, taking their 3% or whatever return on appreciating values. Makes it harder to redevelop properties better suited to other uses. That can’t be all good.

        If we are going to tax capital gains as income it seems unfair to only be able to offset capital losses against capital gains that may never materialise, especially for older investors.

        I only invest in shares. Generally lots of small investments so I can manage the capital losses (lots of them too unfortunately) reasonably well. I can’t argue the current system is fair, I get too good a deal on tax I think.

  16. Peter C March 13, 2017 at 11:56 AM #

    One of the so called “reasons” for the change in 1999 was the old system was complex. It is not complex to work out because I don’t have to work it out at all. I once had this issue with some Nab shares I sold where I used the benefit of a dividend reinvestment plan.

    How did I solve this seemingly complex issue? I didn’t have to, I let e-tax do it for me, and some parcels I used the 50% and others the frozen indexation method.

    For the record, in the old days I could correctly work the maths using nothing but a calculator and the Tax-Pack instructions. It was time consuming though.

    My point is, in this modern world it is not complex at all, we have computer programs to work out the indexed capital gain and with no extra time needed.

  17. Chris Jones March 20, 2017 at 10:49 AM #

    The reason capital gains are treated relatively generously in a number of jurisdictions is that in a progressive tax regime, large capital gains are subject to the top marginal tax rates, even though the gain may have been accumulated gradually, over many years. If the capital gain discount were to be eliminated, there would also need to be a re-introduction of averaging provisions.

    For capital gains to be treated the same as interest, indexation would be disregarded, but the gain would need to be averaged over the period of time the asset was held and taxed at the owner’s marginal tax rate for each year the asset was held. This approach would require tax records to be held for very long periods, perhaps 50 years or more. Clearly this approach is impracticable but to eliminate indexation of capital gains without comprehensive averaging would actually be to treat capital gains more harshly than interest.

    Perhaps the original approach of indexing the cost base of capital gains, combined with limited (5 year) averaging of gains was a reasonable compromise.

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