Should the capital gains tax discount simply be abolished?

It looks increasingly likely Treasurer Jim Chalmers will make changes to the capital gains tax (CGT) discount in the federal budget in May.

Under the current system, a person who has held an asset for at least 12 months receives a 50% reduction in the capital gains tax bill they would otherwise pay when they sell the asset, such as shares, real estate or crypto.

Reports suggest the discount may be cut to 33% or 25%, or that it might even be abolished entirely. This comes after a parliamentary committee found the 50% discount distorted investment decisions and skewed home ownership towards investors.

At the same time, there is speculation about some clawback on the generous negative gearing benefits that – together with the CGT discount – may have helped to turbocharge 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 then-Treasurer Peter Costello. The aims were to:

• encourage investment (particularly in shares)
• compensate for inflation and
• improve international competitiveness to attract investors.

These were dubious aims and were never likely to be achieved. Instead, research over the past 25 years shows the discount has produced outcomes that substantially diverge from the original policy intent. The 50% discount rate introduced in 1999 has produced significant inequities, inefficiencies and revenue losses, while failing to meet the principles of a well-designed tax system.

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.

Why should it be wound back or abolished?

In terms of fairness, the discount promotes inter-generational inequity. 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 smaller, if any, capital gains.

There is also a problem with “horizontal equity”. People with income from different sources (earnings, business profits, rent, interest, capital gains) should pay the same amount of tax, no matter what the source of the income.

Currently, people with income from selling an asset (a capital gain) pay half the tax of people with salary or other income.

The discount is inefficient because it distorts investment decisions. People are more likely to invest in a safe asset such as an investment property where only half the gain is taxed rather than in a productive investment, such as a new business, where they face tax on the full amount.

Combined with negative gearing, these two tax breaks tilt the housing market significantly in favour of investors over owners, particularly first-home owners, according to the parliamentary committee report.

And, finally, we come to cost. The discount is one of the biggest giveaways in the budget, costing taxpayers up to A$23.7 billion a year.

A range of options for change

Clearly, a reduction in the amount of the discount – whether to 33% or 25% – 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, when only the gain in the asset above inflation was taxed. Before 1999, house prices didn’t rise much more than inflation. After the tax change, house prices surged as investors moved into the housing market and pushed prices up.

But that may still be too generous. After all, we don’t inflation-proof any other parts of the tax system, so why should we give preferential treatment to capital gains? This is most starkly seen in the way inflation is allowed to steadily erode the value of the income tax-free threshold (so-called “bracket creep”).

Another option might be to adopt the solution that prevails in many other countries and simply provide an annual exempt amount. This would be like a tax-free threshold, but specifically for capital gains. This exempt amount might be something like $10,000 per individual, regardless of the size of the capital gain.

Are transitional measures needed?

One of the main problems that will arise if changes are made to the CGT discount is the complaining 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.

An immediate reduction or withdrawal might also cause unintended consequences. If a limited grace period is offered before the change takes effect, the market may be flooded with properties that investors are attempting to sell to take advantage of the 50% discount.

By the same token, if existing property investors are allowed to keep the full discount as long as they own the property (in other words their property is “grandfathered”) then they may decide never to sell.

Neither outcome is desirable and so 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% in, say, July 2027, 25% in July 2028, 10% in July 2029 and finally removing it completely in July 2030.

In that way, the perverse outcomes of a sudden change are carefully neutralised. Property investors will 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.

Chris Evans, Emeritus Professor, School of Accounting, Auditing and Taxation, UNSW Sydney

This article is republished from The Conversation under a Creative Commons license. Read the original article.

Chris Evans

View all articles by Chris Evans →