OPINION: AS the Government and Opposition circle each other on tax reform, it’s clear that capital gains tax is on the agenda, in particular the current 50% rate of discount available to some taxpayers.
But what the current debate around capital gains tax is failing to recognise is that the CGT discount is not some sort of a free kick or a concession. The discount was designed as a pragmatic, simplified methodology that recognises that it is fundamentally unfair to be taxing a capital gain that’s the result of inflation.
This key consideration has informed the entire history of capital gains tax reform, and it is this essential point that risks being lost in the current characterisation of the CGT discount as an unfair concession to the rich.
Let’s go back to the beginning. Our current capital gains tax is a legacy of Paul Keating’s days as Federal Treasurer.
The case for our comprehensive capital gains tax regime was laid out in the June 1985 Draft White Paper ‘Reform of the Australian Tax System’. The White Paper accepted that a comprehensive definition of income included capital gains, and that ownership of capital was concentrated among higher income groups.
The Keating Treasury recognised that the lack of a comprehensive regime capable of accounting for capital gains meant that taxpayers who received capital gains were essentially receiving more favourable tax treatment than those who received ordinary income – a state of affairs that left higher income groups at a distinct advantage.
Clearly, capital gains tax was a necessary reform to remedy this situation and ensure that all income groups were being taxed fairly.
However, a realised capital gain is also partly the result of inflation as well as real economic growth, and the Keating Treasury recognised that applying marginal income tax rates to nominal capital gains would be unfair during periods of inflation.
A number of options to deal with inflation were canvassed including taxing a proportion of the nominal capital gain, taxing the full nominal capital gain at reduced rates, or adjusting the nominal capital gain to compensate for the effect of inflation.
While it introduced some complexity, the Keating Treasury’s solution to the inflation issue involved allowing the indexation of a capital asset’s cost base when calculating the taxable capital gain for all taxpayers, and providing individuals with a form of averaging to counteract the effect of taxing in one year a gain that accrued over many years. Averaging involved calculating the capital gains tax that would be payable if only 20% of the capital gain were taxed and multiplying the result by 5.
In 1998, Peter Costello as Treasurer ordered a review of business taxation. Amongst other things, the Review examined whether Australia’s capital gains tax regime ‘constrained wealth creation, new business formation and employment opportunities’.
The Review recommended the removal of indexation adjustment and averaging system for calculating capital gains tax and the introduction of the current discount treatment – 50%for capital investments held for more than one year by individuals and trusts– as a way of simplifying the law and reducing compliance costs.
Far from being a sop to the wealthy, the Costello CGT discount reforms resulted in a fairer, less complex, and more transparent tax system. A simple system is a level playing field for all market participants, and the 50%discount provides incentive to invest in capital investments – which is an integral driver of economic growth.
The problem with public policy in an age of ever shorter media cycles is that it is both short-sighted and insufficiently cognisant of histories of reform. When it comes to making tax policy, failing to look forward to the future and back to the past can result in critical errors.
It is possible that some changes to the CGT discount may have a role to play in a holistic review and reform of the taxation system. For example, a reduction in the capital gains tax rate in isolation could simply result in shifts of investments to lower taxed vehicles such as companies, which will ultimately increase complexity of the system.
But reducing the discount as a unilateral action and in isolation of broader reform measures just to provide a quick fix to perceived inequities should be avoided. Such actions could pose serious threats to capital investment and economic growth and could significantly increase complexity and distortionary effects in our tax system.
What needs to be remembered from this trip back in time is that the CGT discount is not a free kick. Rather, it is a long term systemic solution compensating for the effects of inflation.
By Michael Langhammer is Executive Director, Pitcher Partners.
