Tax reform and the simplistic nature of the capital gains tax discount

Various calls for changes to Australia’s perceived “generous” capital gains tax regime have arisen given the current federal budget deficit. For example, a suggestion is for a reduction of the current CGT discount from 50% to 40%.

But any change should require revisiting and considering the previous system of capital gains tax calculation to understand relevant issues before tending towards simplistic, arbitrary solutions.

Many would be surprised to find that the current discount regime, in many circumstances, results in greater CGT payable than under the regime it replaced. So it is worth delving back a short way into history before rushing into any wholesale change based on political agendas.

Comparing the regimes

Any review of the CGT discount must consider the basic problem that the income tax system is based on an annual assessment of taxable income, but that capital gains arise over a number of years. Hence, the sticking point becomes a matter of how to tax those long term gains in the single year in which they are realised and whether, and if so how, to account for the effects of inflation.

Under the current system, the CGT discount means that, for assets acquired after 21 September 1999 and held for at least 12 months, only one half of the amount of any capital gain is included in the taxpayer’s assessable (taxable) income.

So, an asset acquired for $500,000, held for 10 years and subsequently sold for $1 million would result in a nominal capital gain of $500,000. The 50% CGT discount is applied to the amount of the nominal gain, resulting in $250,000 being included in the taxpayer’s assessable income. For a taxpayer on the top marginal rate of 49% (including medicare and budget repair levies), tax of $122,500 will be payable on the capital gain.

From an economic viewpoint, capital gains should be measured in “real” terms, with consideration given to any erosion of purchasing power due to inflation over the period that the asset has been held. This is why, for example, economists consider “real” rather than “nominal” increases in gross domestic product (GDP) in determining the actual extent of economic growth. This is an important point to understand when it comes to comparing the current and previous CGT regimes.

Under the regime prior to 21 September 1999, the cost base of an asset held for at least 12 months was indexed by the consumer price index before calculating any gain subject to CGT. This meant that the part of the increase in the asset’s value due only to inflation was not taxed. This pre-CGT discount regime was consistent with only “real” capital gains in excess of inflation being subject to tax.

So, returning to the earlier example, assume inflation of 3% per annum compound over the 10 years the asset was held. Under the old regime, the asset’s cost base of $500,000 would be indexed to $671,950, resulting in a gain subject to CGT of $328,050 (given sales proceeds of $1 million).

If taxed at a marginal rate of 49%, tax payable would amount to $160,745. This represents a considerably higher amount than the $122,500 under the current 50% discount treatment. For this example, the current CGT discount treatment does appear to be generous.

But now assume that inflation had been 6% per annum over the ten years. In this case, the asset’s cost base under the earlier CGT treatment would be indexed to $895,400, resulting in a gain subject to CGT of $104,600 and tax payable (at the top marginal rate of 49%) of $51,254. On this basis, it can be seen that the often perceived generous CGT discount treatment results in a greater amount of tax payable ($122,500 versus $51,254 in this example).

Hence, while the current CGT discount rule is often considered to represent a burden on tax revenue, it can actually result in higher CGT being payable than under the regime it replaced, where only capital gains above the rate of inflation were taxed.

Another example illustrates this point clearly. Imagine an asset that increases in value perfectly in line with movements in the CPI and is then subsequently sold. Under an indexed cost base system, based on taxing only “real” gains, no CGT would be payable. Think about an asset acquired for $500,000 and held for 15 years.

Assuming inflation averaging 4% per annum over the 15 years, an asset increasing in value exactly in line with that rate of inflation would increase to a value of $900,450. If sold for that amount, no CGT would be payable if the gain was measured by reference to the “real” gain (as under the earlier CGT method).

But under the current tax treatment, CGT of $98,110 would be payable on half the $400,450 nominal gain (given a marginal tax rate of 49 per cent). This highlights the manner in which the current CGT discount regime taxes gains that have arisen merely due to inflation, and not due to conditions that have provided the taxpayer with greater wealth in terms of purchasing power.

And consider the parallel situation of the indexing of various government benefits, such as aged pensions, for inflation. Nobody considers those increases to represent an increase in wealth for the recipients – the increases merely compensate pensioners for price rises to maintain their purchasing power. And everyone recognises that, if benefits are indexed at less than the rate of inflation, then recipients are worse off.

Consider realities

What is clear is that the CGT discount regime can be extremely generous for assets held for short periods of time when inflation is low. But equally, it results in greater CGT payable, in comparison to the indexed cost base system it replaced, for assets held for long periods and when inflation is higher. And note that inflation has been at historically low levels over the recent past.

The above analysis highlights that the previous capital gains tax regime, by indexing an asset’s cost base for inflation, is consistent with an economic view of measuring gains in “real” terms. It also highlights that the capital gain discount regime which replaced it 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.

It is to be hoped that any calls for revision of the current CGT discount will consider the realities of economics and inflation. While it is unlikely that there will be a complete return to the prior indexed cost based system, any reform should consider that previous system to understand relevant issues before tending towards simplistic, arbitrary and political responses. But that is probably too much to hope for.

Graeme Wines does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.