How Australia can resolve its capital gains tax issue

 

In 1985, Paul Keating established capital gains tax, marking a significant reform for fairness and integrity in Australia's taxation system.

He set up CGT with the idea that only genuine capital gains—those that account for inflation—should incur taxes.

This concept was valid back then and continues to hold true today.

Regrettably, the process of adjusting the original cost to reflect inflation became complicated and hard to manage. While accountants grasped it, many taxpayers struggled to understand.

The need for simplification was quite evident.

In 1999, Peter Costello effectively presented the argument for simplification, but his approach led to a nonsensical outcome.

By implementing a one-time 50 percent discount after a capital asset has been owned for 12 months, he caused a major distortion, undermining the fairness of Keating's initial reform.

How is it logical to incur a 100 percent tax on an asset sold in the 12th month after purchase, yet only pay 50 percent if sold in the 13th month?

For several years, sellers will enjoy an unfair and unreasonable edge over wage earners, who are taxed on their entire income.

According to the Grattan Institute, using government statistics, the CGT discount largely favors the affluent. The top 20 percent of Australians receive almost 90 percent of the CGT discount.

In a submission to a Senate committee, the institute also notes that this discount significantly contributes to older Australians facing a lower tax rate on their income compared to younger Australians who are actively employed.

This is a significant issue regarding fairness among generations, without considering the effects of the capital gains tax discount on real estate.

What actions should Costello have taken? The optimal approach would have been to implement a graduated discount system linked to the Reserve Bank’s inflation target.

This target could range from 2.5 to 3 percent annually, or up to 5 percent if a slight buffer is included to account for occasional increases beyond the target range.

This would have required investors to pay tax at the full rate of 100 percent on their capital gains in the initial year, followed by 95 percent in the second year, and so on. It would have also been feasible to cap the discount at 50 percent in the tenth year and beyond, or to reduce it to 25 percent after 15 years.

Nonetheless, it is now too late to return to that approach. Doing so would only increase the discount for some without any clear advantages.

However, there are practical options to consider.

We could revert to using indexation, but there’s a shared reluctance to complicate the tax system unnecessarily.

One possible alternative to the initial proposal would be to gradually decrease the discount from 50 percent to 25 percent over a five-year period and maintain it at 25 percent for as long as the asset is owned.

I am uncertain what, if any, reform Treasurer Jim Chalmers is contemplating regarding capital gains tax. It will require considerable political bravery to confront the established interests that profit from the current high discount.

It is likely that wealthy recipients will resist losing their advantages. They will likely attempt to rally the disadvantaged to support their position.

"Parents" investors will be at the forefront of the discussions, concealing the reality that the primary beneficiaries, the richest investors, are actually behind them.

Initial signs suggest that the Liberals will back the continuation of the current substantial discount. I believe their contributors might demand it.

Both reason and fairness indicate the same conclusion: A discount that reflects actual profits, rather than an unjustified large discount that skews investment choices and disadvantages diligent and younger taxpayers.

This can form a strong case, but it won't be a straightforward political battle to emerge victorious in.