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A capital gains tax discount is legitimate but how much?

Australia’s chronic shortage of housing is prompting widespread calls for changes in a wide range of policies that affect the demand and supply of places to live. A forecast net intake of 700,000 migrants over two financial years to 30 June 2024 (and 1.75 million by June 2028) at a time of construction shortages and rising rates has created an historically-low rental vacancy rate. Contrary to expert predictions, house prices have risen in 2023 as home demand outstrips supply.

At such times, two policies targeted for criticism in favouring investors over owner-occupiers are negative gearing and the capital gains tax (CGT) discount.

With negative gearing, where costs of owning a rental property exceed revenues, the ‘loss’ can be charged against other personal income. Some people seem to think the loss itself is a good thing because it reduces their tax, but the tax savings only reduces the loss: it is still a loss. This is little comfort to the aspiring homeowner who is beaten at an auction by an investor happy with the income offset in return for future capital gains.

As if that wasn’t enough, investors also receive a 50% CGT discount if they sell after holding the asset for longer than 12 months. Little wonder Australians love investing in real estate.

But why should a dollar made as a capital gain be taxed at a lower rate than a dollar earned as income? Nobody can claim a personal income tax deduction if they’ve held a job for longer than 12 months. That seems a ridiculous notion.

Why do we have a CGT and a discount?

CGT was introduced almost 40 years ago in Australia in 1985 to stop schemes that converted income into capital to exploit its tax-free treatment at the time.

The CGT discount started as a recognition that in calculating capital gains, it is fair to tax the real increase in the value of the asset, after allowing for inflation. Any asset which only keeps up with inflation is not really increasing in value. For example, the annual Consumer Price Index reached 7.8% in December 2022, the highest for three decades. If an asset was bought for $100,000 a year earlier, its value would need to rise to $107,800 to retain its real value. That is, in December 2022, it cost 7.8% more to buy goods than in December 2021, so it is legitimate to adjust a capital gain for inflation. As the chart below shows, inflation adjustment matters again.

So where does the 50% discount come from?

Prior to 1999, the calculation was based on an adjustment to the cost base for CPI, but it was considered overly complicated. Investors needed to calculate the inflation adjustment between buying and selling dates. This seems a trivial reason, as online data and calculators could easily be provided by the Australian Taxation Office (ATO) and others. But at the time of the 50% discount introduction, it was justified on simplicity grounds. And the 15% tax on superannuation in accumulation mode receives a 33% discount, giving a tax at 10% instead of 15%.

It is easy to see who benefits and who loses from the move from CPI to 50%.

Winners: Investors who hold an asset for a little over 12 months when inflation is low.

As with most developed countries, Australia went through a golden period of low inflation starting in about 1996 and running until the pandemic. The timing of the 50% discount was of great benefit to many investors.

Losers: Investors who hold an asset for a long time during high inflation.

It's not all win-win in investor land. Using the Reserve Bank inflation calculator, an asset bought for $100,000 in 1992 and held for 30 years until 2022 would need to rise in value to $212,610 to retain its real value. The cost base would rise by $112,610 under a CPI adjustment. If the asset sold for its CPI-adjusted level of $212,610, the CGT would be zero under the old system. Under the 50% system, half the gain or $56,305 would form part of the investor’s taxable income.

So in certain circumstances, the 50% discount is unreasonably low. Now we have a return to higher inflation which looks like sticking around for some years above the Reserve Bank target range of 2% to 3%. Online calculators debunk the idea that the calculation is too complex, and it seems a fairer system to adjust the tax base for inflation.

The CPI adjustment also encourages holders who do not flip investment properties every year or two, and it’s easier to sell politically. The 50% number sounds generous, and it was in a low inflation environment. Everyone can understand the legitimacy of a CPI adjustment.

What are some of objections to the CGT discount?

In its 2023 paper, ‘Back in black? A menu of measures to repair the budget’, the Grattan Institute argued that successive Australian governments cannot continue to massively spend to keep voters happy while not collecting more revenue to pay for it. Among a range of measures was a proposal to reduce the CGT discount to 25% to raise $5 billion a year.

The main rational for the change was:

“If income taxes are applied to nominal capital gains, inflation can erode part of an investor’s wealth. But given low inflation for most of the past decade, the 50% CGT discount overcompensated many investors for inflation. The policy has also over-zealously protected savings at the expense of competing considerations. The economic benefits of tax neutrality for savings are small, and the 50% CGT discount encourages investors to focus too much on investments with capital growth rather than annual income. This is a major distortion which, together with negative gearing, encourages property speculation over more efficient investments. The current discount also compromises income tax integrity by encouraging artificial transactions and makes the tax system less progressive. The 50% CGT discount for individuals and trusts should be reduced to 25%, with a gradual phase-in (rather than grandfathering).”

Earlier modelling showed the top 10% of households by income receive nearly three-quarters of tax benefits.

Other critics argue Australians do not need these tax incentives to buy property, and it disadvantages people without the resources to invest in property at the expense of more productive businesses. The discount is available to people who are wealthy enough to own capital and they should not pay less tax than someone who relies on income.

The Henry Tax Review recommended reducing the 50% CGT discount to 40%, but like much of Henry, this was rejected. However, this needs to be read in the context of Henry's sweeping changes, which recommended a move to a broad 40% discount on many forms of personal savings to remove distortions and incentives. The Henry Review said of the different ways income and capital gains are taxed:

"There is considerable evidence that such tax differences can have large effects on the assets in which a household’s savings are invested. The large variations in tax treatment can therefore alter the allocation, ownership and the management of the nation’s savings. This can have adverse impacts on overall economic efficiency, capital market stability and the distribution of risk between individuals. The tax advantages from borrowing to invest in a rental property, also relevant for shares, leads to investors taking on too much debt and distorts the rental property market. A move to a broad 40% discount for income from bank deposits, bonds, rental properties, and capital gains and for certain interest expenses would address these problems by providing more consistent tax outcomes. Savings would be allocated more productively, distortions to rental property and other markets would be reduced, and household investment and financing choices would better suit their circumstances and risk-preferences."

While economists such as Saul Eslake supported this proposal, a 2016 paper by Professors George Fane and Martin Richardson noted:

‘the simplest way to repair the capital gains tax is to return to the pre-1999 arrangements’.

Note also that investors can add to the cost base the expenses incurred in acquiring the asset such as inspections, surveyor costs, stamp duty or costs of transfer. The ATO has a detailed list here. CGT discounts are available to individuals and trusts but not companies.

A discount is justified

As various policies relating to housing and tax are kicked around for change, we can debate the amount of the discount – 25%, 40%, 50%, linked to CPI – but the justification for some level of discount is strong. The CPI adjustment to allow for the real value of the asset seems easiest to justify and explain.

However, the impact on housing supply is uncertain. While owner occupiers would prefer fewer competitors on auction day, renters would not want a policy that materially reduces the availability of rental properties.

 

Graham Hand is Editor-At-Large for Firstlinks. This article is general information and does not consider the circumstances of any investor.

 

27 Comments
peter c
February 18, 2024

One year is too short to receive any CGT discount. Personally I would reduce the discount to 25% but only if asset held for 5 years and 50% if held for 10 years. This will encourage a long term mindset from investors and help our companies plan for the long term, rather than 6 or 12 month timeframe which many have now.

Frank
July 06, 2023

The 50% CGT discount is a rort. A legal rort but a rort nonetheless.

Of course there is an explanation for why the 50% CGT discount is fair and reasonable: there always is a reason why some people believe their wealth should benefit from a tax payer subsidy. And the reason is always calm and logically argued: It doesn't mean the explanation is justified or makes logical sense.

Inflation erodes the value of everything over time. It erodes the value of cash held in the bank. It erodes the value of any future income streams. It erodes the value of your income. Why should capital gains be treated any differently from a tax perspective? There is no reason for this other than someone people are able to get ridiculously rich by exploiting the obvious tax loop hole. It's a rort. I remember once very well known celebrity builder bragging in the newspaper a few years back about how he never paid tax because he'd renovate properties, move into them and sell them after 12 months. All perfectly legal but hardly right. The tax exempt status of the family home is a separate matter but the behaviour is the same: The 50% CGT discount is just another tool for people who want to flip capital after 12 months and has nothing to do with inflation. Meanwhile people without capital and who only have income have to suck up inflation every year when they pay income tax.

Where is the faith in the market systems to price capital appropriately if capital gains taxes are not inflated adjusted? Just tax capital gains at nominal value, just like everything else, and stop introducing complexity into the system under the guise of "fairness". The problem with "fairness" is that it's a question of "Fair to whom?" and the only people who need to worry about CGT are people with capital/money to invest.

Under a capitalist system it is not the job of the tax payer to subsidize people with capital to make investments so that their returns are inflation adjusted at tax time. That's just gravy for the gravy train. The 50% CGT discount would make sense if everyone's PAYG income tax was also inflation adjusted - it's not, it won't be nor should it be.

There is no reason for tax payers to subsidize owners of capital on a wholesaler basis.

James
July 06, 2023

"The 50% CGT discount is a rort. A legal rort but a rort nonetheless." Sour grapes?

Vehemently disagree with your premise!

Consider this. Wage earners get compensated somewhat for "normal" inflation periodically with salary increases. Governments periodically compensate (give back) what inflation takes with bracket creep (as if it's a gift/tax cut).

Why should investors not be compensated for putting their capital at risk, given that investing in the ASX for instance provides companies with much needed capital to build businesses, expand and employ tax paying citizens!

Likewise, given that most rentals are provided by the outlay of capital by private citizens, you risk killing the rental market by destroying any incentive for investors to make a real return (after inflation and often onerous holding costs).

Under a capitalist system it's not the job of the tax payer to endlessly support the "leaners" in society, beyond what is reasonable and fair, which the progressive tax system etc accommodates for. The problem is socialist leaning governments, seeking constituents/voters, by promising a greater share of other people's hard earned money to live beyond the means of what their own endeavours can provide! Lest I be misunderstood, nothing in this precludes helping those in genuine need and those more fortunate contributing more to society (higher taxes), as they already do.

When is enough, enough?



Mike
June 27, 2023

Hi Graham,

I read with interest your article on Capital Gains Tax Discount.

One thing you didn't mention, which I find the most unfair aspect of the CGT system, is that the income is assessed as if it was earned in one tax year.

The old system spread the capital gain over 5 years which is more in line with the principle that the capital gain occurred over many years.

I have recently retired and I have an investment property that I have held for 26 years. I am now faced with the prospect that if I sell it my taxable income goes from close to zero to about $250,000 for one year and then back to zero the next year. Hence for 1 year I am in the highest income tax bracket!

This means that if I sell the property and put the proceeds into Superannuation, I will get less income than if I kept the property.

I expect many others are in this situation and it is holding back supply of properties to the market and contributing to higher house prices.

Kind regards,
Mike

David
June 19, 2023

The original CGT introduced by the Hawke government said that only real gains after inflation would be taxed. This was a lot fairer that the system we now have, which taxes long held assets without applying indexation because it is "simpler". My belief is that the price of gold should be used as an inflation measure. It is a number universally available, not set by any government. The calculation would proceed by working out the cost price of the asset in gold, as priced at the time, and comparing it with the sale price of the asset in gold at the time of sale. Tax is only payable if the sale price in gold is more than the cost price in gold.

David
June 19, 2023

According to CoreLogic, Sydney house prices rose 507% over the 30 years to July 2022. So the $100,000 investment in 1992 would have grown to a nominal $607,000.
From the article, the CPI adjusted value would be $210,610.
So the gain in real value is $396,390.
Under the 50% discount the investor is taxed on $253,500 of capital gain.
This a discount of 36% on the real gain in the investment.
Obviously, the important factor here is the difference between house price rises (6.2% pa over the 30 years) and the CPI increases (2.5% pa). This has been a sure thing for investors over the last 30 years, and over 2 million Australians are playing the game.
The 50% discount was only ever a fudge to simplify the tax calculation, bearing no economic logic.
As Graham Hand says, going back to the pre-1999 system could be handled simply with ATO-developed online tools for the CPI adjustment.
I believe this would be a fair and reasonable reform.

Dr David Arelette PhD
June 18, 2023

The cart is busted, the horse is dying - why bother wasting brain power on what was a Keating late at night tax hit.
Every taxpayer gets an annual cumulative CGT allowance of (say) $7,500 and they can purchase more (say) at a rate of 10% cost in that tax year to a maximum of a further $25,000. Add an inflation rate uplift based on property growth (leave out fruit and veggies et al). It is yours alone and cannot be sold or transferred. Will reduce inflation as accountants will have to retire or charge a whole lot less. A saves the tea trolley costs in Canberra offices.

charles scourfield
June 17, 2023

"CGT was introduced ..in 1985" From memory it existed before then but was only applied to the intention at time of purchase.
Gains from Speculation were subject to CGT. eg buying Poseidon shares on Monday for $1 and selling on Friday for $50. Gains from an intended Investment were not. My broker suggested that every time I bought some shares I should write to the ATO and advise that I had bought XYZ shares "as an investment" so I could fall back on this "intention" if ever queried.

John
June 16, 2023

To explain the 50% CGT discount in a different way - " If capital gain was double CPI then CGT would apply to all gain nett of CPI. If gain was less than double CPI then CGT would be partially taxing CPI. If gain was more than double CPI then some gain would be tax free."

If there was a return to the CPI method the value of gains should be divided by the number of years taken to make the gain if less than 5 years so that a windfall gain made in over 12 months is taxed appropriately.



Trevor G
June 16, 2023

I’m a bit surprised that death isn’t a capital gains tax event. Maybe that’s on the way

MK Adelaide
June 18, 2023

Death taxes used to exist and it is arguable that it’s abolition in Queensland really kick started it’s economic rise.
Whilst SA retained it, migration from there increased and companies moved their share registries out of the state to avoid the duty.
My mum sold off all her SA registry shares to avoid the duty.

There are just a few countries which still have death duties now.

Michael D
June 16, 2023

How about flat tax on income and capital gains?
Zero tax in super. Personally 25% flat.

How many accountants and government beaurocrats are redundant the next day?
Anyone with a primary school diploma can calculate his own tax.

Dudley
June 16, 2023

"stop schemes that converted income into capital":

Need a scheme to stop government turning inflationary portion of interest rates into tax.

Paul
June 16, 2023

I recall at the time some absolute nonsense from then treasurer Costello justifying the change and how it was going to help bring more investment in to tech in Australia. I also recall the then opposition treasury spokesman Latham saying all it is going to do was put a rocket under asset prices, particularly houses, and all the smarties would be gearing up to invest.

The previous system was pretty equitable and we should have stuck with it.

Tony Dillon
June 15, 2023

Interesting Graham. And good arguments to revert back to indexing gains. I touched on a lot of this in my article just prior to the 2019 election, looking at the Labor proposal to drop the CGT discount to 25%, and the marginal tax rate effects. I refer to the second part of the article:

https://www.firstlinks.com.au/two-labor-policies-scrutiny

Richard Brannelly
June 15, 2023

While I am in favour of moving back to CPI adjusted taxing of capital gains in the interests of fairness, there is more complexity than the usual examples provided of a single rental property with one purchase and one disposal. Consider instead shares in an ASX listed company purchased 20-years ago with twice yearly dividend reinvestment - now you have 41 purchase points to be adjusted for inflation.......I am not volunteering to build that spreadsheet?
The housing crisis will require multiple solutions - returning to fully taxing capital gains (adjusted for CPI) is one. We should also be discussing quarantining losses from negative gearing of property to be carried forward against future profits and NOT offset against other income - that too will level the playing field for owner occupiers.
On the supply side we should also be following the lead from overseas where extra and/or higher taxes (land tax, rates etc) are applied to properties left empty for an unreasonable timeframe to boost supply. Extra supply hit instantly and extra revenue for state governments and councils to address structural deficits. I would love to know what % of our housing stock is consistently empty - anecdotally it appears excessively high?

Steve
June 16, 2023

You shouldn't need to build a spreadsheet, accountants or administrative services like Link or Computershare should be able to do that for you - the admin services have records of every purchase and when it happened so its a basic programme for them to write I would expect. Just don't get the govt to do it, it would be clunky and overly complicated.....

Steve Dodds
June 17, 2023

I use Sharesight. It calculates past and potential CGT for all my different holdings and lets me tweak assumptions.

This mainly for my own edification and strategising as I use a very highly regarded tax specialist to do the actual returns.

Whilst I expect them to be on top of everything, I still send them the Sharesight CGT report to keep them on their toes.

Unfortunately it is very share centric, with tolerable handling of funds, basic handling of cash, kludgeable handling of property, and no handling of super.

I already pay more for Sharesight than I think it is really worth, but would pay a bit more for a single program that allowed me to automatically track and analyse everything in one hit.

I would love a single app/program that did all

Heather Jessurun
June 15, 2023

I bought two house and land packages in Brisbane in 2005 and the properties have been rented out ever since. When I decide to sell, once the annual depreciation charge is deducted from the cost base, my capital gain will be stupendous even with only half of it taxed.

Johny
June 15, 2023

Just remembered the other slight of hand that the government introduced at the same time as the change to 50% discount

Previously, the actual tax was a little more complicated but fairer. You took 20% of the taxable gain, added it to your taxable income and calculated the increase in tax liability. Then you multiplied that increase by five.

A bit more complicated but what it did was reduce the likelihood of you being pushed into the highest tax bracket because all of the taxable gain was added into the current year's income

Consider an example. Bought a house for $100k 20 years ago. Sold it for $1000k. Under the 50% gain approach, $450k was added to your taxable income. so a lot of it was taxed at the top marginal tax rate. Under the old indexing system and for the purposes of simplicity, lets say that the index cost base had increased to $550k, so again the taxable gain was $450k. But now, $90k (20%) of that gain is added to your income, the tax calculated then multiplied by five. This would mean that very little of the gain would be taxed at the top marginal tax rate.

Steve
June 15, 2023

The modification the Democrats pushed for many years ago was eminently sensible. This used (a) the real capital gain, which as you note is easily calculated these days and (b) I think importantly in the interest of fairness, the division of the capital gain by 5 which was added to the taxpayers income and the additional tax calculated on this amount, and this was then multiplied by 5 to apply over the full capital gain. This allowed for those on modest incomes being shielded from a one-off tax hit which is disproportionate with their circumstances, for example if an asset was sold for $200k after being acquired for $100k say 5 years earlier. The nominal capital gain was $100k, the real gain with say 4% inflation would be around $80k. One fifth of that is $16k. Now assume the taxpayer is in the 32.5% bracket, the tax would be $5200 on $16k, so multiplied by 5 it becomes $26k on the full $80k gain. Without the one-fifth factor they could be pushed one or even two brackets higher for a gain that in fact took a number of years to accrue. If they are in the top bracket it makes no difference as the one fifth calculation would be done at the top rate anyway.
The 50% factor used today while simple is only correct or fair once (like a broken clock). It is always going to be too generous or too onerous depending on your circumstances. Also if "real" gains are taxed it removes one of the big arguments about tax concessions, which has to be a good thing if we can move to a more sensible/rational conversation about tax in general, which tends to be more emotive than rational depending which side of politics you are on.

john
June 16, 2023

A good argument for the stage 3 tax cuts that flatten out the tax scales

Aussie HIFIRE
June 15, 2023

The obvious answer as stated here is to move back to indexation in line with CPI. It's slightly more difficult to calculate than a blanket 50% discount, but we're not exactly talking rocket science here, and it's a lot fairer to everyone.

The question really should be why is this not still the system!

Michael
June 15, 2023

A great article on a very important subject, Graham. With the discount being widely seen as a rort, we are in real danger of it being removed without any replacement to compensate for the effect of inflation on the investment - with likely devastating effects on investment in housing, similar to when Keating tried abolishing negative gearing.

But in times of rapid upward price movement despite low inflation, the 50% discount can be a rort for short-term holders, as you point out. While that exists, the danger of uncompensated removal grows.

Surely, the perfect solution is as recommended by Fane and Richardson, asap.

Johny
June 15, 2023

As one that worked in finance in 1999 I have some recollection of the change, and in particular the comments of the "experts" at seminars at the time. They were all excited about the change. It will make things simpler and would reduce tax. At the time (and today too) I was more in what was "fair", as stated in Professors George Fane and Martin Richardson comment: ‘the simplest way to repair the capital gains tax is to return to the pre-1999 arrangements’. There is nothing "fair" about an arbitrary 50% discount. There is something intrinsically "fair" about taxing real gains (after adjusting for inflation).

john Flynne
June 15, 2023

graham, perhaps a sliding scale of getting to 50% over a period 5 -7 years would be more equitable

Greg
June 15, 2023

Let's say that a reasonable projection for ongoing gains on the stock market is 7%, comprised of 4% dividends and 3% capital gains. If inflation gets back to 2% (which is unlikely) that leaves a real gain of 1% and a nominal gain of 3%. Therefore, the discount needs to be 66% to result in a fair outcome. This equally applies to housing. Talk of reducing the discount below 50% is just uninformed nonsense.

 

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