A long-time Firstlinks reader lamented recently that investors with assets held since the early 1990s will be disadvantaged by the new CGT rules. The changes will see the 50% discount on nominal capital gains replaced by indexation of the asset’s cost base for inflation. He argues that freezing indexation as at 30 September 1999 fails to recognise the erosion of purchasing power over long holding periods.
He also has a broader concern about whether the new regime effectively taxes real gains and recognises the economic cost of long-term saving and investing.
The good news for our reader is that the new legislation doesn’t force all pre-1999 assets back onto the old frozen indexation method. The existing rules permit eligible holders of pre-September 1999 assets to choose between the 50% discount and frozen indexation methods and continue to apply that to gains accrued up to 1 July 2027. From that date, the cost base is reset to the asset’s value at 1 July 2027, with gains accruing from that date indexed for inflation.
The Budget reforms do not retrospectively tax the entire historical gain under the new system.
The 50% discount may reward risk as well as inflation
But the reader's question raises a broader issue.
Do the new CGT arrangements reflect a fundamental shift away from recognising investment risk? Is indexation of the cost base for inflation enough? Should we also make some sort of allowance for risk? And how would that work?
Many view the shift from taxing discounted nominal gains to taxing real gains as simply a more precise adjustment for inflation. Yet the 50% discount may also contain an implicit allowance for risk.
Theory tells us that the expected return on investment should increase with risk. Assume that a risky asset purchased for $100 is held for a period and then sold for $150. A less risky asset is purchased at the same time for $100 and sold for $130 at the time of sale of the riskier asset.
Inflation was such that the cost base for both assets was indexed to $120. The real gain on the risky asset being $30, while the gain on the less risky asset is $10. The nominal gains were $50 and $30 respectively. The risky asset will therefore be taxable on 60% of its nominal gain ($30 real gain out of $50 nominal), with the less risky at just 33% ($10 real gain out of $30 nominal).
Yet under the 50% discount approach, both assets have 50% of their nominal gain taxable. It can preserve a greater share of the return as gains increase than indexation does.
The marginal after-tax reward from an additional dollar of gain adds only 50 cents to the taxable gain. Whereas with a fixed indexed cost base, each extra dollar adds a dollar to the taxable gain.
This is exactly the concern that tech start-ups and the like have with the move to an indexation CGT system.
Why indexation changes the incentive structure
The example shows that when taxing real capital gains by removing inflation from the calculation, the proportion of the taxable nominal gain can rise as the investment return rises relative to inflation.
But taxing discounted nominal gains leaves a fixed proportion of the gain taxable, with the investor retaining a constant proportion of each additional dollar of nominal gain. This can provide greater compensation for risk-taking than taxing real gains.
Therefore, while indexation may measure real gains more accurately, it may not encourage risk-taking as effectively as the existing discount system, particularly when the tax treatment of marginal gains is considered. Noting this doesn’t imply that the discount method necessarily produces superior after-tax results, because that will depend on actual inflation, return, and term of investment.
By delivering better marginal results, the 50% discount may encourage risk-taking more effectively than indexation. But in the end, it is a blunt instrument. It doesn’t explicitly distinguish between inflation, compensation for risk, or the length of time that capital is committed. Nor does it differentiate between levels of risk because low-risk investments receive the same discount on gains as speculative investments.
A case for indexing the cost base beyond inflation
The CGT debate should go beyond discussion around inflation adjustment, or whether the 50% discount is too generous. It should also consider how the system affects the reward for taking on investment risk. How should CGT policy recognise the return required to commit capital, and the risks involved?
Now that cost-base indexation is the preferred CGT mechanism, albeit only to account for inflation, here’s a radical idea: could we index for risk?
At a minimum, that might look like indexing the cost base at a risk-free rate like a government bond yield, to at least compensate for tying money up. But then why not go all the way and compensate for putting the capital at risk? This would require indexation at an appropriate risk-adjusted rate.
Three ways to define a taxable gain
Essentially therefore, three different levels of cost base adjustment would be possible:
- Inflation: leaves just the real capital gain taxable (the new method from 1 July 2027).
- A risk-free return: exempts a return that could have been earned without taking investment risk. Compensates for committing capital over time.
- A risk-adjusted return: exempts a return that could have been earned taking investment risk. Compensates for committing risk capital over time.
The third level of adjustment may accommodate investors who require an expected return to justify taking on risk. Without it, the after-tax reward may be insufficient to compensate for the risk involved, and investment may not go ahead.
We are seeing that presently with reports of property developers pulling projects post the May Budget. Large Sydney developer Bathla Group left thousands of homes under construction or in the pipeline with an uncertain future, as it was placed into voluntary administration in August. Management attributed the failure to a “perfect storm” of rising construction costs and the May Federal Budget.
Higher expected returns are the reward for risk, but they are never guaranteed. Allowing investors to retain more of any gains may encourage capital to flow into riskier, potentially more productive investments.
The challenge of measuring risk
What might a return that includes compensation for risk look like? Should it vary with risk, and how would losses be treated?
Implementing a risk-adjusted rate depending on the investment would be problematic. How would the system determine how much risk allowance a particular investment deserves? It shouldn't be so high that it encourages investing in ostrich eggs, for example.
Perhaps a prescribed rate might be appropriate to encourage investment and entrepreneurship.
Returning to the numerical example with the risky investment of $100 selling for $150. The inflation-adjusted cost base of $120 yielded a $30 taxable gain. But suppose a risk-adjusted cost base of $135 instead produces a taxable gain of $15.
In that case, the investor would retain more of the gain from a successful investment. And the prospect of better after-tax gains might see more projects proceed in general.
Importantly though, an incentive-based tax system doesn’t remove the risk of a loss. Nor does it necessarily mean less aggregate tax revenue if it encourages more investment and flow-on economic activity. And if productive capacity is lifted more broadly, then all the better for the economy.
Such a prescribed rate could be set at a risk-free rate plus a balanced margin. In effect, only taxing gains in excess of a reasonable benchmark return would be taxed, as opposed to real gains under the new regime. It would effectively be a system with a deduction for a ‘deemed’ return on capital, that could improve the attractiveness of investment.
What about losses?
Careful consideration would need to be given as to how capital losses are handled. I have been an advocate for the symmetric treatment of losses under the new CGT regime such that real losses should be allowed against gains or carried forward in the absence of gains. The new system, however, only allows nominal losses into the equation.
So should a tax system that gives investors more upside on investment be symmetric in its treatment of losses?
Enlarging the loss on an underperformed investment might be too generous and could encourage excessive risk-taking behaviour. In any case, a taxable loss larger than the actual economic loss would not be desirable. Measuring losses against a cost base indexed for inflation only, might be a suitable compromise, but that would require two different indexed cost bases, depending on whether the investment made a gain or a loss. It is a complication that requires further thinking.
A radical idea, but not unprecedented
A risk adjustment allowance to CGT may not be as radical as people think. After all, it wouldn’t even be the most generous capital gains concession among developed nations. For example, New Zealand and Singapore generally do not tax capital gains, providing an even greater incentive to invest than any form of indexed cost-base system.
Whether policymakers have any appetite for such an approach is another matter. Our reader's concern may therefore extend beyond inflation to the shift from a regime that provided some implicit allowance for the risk taken to generate gains, to one that allows only for inflation.
Tony Dillon is a freelance writer and former actuary. This article is general information and does not consider the circumstances of any investor.