The simple truth about capital gains

A bit of history and politics

Prior to September 1985 we didn’t tax capital gains in Australia. This was a hang-over from our English monarchical heritage, when the King was happy to tax the toils of peasants and the profits of ‘dirty’ merchants, but couldn’t afford the political fallout associated with taxing any appreciation in the capital value of the landed class. To be fair, prior to the late 1700s and early 1800s there wasn’t really much in the way of real capital gains to tax. This is because capital gains are largely a product of real increases in the productivity of capital, and there wasn’t much of this prior to the Industrial Revolution(s). ‘Capital assets’ were largely a store of wealth, rather than a generator…

As productivity and population increases took off and accelerated during the twentieth century, the distinction between taxed ‘income’ and untaxed ‘capital gains’ became more and more stark. Many tax cases were fought on this income-capital distinction around the common law world. The Tax Office would seek to characterise a surplus as ‘income’ (the product of toil), while the taxpayer would argue it was a ‘mere’ realisation of a capital gain.

September 1985… and the taxation of ‘real’ gains

In Australia, this debate largely ended in 1985, when the Hawke-Keating Labor government brought in a comprehensive capital gains tax along with a number of other significant tax and income reforms.

Like many things of the Hawke-Keating era, this tax policy was very well thought through, and based on rigorous academic analysis – in stark contrast to the poorly constructed ‘reforms’ by both sides of politics in recent times. The 1985 policy was to tax ‘real capital gains’ on the same basis as income – thereby effectively eliminating the income-capital distinction.

This policy was achieved by taking the original cost of the asset and ‘inflating’ it to remove the impact of inflation over the ownership period (called ‘indexation’), and then subtracting this ‘indexed cost’ from the proceeds received from selling the asset. This would arrive at the ‘real’ capital gain (or loss). The real capital gain was then added to the taxpayer’s ordinary income, to arrive at their total taxable income. In this way, only an increase in the taxpayer’s real ‘purchasing power’ was taxed – just like their income. Importantly, any fall in purchasing power (due to inflation) was not taxed. The reason for not taxing inflation was to avoid the disincentive to invest over the long-term associated with taxing inflation.

Let’s see how this works.

Say you purchased an asset for $1,000 in December 1985, and you sold it for $3,000 30 years later in December 2015. Your nominal gain is simply $2,000 ($3,000 proceeds less $1,000 original cost). But it would cost you $2,676 in 2015 to buy the same bundle of goods you could get back in 1985 for $1,000 (due to inflation). So your ‘real’ gain in purchasing power is only $324 ($3,000 less $2,676). Now if you pay tax on the full $2,000 nominal gain at 47%, you would be left with $2,060 today ($3,000 less $940 tax). So investing the $1,000 back in 1985 has COST you $616 in purchasing power ($2,676 less $2,060). In real terms, after-tax, you have made a loss. Any rational person would have spent the $1,000 back in 1985, rather than invest it (taking an investment risk) to end up with less purchasing power 30 years later. This is why taxing nominal gains acts as a disincentive to invest long-term. It is why the Hawke-Keating government brought in a regime that avoided this pitfall.

The other thing to bear in mind is that the latter part of this period has had very (very) low inflation from a historical perspective – and way below the RBA target of 3% per annum. The disincentive to invest noted above increases with the rate of inflation.

So far so good, we had a capital gains tax that only taxed the real gain, and therefore there was no disincentive to invest over the long-term. In the above example, you would only pay tax on the real gain of $324. At a tax rate of 47% you would pay $152 tax, leaving you $172 better off in 2015 than back in 1985. Furthermore, the taxation treatment of gains and income was largely the same. The only ‘distortion’ left in the system was the continued tax-free status of gains on assets purchased prior to 1985.

Then Costello got involved… and gave us all a ‘discount’

Then in September 1999 some genius (à la Treasurer Costello) decided to remove the indexation of capital gains and replace it with the general ’50% CGT discount’. It is hard to understand why, but for a limited group of taxpayers, it was a great change. The 50% CGT discount massively benefits speculators and successful entrepreneurs, who make high, short-term gains, off low original investments. But for the vast majority of long-term investors in capital assets – it is a silly change.

Let me explain.

During the end of the Dot-Com bubble, the 50% CGT discount was manna from heaven. You could set up a company for little up-front investment, grow it rapidly, sell it after a couple of years for a massive gain, and only pay around 24% tax (after the discount). For relatively short-term and high capital gains, the discount rules. The bigger the gain, the bigger the tax saving. Inflation was also dead, and was therefore not a big factor. Add to this a debt-fuelled bubble in almost all asset classes, and everyone loved the 50% discount! (Except Labor…)

However, this is not how capital grows over the longer term, and for the vast majority of taxpayers. On average, capital gains are made up of two things, and two things only – increases in productivity, and inflation. That’s it. Capital productivity in Australia has been stagnant for decades, and long-term multi-factor productivity has been below an anaemic 1% – well below the OECD average over the same period. Inflation – as measured by the ABS – has also been low. However, we all know that is not what has been happening to asset values – they have been booming. As noted above, assets of all classes have been tied to the rocket of debt – which has been growing at an exponential rate. So speculators in assets have been riding a debt-fuelled asset price bubble, and only paying a relatively low top rate of around 24% tax. This is what Labor is upset about.

So what does all this mean?

First, the 50% discount has no logical rationale. It gives rise to winners (who make short-term, high gains, off low original investments), and losers (who make long-term, inflation-adjusted gains, from relatively high initial investments – i.e. most of us). The longer you hold an asset, the more likely you will be worse off with the 50% discount, and would have been better off with indexation (i.e. taxation of inflation-adjusted real gains). This is because the value of the ‘fixed’ 50% discount falls over time as the component of the gain referable to inflation rises. This assumes you actually made a ‘capital investment’ in the first place.

Secondly, the method of taxing only ‘real’ (inflation-adjusted) capital gains is the least distorting policy. It truly equates capital gains and ordinary income, and taxes them both fairly. This is what Hawke and Keating introduced.

For example, in the case of a high-tech company that starts with little up-front capital investment, and grows over time by fully deducting the cost of funding its growth, the ‘fair’ thing to do is to tax the resulting gain in a similar manner to ‘income’. There is no original ‘investment’ here that produces the gain. The progressive investment in research, wages and overhead is fully deducted along the way (even incentivised in the case of R&D). To the extent a deduction is not available for certain costs along the way, then the costs accrue to the cost base and ultimately reduce any assessable gain at the end.

Take for example our friends at the software company Atlassian who have started a company from nothing and grown it into a multi-billion dollar guerrilla in less than a couple of decades. As and when they cash out, they pay a top tax rate of below 24% on the ‘gain’ (after the 50% discount), while a person working for a wage their entire life pays a marginal rate double the size on their ‘ordinary income’. How is the end product of Mike Cannon-Brookes’ daily efforts any different to those of Jo-Blow? Basically, if you can afford to defer earning cash for more than 12 months, you end up paying half the rate of tax.

This is not going to be a popular view, but it is internally consistent with the policy of taxing gains and income in a similar fashion – to remove any distortion. On the other hand, if we tax all ‘capital gains’ on some concessional basis (other than allowing for inflation), then two things happen: First, us lawyers have fun arguing the distinction between what is truly a ‘capital gain’ and what is ‘income’. Secondly, economic decisions are going to be distorted towards earning gains at the expense of short term income (hence our love-affair with ‘negative gearing’).

I should say that if the Government wants to encourage or reward certain behaviour, then they could provide a targeted concession for certain capital gains, such as they do for your home or for small businesses. However, the ‘general’ 50% discount provides a blanket concession for all capital gains – hence the strong incentive towards negatively gearing almost any asset that an Australian can get their hands on.

Taxing nominal gains without indexation

Finally, on the other hand, taxing nominal gains (not adjusted for inflation) is biased towards current consumption, and against long-term prudent investment – and is therefore also a very bad policy. The Hawke-Keating government would never have imagined the concept of taxing nominal gains, not adjusted for inflation. Crazy concept!

The Shorten Opposition proposed halving the CGT discount to 25%, or maybe eliminate it completely. No mention of re-introducing indexation (i.e. adjusting for inflation)… This is the worst possible policy. It neither equates gains with income, nor taxes them fairly, and is likely to create a bias against long-term prudent investment in productive assets.

Let’s go back to the future, and eliminate the discount and re-introduce indexation for all gains. If the Government then wants to encourage certain investment, it can provide targeted and transparent concessions. Simple, really.

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