Reforming Capital Gains Tax: The Myths and Reality behind Australia’s Most Misunderstood Tax - The Centre for Independent Studies
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Reforming Capital Gains Tax: The Myths and Reality behind Australia’s Most Misunderstood Tax

Capital gains tax (CGT) has been a feature of the Australian tax system since 1985. The reforms instituted by the Ralph Business Taxation Review in 1999 sought to alleviate one of the world’s highest capital gains tax burdens that resulted from Australia’s then internationally anomalous taxation of capital gains at the same rates as ordinary income. The Ralph review recognised that an improved capital gains tax regime was needed to stimulate saving, investment and economic growth.

However, the Ralph reforms left an ambiguous legacy in terms of overall tax burden on capital gains. While the 50% CGT discount for individuals is widely thought to have halved the effective marginal tax rate on capital gains, it has been less widely acknowledged that the abolition of inflation indexation raises the marginal tax rate when capital gains are less than twice the rate of inflation. The implications of the Ralph CGT reforms vary widely depending on the type of taxpayer, asset class, and inflation environment.

The review of the tax system by Treasury Secretary Ken Henry (the Henry review) has identified Australia’s relatively high tax burden on capital as a priority for further reform. It remains to be seen how and to what extent the Henry review proposes to alleviate the tax burden on capital when it reports in March 2010. Given the constraints under which the Henry review is being conducted, any further reform of capital gains tax is likely to reflect new trade-offs made as part of reforms to the overall tax system. There is a risk that the review may see some backsliding on the Ralph CGT reforms.

Further reform of CGT should instead seek to build on the Ralph reforms by extending the current concessional treatment of capital gains tax. Given the scope for substantial gains in economic efficiency, as well as dynamic revenue gains from an expansion of the tax base that would offset any static revenue losses, further reform of CGT should be viewed as a priority for the tax reform process.

The economic case for taxing capital gains is widely acknowledged to be weak, even by supporters. CGT raises little revenue, but at a substantial cost in terms of economic welfare. The case for taxing capital gains rests almost entirely on equity considerations.

Growth in CGT realisations and revenue from individuals and funds since 1999 has outstripped that from companies, which did not benefit from a discount under the Ralph reforms. Individuals received a larger discount than funds (50% versus 33%), yet CGT revenue collected from the former has exceeded growth in the latter. The CGT share of Commonwealth tax revenue has nearly doubled since the Ralph reforms, from 3.4% to 6.6%. The data suggest that the Ralph reforms have seen more CGT revenue being collected, not less. This is consistent with international evidence on the responsiveness of capital gains realisations and tax revenue to changes in the CGT rate and predictions made a decade ago by those who advocated reform of Australia’s CGT regime.

In conjunction with negative gearing of investment property, the principal residence exemption from CGT and the Ralph capital gains tax discount are widely seen as skewing saving and investment decisions in favour of housing and putting upward pressure on house prices. Critics of capital gains tax concessions have focused on the short-term demand-side implications of this tax treatment, while ignoring the implications for long-run housing supply.

Looking through the regular cyclical fluctuations in housing activity, the dwelling investment share of GDP has been little changed on average over the post-War period under three different CGT regimes (pre-September 1985, post-September 1985, and post-September1999). However, this investment is yielding fewer new dwelling units per person than at any time since the late 1960s due to increased constraints on the supply of new housing. The result has been upward pressure on house prices and rents and reduced housing affordability. The solution to this housing affordability problem is not to impose new taxes on housing but to alleviate the supply-side impediments to the construction of new homes.

Options for further reform include a flat tax rate for capital gains, the abolition of minimum holding periods for concessional tax treatment, and the reinstatement of the indexation of capital gains for inflation.

Dr Stephen Kirchner is a Research Fellow at CIS. He was an economist with Action Economics, LLC and Director of Economic Research with Standard & Poor’s Institutional Market Services in Sydney and Singapore. He has lectured in economics at the University of New South Wales, Macquarie University, and the University of Technology, Sydney. He has a BA (Hons) from the Australian National University, a Master of Economics (Hons) from Macquarie University, and a PhD in economics from the University of New South Wales.