Capital gains tax discount and negative gearing
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Keep negative gearing, scrap the Capital Gains Tax Discount
Negative gearing gets a beating in the media for causing increases in the price of housing. We at the Science Party believe that there is a more complicated reason why negative gearing is problematic: its combination with the 12 month Capital Gains Discount.
All income is a form of return on capital
Whether it's interest from a savings account, dividends from share holdings, or wages and salaries that reflect human capital - the skills and abilities people have - all income ultimately flows out of some form of capital. A capital gain on an appreciating asset represents income, like any other.
All forms of income should be taxed the same way
In an ideal tax system, to the greatest extent that is practical, the different types of income should not be treated differently - they should all fall under the same scheme of progressive, marginal, personal income taxation.
First, as a matter of efficiency — taxing any form of income advantageously induces people to over-invest in generating that type of income, creating a deadweight loss - an economic cost to society of the tax beyond the amount of revenue raised.
Second, as a matter of equity — differential treatment can give rise to unfairly differential outcomes. Preferentially taxing capital gains is one of the most regressive types of tax concession imaginable, because of all the types of income there are — wages, bank interest, Centrelink benefits, etc. — poorer and marginalized Australians have the least access to capital gains.
Capital gains typically accrue over long periods of time, unlike other forms of income which are more typically earned on a weekly or monthly basis. The tax system must obviously take this into account, but not in a way that provides distortionary or unfair tax breaks.
How negative gearing works
If there are expenses in running an investment (such as maintenance or interest paid on loans) and they exceed the revenue made by the investment (such as rent), then you can reduce your other income by that amount. For example, if a rental property makes $30 000 in rent in a year, but the owner pays $50 000 in maintenance and interest payments and so makes a $20 000 loss that year, then the investor can subtract that $20 000 from the taxable income they get from their regular job.
Essentially, the idea of negative gearing allows people to make a loss in one year, which reduces their income in that year. If the investment makes a profit in later years it will be taxed then (either through tax on earnings or on capital gains)
How the Capital Gains Tax discount works
When you buy an asset, and sell it for more money than you bought it for, the asset has made a capital gain. As money has been made on the investment, you need to pay tax on it and that tax is paid at your marginal tax rate.
Under the current taxation scheme, there is a concession applied: if you held the investment for longer than 12 months you would qualify for the Capital Gains Tax Discount. The Capital Gains Tax Discount decreases the amount of the gain you are taxed on by 50%, essentially resulting in a 50% reduction in the tax you pay on that income.
Why do we have a Capital Gains Tax Discount in the first place?
The Capital Gains Tax Discount originates from the idea that when we calculate capital gains, we have to take into account inflation, i.e. we should tax only the real increase in the value of the asset.
An asset that only keeps up with inflation doesn’t actually increase in real value. For example, imagine you have an investment worth $10 000 in 2015. In 2016 you sell it for $10 300 (or a 3% increase) and the consumer price index goes up by 3%. In 2016 you can only buy about the same amount of things for $10 300 that you could with $10 000 in 2015.
Prior to 1999, the cost base of assets for CGT purposes was adjusted according to the Consumer Price Index (CPI). This was a complicated calculation to do with pencil and paper: it required investors to determine when money was invested, when it was taken out, and what the inflation adjusted value of the invested money was at the time of selling the asset. At the time, the introduction of the flat 50% CGT Discount was justified on the grounds that the calculation was too difficult. A simple 50% reduction in the capital gains when calculating taxable income therefore resulted in a 50% reduction in taxes paid.
What’s wrong with a Capital Gains Tax Discount?
The Capital Gains Tax Discount is essentially a tax hand out to people who own capital: people who are wealthy enough to generate their income by buying and selling capital assets (held for longer than 12 months) end up paying a lower tax rate on that income than those who work to earn the same amount of money. In this way, the Capital Gains Tax Discount causes distortions in the way people invest money, particularly with regards to investment in residential property, and this has implications for housing affordability.
The original purpose for the CGT discount no longer exists
When the CGT discount was first introduced to replace the more complex indexation method, it may have been possible to successfully argue that the benefits of making capital gains easier to calculate outweighed the distortionary impact of the discount. In the era of cloud computing and ubiquitous apps that we live in today however, this argument no longer holds water.
The current CGT discount is too generous
In the figure below, we show how excessively generous the Capital Gains Discount is in comparison to a CPI adjusted system. An asset is assumed to have been purchased for $100,000 and held for 10 years. CPI is assumed to grow at 2.61% (20 year historical average) and the individual is assumed to be earning enough to enter the top marginal tax bracket (47% marginal tax rate). As the CPI adjustment varies depending on the percent return on investment, we consider four investment scenarios:
- Returns are equal to CPI growth (no change in asset value in real terms)
- 5% annualised growth
- 10% annualised growth
- 25% annualised growth
The figure shows that people who own assets that only keep up with the CPI are taxed too much (when they shouldn’t be taxed) while people who own assets that increase in value greatly pay approximately half the tax that they would under a CPI adjusted CGT system.
Note that this modelling does not take into consideration when capital gains take an individual into higher tax brackets. Under such situations, individuals may pay even less than half the tax that they would expect to pay under a CPI adjusted system.
Recommendation 1:
That proper CPI-indexed taxation of capital gains be restored, with the flat 50% discount abolished.
Recommendation 2:
Investigate mechanisms by which moderate income earners may minimize their exposure to high tax liabilities from “lumpy” capital gains income streams.
For instance, it may be worth considering a general scheme whereby capital gains on large assets are recognized as income over more than one taxable year, (e.g. the same number of years for which the asset was held) In this way, a typical person on a mid-range marginal tax bracket whose savings are mostly tied up in a few large assets can experience capital gain events without paying nearly all their tax on that income at the top marginal rate.
Taxation of housing
The Australian housing market does not need tax breaks and subsidies to bring ever more money chasing after it. It needs more supply, through planning, development and land use reform.
Owner-occupiers of housing already receive a large effective tax break - namely, the value of their imputed rent. If you have an income producing asset (including yourself), and from that income you pay rent, the cost of your housing is not a tax deduction - you pay the full rate of tax on the income. However, if the asset in question happens to be your own home, in which you live (in lieu of charging a tenant rent), the value that the asset generates does not count as income. Effectively, your rent is now being paid by a completely tax free form of income.
Increasingly, home ownership is beyond the reach of the young and the poor, so this becomes another subsidy to the well-off. We are facing a generation for whom “the family home” will not be a politically sacrosanct asset, because the family home will be rented. Given this, a 0% rate of taxation for capital gains is unconscionable.
Recommendation 3:
Apply normal capital gains treatment to all housing, both owner-occupied and investment; taxing gains to the improved value of; or, if land taxation is not implemented (see Land Value Tax section), the total value of all housing.
Owner occupiers should be given means to record costs associated with significant value improving expenditures (e.g. the construction of a new storey on a house) in their personal income tax return. In this way, owners aren’t penalised for improving their homes, only the real capital gain is taxed.
Bank interest
Recommendation 4:
That bank interest on deposits be eligible for a CPI indexed discount, in which a bank will be able to declare “non-taxed” and “taxable” interest. The tax payable on interest will be determined as the amount that brings the interest above the rate of CPI. Interest rates that are below the CPI will not be eligible for a carryforward “interest loss”.
Inflation causes money to lose value with time. What we can buy with $100 in a year will generally be less than what we can buy with $100 today. It is for this reason that interest earnt on bank deposits do not represent pure profit; rather, some of the interest earnt on deposits represent the decreasing value of money with time.
We recommend a system that is simple and treats capital gains income and interest income fairly.
To simplify the calculation of taxable bank interest, the CPI adjustment is performed at the date that the interest is paid. The CPI adjustment rate will not be the real CPI, as it takes some time for that figure to be calculated accurately. Instead, the Australian Taxation Office (ATO) will provide a CPI adjustment rate based on recent historical averages and trends. For example, the ATO may say that the nominal CPI adjustment of bank interest is 2.5% PA. Although real CPI may be higher or lower than the estimated level determined, we believe that the simplicity in calculation is more important than perfect adjustment.
Some additional rules may need to be determined at a later date. For example, it may be necessary to provide some legislative guidance as to how to calculate the interest rate. Basing interest on the maximum value deposited in that account for the period over which interest rates are calculated (e.g. a month) will allow the account holder to claim more CPI adjustment than they are entitled to. We believe that this is an unlikely not impossible strategy that banks could use to provide advantageous taxation positions for their clients.
Calculation Example 1:
Consider an account that earns $1000 in interest in a year, and interest is calculated annually. Let us assume that the interest rate is 4% PA and CPI is 3% PA. The ratio of these rates is 0.75. The bank will indicate to the account holder that they have accrued a "taxable interest" of $250, and non-taxable interest of $750.
Calculation Example 2:
Consider an account that earns $100 in interest in a month, and interest is calculated monthly. Let us assume that the annual interest rate is 4% PA and CPI is 3% PA. The monthly interest is calculated as being 0.327% per month. The monthly CPI adjustment is 0.247%. The ratio of these values is 0.755. The bank will indicate to the account holder that they have accrued a "taxable interest" of $250, and non-taxable interest of $75.50.
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