IAN McAULEY. Capital gains taxes: Keating got it right in 1985

Apr 19, 2017

Most commentators on the crisis in housing affordability correctly attribute the problem, in part, to the Howard Government’s decision in 1999 to “halve the taxation of capital gains”. But that was only one aspect of the 1999 change: the other was an end of indexation. The combined effect was to shift investors’ incentives to favour speculation in high-growth but risky assets such as housing while penalising more conservative investments. Labor proposes to reduce the discount on capital gains, from 50 per cent to 25 per cent, without restoring indexation, but this would retain some of the worst aspects of the Howard changes. 

Last week I mentioned the Hawke-Keating Government’s two major business taxation reforms – dividend imputation and indexation of capital gains tax (CGT). I wrote about dividend imputation: this week I will cover Keating’s CGT reform.

Until 1985 Australia really had no system of CGT. Anyone with a half-competent accountant could find a loophole to avoid CGT.  That was a serious omission.

Taxation theory and commonsense both suggest that all financial returns from investment – a parcel of shares, an investment property, an antiquity –  should be taxed in the same way. Those returns are some combination of dividends over the life of the investment and a capital gain when the asset is sold.

To tax dividends and not capital gains distorted investors’ incentives. One effect was to encourage established firms to re-invest profits in their own expansion, rather than paying out dividends to investors who could allocate the cash to more promising investments.

Whenever there is inflation, however, some of the supposed capital gain is simply the result of inflation, and ideally only the “real” (inflation-adjusted) component of capital gain should be subject to tax.

In 1975 the Commonwealth’s Taxation Review Committee had produced a report (known as the “Asprey Report”), recommending that CGT be imposed when assets are sold, with indexation to remove the distortion of inflationary gains. The Asprey Report sat on the shelf for ten years, until as Treasurer in the recently-elected Labor Government, Keating implemented that reform in 1985.

In 1999, however, on the advice of the Review of Business Taxation, the Howard Government abolished indexation of CGT, but allowed a 50 per cent discount on the nominal gains on sale of an asset.

That change distorted incentives for investors, shifting them back towards the pre-1985 era. It favoured investors in assets with high growth in value – that is high capital gain – while comparatively penalising investors in more conservative assets.

A high growth in an asset’s market value can come about in two ways. One is through solid, real growth, such as occurs in our most successful companies. Over the long run, through good management and wise investments, such corporations achieve consistent growth above inflation.

The other way is through speculative investment on assets that are essentially static but in short supply. Their price rises as investors bid against one another. Such assets include rare coins, paintings by Monet, low number car number plates, and housing in capital cities. The dividend yield in such investments may be zero (in the case of antiquities ), or even negative in the case of housing when investors pay more in interest on a loan to finance the property than they receive in rent. That’s known as “negative gearing” – a story in investor distortion in itself that I won’t cover here.

To understand the way the Howard CGT changes favoured housing speculators over patient investors, I will walk through two examples – speculation in Sydney housing and an investment in a conservative share portfolio, comparing the outcomes under the original Keating system and the Howard system. Warning – mathematics ahead: If you wish to avoid the figures I suggest you jump to the concluding section.

A worked comparison between property speculation and share investment

Consider an investor who bought a house in Sydney in 1996 for $200 000 and sold it in 2016, twenty years later, for $900 000. That is in line with the 4.5 times rise in Sydney’s established house prices revealed in the ABS property price index.

Under Keating’s indexation method CGT would have been payable on the inflation-adjusted capital gain, and applying the rise in CPI over that period, 60 per cent, the cost base would be indexed up to $320 000 (i.e. $200 000 x 1.6), meaning CGT would have been payable on an inflation-adjusted gain of $580 000 (i.e. $900 000 – $320 000).

Under the Howard amendments, CGT would be payable on half the nominal gain of $700 000 (i.e. $900 000 – $200 000), or $350 000.  That’s a considerable reduction on  Keating’s indexation method.

Now consider a more conservative investor who in 1996 had put her $200 000 into 50 000 shares in Australian Foundation Investment Company, a listed investment company with a broad portfolio of investments, and a favoured vehicle for small and conservative investors.

In 1996 AFIC’s share price was $4.00, and in 2016 it had risen to $6.00. Therefore she would have realised $300 000 on the sale. (I have rounded the prices to keep the arithmetic manageable.)

Under indexation the cost base of those shares would have been indexed up to $320 000 – the same as for Sydney property speculator. But her profit for CGT would have been minus $20 000 (i.e. $300 000 – $320 000), a loss she could have offset against other capital gains.

Under the Howard amendments, however, CGT would be payable on half the nominal gain of $100 000, or $50 000. She’s had to pay tax on illusory capital gains.  Illusory, because for static assets such as housing (and particularly so for antiquities), there is no change in the nature of those assets.  Companies expand and grow: houses, apart from those that undergo substantial modernisation, stay the same or even depreciate.

The abandonment of indexation is an aspect of the Howard changes that few commentators mention.  (To his credit Crispin Hull of the Canberra Times wrote about it last weekend, but he’s a rare exception among journalists.)  Most commentators simply say that the Howard Government “halved the rate of CGT”.  But his changes, in failing to take inflation into account, actually penalised investors in low-growth or capital-stable assets.

This brings us to the changes Labor proposed in last year’s election: they involved subjecting 75 per cent of the nominal capital gain to CGT, rather than 50 per cent under the Howard changes.  Or as some put it, to reduce the discount from 50 per cent to 25 per cent.

Coming back to our two investors, the Sydney housing speculator would be assessed on a nominal gain of $525 000 (i.e. 75 per cent of $700 000). That’s close to the $580 000 that would have applied under the indexation method.

The share investor, however, who made a nominal gain of $100 000, but a loss in real (inflation-adjusted) terms, would be assessed on a capital gain of $75 000, rather than $50 000 under the Howard scheme, and a tax credit under the Keating indexation system.

Labor’s proposal retains the distortion of the Howard changes, and actually imposes an even heavier liability on those whose investments do not enjoy a high capital gain.

My guess is that Labor designed its proposal with average returns in mind – and for such investments it comes out close to the original indexation system – while ignoring the range of investment returns and its deleterious effects on conservative investors.  (I have covered the comparisons more formally in a New Matilda article published earlier this year.) 

Conclusion – let’s go back to Keating’s indexation system

The case for a return to CGT indexation without any discount is strong. It would essentially restore tax neutrality between dividends and capital gains, and more importantly, it would help channel investment away from assets whose supposed capital gain is the illusory price rise resulting from speculators outbidding one another.

It’s notable that two of the three members of the review that advised Howard on CGT changes were from the finance sector – John Ralph from the Commonwealth Bank and Bob Joss from Westpac. That’s the sector which has done so well, on paper at least, from the housing bubble. And all three members were managers or board members of large corporations – the stakeholders who, as I explained last week, have a vested interest in taxation arrangements favouring retention of earnings over payment of dividends. For these stakeholders corporate growth always trumps other objectives.

I have heard another explanation for the changes from two former senior public servants in Treasury. They claim that the Treasurer at the time, Peter Costello, couldn’t get his head around indexation, so opted for the simpler method proposed by the review. The explanation is plausible, but I have no way of verifying it.

Ian McAuley is an Adjunct Lecturer in Public Sector Finance at the University of Canberra and a Fellow at the Centre for Policy Development.

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