Back to 1999: Think tank floats return to pre-CGT discount cost base indexing

In a submission to the government inquiry into the capital gains tax (CGT) discount, a policy think tank has urged policymakers to consider replacing the discount with a general allowance for inflation and income averaging, akin to the system in place prior to 1999.

The e61 Institute argued the 50 per cent CGT discount was “inequitable and inefficient,” and failed to address the two key issues it was designed to fix: taxation of inflation, and the treatment of ‘lumpy’ capital gains in Australia’s annualised income tax system.

“The current discount fails to properly mitigate either of these concerns. It overcompensates high-income earners and undercompensates low-income earners for these issues,” the report’s authors, Greg Kaplan, Matthew Maltman and Matt Nolan, said.

“This is not just inequitable, but distorts the way Australian’s work, save, invest, and finance their investments – generating broader productivity costs and reducing the ability for the tax system to raise necessary revenue.”

The authors argued that the CGT discount, in its current form, breached principles of horizontal equity in the tax system for higher earners. Their analysis found that individuals at the 99th income percentile could see effective tax rates ranging from 19 per cent to almost 40 per cent in a given year.

The CGT discount explained nearly 80 per cent of this discrepancy, the researchers found.

“If the tax system aims to tax a dollar of income equally regardless of how it is generated, then this differential treatment violates horizontal equity – the concept that individuals with the same ability to pay should face similar tax burdens irrespective of how their lifetime income is earned,” the submission noted.

Furthermore, while the researchers said compensating taxpayers for inflation was a good idea in principle, they noted this logic was not applied uniformly across the tax system. For example, nominal interest and dividends remained fully taxable.

“Currently, Australia taxes the inflationary component of other capital income which means capital gains are being treated differently to other capital income in the presence of inflation,” they noted.

Given this, the authors said inflation alone was not enough to justify the CGT discount. That being said, if the government sought to give an allowance for inflation, the e61 Institute suggested a return to cost base indexing could be appropriate.

Looking to the second issue that the CGT discount sought to address - the treatment of ‘lumpy’ income in Australia’s annualised income tax system - the e61 Institute suggested that income averaging could be applied.

“A revised form of income averaging — allocating the gain across the years the asset was held — could substantially improve the fairness and neutrality of capital gains taxation,” the submission noted.

However, the authors acknowledged that this would require complex multi-year liability calculations which would impose “unreasonable” burdens on taxpayers without strong administrative support.

The e61 Institute added that income averaging could create opportunities for tax planning through trusts, one of the reasons that the capital gains tax discount was introduced in 1999.

Regardless, the authors argued that modern administrative capabilities had altered the trade-off between simplicity and accuracy in taxing capital gains. Digital record-keeping, pre-fill and better ATO systems would make it considerably cheaper and easier to collect accurate asset-level information than in the pre-1999 environment.

This raised the possibility of returning to the pre-CGT cost base indexing system, which more closely aligned tax with economic accrual, the submission noted.

“Ultimately, the taxation of capital gains reflects a clear trade-off. A discount-based system offers simplicity, but at the cost of significant inequities and distortions. A system that aligns tax liabilities with real economic income offers greater fairness and efficiency, but requires more sophisticated information and administration,” the submission read.

“The central question is whether modern technology and reporting systems now make it possible to implement a more principled approach at reasonable cost — and whether the benefits of simplicity in the current system continue to outweigh the inequities and inefficiencies.”