In an ideal accounting world with a comprehensive income tax, all increases in a taxpayer’s stock of wealth in a given accounting period would be taxed at the end of that period. If your investment property’s value went up in one year, for example, you’d pay tax on the increase at the end of that year (on an accruals basis). Likewise, all decreases in wealth would be deductible on the same basis.
Australia, like many countries, varies from this ideal by only taking capital gains and losses into account for tax purposes when they are realised.
This model results in tax induced distortions in investor behaviour. Capital gains and losses on assets are not given the same tax treatment as gains and losses on economically equivalent investments. It’s the reason negative gearing is so popular. You get the deduction each year but don’t pay tax on the increase in the value of the asset until you sell it.
Two key distortions flow as a result of Australians only being taxed when they realise the gains on their assets. Firstly, in the absence of an adjustment for inflation, inflationary rather than real gains are taxed. Second, there’s a deferral advantage from having the gain on an appreciating asset taxed some time in the future as compared with investing in an asset which produces an annual return which is taxed each year.
Australia’s current tax law exacerbates the deferral distortion by: not taxing gains on pre-CGT assets; not taxing gains on a taxpayer’s main residence; and by discounting gains derived by individuals, trusts and superannuation funds.
One way to fix this distortion would be to continue to tax capital gains on all assets on a realisation basis, with an adjustment for inflation, but give no discount.
At the same time, there could be an additional compensatory tax on realisation. This would provide equal tax treatment with an investor who derived and was taxed on the same gain periodically over the same term as the owner held the asset.
For these ideas to be pursued systematically to their logical conclusion the following changes would also need to be implemented:
Prospective taxation of capital gains on all pre-20th September 1985 assets and main residences by allowing a cost of market value at the date of introduction of the changed system;
Regarding death as a realisation event with a rollover where the beneficiary is a spouse or dependant.
This approach would reduce the tax distortions affecting savings and investment decisions, resulting in a more efficient allocation of resources. The use of a broader base would provide revenue for a general lowering of tax rates.
It would also neutralise negative gearing as an investment strategy, since it only works because the interest deduction is allowed in the current year while tax on the capital gain is deferred until realisation (and then given a discount for individuals, trusts and super funds).
Amending taxation in this way would also increase vertical equity as capital gains are currently concentrated in the asset owning segment of the population. It would simplify tax legislation by removing more than 170 provisions currently in the Income Tax Assessment Act.
The proposal would also open up a more radical possibility – only taxing individuals and not taxing entities such as companies, trusts or superannuation funds. Distributions from companies, trusts and superannuation funds to individuals and capital gains, and losses on interests in these entities would still be taxed at the individual taxpayer level.
Abolishing entity level taxation would be a radical response to profit shifting by multinationals. It would be expensive and would have to be phased in over time. Ideally existing bilateral tax treaties with at least Australia’s trading and investment partners would have to be reworked.
Abolishing entity level taxation would represent a significant shift to taxing income (in the broad sense of “gain”) where individual investors reside. Removing entity level taxation would enable further significant simplification of tax legislation by the repeal of whole divisions dealing with such matters as debt and equity rules, thin capitalisation, dividend streaming, franking credit trading and so on.
John Taylor is a Professor at the School of Taxation and Business Law at UNSW Australia.
This article was first published on The Conversation.