Thilini Wickramasuriya uncovers a fundamental problem within the tax system and asks if it’s fair for wage earners to be taxed at double the rate of those who accumulate their wealth in capital gains.
The debate on negative gearing is not just about negative gearing, it is about something far more fundamental. Simmering under the recent public commentary on negative gearing is the issue of whether we should continue to tax capital less than income. Is it fair to tax someone who earns money on the sale of a property at half the rate of someone who earns money from employment?
The potential tax advantage of negative gearing is mainly the reduced tax rate on the capital gain earned from the asset. It would be more equitable and less complex to address the negative gearing issue by removing the 50% capital gains tax discount. Where interest expenses in relation to a capital asset are deductible in the year in which they are incurred, it is inequitable that only 50% of a capital gain realised in a later year is subject to tax. So why the reluctance to remove the tax discount on capital gains?
The Australian tax bible, Parsons’ Income Taxation in Australia (which was coincidentally published in 1985, just before the capital gains tax came in), described the hot debate at the time on taxing capital gains. Parsons noted that the case for including capital gains in the base for income tax “is made in terms of the need to make the income tax comprehensive in order to cure inequity. There is a failure to treat equally persons with equal gains, and those who are not taxed because their gains are capital gains tend to be those who in total have the greater gains.”
As the recent Murray Inquiry into our financial system explained, this is worse in relation to leveraged investments (i.e. negatively geared capital assets). Such investments are taxed in an asymmetric way because expenses incurred in borrowing to buy the asset are tax deductible immediately, but the capital gains on the asset is taxed only when realised, and then at a concessional rate. This results in an after-tax return above the pre-tax return (i.e. the tax tail wagging the commercial dog). This increase in after-tax return is larger for those on higher marginal tax rates (i.e. higher incomes). That is, the benefit of negative gearing is greater for the wealthy.
The case against taxing capital gains is described as discouraging investment. It is also described as causing liquidity issues (if you have a capital asset and you haven’t sold it yet, how will you have the cash to pay the tax?) and mobility (if you only tax on the sale, so that you have the cash to pay the tax, won’t that just stop people from selling capital assets?). Yet the Murray Inquiry found that reducing capital gains tax concessions for assets would lead to a more efficient allocation of funding in the economy. As the Asprey Report pointed out in 1975, the case for taxing capital gains is based not just on equity but also on economic efficiency. When capital gains are taxed less than income, investments in the kinds of assets on which capital returns can be made will become more profitable, leading to a misallocation of resources on the basis of tax outcomes.
Every year, the treasury publishes a statement describing the Australia government’s tax expenditures. The annual Tax Expenditure Statement essentially details the revenue forgone by the government due to carve-outs in our tax system. The statement is published in order to inform debate about the efficiency and equity of our tax system. Every year, the statement shows that the biggest tax expenditure is the capital gains tax main residence exemption. The estimated revenue forgone from this measure was a staggering $25,500,000,000 in 2014-15. The CGT discount for individuals and trusts is also up there with revenue forgone of $5,800,000,000. The statement was released with little public fanfare.
Fundamentally, we must ask ourselves whether those who generate income from working and earning salary and wages, should continue to be taxed at double the rate of those who accumulate their wealth in capital assets. As the French economist Thomas Piketty has pointed out, the wealthiest among us have much more capital and this gap is increasing because capital grows relatively fast. One cannot become extremely wealthy in this era simply on the basis of one’s job. In this context, the concessional taxation of capital gains exacerbates this inequality and undermines the progressiveness of our tax system.
It is little wonder that taxing capital less than income has become a political hot potato.