It appears that capital gains and negative gearing tax concessions are on the nose with everyone except the Prime Minister.
How on earth did we come to be lumbered with a tax rule so bad it is disliked by the Treasury, the Reserve Bank, the Business Council, the Council of Social Service, the Organisation for Economic Co-operation and Development, and both of Tony Abbott’s most trusted business advisers?
And why on earth is Abbott still clinging to it?
The story of how we came to be saddled with a system that taxes wages at twice the rate of profits made from trading real estate is an epic tale of revenge, incompetence, bloody-mindedness and gullibility. Along the way it has forced Treasurer Joe Hockey to set income tax rates higher than he should and fed an explosion in house prices by supercharging negative gearing.
It is, as economist Rory Robertson told his clients in the early 2000s, “almost as though the Australian tax system has been screaming at taxpayers to gear up to earn increased capital gains rather than to work harder to earn increased wages or salaries”.
The tale begins in 1985 with what now seem two unremarkable decisions.
As part of the tax white paper process, Labor treasurer Paul Keating made fringe benefits and capital gains subject to tax. Remarkably, up to that point they hadn’t been. It meant that if you were paid half your salary in benefits you weren’t taxed on it. If you made half your income buying and selling property or shares, you weren’t taxed on that. Only ordinary wage earners paid full tax.
These days the Coalition claims to have supported Labor’s reforms of the 1980s. But it didn’t support those two. The then opposition leader John Howard fumed. “Both should be scrapped – lock, stock and barrel,” he said.
Labor made a generous and unnecessary concession. Instead of taxing the entire profit on the purchase and resale of shares or property, it taxed only the profit over and above the rate of inflation. This meant a negatively geared landlord could deduct from their taxable income all their interest payments (including the inflation component) but would have added to their taxable income only their “real” profit (excluding the inflation component).
But over time the rate of inflation fell. More than 8 per cent when Labor introduced the concession, it was heading to 2 per cent by the time Howard took over as prime minister in 1996. Speculators were close to being properly taxed. So under cover of introducing the goods and services tax, he asked his friend John Ralph to conduct a review of “business” taxation, sneaking in a very specific reference to personal tax.
The panel was to examine “capping the rate of tax applying to capital gains for individuals at 30 per cent”.
The stock exchange lobbied hard. It commissioned a US economist associated with Reagan-era tax cuts to produce modelling showing that cuts to the capital gains tax rate “ would be close to self-funding“.
They would “yield large revenue feedbacks as holders of relevant assets are provided a greater incentive to sell”. Really.
The stock exchange put (rough) numbers on it. At the time capital gains tax collections amounted to 0.4 per cent of GDP. If Australia cut the rate to near where it was in the United States, collections could climb to 0.7 per cent.
Ralph bought it. Under the heading “Rewarding Risk and Innovation”, he told Howard to tax only half of each capital gain, and found that on balance the change would bring in more money than it lost.
Fifteen years on, it’s possible to assess that claim. Before the cut, capital gains tax accounted for 0.4 per cent of GDP. In the latest year for which we have figures (2012-13) it brought in just 0.2 per cent.
Had capital gains tax been as effective as it was before Howard cut it, it would have brought in an extra $3 billion.
Ralph thought the cut would “encourage a greater level of investment, particularly in innovative, high-growth companies”. Instead, it delivered windfall gains to those who had already bought real estate and encouraged everyone else to dive in.
Labor’s Kim Beazley waved it through. Only Labor’s Mark Latham was prescient, telling a largely uninterested Parliament the cut would “add to the great Australian disease of asset and property speculation, particularly in our big cities”.
Reserve Bank official Luci Ellis told a parliamentary hearing last week that the capital gains tax cut boosted property prices more than share prices because property was easier to borrow against.
“It is just more profitable to negatively gear property, because you can gear it more,” she said.
The Bank’s submission to the home ownership inquiry fingers the capital gains tax cut as one of the key reasons borrowing to buy investment properties exploded from 1999. These days more than half of all the dollars lent to buy houses are snapped up by investors.
Tony Shepherd, handpicked by Abbott to head his commission of audit, says he would scrap the discount. “I can’t see any reason for treating capital gains any different from income tax,” he told a conference in June.
David Murray, picked by Abbott to head his financial systems inquiry, came out in favour of cutting the capital gains concession. The Business Council has called for a rethink, saying such concessions “ distort investor behaviour, particularly at a time of rapid capital gains“. The Henry tax review wanted the discount to be cut to 40 per cent and applied to all forms of saving. Labor said no. The Treasury uses its latest tax discussion paper to pose a simple question: to what extent do the benefits of the concession outweigh the cost?
Axing the capital gains tax discount would render negative gearing impotent. It would fund a cut in income tax and take the heat out of the property market. Just about everyone in Abbott’s corner agrees, apart from Abbott himself, who’s stopped listening.
Peter Martin is economics editor of The Age.