The other day, responding to suggestions for reform of the capital gains tax, I drew attention to the favourable treatment that capital gains already receive, being discounted by 50% before being taxed. In yesterday’s Crikey, Chris Roach suggested that the 50% discounting was just a quick and easy substitute for the old method of indexing capital gains for inflation, not a subsidy to asset owners.

There’s certainly some truth in this. But with inflation at around 3% a year, you need to hold an asset for a long time for that to be worth a 50% discount. And when the 50% rule was introduced, it was made optional – taxpayers who would be better off continuing to use the indexation method were free to do so – so there’s not much doubt that asset owners were getting an added benefit.

More interesting, however, is the question of why inflation should be thought to be a special problem for capital gains. Other income isn’t treated that way: if you earn bank interest at 4%, you have to pay tax on the whole lot, even though most of it is just preserving the value of your deposit against inflation. A taxpayer on the top marginal rate would actually be going backwards, since the “real” component of the interest would be less than the tax payable.

The fact that capital gains are treated differently just creates another distortion in the tax system, since instead of maximising income people put much of their effort into getting it into the right categories.

For tax purposes, interest earned is probably less important than interest paid, as a deduction to offset income. I can borrow money to buy an income-producing asset, and deduct the full cost of the interest against the income: even though, due to inflation, a large part of the interest is really just paying for the increased capital value. Then when I sell the asset, I get a 50% discount to compensate for inflation!

While this looks like a straight loss to the tax office, in fact it is made up by tax rates across the board being higher than they need be.

Asset owners gain in the short term, but everybody loses when tax fiddling replaces productive activity.

Peter Fray

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