Don’t let them screw up CGT

So… here’s another “I was going to write about something else until…” article.

I was going to write about the hugely disparate recent returns of the different ASX sectors over the past year, but that’ll have to wait until next week.

Because I want to talk about something that’s, frankly, a little drier (way to grab people’s attention, Scott!), but far more consequential, because the impacts may be measured over decades.

And while I’m putting readers off, it’s also something that I’ve written about only reasonably recently (but please read on, anyway!):

Capital gains tax.

Yes, some of you may yawn. But I hope most of you might have just leaned in a little.

Because as investors, regardless of the asset class in which we’re invested, the rate and basis of capital gains tax has a significant impact on our total returns.

So we really should be paying attention.

Especially when our politicians (and various lobbyists) are arguing about potential changes.

Now, last time I wrote about CGT, it was to disabuse my readers of the notion that changes to the way capital gains are taxed would have any significant long-term impact on house prices.

Frankly, I’ve not seen a serious piece of economic research, from anywhere across the ideological spectrum, that suggests CGT changes would have any sizeable ongoing impact on housing affordability – a view that completely accords with my own.

You can read that article here.

So why am I returning to the well? Not to restate that view on house prices, but because it seems that there is a groundswell to change CGT anyway.

And, if it’s going to change, my fear is that focus-group-focused politicians will be inclined to make a change that sounds good, and maybe one that lends itself to a good headline, rather than one that makes any sense.

(Yes, that’s not a stretch, based on recent policy announcements from both sides of politics! But that’s why I thought it was important to step once more into the breach.)

That last article has a little of the history of CGT, including the past approach of ‘indexation’ which you can read at will, if you like.

But let’s start from first principles.

If you buy an asset today, and hold it for more than a year, there’s a very good chance that part of the increase in the price of that asset is the result of inflation.

Let’s assume you invest in a mint condition old-school Coca-Cola yo-yo (kids, ask your parents) for $50 today.

In a year’s time, you sell it for $55. But during that time, inflation was 4%.

Now, inflation doesn’t impact all prices by exactly the same rate, but it’s fair to assume that, on average, some of the price increase from $50 to $55 is because of inflation.

If the government was to tax you on your full $5 gain, they’d essentially be taxing inflation.

That’d be… bad.

The solution? A fair policy would note that inflation would have taken the price from $50 to $52, so the true investment gain is just the difference between $52 and $55, or $3.

And feel free to take a different view, but I’m yet to have anyone disagree with that basic logic.

So, if you were going to design a system to tax capital gains, you’d allow a taxpayer to ‘index the cost base’ (that is, increase it by inflation) before calculating the true (‘real’ in the economic jargon) gain for the purposes of taxation.

Yes, you’ll need the inflation numbers, but the Australian Bureau of Statistics is very good at providing those, and the ATO could just give us a standard table to use. Throw in computerisation, and it’s a doddle that the average primary school kid could do standing on their heads.

Spoiler alert: if that approach feels familiar, it should: ‘indexation’ is the approach we used to use between 1985 when CGT was introduced, and 1999, when a new method replaced it.

And the new method is what’s now being discussed.

It introduced an arbitrary 50% discount to all capital gains, and did away with the indexation method.

Why 50%?

Politics. (The argument was that it was ‘simpler’, and it is, a very little bit, but it was unnecessary in 1999 and even less so now, in the age of ubiquitous computerisation.)

And the current debate? Well, some are saying the discount should be cut to 33%. Or 25%.

Why? Again, politics.

I’ve seen no cogent argument as to why a 33% or 25% discount is a more appropriate and justified basis for taxing capital gains.

You’ll get the usual motherhood ‘It makes property investing less attractive for investors’ and the like, but given the research I mentioned above, that’s a very, very thin argument, even if the good intentions – giving more young people a fighting chance to buy their first home – is admirable, and is a vital thing for us to tackle.

See, even if they’re directionally right (though the impact would likely be tiny), the proposed changes are entirely arbitrary. At best, ‘less incentive is better’. At worst ‘the punters will think we’re doing something about housing’.

And there will still be absolutely no policy-based justification for the approach.

The only intellectually honest way to tax capital gains is by recognising that inflation shouldn’t be taxed.

(By the way, the discount, whether 50%, 33% or 25%, could mean you end up being taxed on inflation – or make a windfall gain – depending on the relative levels of the investment gain and the inflation rate. An investor in any asset shouldn’t have to take a punt on the future inflation level when deciding what to invest in.)

I understand the interest in potentially changing CGT, based on concerns about housing affordability. It’s a poor tool for that job, given the history and research, but for some, it’s better than nothing.

That aside – or maybe because of that – it’s important that any change to CGT is not just a knee-jerk reaction to perceived issues, and that any new CGT structure is based on sound economic and tax policy thinking.

My fear is that, if we don’t speak up, those in power will go for a ‘simple-but-wrong’ answer instead. And that’s why I went back to the well on CGT, today.

Don’t get sucked into the political games, particularly that CGT will be a meaningful contributor to housing affordability.

It should be changed, but to a more justified policy-based regime – not as a pretend fix to a very real problem.

So, to be 100% clear:

1. Capital Gains Tax shouldn’t tax inflation

2. An arbitrary discount – 50%, 33% or 25% – is a poor way to achieve that

3. ‘Indexation’ – increasing the cost base by inflation, before calculating the ‘real’ gain, is the best approach

Remember, if we don’t speak up, the louder voices will have their way, instead. And that’s why it was important to write about this again, today.

Have a great weekend!

Fool on!

The post Don’t let them screw up CGT appeared first on The Motley Fool Australia.

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Motley Fool contributor Scott Phillips has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.