Capital gains tax glitch

For the first time in more than a decade the inflation rate in Canberra is higher than the rate of the increase in property prices.

This has profound taxation implications.

For a long time many Australians have bought investment properties and mortgaged them to the hilt. Rent has never met the outgoings, particularly the interest on the mortgage.

Never mind, the shortfall could be offset against wage-slave income, to reduce income tax. The investor was still behind year on year, but ultimately all came good when the investor sold, because by then the value of the property had increased by far more than the negative returns over the years.

The Tax Office partially subsidised the investment.

Then Paul Keating introduced a capital gains tax in 1985. Fine, you had to pay tax on your REAL gains. I emphasise REAL. You subtracted the purchase price from the selling price and then made an allowance for inflation before adding the result to your taxable income.

It was messy, but fair. Why shouldn’t people pay tax on capital gains? They are income as much as the wage from selling labour.

The messiness irked business. They called for change.

Along came Saint Peter Costello who “halved” the capital gains tax. That’s right, he said, you add only HALF the gain to your taxable income.

But, and it is a big but, there would be no allowance for inflation.

That was fine when inflation did not amount to much and the gains were much higher.

But in the March quarter in Canberra (an in other places in other quarters) inflation outstripped increases in property prices. Property went up 1.0 per cent in the quarter or 4 per cent annually. Inflation went up 1.3 per cent in the quarter or 5.2 per cent annually.

So? What would happen if this kept up for several years and you were unlucky enough to buy a house in the March 2008 quarter? There is every indication that inflation is a worry and that property prices are flattening. It could well be the case that inflation outstrips property prices rises over five years.

Let’s extrapolate the March quarter figures and assume someone has bought a place for $500,000.

After five years with a 4 per cent annual increase the market price of the place would be (on the compound interest formula) $611,000 (rounded to the nearest $1000). But the real value of the $500,000 in 2013 prices given an inflation rate of 5.2 per cent would be $649,000. In effect the investor would have lost $38,000 in 2013 prices.

But what does the Tax Office say under Costello’s “halving” of capital gains tax. It says there is no allowance for inflation. You have made a gain of $611,000 minus $500,000, or $110,000. Add half of that, or $55,000, to your taxable income. Say that is taxed at 42 per cent, you pay $23,100.

In effect, you pay $23,100 on a real loss of $38,000.

Under the pre-Costello arrangement you would have paid no tax at all because the allowance for inflation would have wiped out all the notional gain.

The Federal Government says it is to review the tax system. It should have a thorough look at capital-gains tax. No sensible person wants a holiday, but it is realistic to assume there will be cases of people selling in a higher inflation environment. We have had 17 per cent inflation before. That would be a capital-gains nightmare.

In general, taxing losses seems a bit over the top.

Indeed, some smart constitutional lawyer might well argue that law which does such a thing is not a law “with respect to taxation” and therefore beyond the power of the constitutional power of the Commonwealth.

A tax has to attach to something. If a levy attaches to a negative, it may well not be a tax.

In any event it is unfair.

Costello’s so-called capital-gains tax relief was nothing of the kind. It has a hidden trap.

In any review of capital gains tax, allowance should be made for inflation.

It would also we worthwhile to address the long capital-gain tail. Businesses and farms can be handed down through generations without triggering a capital-gains-tax event. But ultimately they get sold outside the family. It may be 100 years away.

It would be better to have a sliding scale over, say, 10 or 20 years, after which no capital-gains tax is payable, rather than the Costello arrangement where the tax goes from 100 per cent of the gain to 50 per cent of the gain after the first year and no further steps.

A tapering system would discourage speculation and tidy up some anomalies.