taxing capital gains - Journal of Australian Taxation

TAXING CAPITAL GAINS: ONE STEP FORWARDS OR TWO STEPS BACK? By Chris Evans* The manner in which capital gains are taxed in Australia (and in other countries) has undergone fundamental reform in recent years. A "new" Capital Gains Tax ("CGT') regime based on the identification of (currently) 39 CGT events was legislated in Australia with effect from 1 July 1998. In addition a 50% CGT discount has been introduced for certain taxpayers from 21 September 1999. At the same time averaging has been abolished, indexation has been frozen, and small business CGT concessions have been made significantly more generous. This article evaluates these recent CGT changes from a policy perspective. It draws upon revenue and other available statistics to identify the impact of the changes upon the capacity for revenue generation/protection and for the operating costs of the CGT system, and concludes that the recent changes do not deliver the benefits that have been claimed and anticipated. Efficiency arguments dominate, with some lip-service paid to the simplicity criterion (usually manifested by vague assertions about reducing compliance costs for taxpayers and administrative costs for the revenue authority). The integrity of the tax system, and in particular notions of equity and perceived equity, may suffer, and the supposed efficiency and simplicity gains may not materialise.

1. INTRODUCTION Whoever hopes a perfect tax to see Hopes what ne'er was, or is, or e'er shall be1

*

Associate Professor of Taxation and Director of ATAX, part of the Faculty of Law at the University of New South Wales. The author is indebted to his ATAX colleagues Yuri Grbich, Binh Tran-Nam, Michael Walpole and Colin Fong and to an anonymous referee, for their helpful comments. The usual disclaimer applies. Any errors or misjudgments are the responsibility of the author alone.

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JOURNAL OF AUSTRALIAN TAXATION

TAXING CAPITAL GAINS There is no perfect way to tax capital gains. This is hardly surprising given that there is no real consensus at to what capital gains are,1 or whether they should be taxed at all.2 But the fact that perfection may not be attainable does not prevent Governments and their advisers from seeking the best possible approach to taxing capital gains. This article examines recent Capital Gains Tax ("CGT") policy and legislative developments in Australia. It evaluates those developments in the light of essential criteria and benchmarks that are regarded as important for the integrity of CGT regimes and for tax systems more generally. And it concludes that far from leading to improvements in the tax system, the recent changes have often represented a departure from good tax design principles. Whilst CGT policy and legislative developments have made limited progress on some fronts, many of the changes have moved the tax system further from the ideal with a consequent loss of social welfare. In short, the developments may constitute one step forwards towards a "better" tax system, but two steps backward. The structure of the article is as follows. The rest of this Part sets the scene. It provides the context for subsequent analysis by providing some historical background on how CGT regimes have developed over the past 90 years or so, and identifies the rationale for introducing and maintaining CGT regimes. It also explains why an ideal model for taxing capital gains cannot be achieved and identifies the compromises that are necessary to achieve the best outcomes possible. In so doing it establishes benchmarks against which changes can be evaluated. Part 2 explores recent Australian

1

McCulloch's adaptation of Pope, cited in C Sandford, Taxing Inheritance and Capital Gains (1967) 9. Pope was referring to a "faultless piece", in the sense of a piece of written work. The author knows how he feels! 1 See, for instance, H Ault, Comparative Income Tax: A Structural Analysis (1997) 194; or J King, "Taxation of Capital Gains" in P Shome (ed), Tax Policy Handbook (1995) 155-158. 2 An interesting analysis of the case against taxing capital gains is contained in B Bracewell-Milnes, A Discredited Tax: The Capital Gains Tax Problem and its Solution (1992). (2002) 5(1)

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C EVANS CGT developments, and evaluates them against the benchmark criteria developed in this Part. Part 2 draws conclusions from the preceding analysis. 1.1 International Perspective Regimes for taxing capital gains have featured in most developed and developing countries since the first CGT regime was introduced in Norway in 1911 followed by the USA in 1913. Nearly all of the countries in the Organisation for Economic Cooperation and Development ("OECD") now have CGT regimes in place with the notable exception of New Zealand. The OECD, in its 2000 Economic Survey of New Zealand, recommended that a separate CGT should be introduced in that country. However, there appears to be little support for that suggestion in New Zealand itself. The Final Report of the Tax Review, conducted in New Zealand in 2001, firmly concluded that New Zealand should not adopt a general realisation based CGT. It noted that "... such a tax would not necessarily make our tax system fairer and more efficient, would not lower tax avoidance and would not raise substantial revenue that could be used to lower tax rates. Instead any such tax would be more likely to increase the complexity and costs of our system".3 The conclusion of the Review was that a "risk free return method" ("RFRM")4 could be used to supplement New Zealand's existing policy of dealing with capital gains issues as they arise by means of specific legislative provisions. So far as non-OECD countries are concerned, South Africa is the most recent example of a country that has introduced a CGT. Its

3

Tax Review 2001 – Final Report (October 2001) para 3.14. Essentially the RFRM taxes certain assets where a start of year value is available (designated investment vehicles, such as shares in a company) on a statutory risk free real rate of return. The tax liability is calculated by multiplying the value of the asset at the beginning of the year by a designated inflation adjusted tax free rate of return, and multiplying that sum by the investor's tax rate.

4

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TAXING CAPITAL GAINS regime was initially due to operate from 1 April 2001 but the start date was subsequently deferred to 1 October 2001.5 It has been suggested that "CGT is probably the next most rapidly growing tax after VAT".6 Table 1, which summarises the numbers of countries that have or do not have CGT regimes, provides strong evidence in support of this suggestion. As the table shows, approximately 70% of countries have some sort of CGT system in place. Table 1: Review of Countries with CGT Systems in Place7 Region

Number of countries with a Number of countries without a CGT system, CGT system or where information not available

Africa

29

14

Americas

17

2

Asia/Asia Pacific

25

21

Caribbean & Middle East

10

12

Europe

31

0

Total

112

49

5

Capital Gains Tax in South Africa: Briefing by the National Treasury's Tax Policy Chief Directorate to the Portfolio and Select Committees on Finance (24 January 2001) ("SA Treasury"). Sourced from http://www.sars.eov.za. 6 C Sandford, Why Tax Systems Differ (2000) 100. 7 Summarised from SA Treasury, 5-10. (2002) 5(1)

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C EVANS The reasons for introducing CGT regimes can vary. An OECD Report8 identified "fiscal equity" as the main reason given by countries for adopting a CGT. In other words, they saw that such gains constituted an accretion of economic or spending power, and horizontal equity required that it be taken into the tax reckoning. Other reasons given in the survey included: expansion of the tax base; limiting income tax avoidance; improving vertical equity; and reducing the investment distortion that can occur in the absence of a CGT. CGT regimes are not typically introduced as a means of increasing revenue yield. They may stem revenue leakage that would otherwise occur where capital gains are not subject to tax. And they may actually give rise to larger than expected tax yields, even when concessions such as the indexation of the cost base are built in to their initial design, as in Australia. For example, at the time of its introduction in 1985 the Treasurer had suggested that the yield for 1990-91 from the Australian CGT would be AUD$25m. It actually raised AUD$339m in 1990-91. But, as Table 2 illustrates, the yield from CGT is usually a relatively small proportion of income tax and the total tax yield, and always less than 1% of GDP. The essential role of the CGT is therefore not to raise revenue. It is to act as a "backstop" to the income tax system – to act as an integrity measure. Without a CGT it is possible to recharacterise ordinary taxable income into non-taxable capital gains, and escape tax.

8 OECD, Taxation of Net Wealth, Capital Transfers and Capital Gains of Individuals (1988).

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TAXING CAPITAL GAINS Table 2: Summary of Australian CGT Tax Yield 1989-90 to 1998-999 Year

CGT revenue as a % of

CGT Revenue (AUD$m) lncome tax revenue

Total tax revenue

GDP

1989-90

530

0.81

0.70

0.14

1990-91

339

0.50

0.44

0.09

1991-92

376

0.58

0.51

0.09

1992-93

591

0.90

0.79

0.14

1993-94

1,810

2.68

2.32

0.40

1994-95

884

1.15

1.00

0.19

1995-96

1,455

1.70

1.48

0.29

1996-97

2,335

2.50

2.19

0.44

1997-98

3,904

4.1I

3.54

0.69

1998-99

4,242

3.85

3.14

0.71

Most countries accept the validity of the comprehensive income concept (as defined and used by economists) as the ideal tax base. This approach, outlined by Haig and Simons in the first part of the twentieth century, "means that the total sum of all revenue streams over the tax period should be included in the income tax base, as it

9

Summarised from Australian Taxation Office, Commissioner of Taxation Annual Reports, various years and Australian Bureau of Statistics, A Statistical Profile of Australia: National Accounts, various years. (2002) 5(1)

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C EVANS constitutes increases in the purchasing power of at taxpayer. Capital gains represent one of these income streams and should attract the same income tax charge as all other revenue streams".10 In the words of the Canadian Carter Report "a buck is a buck is a buck".11 But whilst most countries recognise the need for taxing capital gains, there is little consensus as to how the capital gains should best be taxed. Given the diversity and the complexity of CGT regimes as they have developed internationally, identifying an ideal is an impossible task. Instead, the critical task is to identify benchmarks against which any reality can be tested. 1.2 Striving for Perfection – the Concept and the Reality The basic idea of a capital gain is simple. A capital gain is the increase in value of a capital asset.12 But if the idea is simple, the means by which the capital gain is captured within the tax base is not. Evans and Sandford examined the taxation of capital gains in six English-speaking countries and concluded that there was a complete lack of unifying principle in the taxation of capital gains in those countries.13 The countries concerned differed on the definitions they used for capital gains and on structural issues relating to whether the CGT was integrated with the income tax or existed independent of it as a separate tax. They also differed on the treatment afforded to short term and long term capital gains, and on the concessions built into the regimes. In other words, there were fundamental differences relating to the tax base, the tax rates and the preferences involved in the design of the CGT. These differences point to the fact that there is no one and ideal way to tax capital gains. According to Gammie: 10

As quoted in SA Treasury, 4. K LeM Carter, Royal Commission on Taxation (Report) (1966) 9-10. 12 L Burman, The Labyrinth of Capital Gains Tax Policy: A Guide for the Perplexed (1999) 10. 13 C Evans and C Sandford, "Capital Gains Tax – The Unprincipled Tax" (1999) 5 British Tax Review 387, 403. 11

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TAXING CAPITAL GAINS 35 years of constant tinkering with capital gains tax suggests that the UK is no closer than it was in 1965 to knowing how to best tax capital gains.14

Much the same could be said of many of the other countries that tax capital gains. All have had to compromise, reflecting that the CGT, like so may other aspects of economic and taxation policy, is a trade-off between the competing objectives of equity, efficiency and simplicity. The rationale for taxing capital gains is to be found primarily in the improved equity that such a tax introduces to the tax system. Without a CGT the potential for avoidance is immense. The Draft White Paper that preceded the introduction of the Australian CGT in 1985 identified that the "lack of a general capital gains tax represents a structural defect in the income tax system which lies at the core of many avoidance arrangements ...".15 A CGT protects the integrity of the income tax base by preventing leakage through dressing income up as, or converting income to, capital. In addition, the introduction of a CGT can lead to greater neutrality and efficiency in the tax system, though potentially at the cost of reduced simplicity. Australia, in common with most of its OECD counterparts, accepted that trade-off in its quest for the optimal tax structure. It is possible to identify certain propositions that reflect the best possible compromise relating to the taxation of capital gains.16 These propositions attempt to combine equity, efficiency and simplicity in such a manner as to achieve the optimal tax structure – defined by Stiglitz as "the one that maximises social welfare, in which the choice between equity and efficiency best reflects society's attitudes

14 M Gammie, "Taxing Capital Gains – Thoughts from the UK" (2000) 23 University of New South Wales Law Journal 309, 311. 15 Draft White Paper, Reform of the Australian Tax System (1985) 78. 16 These propositions are loosely based on analysis contained in Evans and Sandford, above n 14, 403-405.

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C EVANS toward these competing goals".17 The propositions might be stated as follows: Proposition 1 – So far as practicable a capital gain should not be treated any differently to the treatment meted out to other forms of income. Proposition 2 – The taxation of capital gains should operate on a realisation basis rather than on an accruals basis, in recognition of the very real problems of liquidity and valuation that would exist if an accruals basis of taxing capital gains was adopted. Proposition 3 – The occasion of death, as well as the gifting of capital assets, should be treated as a realisation for the purpose of triggering a charge to CGT. Proposition 4 – Capital gains should be charged to tax at prevailing marginal income tax rates in order to minimise the possibilities of the tax arbitrage that will inevitably occur where capital gains are taxed differently from other income streams. Proposition 5 – Concessions and preferences may be necessary for sound policy and political reasons, but should be kept to the minimum possible. For instance, political reality dictates that the family home should be kept out of the CGT net for the vast majority of taxpayers. But there is no reason why this particular concession should not be capped, as in the US, with a financial ceiling on the amount of the relief. The ideal cannot be attained. But these propositions, reflecting a compromise of the benchmark criteria of equity, efficiency and simplicity, represent something approaching the best second-best outcome that can be achieved in the taxation of capital gains. And it is against these benchmarks and propositions that recent CGT changes can be evaluated.

17

J Stiglitz, Economics of the Public Sector (2nd ed, 1988) 478-479.

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TAXING CAPITAL GAINS 2. RECENT AUSTRALIAN CGT DEVELOPMENTS18 The Australian CGT has undergone a number of fundamental changes in recent years. The process of change began in the mid1990s with the virtually complete re-write of the CGT provisions, ultimately enacted in Pts 3-1 and 3-3 of the Income Tax Assessment Act 1997 (Cth). The pre-existing framework, which required the existence of an asset, an acquisition and a disposal, was replaced with an events-based approach that was able to operate independently of this triptych. For each of the 39 CGT events19 the provisions create a self-contained code which: •

describes how a capital gain or loss can arise;

•

identifies the time of the gain or loss;

•

specifies the calculation rules for the gain or loss; and

•

identifies any specific exceptions that might apply.

The intention of the rewritten legislation was to make the provisions more accessible and more flexible by providing a logical and coherent structure. There is little doubt that the earlier provisions (contained in Pt IIIA of the Income Tax Assessment Act 1936 (Cth)) were an incoherent mess. To that extent the re-write was both necessary and sensible. However, there are some concerns that an approach which attempts to list all of the acts, transactions and events that might conceivably give rise to a capital gain is less likely to operate successfully than one which is drawn together by a strong, overarching concept. Lists can have a habit of always being incomplete, and can afford aggressive tax planners the opportunity of

18

Parts of this and Pt 3 draw upon: C Evans, "Curing Affluenza: A Critique of Recent Changes to the Taxation of Capital Gains in Australia" (2000) 23 University of New South Wales Law Journal 299. 19 There were originally 36 CGT events when the re-written legislation commenced on 1 July 1998. Since that date four events have been added (initially CGT events J1 and J2, and more recently D4 and K7) and one has been repealed (CGT event K1). (2002) 5(1)

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C EVANS constructing transactions in such a way as to fall between specified CGT events and thereby escape taxation.20 It has also been pointed out21 that the CGT legislation has increased from approximately 300 pages in the 1936 version to approximately 500 pages in the 1997 version, although there may be factors other than the rewrite at work in this increase. For example, the increasing sophistication and complexity of commercial transactions itself leads to the need for ever more detailed (and lengthy) legislation. The CGT legislative re-write (along with the incomplete and now abandoned re-write of other parts of the income tax legislation in Australia) has been a significant change. But its primary significance is in the technical sphere, and it was not intended to lead to any major policy changes (although inevitably it may have done so). At the policy level, however, the major recent Australian CGT developments have arisen as a result of the Review of Business Taxation ("Ralph Review"),22 which was made public in September 1999. The Ralph Review proposed the following major CGT changes: •

the introduction of a CGT discount for individuals and trusts (one half of the capital gain to be excluded) and for superannuation funds (one third of the capital gain to be excluded) where assets have been held for at least one year;

•

the abolition of averaging;23

20

Interestingly, the initial South African CGT proposals were based on identifying CGT events and appear to have been strongly influenced by the Australian approach. However the legislation as actually enacted in South Africa has moved away from what might be termed the "list of events" approach. 21 G Lehmann, "Re-Focussing on the Key Objectives: TVM – The Policy Arguments For and Against" (paper delivered at the Tax Value Method Consultative Conference at ATAX Sydney; 2001). 22 Review of Business Taxation, A Tax System Redesigned (1999) ("A Tax System Redesigned"). 23 Averaging is a mechanism designed to overcome some of the worst effects of "bunching". Although the capital gain may have accrued over a number of years, the 124


TAXING CAPITAL GAINS •

the freezing of indexation;

•

the rationalisation and extension of a series of small business retirement and roll-over concessions;

•

the removal of depreciable assets from the CGT regime;

•

the introduction of an optional scrip for scrip roll-over relief in takeovers and similar circumstances; and

•

the introduction of CGT venture capital relief for certain non-resident tax exempt pension funds.

All of these changes were accepted by the Government and have now been enacted – some in an expanded form. This is in sharp contrast to the fate of many of the other non-CGT Ralph Review proposals, such as the Unified Entity Regime ("UER") and the Tax Value Method ("TVM"), which have either been discarded despite initial acceptance (UER) or carefully marginalised prior to possible ultimate rejection (TVM). In order to be able to evaluate these CGT policy changes, it is necessary to understand the policy objectives adopted by the Ralph Review in proposing the changes. In the Ralph Review24 three national objectives were established, not significantly different from the traditional benchmark criteria of efficiency, equity and simplicity. The Ralph objectives were: •

optimising economic growth;

realisation basis requires that all of the capital gain falls to be taxed in one income year, thereby potentially moving taxpayers into higher than would be expected tax brackets. Under the Australian averaging provisions, tax was calculated on one fifth of the capital gain as if that was ordinary income, and that amount was multiplied by five to identify the total tax payable on the capital gain. In that fashion, a simple form of top slicing relief was obtained. But averaging came to be a valuable planning tool for the non-working spouses of taxpayers on high marginal tax rate, and – in the eyes of the Government – a blatant tax abuse. Such spouses could make capital gains of up to AUD$27,000 tax free each year, as one fifth of that amount represented the tax free threshold available to resident taxpayers. 24 A Tax System Redesigned, 13. (2002) 5(1)

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C EVANS •

promoting equity; and

•

promoting simplicity and certainty.

It was noted that particular objectives were not matched to particular recommendations, and that inevitably judgments have to be made and accepted about trade-offs between particular objectives. In considering the changes to CGT it was also noted that the recommendations were designed to enliven and invigorate the Australian equities markets, to stimulate greater participation by individuals, to achieve a better allocation of the nation's capital resources, and to make the CGT regime more internationally competitive.25 The focus in the CGT recommendations is highly skewed to terminology that reflects the first of the Ralph objectives (optimising economic growth), although there is some recognition of the importance of simplicity and certainty. Noticeably the chapters dealing with the CGT changes barely mention the equity criterion – an ironic omission given that the fundamental rationale for the existence of the CGT rests significantly on the importance of those equity considerations. Some of the Ralph CGT changes represent sound policy initiatives that may promote simplicity and reduce the burden of compliance costs, help business growth and otherwise stimulate sensible economic activity. The removal of indexation and averaging, aspects of the rationalisation of the small business CGT reliefs and perhaps the introduction of the scrip for scrip roll-over relief may be placed in that category. But these positive impacts are far outweighed by the negative policy implications that arise from the central feature of the CGT changes – the elimination of 50% of the charge to tax when individuals and trusts make capital gains. This preferential treatment can be criticised by reference to the usual criteria for assessing tax policy initiatives – equity, efficiency and simplicity.

25

Ibid 598 and 611.

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TAXING CAPITAL GAINS As noted above, the essential reason for introducing regimes for taxing capital gains is one of equity. However the introduction of the 50% CGT discount savagely offends both the horizontal and the vertical aspects of equity. Salary earners are disadvantaged compared to investors, and the wealthy in society receive considerably more benefit than those without the capacity to take their income in the form of capital gains. Despite assurances that we are increasingly becoming a share owning democracy, it is important to remember that most of the population who own shares own very few shares.26 The capacity to make the largest savings of tax on the largest capital gains is reserved for a minority of the population – as any survey of Taxation Statistics will rapidly reveal.27 Cutting tax rates sounds inherently attractive. But when the bulk of the benefit is reserved for, or primarily claimed by, just one small sector of society, the appeal is less resounding. Efficiency is claimed to be the primary rationale for the introduction of the discount. With capital gains taxed at marginal income tax rates, the economic incentives for investment are destroyed, it is claimed, and the market cannot operate in an efficient fashion. Reducing the effective rate of capital gains taxation by introducing the CGT discount will, on this analysis, free the market from its chains and permit taxpayers to unlock themselves from inefficient investments and chase the best dollar. But this supposed freeing up of the market and removal of economic distortion itself gives rise to a number of questions. Is the new policy efficient (or more efficient than it was)? What does it tell

26

As at November 2000 40% of adult Australians owned shares directly (slightly down from 41% in 1999). About half of this number hold only one or two stocks in their share portfolio, and about the same proportion had not traded in the previous 12 months: Australian Stock Exchange, Fact Book 2001: Statistics to 31 December 2000 (2001) 30 ("Fact Book 2001"). 27 For example, Taxation Statistics 1998-99 (the latest available) reveals that 71% of all tax paid on net capital gains by individuals was paid by those with a taxable income of more than AUD$50,000: Taxation Statistics 1998-99 (Commonwealth of Australia, Canberra, 2001) 108. (2002) 5(1)

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C EVANS us about the need to transform highly taxed income into preferentially taxed capital gains? Will these proposals lead to distortionary investments and economic inefficiencies? Will lock in and bunching be significantly mitigated, or do we have to look at the one-year trigger28 and the 15 year trigger29 very carefully? What will it do for speculative investment and negative gearing? Is the tax tail going to wag the commercial dog all over again as we seek to obtain the best arbitrage outcomes possible as a result of the increased wedge driven between the rates at which we tax income and those at which we tax capital? It is difficult to believe that the introduction of the CGT discount can lead to a more efficient outcome than was the case when all forms of income were taxed at roughly the same rate. It is also very difficult to ascertain, in any empirical sense, what the behavioural responses to the CGT changes have been. Anecdotally, there are suggestions that highly taxed income is being transformed to preferentially taxed capital gains at the "top end of town". But it will be a number of years before this can be formally established. It would be expected that CGT tax revenues would increase over time (refer Table 2), but that may well be at the expense of reduced income tax yield. Certainly, a simple analysis of the trends on the Australian Stock Exchange appears to confirm the view expressed in the Ralph Review that "there is likely to be considerable extra turnover on Australian equity markets as equity holders respond to reduced lock-in by realigning their portfolios".30 Table 3 indicates that there was an increase in the number of stock market transactions following the changes in September 1999, although the figures need to be treated with caution. The average number of daily transactions was increasing steadily up to the quarter in which the CGT changes took place. There were then significant increases in the two quarters following the change 28

Assets must be held for one year before they attract the CGT discount. Where a small business taxpayer has held an active asset for at least 15 years, complete exemption of the capital gain may be available. 30 A Tax System Redesigned, 598. 29

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TAXING CAPITAL GAINS (such that the daily average in the January-March 2000 quarter is very nearly double that of the quarter immediately before the change). Thereafter, there has been a steady decline from the peak, although the daily average is still above the level that existed before the change. Table 3: Average Number of Daily Transactions on Australian Stock Exchange31 Quarter

Average Number of Daily Transactions for Quarter

Jul-Sep 1998

27,190

Oct-Dec 1998

28,390

Jan-Mar 1999

35,290

Apr-Jun 1999

40,250

Jul-Sep 1999

39,300

Oct-Dec 1999

47,260

Jan-Mar 2000

75,870

Apr-Jun 2000

57,310

Jul-Sep 2000

53,630

Oct-Dec 2000

48,180

31 Figures summarised from Fact Book 2001, 33; Fact Book 2000: Statistics to 31 December 1999, 34; and Fact Book 1999: Statistics to 31 December 1998, 29.

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C EVANS Whilst this may say something about the reduction of lock-in, the matter is not free from doubt. There may have been other factors at work, and no attempt has been made to control for other variables. Cause and effect has not yet been established. Most importantly, work still needs to be conducted to establish whether this is evidence of the significantly increased number of realisations that supporters of the Ralph Review changes indicated would occur in the Senate proceedings in November 1999.32 So far as the criterion of simplicity is concerned, it is certainly questionable that the CGT changes will do very much to produce a simpler CGT regime than the one we already have. Certainly the removal of indexation and averaging helps to simplify aspects of the regime, although applying a CPI adjustment to elements of the cost base was never particularly complex or problematic. The introduction of the CGT discount has created the need for major changes (and some increased complexity) to the manner in which the net capital gain or loss for the year is calculated. It has also occasioned the introduction of specific anti-avoidance provisions that themselves are complex or convoluted.33 But simplicity is not usually a benchmark criterion for CGT, as the Asprey Committee34 long since recognised, when it concluded that a CGT could not be justified on the grounds of simplicity. It noted: It is a tax which, in any administrable form, must be complex and difficult, and produce some anomalies and inequities of its own. There is no doubt whatever that any revenue it raises could be more cheaply and easily raised in other ways. By the criterion of simplicity it fails.

32

Senate Finance and Public Administration References Committee, Inquiry into Business Taxation Reform (Commonwealth of Australia, Canberra, November 1999). 33 For example, the provisions of Income Tax Assessment Act 1997 (Cth), Div 115-45. 34 K Asprey, Taxation Review Committee – Full Report (1975) 414. 130


TAXING CAPITAL GAINS Perhaps, rather than simplicity, we should at least be striving for greater certainty, as recognised by the Ralph Review. Sadly, it is difficult to see that these proposals make the CGT regime more certain than was the case before. There are also arguments that stability and sustainability are important aspects of tax design, and the recent Australian changes do not appear to contribute in any meaningful manner to the development of a more stable or sustainable tax system in Australia. In summary therefore, the recent Australian CGT changes considerably diminish the equity of the Australian taxation system; are of dubious and unproved benefit so far as efficiency is concerned; and may have only a marginal impact on the simplicity of the regime (and it is not even certain that this marginal impact is positive or negative). They represent significant departures from the already compromised ideal identified in Pt 1. Propositions 1, 4 and 5 are further undermined. More explicitly, the Australian regime now affords significantly different treatment to different forms or streams of income, imposes significantly different tax rates on different forms of income and creates new and unnecessary preferences and concessions.

3. CONCLUSION Australia is not unique in undergoing significant changes to the way that capital gains are taxed in recent years. The experiences of South Africa and New Zealand have already been briefly mentioned. The UK has also undergone significant CGT policy changes recently. In 1998 the UK introduced taper relief for non-corporate taxpayers – essentially "a system under which the percentage of the gain brought into the charge to tax drops as the years go by".35 At the same time, it froze indexation and phased out business retirement relief. Since 1998 there have been significant legislative amendments to the taper relief in each annual Finance Act, and it is clear that the system is not yet working either efficiently or effectively. Indeed, 35

J Tiley, Revenue Law (4 th ed, 2000) 741.

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C EVANS there is considerable unease at the additional compliance burden that the introduction of taper relief has imposed, as well as concern at the distortive impacts of the change. A submission on taper relief to the UK Inland Revenue by the Institute of Chartered Accountants in England and Wales notes that "we find that coping with ... taper relief is absorbing an unprecedented amount of time".36 Earlier in the same submission, the point is made that "the system, as it currently stands, appears to be creating inequities between taxpayers and encouraging distortions in decision making, the exact opposite of what the system should aim to achieve".37 As a result of these sorts of concerns, the idea of extending the taper relief to capital gains made by the corporate sector was abandoned. But if the UK experience with CGT policy changes is less than encouraging, the Australian experience in recent years is arguably far worse. The early Ralph Review discussion papers in Australia raised the possibility of some concessions for CGT, such as the introduction of taper relief on the UK model, the introduction of an annual CGT exempt amount (again as used in the UK), or the capping of the CGT rate at 30%. It has been argued elsewhere38 that there are strong grounds for the second of these proposals. The introduction of an annual exempt amount would do much to improve the simplicity of the Australian CGT regime by removing many of the "minnows and tiddlers" from the CGT regime at little cost to the revenue.39 Based on 1994-95 figures, earlier analysis has indicated that up to 40% of individuals affected by CGT could be removed from the tax net at a

36

"Capital Gains Tax: Simplifying Taper Relief" (paper submitted in September 2001 to the Inland Revenue by the Institute of Chartered Accountants in England and Wales) para 3.3. 37 Ibid para 2.3. 38 C Evans, "The Australian Capital Gains Tax: Rationale, Review and Reform" (1998) 14 Australian Tax Forum 287, 317-320. 39 It is noticeable that the recently introduced South African CGT regime also contains a de minimis annual exclusion (of R1,000), although arguably the exclusion needs to be somewhat bigger to be really effective. 132


TAXING CAPITAL GAINS cost of only 5% of CGT revenue with an annual exempt amount of AUD$5,000. The ultimate Ralph proposal of introducing the CGT discount and exempting half of the gain for individuals and trusts came as a surprise to most, and many suspect that the decision owed more to political considerations than to sound policy. Sadly – and ironically – the introduction of the CGT discount has undermined one of the very few aspects of the Australian CGT regime that added integrity to the tax system – the fact that all forms of income, including capital gains, were taxed at more or less the same rate of tax. There is no doubt that in many circumstances Australia's CGT was – before 21 September 1999 – more onerous than that of many international competitors. Modelling40 showed that an unmarried individual on twice average annual earnings who made a capital gain selling US$40,000 worth of shares in August 1998 would face an effective tax rate of 47% (ignoring Medicare) if the gain occurred in Australia, compared to 38% in Canada, 20% in both the UK and US, 19% in Ireland and 0% in New Zealand. The tax payable on that capital gain would amount to US$15,801 in Australia, compared to an average of only US$8,069 for all six countries mentioned. Clearly there is cause for concern if one looked at only the stark figures shown by these comparisons. But the stark figures mask complications. Australia (largely by the accident of its CGT design) was the only one of those six countries that would have charged the same amount of tax (in the scenarios modelled) regardless of whether the gain was treated as a capital gain or as "ordinary" income. And that was a fundamental principle of which Australia should have felt proud rather than immediately rushing off to reduce the tax payable on capital gains. Until 21 September 1999 it treated all gains – all accretions to net wealth, whether income gains or capital gains – on the same basis.

40

See Evans and Sandford, above n 14, 396-399.

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C EVANS Of course, it would be better for international competition if Australia's tax rates – on income and capital – were not as high. But to have reduced one and not the other is to deal a body blow to the major reason that CGT regimes exist: to ensure horizontal equity in the tax system. Australia was one of the last OECD countries to introduce a CGT, and the primary reason for its introduction was to prevent the blatant unfairness that had hitherto existed whereby a taxpayer (usually wealthy) could enjoy tax-free capital gains whilst other taxpayers were fully taxed on their income. Equity is not the only consideration in the design of the tax system. Efficiency and simplicity are also important criteria. Indeed, the recent clamour for reform was largely driven by those who considered that the pre-existing CGT regime in Australia distorted economic decision making and acted as a disincentive to investment. But the evidence for this was flimsy at best and did not constitute a sufficiently strong case for destroying the integrity of the CGT regime, as it existed prior to 21 September 1999. It is difficult to justify the introduction of the CGT discount and other changes on any tax policy grounds. The changes have considerably reduced the equity of the tax system, may be of dubious benefit on efficiency grounds, and do very little for the simplicity of the Australian CGT regime. Moreover, they are likely to cost the public purse considerable sums of money, contrary to claims of revenue neutrality. Cynically viewed, the changes are an exercise in good politics rather than good tax policy. They have been sold (and have been largely accepted) as a sop to the growing numbers of shareholders who fear that the tax system may strip them of their easily won gains from volatile and burgeoning stock markets. In reality, they provide relatively insignificant relief for the vast bulk of share investors (many of whose gains have proved to be illusory), whilst furnishing significant concessions to the wealthiest sector of society.

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TAXING CAPITAL GAINS Gammie has noted that CGT "is a compromise, and, as is so often the case with a compromise, it functions badly and pleases no one".41 But the compromise that existed before 21 September 1999 in Australia may have been more equitable and efficient than the compromise that now exists. Some progress was made in Australia with the abolition of averaging and the freezing of indexation in September 1999. But those small steps forward have been countered by the backward march towards an inefficient and inequitable CGT regime resulting from the introduction of the CGT discount.

41

Above n 15, 309.

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