Wednesday, April 21, 2004

The damage halving capital gains tax did

For a moment there I thought that Bob Carr had done the wrong thing. I read that his new transaction tax on sale of investment properties was a "shocker", a "major attack" that would erode retirement savings and consign the property market to "oblivion". And those were just the reactions in the Herald.

In The Australian Financial Review an industry analyst explained that for an investor who bought a property for $600,000 and then sold it for an extra $200,000, the tax take would be $22,000 on the way in, $18,000 on the way out and $39,000 in capital gains tax - a take he described as "outrageous".

And then the spell broke.

The taxes in the analyst's example add up to just 39 per cent. Australia's top marginal rate of tax is 48.5 per cent. The rate below that is 43.5 per cent. About half of us pay those rates on every additional dollar we earn at work, as well as on every single dollar we earn in interest on our savings.

Looked at that way, the real question isn't "how did the taxes on trading in property ever get to be so high?" but "how did they ever get to be so low?"...

Most of the blame (or credit) belongs to two people: the Treasurer, Peter Costello, and John Ralph, the doyen of Australian company directors, at present chairman of both Telstra and the Commonwealth Bank.

In 1998 Costello asked Ralph to inquire into business taxation. One of the terms of reference was odd, and extremely specific. It dealt with individual, rather than business taxation. Costello wanted Ralph to examine "the scope for capping the rate of tax applying to capital gains for individuals to 30 per cent". Until that point capital gains had been taxed at the individual's marginal tax rate, minus inflation.

Ralph went further than Costello had suggested. In September 1999 he recommended that only half of each capital gain be taxed, which as he pointed out would effectively cut the top rate to 24 per cent.

What followed was an avalanche of funds pouring into investment real estate, and a change in our financial psyche. One in every eight Australian taxpayers now owns an investment property, firming to one in every three where annual income exceeds $100,000.

Ralph didn't see it coming. His report contained not a word about real estate. He said instead he expected the cut to bring about a surge in sharemarket investment, "particularly in innovative, high-growth companies".

Mark Latham saw it more clearly than most. In an extraordinarily prescient speech he said the cut would add "to the great Australian disease of asset and property speculation, particularly in our big cities. It will take away resources from the knowledge economy and put them into the least productive, least honourable aspects of Australian economic activity."

It was already legal to negatively gear. That is, to borrow so much to buy a property that your interest payments ensured you made a loss each year, which you could use to cut your income for tax purposes. It was also legal to claim a depreciation deduction after buying a new house or unit, regardless of whether or not the investment actually declined in value.

But as attractive as these benefits were, they did little more than defer the payment of tax. It would be paid on the day the property was sold. Or that was the theory, until September 1999. From that date, as Melbourne University's Professor Cameron Rider puts it, only half of the deductions were recouped - the other half were converted from a deferral of tax to a permanent exemption from tax.

The changes gave property an advantage over competing forms of investment. Shares could match it when it came to negative gearing and capital gains tax, but couldn't match the associated depreciation deduction, as scores of mesmerised Australians were being told in investment seminars each weekend.

Borrowing to buy property became the "smart" thing to do, even for Australians who had never borrowed before except to buy their home. As Macquarie Bank's Rory Robertson told his clients: "It is 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."

Or to make money renting out the properties they bought. The Tax Office says six out of every 10 of Australia's landlords actually lose money on an operating basis.

This tax-driven diversion of money and effort away from work, away from small businesses, away from productive investments, is without recent precedent. It has helped push property prices into uncharted territory and may have brought on our last two interest rate increases.

All this from a change that Ralph recommended in order to "achieve a better allocation of the nation's capital resources".

When Latham tried to have Labor oppose it in September 1999 he was overruled by his leader, Kim Beazley. Shortly after becoming shadow treasurer last July he explored with Access Economics a plan to restore full tax to capital gains and use the billions of dollars liberated to cut the top tax rate for all forms of income. Access believed it could sell the plan as being fairer for both high and low income earners.

When news of the plan leaked last month, Latham ruled it out. He did so again this week.In election mode neither Latham, Howard nor Costello is likely to propose what an increasing body of expert opinion believes has to be done.

The Productivity Commission is said to have recommended some sort of action on property taxation to Costello. He is yet to release its report.

By rushing in and taxing where our federal leaders are scared to tread, Bob Carr and his Treasurer, Michael Egan, may have done the nation a favour.

And they get to keep the money as well.