Higher gearing encouraged
While all the attention is now on Labor's proposal to limit negative gearing deductions to newly constructed properties, its proposal to tax 75 per cent of all capital gains on assets bought after July 1, 2017, will be more important for making future investment decisions.
The original 1985 capital gains tax exempted gains on assets owned for longer than 12 months accruing solely due to inflation. The remaining gain was then subject to income tax but recognising the gains may have accrued over many years and be large, was levied until 1999 at a marginal rate calculated by adding one-fifth of the gain to the taxpayer's other income.
This ensured that investors were not taxed on gains due solely to inflation and ameliorated the adverse impact of taxing gains accrued over many years in one tax year.
While cumbersome to administer, this helped conservative investors seeking to maintain the real value of their investments after tax.
The post-1999 tax arrangement offering a 50 per cent exemption of gains by contrast favours investors making high percentage gains over a relatively short period.
Conservative longer-term investors seeking more modest gains over an extended period also pay no tax on real capital gains if their realised returns on average are twice the rate of inflation. But if the tax-exempt proportion of the gains is reduced to 25 per cent, an average annual return of four times the rate of inflation is required to ensure only real capital gains are taxed.
This will change the fundamental original objective to subject only real capital gains to tax.
Ironically, if implemented along with the negative gearing proposal, this change would encourage conservative investors to increase their portfolio gearing for example to achieve a neutrally geared outcome.
The capital gains tax provisions have from the outset favoured geared investments, encouraging higher levels of gearing. The less money used to buy the asset, the higher will be the after-tax percentage return on the cash outlaid.
The pre-1999 indexation method provided the investor a tax-free return equal to the inflation rate on the total purchase price including the debt used to finance the transaction. This provided a larger after-tax percentage return to geared investors.
If Labor's proposed changes are implemented after July 1, 2017, gearing new investments will be encouraged to protect the real value of capital from being taxed. For example, a 50 per cent neutrally geared investment would require a capital gain only equal to twice the rate of inflation to ensure that the investor's real capital is not subject to capital gains tax.
Without gearing, a return of four times the rate of inflation will be required.