1. Australian Capital Gain Tax Discount: Principle, Tax Policy and Alternatives
by
Dr. Cheaseth Seng
Official
in
Cabinet of H.E. Deputy Prime Minister, Minister in charge of Council of
Ministers
Kingdom of Cambodia
Associate Dean, Faculty of Business and Economics
Pannasatra University of Cambodia
1. Introduction
Capital gain tax (CGT) is a part of Australian income tax system and came into force
on the 20th of September 1985. The taxable capital gain is the net capital gain of all
capital assets held by the taxpayers. Capital assets are assets that defined by CGT
legislation as to subject CGT. Thus not all capital assets are subjected to CGT. The
taxpayers need calculate capital gains or losses of each of their capital assets held to
determine their taxable capital gain. There is no separate CGT liability, as the taxable
capital gain is included in the taxpayers’ taxable income and assessed based on
personal marginal tax rate (ATO Website 1).
The current CGT legislation, which included recommendations from the Ralph
Review reforms of business taxation, provides three methods to calculate capital gain
and one method to calculate capital loss (ATO, 2008; Kenny, 2005). The capital loss
is calculated by subtracting the purchase cost of the capital asset and associated costs
from capital proceed from the asset. The three methods allowed for computing capital
gain are indexation method, discount method and the ‘other’ method. The three
methods are used in different situations (capital event and timing). The discount
method was introduced under the recommendation of the Ralph Review and driven by
tax policy objectives (Kenny, 2005). There are conflicting views of the merit of its
introduction. The majority of the attentions are focused on whether it achieves the
intended objectives or not and that it induces some distortions to economic behaviours
(Kenny, 2005).
The current paper has three objectives. First, it introduces the three methods used to
determine capital gain. Example illustration will be given for each method. Second,
the paper discusses, in detail, the tax policy reasons for the introduction of the
discount method. The outcome of this normative analysis is used to determine the tax
policy that subjected to the conflicting views. Lastly, the paper suggests alternative
courses of action to frame the CGT discount provision and thus attempting to solve
the problems identified. The underlying reasons for the alternative methods will be
provided. This paper is structured accordingly.
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2. 2. General Rule
The general rule used to compute capital gain is subtracting capital proceeds from the
sales or dispose i.e. change of ownership of capital asset by its cost base. The cost
base of an asset consists of five elements, namely money paid or property given for
the asset, incidental costs of acquiring the asset or of the CGT event1, cost of owning
the asset, capital costs to increase or preserve the value of the asset and capital costs
of preserving or defending the title or rights to the asset (ATO Website 2). The
indexation method allows the taxpayer to increase each element of the cost base,
except for the third element, by an indexation factor. The indexation factor is
calculated by dividing the consumer price index (CPI) for the quarter the CGT event
occurs with the CPI for quarter when expenditure incurred. This option is given to
taxpayers when the CGT event happened to asset acquired before 11.45am on 21
September 1999 and the asset is owned for at least 12 months. The general formula
and illustration of the indexation method is provided in Exhibit 1.
Exhibit 1: Indexation method
Indexation formulae:
1. CGT event occurs on or after 11.45am on 21 September 1999
Indexation factor = Consumer price index (CPI) for quarter ending 30.9.99 / CPI for
quarter which expenditure was incurred
CPI is frozen on the 30.9.99 upon the introduction of the Discount method
2. CGT event occurs before 11.45am on 21 September 1999
Indexation factor = CPI for quarter when CGT event happened / CPI for quarter in which
expenditure incurred
Example illustration:
Val bought a property for $150,000 under a contract dated 24 June 1991. The contract
provided for the payment of a deposit of $15,000 on that date, with the balance of
$135,000 to be paid on settlement on 5 August 1991. She paid stamp duty of $5,000 on
20 July 1991, she received an account for solicitor’s fees of $2,000, which she paid as
part of the settlement process. She sold the property on 15 October 2001 (the day the
contracts were exchanged) for $215,000. She incurred costs of $1,500 in solicitor’s fees
and $4,000 in agent’s commission.
Val’s capital gain calculated using indexation method
Deposit X (multiply) indexation factor
$15,000 x (123.4 / 106.0 = 1.164) = $17,460
Balance X indexation factor
$135,000 x (123.4 / 106.6 = 1.158) = $156,330
Stamp duty X indexation factor
$5,000 x (123.4 / 106.6 = 1.158) = $5,790
Solicitor’s fees for purchase of property
$2,000 x (123.4 /106.6 = 1.158) = $2,316
Solicitor’s fees for sale of property
(indexation does not apply) = $1,500
Agents commission (indexation does not apply) = $4,000
Source: ATO (2008)
Cost base (total) $ 187,396
1 Capital proceeds
CGT event describes the sales or transfer of ownership of the capital assets. 215,000
$
Capital gain $ 27,604
2

3. The ‘other’ method is the simplest methods of the three. This method applies the
general rule (mentioned above) to determine capital gain. This method is the only
method available to taxpayers when the capital asset under consideration owned less
than twelve months or with CGT events that do not involve an asset. Exhibit 2
provides example illustration of the ‘other’ method.
Exhibit 2: ‘Other’ method
Marie-Anne bought a property for $150,000 under a contract dated 24 June 2002. The
contract provided for the payment of a deposit of $15,000 on that date, with the balance of
$135,000 to be paid on settlement on 5 August 2002. Marie-Anne paid stamp duty of
$5,000 on 20 July 2002. On 5 August 2002, she received an account for solicitor’s fees of
$2,000 which she paid as part of the settlement process. Contracts for the sale of the
property for $215,000 were exchanged on 15 October 2002. Marie-Anne incurred costs
$1,500 in solicitor fees and $4,000 agent’s commission.
Deposit = $15,000
Balance = $135,000
Stamp duty = $5,000
Solicitor fees for purchase = $2,000
Solicitor fee for sales = $1,500
Agents commission = $4,000
Cost base $ 162,000
Capital proceeds $ 215,000
Capital gain $ 52,000
Source: ATO (2008)
Lastly, the discount method is available to individual, trust and complying
superannuation entity when the CGT event happened after 11.45am on 21 September
1999. The taxpayers need to own the asset for at least 12 months and opt not to use
the indexation method. The discount method is generally not applicable to company
and excluded certain CGT events. The CGT events that excluded from the discount
method are D1, D2 D3, E9, F1, F2, F5, H2, J2 or J32. The discount percentage is 50%
for individuals and trusts and 33.33% for complying superannuation entities. Exhibit
3 provides illustration of the discount method at works.
Val bought a property for $150,000 under a contract dated 24 June 1991. The contract
provided for the payment of a deposit of $15,000 on that date, with the balance of
$135,000 to be paid on settlement on 5 August 1991. She paid stamp duty of $5,000 on
20 July 1991, she received an account for solicitor’s fees of $2,000, which she paid as
part of the settlement process. She sold the property on 15 October 2001 (the day the
contracts were exchanged) for $215,000. She incurred costs of $1,500 in solicitor’s fees
and $4,000 in agent’s commission.
Deposit = $15,000
Balance = $135,000
Stamp duty
Exhibit 3: Discount method = $5,000
Solicitors fees for purchase = $2,000
Solicitors fees for sales = $1,500
2
Agents commission = $4,000
Refer to Appendix 1 of Guide to Capital Gain Tax 2008 for detail of each CGT event
Cost base (total) $ 162,000
Capital proceeds $ 215,500
Capital gain 3 $ 52,000
Less 50% discount ($ 26,250)
Net capital gain $ 26,250

4. Source: ATO (2008)
3. Taxation Principles
The merit of an income tax system is generally assessed based on tax principles. The
common tax principles used to assess an income tax system or part of includes, inter
alia, equity, robust, effectiveness, flexibility, economic efficiency and simplicity. The
introduction of the discount method was mainly driven by economic efficiency tax
principle (Kenny, 2005; REIA; SAECCI, 1999; ACCI, 2007). This tax principle
concerns with the impact of tax system on economic behaviours. It contends that a tax
system should have neutral characteristic i.e. no distortion impact on or alter
economic behaviours. For example, a company income tax system should not alter
investors’ behaviours to or from investing in company structure of organisation.
The economic efficiency objectives of the discount method include encouraging
savings, investment and economic growth, reducing the lock in effect of CGT and
equity financing (Kenny, 2005). Each of these objectives will be discussed in turn.
First, CGT is considered as ‘a wedge between current and future consumption’ (p.25,
Kenny, 2005). This is because the realisation of capital assets is subjected to CGT.
The greater the percentage of income tax shared of taxpayers’ taxable income is the
less that left for saving. Therefore, CGT distorts economic behaviours and bias toward
saving. As the result a preferential treatment of CGT, such as reducing the capital gain
by 50% (individual and trust) or 33.33% (qualified superannuation funds) would
increase disposable income available for saving. The example illustrations above
indicate that in comparison to other methods i.e. indexation and the ‘other’ methods
the capital gain computed under the discount method is the lowest of the three. The
increase in disposable income is expected to have positive relationship with saving
and in turn reduce the extent of economic distortion. In addition, saving was the
government’s objective at time of legislating Ralph Review’s recommendations. The
Treasurer indicated that ‘with more saving we can finance more out of investment to
growth the economy faster’ (cited in Kenny, 2005). The American Council of Capital
Formation (ACCF) (1999) and Kenny (2005) provide that level of saving is linked to
capital investment and in turn linked with economic growth. Figure 1 provides the
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5. chain of effect of using the discount method to calculate CGT taxable capital gains
and economic growth.
Figure 1: Chain effect of Savings
Source: Kenney (2005)
The argument of the positive link between increase in disposable income or higher
rate of return of investing in capital assets, saving and economic growth is debatable.
This is because empirical studies on the affect of reducing tax rate on savings indicate
that savings are not very responsive to higher rate of return (Kay and King, 1990;
Gann, 1980; Gordano, 1986; Kenny, 2005). In addition, the characteristics of
Australia’s capital assets and their incomes suggest the same weak link. Kenny (2005)
provides four capital assets related reasons to illustrate the weak relationship between
higher rate of return and saving. Firstly, capital gain is only 31% of reported capital
income. Hence, increase rate of return by discounting capital gain will have little
impact on total capital income and in turn saving. Second, the incomes produce by
capital assets are mainly in the forms of dividends, interest and rent instead of capital
gain. In other words, realisation of capital assets is not the major source of capital
income. Third, saving is insensitive to rate of return when saving is done for
precautionary or liquidity purpose. Lastly, CGT preferential treatment would not
greatly impact on tax exempt bodies or low taxed superannuation fund.
Turning to empirical studies, Kay and King (1990), in their study of the affect of
changes in real interest rate in the UK in 1970s and 1980s, assert that savings are not
very responsive to the rate of return. Gann (1980) and Gordano (1986) also found the
same weak relationship between higher rate of return and saving. Their studies were
focused on US context and the changes in income tax rates.
Lastly, there are indications that savings does not have a clear link with economic
growth. Schmidt (2003) examines the long-term and short-term relationship between
Australia’s savings, investment rates and economic growth provided changes in level
of saving have no impact on national investment and economic growth. Chaudhri and
Wilson (2000) also found savings have no impact on economic growth. They find the
level of savings is neither necessary nor a necessary requirement for economic
growth.
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6. In conclusion, the saving, investment and economic growth reasons lend little support
in introducing the discount method to calculate CGT. The CGT discount method has
little impact on saving and economic growth.
The second objective of the discount method is to reduce the lock in effect of CGT.
The lock in effect of CGT arises when investors are unwilling to realise their capital
assets in response to new information. The investors are reluctant to change their
portfolio investment even if others profitable investment opportunity arises. This is
because realising their assets will subject to CGT. Thus the investor is said to have
locked in with current investment portfolio. Therefore, CGT induces misallocation of
capital assets among industries and firms. In addition, there are claims that CGT alters
‘the mix of financial assets that firms supply, the ratio of debt to equity and the
allocation of risk bearing in the economy’ (p. 35, Kenny, 2005). In other words, CGT
distorts investment behaviours.
The introduction of the discount method would reduce this lock in effect. The CGT
discount gives investors (individual, trust and qualified superannuation firms) some
relieve of their CGT, which in turn encourage realisation of their capital assets when
others profitable opportunity arises.
Similar to the saving, investment and economic growth objective, the lock in effect
objective is not a strong argument for introducing the discount method. There are
several counter arguments as follow. First, the Australian Stock Exchange (ASX)
provides that majority of share investors sell their shares quickly in response to poor
company performance (cited in Kenny, 2005). In addition, these investors are
comprised of lower taxed superannuation funds and foreign investors (Australian
Prudential Regulation Authority, 2003) which are not greatly affected by CGT. The
low taxed superannuation funds face little CGT liability and the foreign investors are
excluded from CGT discount. Furthermore, investors with large portfolio of assets
will have both capital losses and gains. The capital loss will offset the capital gains.
In sum, the lock in effect is not a major issue for Australian share market.
Second, Burman (1999) contends that the discount method could create a reverse lock
in effect for investors. This situation arises where an investor is better off to realise
their assets and face CGT and acquire a more profitable (highly appreciated assets)
than waiting for the discount relieve.
Third, the CGT discount may induce a further lock in effect. This is because investors
need to hold their assets for at least 12 months to get the discount relieve. This
requirement affects free operation the market and in turn further induces distortion to
economic behaviours. In this context, the discount method does not achieve its
intended objective.
Lastly, Krever and Brooks (1990), in their study of the effect of New Zealand CGT,
point out a number of situations where lock in effect will not apply to investors. The
situations include where the investors have no choice but to sell the assets for business
consideration or through forced disposals. In addition, assets with short lives like
leases, patents and mineral deposit are not affected by lock in effect. Their short lives
force the investors to sell the assets. Lastly, CGT exempt assets attract no lock in
effect either. Thus, the discount method is not relevant to these situations.
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7. Once again, there are arguments for both for and against the introduction of the
discount method and merit of the driving tax principle, namely the economic
efficiency tax principle. The lock in effect issue is seemed to have insignificant effect
on share market and the discount method induces further lock in effect and economic
distortion.
The last objective of the discount method chosen for discussion in this paper is equity
financing. The argument for discounting capital gain is that it would encourage risk
taking, equity financing, entrepreneurial activity and new business start ups (ACCF,
1999; Reynolds, 1999; Kenny, 2005). Discounting capital gain will lower CGT rate
and in turn decrease the cost of capital for business. This would be beneficial for
businesses that rely on equity financing. Such businesses include small growth
companies that have insufficient retained earnings and limited borrowing capacity.
This equity financing argument is another weak one. As previously mentioned major
contributors to equity market are low taxed superannuation funds and foreign
investors. The cut in CGT rate have little impact on their after tax rate of return. In
addition, CGT discount applies to all types of assets, namely productive and
unproductive ones. This makes the CGT discount a poor choice to encourage
entrepreneurship.
Overall, the economic efficiency objectives of introducing the discount method to
calculate capital gain are insufficient and somewhat weak. The objective that the
discount method reduces the problem of economic distortion toward saving,
investment and economic growth behaviours faces many criticisms. This is because
there is a weak relationship between CGT discount and savings. The equity financing
objective is also faced with the similar criticisms. For the lock in effect objective, the
discount method has little impact on reducing the lock in effect as it is not a major
issue in the market. Moreover, the discount method induces further lock in effect as
investors need to hold their assets for at least twelve months to receive the discount
relieves. This distorts the free market operation and in turn economic efficiency of
CGT. As the result a change to the discount method is required, especially regarding
to the lock in effect matter.
4. Proposed Change
The majority of current proposals for changes toward CGT are focused, once again,
on economic efficiency (ACCI, 2007; SAECCI, 1999; REIA). The proposals focus on
CGT rate and holding period. The Australian Chamber of Commerce and Industry
(ACCI) (2007), the Real Estate Institute of Australia and South Australian Employers’
Chamber of Commerce and Industry (1999) are all proposing a ‘stepped rate’ method.
The method is considered to ‘significantly reduce the burden of tax on capital gains
and encouraging increased investment’ (p. 8, ACCI, 2007). Table 1 provides the
ACCI proposed ‘step rate’ method.
Table 1: Capital gain tax schedule
Time asset held Proportion of Gains Subjected to Tax
Less than 1 year 100%
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8. 1 – 2 years 50% (25% small business active asset exemption)
2 – 5 years 25%
5 – 10 years 10%
More than 10 years 0%
Source: ACCI, 2007
This ‘step rate’ method provides relieves to taxpayers and meets some of the
objectives discussed above. However, in term of lock in effect, it still induces further
lock in effect and if an investors would like to get the full exemption of CGT, a 10
years holding period is required. The distortion to free market operation is still
present.
An alternative to the ‘step rate’ method is to allow for CGT discount immediately
with no waiting period. This way it eliminates the lock in effect and not induces any
distortion to free market operation. In addition, it serves the original purpose of
introducing the CGT discount. This method does however attract conversion of
income into capital. According to Evan (1999), this proposed method provides
incentive to taxpayers to convert their income into capital in order to receive
concessional CGT rates. Nevertheless, the issue of converting income into capital is
also present with the original and ‘step rate’ methods (Evan, 1999). Reynolds (1999)
provides that the introduction of CGT concession rates has revenue elasticity of – 1.7
in the first two years and – 0.9 in the five years.
Lastly, Kenny (2005) suggests that the CGT discount should be abolished. According
to the above discussions, the discount method has little impact on saving, investment
and economic growth objectives as well as equity financing and lock in effect
objectives. The abolition of the CGT discount thus eliminate the further distortion
created. Moreover, it serves the original purpose of CGT, which is a form of wealth
tax that aims to achieve vertical equity. Kenny (2005) provides majority of capital
assets are held by small proportion of wealthy taxpayers. In addition, abolition of
CGT discount eliminates the behaviours of converting income into capital as
mentioned above.
5. Conclusion
In conclusion CGT is an essential part of Australian income tax system. It helps
ensure equity treatment of the system. It is designed to prevent the conversion of
income into capital. There are three methods allowed for calculating capital gains,
namely the indexation, discount and the ‘other’ methods. The discount method was
introduced based on Ralph Review recommendations and on economic efficiency tax
objective. The arguments for its introduction were, however, quite weak and subjected
to many criticisms, particularly, the reduction of lock in effect objective. The discount
method induces a further lock in effect and distorts to free market operations instead
of solving it. In light of this problem, there are several proposed of alternative
courses of action. The proposed courses are ‘step rate’ discount method, immediate
discount with no waiting period and the abolition of CGT discount overall. Each of
these proposed methods has both up and down sides. The paper suggests the
immediate discount method without waiting period. This is because this method
reduces the lock in effect and distortion of free market operation. The incentive to
convert income into capital embodied with this method is present with all other
8

9. proposed methods. In addition, it meets most of the economic efficiency objectives
that drive the introduction of the original discount method. Thus, it is the best
alternative course of action.
Reference
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