Yes, we need big changes to tax, but here's why the budget isn't the place for it

Hopefully, it will be more than the half-hearted tinkering we have seen so far on major policy matters: the corruption commission, superannuation, and gambling.

However, the budget process is the wrong vehicle for an overhaul of the tax system. It is inherently secret, so there will be no input from academics, think tanks, and other outside experts, and no scrutiny or testing of proposals until it is too late and the government is locked in.

First, an apology for being very detailed in what follows, but bear with me. Too often sweeping, simplistic, notionally appealing policies in fact contain deep flaws that shut out many in society.

A classic example of this was the 1999 budget which created much of the tax mess we are in now.

Then Treasurer Peter Costello pulled out of the hat the 50 per cent capital gains tax concession. It wasn't a tax policy. It was a vote-buying thought bubble - more bubble than thought.

And it is deeply flawed at both ends: too much concession in the short term and a vicious, unfair penalty in the long term.

The 1999 changes when combined with negative gearing created a housing monster that has white-anted the Australian dream of home ownership.

For the past few decades more and more investors have been buying more and more houses with high interest repayments and high outgoings which they deduct against existing wage, salary, and professional earnings, reducing their tax liability.

They wait a few years in which the dwelling's value increases, because population increases fuel housing demand. The increase is usually much more than the outgoings, especially as the outgoings have been tax deductible. They then sell the dwelling making a big capital gain - only half of which is taxed.

In effect, the high-income earners convert income taxed at 47 per cent to income taxed at 23.5 per cent.

The social downside is that these investors are shutting out people who want to buy dwellings to live in (fancy that!) by driving up prices beyond their reach.

Sure, a radical reduction in immigration would help ease demand but the investors would still sniff around the housing market while ever the catalytic combination of capital gains concessions and negative gearing gives high-income earners a vehicle for tax minimisation.

In 1999, 73 per cent of occupiers owned or were buying their dwelling and 27 per cent rented. Of those renting, three-quarters were from private landlords. So, the private-investor share of the market was just 20 per cent.

By 2025, that had shot up to well over 30 per cent. Worse, investors were sucking up more than 40 per cent of new housing finance - again making things more difficult for those buying to live in.

But millions of people have arranged their financial affairs around these tax concessions, so they are going to be hard to unwind.

Often governments engage in what is called "grandfathering" to allow (usually old) people to keep existing arrangements while only applying new rules to newcomers.

In Australia's property market, however, it might take a few decades for grandfathering provisions to work through the system, because only a small portion of property investors are old grandfathers. Many are quite young.

It would be better to do a phase-out. More on that anon.

The other flaw in the Costello arrangement was that he removed any allowance for inflation, thinking that his generous 50 per cent concession would cover that.

As a result, people who have held assets for a long time face paying tax on notional gains which are not real gains at all.

For example, someone buying a capital asset in 1999 for $100,000 and selling it today for $200,000 would have half the notional gain added to their taxable income resulting in around $23,000 in tax.

But if you converted the 1999 $100,000 to 2026 dollars you get $208,450, according to the RBA indexation calculator. It means, in effect, that the taxpayer would be paying $23,000 tax on a net real capital loss of $8450.

Worse, the RBA calculator says inflation has averaged 2.9 per cent since 1999, but it is now running at 3.7 per cent. At that average rate over the 26 years our taxpayer would get a $157,000 notional gain and be facing a bill of around $37,000 on their $8450 net real capital loss.

And even if a long-term asset owner made a real capital gain, it would have to be a substantial one to offset the tax levied on that part of the "gain" which was purely notional or unindexed.

This is a real problem for people holding assets for long periods - like farms, businesses, and artworks. It is what happens when tax policy is created by thought bubbles in a budget aimed at voters in the next election.

Rather than grandfathering negative gearing and the capital gains concession, they should be tapered out over, say, five years at 20 per cent a year. Ultimately, earnings and outgoings on passive investments (property, shares, art and so on) would be boxed in so taxpayers could only deduct passive-investment losses against passive-investment gains, but not against income from wages, salaries, and business activity.

There is a precedent. Deductions for medical expenses (especially specialists' fees) were phased out between 2013 and 2019.

Of course, taxpayers should be able to offset any carried over losses against any realised capital gains. It might encourage some investors to sell rather than lose the deductibility of the losses. They might even sell to someone who wants to live in the dwelling.

The capital gains concession should also be phased out and replaced with indexation for inflation. Perhaps taxpayers should get a choice between the two methods for the next, say, five years, after which the 50 per cent concession would be axed, but gains indexed for inflation.

The other problem with the capital gains tax is that it is all added to the taxpayer's income in one year - the year the asset is sold. That puts a large amount of it into the highest tax bracket. Taxpayers should be able to spread the gain over several years, much as sportspeople and entertainers are permitted to even out their spikes in income.

Disclaimer: Yes, I have had negatively geared properties and claimed the capital gains tax concession in the past. But that's how I know where all the bodies are buried.

www.crispinhull.com.au