This submission offers a set of insights into the distribution of capital gains income and the general rationale for a capital gains discount. While we do not make comments or recommendations about specific asset classes, we describe the criteria that need to be considered when thinking about a tax system that treats all investments in a neutral manner. The current capital gains discount is both inequitable and inefficient in how it incentivises investment in capital gains generating assets. However, the discount was introduced as a simple way to mitigate two justifiable concerns:

• Taxation of inflation: An increase in an asset price due to inflation is not real income and so should not be taxed. Although this is right in principle, it is inconsistent with how inflation is treated in the rest of the tax system. The tax system should treat inflation consistently irrespective of the income source.
• The lumpiness of gains: Low to middle income earners who receive an occasional capital gains would be overtaxed in a full-rate tax system, as the concentrated nature of this gain will push these individuals into a higher tax bracket for a single year. However, the appropriate discount depends on the taxpayers circumstances and the length of time the asset has been held.

The current discount fails to properly mitigate either of these concerns. It overcompensates high-income earners and undercompensates low-income earners for these issues. This is not just inequitable, but distorts the way Australian’s work, save, invest, and finance their investments – generating broader productivity costs and reducing the ability for the tax system to raise necessary revenue.

There are principled ways to mitigate these issues: By providing a general allowance for the inflation component of capital income, and by spreading the capital gain over multiple tax-years (income averaging).

Along these lines, the pre-1999 treatment of capital gains was more closely aligned with tax principles – with the cost base inflated by CPI and optional income averaging. Given reductions in compliance and administration costs due to technological change since 1999, it is worth investigating whether the current discount could be replaced with a more principled approach.