Australia's Future Tax System

Architecture of Australia's tax and transfer system

8.2 Differences in the tax treatment of different assets and financing arrangements

When examining the tax treatment of savings and investment, including through different assets and financing arrangements, it is important to understand the different components of income that can be earned from an asset (Chart 8.2).

The return to capital can be split into four components:

  • the inflationary component — which compensates for rising prices;
  • the compensation for deferring consumption — sometimes described as the 'return to waiting'. Combined with the inflationary component, this represents the 'normal', or risk‑free, return to capital;
  • the risk premium — for projects with uncertain returns; and
  • the 'supernormal' return — an additional return arising from access to a unique asset or idea, a patent, or other factors.

In addition, for a particular investment, there can be a difference between the expected return at the start of an investment and the actual return. This uncertainty about the return can be called good or bad luck. Across the economy and over a sufficient period of time, this would be expected to net to zero.

Chart 8.2: Components of the return to capital

Chart 8.2: Components of the return to capital

The inflationary component compensates the investor for the reduction in purchasing power arising from inflation, so that the investor is able to purchase the same quantity of goods and services in the future as they could when they decided to save. In other words, this part of the return does not add to the purchasing power of the investor, unlike the remaining components of the return, often referred to as the real return to capital.

A nominal income tax base includes the inflationary component. Even at low rates of inflation there can be large differences in the effective rate of tax on the change in the purchasing power of the investor depending upon whether the inflation component is taxed.

For example, consider a taxpayer with $1,000 in a bank account earning 6 per cent interest, and inflation at 2.5 per cent. Under a nominal income tax the full $60 would be subject to tax, whereas if the inflation component were excluded, only $35 would be subject to tax. Taxing the entire return to capital results in a higher effective tax rate on the $35 increase in purchasing power, than if only the $35 were taxed. Importantly, the relativities between the real and nominal return to capital vary through time and across different types of assets. For example, the inflation component represents a larger proportion of the return to lower yielding assets such as bank deposits.

Australia notionally has a comprehensive nominal income tax base, but in practice it represents a hybrid income/expenditure base. This is similar to all other OECD countries which have concessions for particular types of savings and returns to investments. For Australia, deviations from a comprehensive nominal income tax base include:

  • the exclusion of the returns from owner‑occupied housing (including imputed rent) and other personal use assets (such as vehicles), and their related expenses from taxation;
  • concessional treatment of investments in superannuation;
  • the taxation of gains in asset values only when an asset is sold, with capital gains tax (CGT) discounts of 33⅓ per cent for superannuation funds and 50 per cent for individuals on assets held for at least 12 months;
  • faster rates of write‑off for some depreciating assets than the actual fall in their nominal value; and
  • rules that limit the use of losses (negative income returns), especially for new businesses.

In addition to income tax, other transaction and wealth type taxes are applied to savings and investment. In particular, conveyancing stamp duties are applied to transactions on houses, and local rates and land taxes are based on the wealth holdings of some land (see Section 2.5). The tax treatment of housing is discussed further in Box 8.1.

For individuals who receive income support, the effective returns on savings and investments are also affected by income and assets tests used to target that support. The degree to which returns are affected depends on an individual's personal circumstances.

Effective marginal tax rates by type of asset and financing

The variation in tax treatment for different assets and financing arrangements can be illustrated by calculating effective marginal tax rates (EMTRs) — see Section 3.5 for more information on options for measuring the impact of taxes. Given the complexities in modelling the interactions with the transfer system, the EMTRs presented in this section do not take account of the implicit taxes arising from income and asset testing.

EMTRs can be calculated for the nominal return to an investment or for the real return. The following analysis incorporates both the impacts of the different tax treatment of different assets (the 'no gearing' cases) and the impacts of different financing decisions (reflected in the differences arising from the 'gearing', where 70 per cent of the investment is assumed to be funded from borrowings).

Chart 8.3 shows nominal EMTRs for investments commonly made by individuals. As the entire nominal return from interest bearing deposits and from bonds is included in a taxpayer's income, the nominal EMTR is equivalent to the taxpayer's marginal tax rate. This outcome is consistent with a comprehensive nominal income tax. Relative to interest bearing deposits, owner‑occupied housing, rental properties, listed shares, and concessional (pre‑tax) contributions to superannuation are favourably taxed.

Chart 8.3: Nominal EMTRs by asset type and financing arrangement

Chart 8.3: Nominal EMTRs by asset type and financing arrangement

Assumptions: Calculated for an individual taxpayer on a 46.5 per cent marginal tax rate. Assets held for seven years. Inflation 2.5 per cent, 6 per cent nominal return. Gearing 70 per cent — not applicable to bank/bonds and superannuation. Tax on debt providers is disregarded. For property, 70 per cent of the return is attributable to capital gains and 30 per cent to rent. A 3 per cent conveyancing duty is assumed on the acquisition value, and annual rates are applied at 0.6 per cent of the value. Land tax applies to rental property at the same rate as annual rates. The 'listed share' is a company holding an asset taxed on an accruals basis. The company retains 50 per cent of its profits each year. There is no duty on the purchase or sale of the listed share and accrued franking credits are assumed to be fully valued by the market. For superannuation, the taxpayer makes a one‑off contribution at the beginning of the period out of pre‑tax income and is eligible for a tax‑free payout at the end of seven years.

Source: Australian Treasury estimates.

The positive EMTRs for owner‑occupied housing and for geared rental property arise from the general operation of the income tax law as well as various housing and land specific taxes. The chart also shows the impact on the EMTR from borrowing to finance rental properties and listed shares and deducting the interest expense (at the taxpayer's marginal tax rate).

For concessional superannuation, the ability to invest out of pre‑tax income produces a negative EMTR. For non‑concessional (post‑tax) contributions the EMTR is 15 per cent. Around a third of the flow into superannuation is made up of such contributions. The effective rate would be lower where the taxpayer receives superannuation co‑contributions from the government of up to $1.50 for every dollar invested, to a co‑contribution limit of $1,000 a year. The results are also sensitive to the assumptions used, particularly for concessional (pre‑tax) contributions to superannuation. For example, for these contributions the EMTR changes from ‑105 per cent for a seven year investment period to ‑26 per cent for 20 years.

Where EMTRs are calculated for the real (inflation‑adjusted) return, their absolute values increase (Chart 8.4). On this basis, the extent of the non‑neutralities between different assets and financing arrangements is greater.

Chart 8.4: Real EMTRs by asset type and financing arrangement

Chart 8.4: Real EMTRs by asset type and financing arrangement

Assumptions: as for Chart 8.3.

Source: Australian Treasury estimates.

The above calculations do not take into account interactions with the transfer system. As noted in Section 7, these are complex and generate very different patterns of effective tax rates based on factors such as family circumstances. Tax‑transfer effective tax rates will also apply to any capital income derived by individuals. For example, for a single income couple on average weekly earnings with two children aged three and eight with a personal income marginal tax rate of 31.5 per cent, the combined nominal EMTR on a bank account could be around 56 per cent and the real EMTR could be around 96 per cent.

As a general observation, the high EMTRs arising from the interaction of the tax and transfer systems will tend to be reflected in disincentives to save, just as they are in disincentives to participate in the workforce. On the other hand, these higher tax‑transfer EMTRs also tend to mean that the value of tax concessions for capital income (including superannuation) may also be greater for some low and middle income families than for higher income families.

Box 8.1: The taxation treatment of housing

The imputed rent and capital gains of owner‑occupied housing are exempt from income tax. The cost of financing the purchase and other expenses are not deductible. Rental properties are subject to income tax, including CGT and are eligible for a 2.5 per cent annual depreciation allowance on the construction cost of the building. Further, the cost of financing is deductible and can be offset against income from other sources. It is not included as part of the cost of the asset when determining the net capital gain for CGT purposes.

Investment in residential property is taxed in the same way as some other assets, but the returns vary, as noted above.

Residential property is also subject to a range of state taxes, with a range of rates and thresholds. Sales of residential properties are taxed through stamp duty on conveyances, and rental properties are subject to ongoing land taxes. Local governments (and the Australian Capital Territory) also tax residential property through municipal rates.

Stamp duty is levied on housing transactions. While paid by the buyer, the incidence of stamp duty is likely to be shared and partly fall on sellers by lowering the after‑tax price received though sale. As a tax on transactions, stamp duties can discourage turnover and influence housing decisions. They may also encourage some home-buyers to buy larger houses in order to avoid further stamp duty from subsequent moves into family-sized homes. Similarly, stamp duties may affect decisions of existing home owners. Some people wishing to upsize may choose to renovate their existing home rather than move. For those who would prefer downsizing to a smaller house, stamp duties can pose an additional difficulty in the relocation process, by increasing the required return on the property sale before they are able to move. These impacts are partly ameliorated by concessions that the States offer to first home buyers and to pensioners who move to homes that better suit their needs.

Other aspects of the tax-transfer system can also generate 'lock-in' effects that may discourage sales of housing. The principal place of residence is generally given a concessional treatment under income support assets tests. This means that moving from owner-occupied housing to rental accommodation can lead to lower pension payments for older people, as their assets are reallocated into non-concessionally treated categories.

Land tax is levied on the unimproved value of land, with investment properties subject to the tax and owner-occupied property exempt. In addition to favouring owner-occupied housing over investment housing, land taxation affects housing investment decisions in two ways. Most land tax regimes have progressive scales, which can discourage large scale investment in land. This impact can be significant. Averaging across jurisdictions, a single company holding ten land parcels worth $300,000 would pay five times more land tax than if the same parcels were held in separate hands. This encourages property investment by small-scale investors, who pay less tax per property than larger entities. Land tax is also likely to encourage greater investor participation in properties where land is a low proportion of total property value (such as apartments) than in detached houses.

Further issues arise in respect of the treatment of net losses on investments and aspects of the treatment of capital gains and of depreciating assets. These issues are not fully reflected in the EMTR calculations above and are discussed below.

The tax treatment of losses

The tax treatment applying to losses can impact on incentives to invest in risky assets. Australia and comparable OECD countries typically have an asymmetric treatment of gains and losses overall.

There is some variation in the treatment of losses across the OECD. While no country provides full refundability, a number of arrangements are used to improve loss utilisation. Some countries, including the United States, United Kingdom, Canada, Ireland and the Netherlands, allow revenue losses to be 'carried back' and used against profits of previous years. The length of the carry‑back is typically around one to three years. These arrangements, however, are of limited use to new companies.

A number of countries also provide flow‑through arrangements for some companies. These arrangements allow losses or expenditure to flow through to investors. Examples include:

  • S‑corporations in the United States, which provides both partnership taxation treatment and limited liability protection for certain companies with no more than 100 individual resident or citizen shareholders;
  • loss attributing qualifying companies in New Zealand, which can allocate company losses to specific shareholders, if the company has five or fewer shareholders who elect to become personally liable for any income tax not paid by the company; and
  • flow‑through shares in Canada, which can transfer expenses in relation to mining, petroleum and certain types of renewable energy to investors.

Taxing gains on a realisation basis

Capital gains are typically taxed upon disposal (a realisation basis). Taxing gains on a realisation basis is considered more practical than accruals taxation due to potential difficulties in measuring gains as they accrue and the cash‑flow problems that an annual accruals tax could cause for some taxpayers. However, there are elements of accruals taxation in the income tax system. For example, tax depreciation provides deductions for the decline in value of assets that are used up in production. An accruals method is also part of the proposed regime for the taxation of financial arrangements.

Taxing gains on realisation creates a tax 'deferral' advantage, as the asset holder is not required to pay tax on any gains until the asset is disposed. It may also induce a 'lock‑in' effect, whereby investors are discouraged from switching assets due to the requirement to pay tax on the accrued gain at the time of disposal.

Depreciation

Capital income may be generated by assets that decline in value as they age and are used up in production. The decline in value is known as economic depreciation. Consistent with an income tax benchmark, where the assets are used in the production of income, the decline in value can be offset against income over time.

Such depreciation deductions can apply to both physical assets (for example, plant and equipment) and intangible assets (for example, industrial property). The 'uniform capital allowance' regime provides different deductions for certain types of capital expenditure, including immediate deductions for small value items.

The introduction of effective life depreciation as part of the Review of Business Taxation reforms, coupled with the introduction in 2006 of the 200 per cent rate for the diminishing value method, has resulted in a greater alignment of tax depreciation with economic depreciation.

The income tax system also provides for caps or upper limits on the lives of a number of assets for depreciation purposes. The caps represent a departure from economic depreciation and give rise to a significant tax expenditure (estimated to be $385 million in 2008‑09). To the extent that different assets have different depreciation treatments, investments can be biased towards concessionally taxed assets, rather than those that generate the greatest pre‑tax returns.

Changes to depreciation arrangements have also been a feature in other OECD countries. Corporate tax rate reductions in many OECD countries, (including Australia in 2000 and 2001) have been partly financed by corporate tax base broadening measures, including the implementation of less generous tax depreciation allowances (OECD 2007f).