Chapter 4

CAPITAL GAINS TAX

Introduction

4.1 Capital gains tax (CGT) was introduced in Australia in 1985, principally to stem the loss of revenue from individuals converting income to capital to exploit its tax-free status. Initial revenue gains exceeded Treasury's expectations considerably and, despite no rate changes since the introduction of CGT, revenue has fluctuated considerably in succeeding years. Australia has, therefore, no experience in behavioural responses to a change in CGT rate and such estimates of responses as are available come from overseas jurisdictions. The USA, for example, has both lowered and raised its CGT rate over the last twenty years and the behavioural responses to those rate changes have been extensively studied. Nor it it clear what the level of Australia's asset base is. There is, however, some level of agreement that Australia's current CGT regime represents a hurdle to investment by overseas entities. Hence the Government's proposals for a new CGT rate regime as outlined in Chapter 2.

The Government's estimate of the fiscal impact of the new CGT regime [1]

	99-00	99-00	00-01	01-02	02-03	03-04	04-05	5 year total
Capital gains tax measures	$m	$m	$m	$m	$m	$m	$m	$m
Reform CGT for individuals	0	0	210	230	210	180	100	930
Reform CGT for superannuation funds	0	0	-70	-50	-70	-60	-60	-310
Freeze indexation for other entities	0	0	10	40	50	60	70	230
Allowance for CGT arbitrage activities	0	0	-20	-50	-100	-150	-180	-500
CGT rollover relief for scrip for scrip acquisitions	0	0	2	-19	-5	11	29	18
Venture capital (including PDFs)	0	0	0	0	0	0	-5	-5
Small business provisions (incl. 15 yr exemption)		*	*	*	*	*	*	nil
Total [2]	0	0	132	151	85	41	-46	363

This chapter focuses on the impact of CGT reform for individuals. The proposals for CGT reform for small business (principally the 50 per cent general and 15 year small business exemptions) and the measures in respect of venture capital are basically estimated to be revenue neutral. Given its focus on fiscal impact, the committee was not able to give this aspect further consideration within the time allowed.

Reform of CGT for individuals

4.2 Much evidence received by the committee concerned the impact on revenue of behavioural responses to changes in the capital gains tax rate. The magnitude of any response, the availability of evidence to support an estimate of the response and whether such responses should properly be included in revenue estimates were key issues. The Ralph Report recognised that data limitations and volatility of CGT collections were a significant problem in estimating the impact of the proposed reforms to capital gains tax. The lack of information required assumptions to be made concerning the value, ownership and composition of the asset stock subject to capital gains tax. Nevertheless, Treasury officials advised that the estimates produced by the secretariat with substantial assistance from the Australian Taxation Office were as good as could be produced.

4.3 There are two highly contentious issues in the proposed changes:

• The level of additional realisations resulting from the change, and
• The potential for arbitrage between ordinary income and capital income.

A third issue raised with the committee concerned the equity impacts of the proposed changes. ACOSS, for example, in its submission to the committee, expressed its deep concern about the serious threat the CGT reforms present to the integrity of the progressive personal income tax system, and thereby to future federal budget revenues. The ultimate concern is that substantial revenue loss from a reduction in the top marginal rates for individual taxpayers will result in the eventual increase in charges associated with user or consumer pays or in the cutting of essential services. This would greatly increase poverty and income inequality in Australia. However, the committee's brief related to fiscal impacts and therefore beyond this the equity issue was not considered in depth.

During the two days of public hearings in November a substantial number of witnesses appearing before the committee expressed a variety of views about the assumptions underlying the CGT figures in the Ralph report which have been adopted by the Government.

Level of realisation of capital gains

4.4 Estimates of the impact on revenue of CGT changes are formulated on the basis of a calculation of the `elasticity' of capital gains realisations at times of a change to the tax rate. Elasticity in this context has been described as follows:

The term 'elasticity' is used in economics to describe responsiveness of one variable to changes in another. … In the capital gains context, the concept of elasticity has been used to characterise the responsiveness of capital gains realisations to changes in the capital gains tax rate. [3]

and

capital gains realisations elasticities (the percentage change in realisations divided by the percentage change in the tax rate). [4]

Elasticities underpinning the Ralph Report and the Government's response

4.5 The Ralph Report stated that a number of submissions to the Review argued that revenue estimates ought to take account of an expected increase in realisation of assets if the tax rate on capital gains were reduced. It noted that literature had developed around the issue of the elasticity of realisations to variations in the tax rate and that, by the large, the literature concludes that there is a significant elasticity - particularly in the short term. It considered that a strong response effect ought to be expected in both the short and longer terms, but especially in the short term. The elasticities adopted by the Review correspond approximately to an elasticity of minus 1.7 in the short term and around minus 0.9 in the long term. These elasticities have a considerable impact on the revenue estimates for the package, converting the capital gains tax changes in the first year from a $480 million revenue loss into a $130 million revenue gain because of the extra realisations:

Ralph estimates of revenue from additional realisations ($m) [5]:

	2000 - 01	2001 - 02	2002 - 03	2003 - 04	2004-05
Individuals CGT static cost	-330	-300	-290	-310	-300
Revenue from extra realisations	+540	+530	+500	+480	+400
Super funds static cost	-140	-100	-110	-100	-100
Revenue from extra realisations	+70	+50	+40	+40	+30

4.6 Both the Financial Planning Association and the Australian Stock Exchange concluded in their submissions that the assumptions in the Ralph Report concerning estimates for behavioural responses were reasonable.

We agree with RBT that a reasonable assumption is an elasticity of -0.9. This was the lowest average estimate of the nine studies examined by Reynolds. Hence it is a conservative estimate! [6]

and

The RBT estimates for behavioural responses (increased realisations of capital gains) are reasonable in comparison with official US government budget estimates for CGT realisation responses to tax rate deductions. [7]

4.7 The ASX also commented that controlling for some structural differences (principally adjusting for the beneficial effects of indexation by taking into account a maximum effective marginal tax rate in Australia on capital gains of 36 per cent) official US Government budget estimates have relevance for consideration of budget estimation in Australia.

4.8 A reduction of the maximum CGT rate from 36 per cent to 24.5 per cent lies in the middle of the band of US rate changes between 1960 and 1997 and therefore the ASX argues that while there are structural differences between the prevailing Australian arrangements and the US history of CGT policy which complicate the adaption of US estimates to Australian revenue projections, the US experience is instructive.

4.9 The ASX concluded, based on a commissioned study by Mr Alan Reynolds, that a long run elasticity value of -0.9 represents a reasonable estimate of realisation responses to rate reductions. It also commented that realisation is more than `a bring forward of tax', there is also a structural impact associated with diminution of the `lock-in' effect, expected to materialise in the form of increased activity and therefore increased revenue from CGT.

4.10 In response to a question from Senator Cook about tax avoidance activity such as an executive who takes $1 million in shares rather than as salary, Mr Reynolds expressed surprise:

I would be surprised if you would not disallow that. I think you should. If someone was given shares in lieu of salary then you should treat that as salary. That is what we do. [8]

Concessional treatment for CGT for individuals will be restricted to certain nominated classes of assets. Derivative products such as the creation of rights and options, which were previously used to great effect to convert income to capital (particularly by employees and directors), will not be subject to concessional treatment under the proposed changes. Therefore CGT events associated with the creation of such CGT assets will be subject to the capital gains tax regime, but will not be eligible for the discount rate.

Professor Krever expressed the view that the remaining categories of CGT assets eligible for the concession 'offer plenty of scope for manipulation, and a well advised taxpayer will be able to convert many ordinary commercial gains into concessionally taxed capital gains'. [9]

4.11 Mr Reynolds criticised Dr Gravelle's fundamental assumption that there was a natural upper limit of permanent realisations.

The life cycle theory behind speculations and simulations claiming that only ephemeral revenue gains can result from a lower capital tax rate is clearly based on many false premises. [10]

4.12 Mr Reynolds also considers the Burman and Randolph study of 1994 flawed for other reasons, including that the combined effects of gradual reductions in CGT and extremely sudden changes in the economy and stock market during Burman and Randolph's short sample period could easily swamp the relatively small differences between USA State tax rates on capital gains. The ASX submission indicated that the inclusion of the most recent empirical paper by Burman and Randolph in 1994 in the Reynolds analysis of theoretical studies in the US (which showed the average of the lowest elasticity estimates was -0.9) would barely affect the average estimate -0.9 elasticity in the long run. In fact, the Burman and Randolph research stopped at 1983 which makes it more outdated than six of the studies included in the Reynold's average. A seemingly older study (Gillingham and Greenlees 1992) extended from 1954 to 1989 and estimated elasticity above [-] 1.0.

4.13 The ASX stated that:

The Burman-Randolph study says there is a 95 percent chance the long-run elasticity could be anywhere between zero and [-]one ('long-run elasticities of 0.0 and -1.0 are both included in a 95 percent confidence interval.') Zero is certainly much smaller than any other study, but [-] 1.0 is a bit above the average ([-] 0.9). Gravelle sometimes asserts that the midpoint between zero and [-] 1.0 ([-] 0.5) could be considered the high point, but that arbitrary opinion is contradicted by most private studies (including Burman-Randolph) and by all official estimates. [11]

4.14 Mr Reynolds saw the ongoing stability of the official US Government figure remaining at -0.9 for so many years as support for his theories. The US Government has not been persuaded to date to amend the long-run elasticity estimate. This was put to witnesses, eliciting a variety of responses.

4.15 There are similar statements of support in relation to the gains from revenue from behavioural responses to tax changes from the Business Coalition for Tax Reform (BCTR) and the Australian Institute of Company Directors (AICD) who consider the gains to be understated and the losses to be overstated.

4.16 Mr Reynolds stated that the following conclusion of Auten and Cordes was still an accurate description of the slightly updated evidence considered by his work for the ASX.

Cross-section and panel studies generally imply that the elasticity exceeds 1.0. Time series studies generally imply that the long run elasticity is between 0.5 and 0.9. [12]

Conflicting evidence on elasticities

4.17 Dr Jane Gravelle, a senior economic specialist in the Congressional Research Service in Washington who was acknowledged by the Australian academics who appeared in this Inquiry as an internationally renowned expert on capital gains taxation, in her submission to the committee, addresses the statistical evidence regarding capital gains realisations elasticities. She concludes that the long run elasticity estimated in the US studies was too high. Dr Gravelle advised that there is not a lot of empirical support for the view that the short run elasticity would be much larger than the long run response. She agreed that, in translating from the US tax rates at which elasticities were measured to Australian tax rates, it was important to adjust for indexation and the difference in tax rates and she also recognised problems in adapting the US data to the Australian situation.

4.18 Her assessment of the elasticities was that the long run elasticity was probably around -0.2 and the short run elasticity was well below 1 at about -0.6, but the basis for increasing elasticity substantially in the short run was weak. The short run elasticity of -0.6 is for a 22 per cent tax rate and a permanent elasticity of around -0.2, or less. The low short run elasticity is apparently based on the assumption that a large permanent elasticity would generate a significantly larger first year elasticity.

4.19 The reason for setting the long run elasticity low is related to her analysis of the studies conducted in the US. Her own work (Limits to Capital Gains Feedback Effects) found that there was an upper elasticity limit of -0.53 at a 22 per cent tax rate, however she concluded that the true elasticity was probably quite low, maybe around -0.2 or -0.3, perhaps even less.

4.20 Dr Gravelle also cited a further study by Burman and Randolph (Measuring Permanent Responses to Capital Gains Tax Changes in Panel Data) where she asserted they estimated a permanent elasticity of -0.22 at a tax rate of 22 per cent. Accordingly, the conclusion was that a very small elasticity or static assumption for the long run would provide a more accurate forecast. Dr Gravelle attributes the Burman and Randolph methodology to having been stimulated by her own work.

4.21 In evidence Dr Gravelle indicated that corporate capital gains are negligible in the US and that she was not aware that in recent years capital gains from corporations in Australia have been more than half the take of capital gain. This and the fact that there will be no preferential tax treatment for CGT for entities was not taken into account in her estimates of either long run or short run elasticities. This reinforces the difficulty in translating US data reliably to application in Australia.

4.22 Dr Gravelle and Professor Auerbach maintain that the studies completed before Burman and Randolph and relied upon by Mr Reynolds are based on methodologies containing significant flaws, principally the inability to distinguish between three kinds of responses: a very large transitory response to a temporary tax cut or increase; a short-run response to a permanent cut; and a long-run permanent effect.

4.23 The Burman and Randolph methodology used variation in tax rates across the US, or panel data, to try to separate the permanent response from the transitory effects. For this reason Dr Gravelle and Professor Auerbach consider it to be a superior study to all others.

4.24 Professor Auerbach suggests, based on the Burman and Randolph methodology and the preliminary results of his, as yet unpublished, work in this area, that the 'realistic number to be using for permanent elasticity [is] somewhere between 0.2 on the lower end and 0.5 on the upper end'. His own research had revealed an elasticity figure of 0.25 percent, very close to that in the Burman and Randolph report. Again allow some margin for error, but it is very unlikely to be much higher than 0.5 as a measure of the long run elasticity.

4.25 Professor Krever expressed serious concern about the impact of ignoring such advice:

the potential revenue leakage would be hundreds and hundreds of millions of dollars … Those studies did not take into account the likelihood of massive increases in negative gearing … [13]

Realisations of CGT - summary comments

4.26 The Ralph Report concluded that behavioural responses are the desired outcome of tax reform but conceded that their size and effect on revenue are difficult to estimate. There is no apparent consensus among economists as to which methodology produces the most accurate results. This presents the committee with yet another dilemma, because the impact of alternative elasticities can be the difference between a revenue neutral package and the failure of the whole package to achieve this key objective. The following table summarises the figures presented to the Committee:

Capital gains tax realisation elasticities:

Researcher	Short term elasticity	Long term elasticity
Ralph Report	1.7	0.9
Gravelle	0.6	0.2
Auerbach	<1.0	0.25

4.27 The evidence presented by Alan Reynolds advised that the elasticity of 11 studies he reviewed was 0.9. In his testimony to the Committee, and this was acknowledged by Dr Gravelle, he noted that 0.9 is the elasticity used by the US Treasury. The choice of elasticity has a very significant effect on the revenue estimate. If Dr Gravelle's figures are used, for example, the revenue gain in 2000-01 will be $215 million rather than the $610 million estimated using the Ralph report's higher elasticity, while in 2004-5, the revenue gain would be $80 million rather than the $470 million in Ralph. Dr Gravelle warned in evidence that authorities should err on the side of caution in making revenue estimates. Mr Ralph also acknowledged this in his evidence and said that he was confident that the Ralph Review had, overall, taken a conservative approach to the revenue estimates. The choice of elasticity figure is ultimately one for judgement, but in making that judgement, it influences the claim that this package is revenue neutral or not.

4.28 Dr Preston confirmed that the Review had access to some limited material concerning the reduction in the basic rate of capital gains tax by the Irish Government from 40 per cent to 20 per cent. This indicated that receipts from capital gains tax jumped by more than 75 per cent. [14]

4.29 Associate Professor Chris Evans submitted that by varying the assumptions about responsiveness of CGT realisations to changes in the CGT rate (and by adopting different assumptions about the propensity of taxpayers to convert highly taxed income to preferentially taxed capital gains) very different revenue outcomes are achieved.

A sensitivity analysis has been conducted which shows that over the five year period covered by the Review, the estimates of the small (positive) revenue impact of $350 million could be transformed (in a worst case scenario) to a very significant revenue leakage of up to $5.5 billion. [15]

Table 1: Impact on PAYE receipts of converting income to capital (a) [16]

Per cent of PAYE receipts converted from income to capital	0.5%	1.0%	1.5%	2.0%	2.5%
Impact (negative) upon PAYE receipts ($m): one year	-179	-359	-538	-718	-897
Impact (negative) upon PAYE receipts ($m): five years	-895	-1,795	-2,690	-3,590	-4,485

(a) based on 1998-99 gross PAYE receipts.

4.30 The overall assertion was that varying the assumptions on the propensity for converting income to capital would have significant revenue effects and thus transform the package from revenue neutrality to revenue loss. Evans states that the particular debate over elasticities has not been satisfactorily resolved over the last 20 years and probably never will be, but even a small change in the elasticity will throw figures out significantly.

Allowance for CGT arbitrage activity

The Government's assessment of the likely level of arbitrage

4.31 In the present context, arbitrage is the practice of individuals switching gains from those with the character of ordinary income to those in the nature of a return on capital in order to obtain the best return. This activity is a behavioural response to the change in tax rates which will lead to variations in revenue. The Government has allowed in its figures for a total loss of revenue from arbitrage of $500 million dollars across five years.

Conflicting views on arbitrage activity

4.32 A concern expressed in the submissions to the committee was that there might be more activity than the Ralph Report provided for directed toward tax minimisation resulting in a loss to revenue. The contentious issue appeared to be the magnitude of the loss to revenue as a result of tax minimisation or arbitrage expected as a result of the change in capital gains tax rates.

The ACTU asserted:

Different tax rates applying to revenues received as incomes and as capital gains creates an inducement to individuals to so contrive their affairs as to receive their revenues in the form which attracts the lowest rates of tax. [17]

Specifically the ACTU believes the 'estimate of the loss to revenue arising from such contrived conversion activity is implausibly low'. [18]

4.33 Similarly, ACOSS was concerned by the Ralph Report's conservative estimate of the loss of income tax revenue from increased avoidance activity arising from the proposed changes to CGT and considered:

This estimate is extremely conservative, given the radical nature of the proposed changes to the CGT regime and the resurgence of avoidance activity they are likely to inspire. [19]

4.34 Professor Chris Evans addressed the issue of conversion of income to capital in his submission to the committee and noted that it seemed `highly contentious' that the arbitrage effect related to the conversion of income to capital would be as low as $500 million over five years. He pointed out that there was very little detail in the Ralph Report to show how the figures were arrived at. He assumed that the figure was based entirely on the increased incentive for shareholders to realise capital gains on shares rather than to receive the income as dividends. He therefore concluded that the Ralph Report figures did not include the impact upon PAYE receipts.

4.35 Mr Reynolds, when asked about the adequacy of the Government's arbitrage figures, said he was unable to identify how income earners could convert their earnings to capital legitimately. He did not believe it was possible. He did indicate, however, that opportunities for tax avoidance exist through negative gearing, which was disallowed in the US in 1993.

4.36 Professor Krever also indicated he believed that the largest source of revenue leakage from the proposals would be negative gearing. He expects 'to see the tax revenue costs from that investment approach to balloon significantly'. [20] This is due to the fact that:

Under current law, if I negatively gear I can deduct my nominal interest now and recognise my inflation adjusted capital gain in the future when I dispose of an asset. Under the proposed law, if I negatively gear I can deduct the full nominal interest now and only recognise half the gain in the future. The mismatch is enormous and the potential and the incentive for tax avoidance by negative gearing must be enormous. [21]

4.37 Professor Krever also indicated that the majority of overseas countries do not allow negative gearing. A regime that does not allow negative gearing does require continuous legislative intervention unless the mismatch in tax rates is altogether removed.

4.38 The changes announced on 11 November are aimed at improving 'the effective operation of the anti-avoidance provision'. [22] When questioned on whether the strengthening of the anti-avoidance rule will have any impact on the ability to convert income to capital gains so as to avoid tax, Dr Preston replied:

I do not think it can do it any harm. [23]

In response to a similar question, Mr Fitzpatrick advised:

To what extent (the announced changes) would have an effect on the arrangements to convert income to capital is unclear. [24]

Scrip-for-scrip rollover relief

4.39 The Ralph Report recommended that rollover relief from taxation of capital gains be provided for exchanges of membership interests in companies or fixed trusts in takeovers involving at least one widely held entity. The government accepted the recommendation but decided to extend eligibility for scrip-for-scrip rollover relief to takeover transactions involving any type of entity where 80 per cent of the target company is acquired. This approach is consistent with that adopted in other countries including the United Kingdom and the United States.

4.40 The Ralph Report considered that the revenue impact of rollover relief depended on three main parameters:

• the extent of increased takeover activity induced by the change;
• the average increase in company value that occurs because of the takeover; and
• the extent of once-off portfolio realignment that occurs at the time of a takeover.

The February discussion paper, A Platform for Consultation, noted that the scrip for scrip relief is likely to impose an up-front cost to the revenue in the first two years or so as tax is deferred, but some of this would be claimed back as shares are subsequently sold. It suggested that the up-front cost may be in the order of $100 million, if the measure were limited to listed public companies. It also noted that the cost could be higher if it was extended to public companies.

Any rollover relief could be confined to publicly listed companies. This would avoid tax avoidance and minimisation problems that might arise if the provisions were extended to unlisted accompanies where the value of shares is less easily determined and because other assets can be shifted into companies for sale in return for shares. [25]

In the July Ralph Report these concerns were partly met. The Ralph Report recommended that the relief apply where at least one of the entities was widely held (that is, at least 300 members and no grouping of 20 or fewer members owning 75 per cent or more of the entity) and where 80 per cent of an entity is acquired. The Report also recommended that it only apply to equity for equity swaps. And, in recognition of revenue concerns, it recommended a review of the provisions after five years. [26]

The Ralph report concluded that the measure would in fact be revenue positive to the tune of $100 million over five years. This was because the relief would lead to a 125 per cent short time increase in takeover activity and a 70 per cent ongoing increase, based on work by Access Economics. In doing so, the Ralph Report took account of a submission from the Securities Institute of Australia that had commissioned Access Economics to produce estimates of the revenue effect of allowing scrip-for-scrip rollover in respect of takeovers by publicly listed companies only.

4.41 Access Economics suggested:

extending rollover relief to share-swap mergers and company demergers would result in a small cost to revenue in the first few years but a net gain to the revenue over time as the rollover relief leads to increased share-swap merger and company demerger activity. [27]

The 70 per cent figure generated by Access appears to be based on an assessment of the US studies on extra realisations generated by cuts to capital gains taxation:

The large number of studies on the broad issue of how change to CGT effects capital gains realisations in the US have failed to reach a definitive conclusion. Nevertheless, the US studies suggest that an increase in the activity of around 40 per cent to 100 per cent may be reasonable, and the mergers model uses the mid-point of that range (70 per cent) as a starting point. [28]

The report also contains figures on the sensitivity of the model to this assumption, showing that a 20 per cent increase/reduction in the elasticity figure affects the revenue estimates by $14.8 million in 2001-02 rising to $27.9m in 2004-05. If Dr Gravelle's elasticity figure of 20 per cent had been used, the reduction in revenue would have been almost $70 million in 2004-05. Thus the argument over realisations elasticities discussed above is also relevant to the scrip for scrip relief discussion.

4.42 The July Ralph report largely adopts the Access Economics estimates on elasticities, and rejects the concerns expressed in its earlier February discussion paper.

4.43 The estimates included in the Ralph Report indicate the scrip-for-scrip measure to be $100 million revenue positive over five years. Access Economics estimated the net impact for combined rollover relief (share-swaps and demergers) to be negative to the extent of $121.2 million dollars for the first five years changing to revenue positive to the extent of $261.9 million by the year 2009-10. The difference in the figures is probably accounted for in the differing assessment of the initial strength of takeover and realisations activity in the short-term, with Ralph using a 125 per cent response and Access using a 70 per cent response. This appears to be consistent with the Ralph approach to individual realisations, with the short-term realisation assumed to be almost twice the longer term response. The report says that the Inquiry added 25 per cent to the estimate of public company to public company takeovers to account for other takeovers involving widely held entities.

4.44 In its response, the Government opted to provide wider relief for scrip for scrip takeovers than the Ralph Report, allowing relief for any takeovers or mergers involving widely held or closely held entities without the restrictions proposed in the Ralph Report. The revenue estimates reflect this wider relief, with an annual cost to revenue of $10-$28 million a year. However, the item is still assumed to be revenue positive to the amount of $18 million over the five year period in question. Professor Krever, in response to a question on notice from Senator Murray, cautioned against the wider relief:

The measures announced by the Government are much broader than those recommended by the Ralph Review. The Ralph proposals contained some safeguards to limit avoidance opportunities. Those do not appear in the Government's proposals. In particular extending the rollover to private companies may open many opportunities for abuse. It is possible, however, that the actual implementing legislation will contain provisions to prevent taxpayers from using company rollovers as an indirect means of disposing of underlying assets. Such legislation would be very difficult to do. A better response would be to follow the original suggestion of limiting the rollover to takeovers involving public companies. Few, if any, of the rational for the rollover apply to takeovers of private companies. [29]

4.45 It is not clear at this stage whether the recommendation to allow roll over relief for business demergers or deconsolidations has been adopted. However, Access Economics showed the tax revenue associated with demergers rollover relief to be revenue positive from year one.

4.46 There is strong support for the scrip-for-scrip rollover measure, including from the Australian Shareholders' Association (ASA) Ltd. In its submission to the committee it stated that a substantial real reduction in CGT was long overdue:

The ASA acknowledges that the Ralph reforms will deliver long overdue benefits to shareholders in the form of an exemption from CGT in scrip for scrip takeovers and in refunds of excess franking credits. However, these changes should not be regarded as concessions for shareholders but as merely rectifying past inequities in the taxation legislation. [30]

Averaging

4.47 The Ralph Report identified averaging of capital gains by individuals as one feature of the current regime which does not contribute to the objectives of encouraging investment or removing inflexibilities in the capital markets. In fact, the averaging provisions reduce revenue substantially. Professor Krever commented that 'the scope of avoidance with respect to capital gains taxation is enormous'. [31]

4.48 Averaging was introduced to address concerns that taxing all gains in one year would push taxpayers into higher tax brackets in that year. For this reason averaging does not benefit companies. Averaging creates the potential for additional and significant taxation benefits for strategic taxpayers, particularly those with variable income from non-capital gains.

4.49 The Ralph Committee published a discussion paper, A Platform for Consultation, [32] which pointed out that the issue of tax minimisation through averaging was particularly noticeable where taxpayers maximised the benefit of the tax-free threshold. The following table is extracted from the discussion paper.

Figure 12.: CGT averaging — how it is abused

(not available electronically)

Source: Unpublished ATO data for 1995-96.

Figure 12.1 illustrates that the average capital gain of taxpayers with zero non-capital gain income is $25,000 and these people pay no CGT. That suggests that a large number of relatively asset wealthy taxpayers are taking advantage of the benefits of averaging the tax-free threshold.

4.50 The benefits to taxpayers of the existing averaging system would generally be expected to fall when the personal income tax rates are reduced.

4.51 The Ralph Report estimated the revenue impact of abolishing averaging to be $1.58 billion over five years. The revenue impact of abolishing averaging was not separately identified in the Treasurer's statement of 21 October 1999, however, the overall impact of CGT reforms for individuals included the effect of abolishing averaging and compares with the overall estimates in the Ralph Report. The legislation for abolishing averaging has not yet been introduced, although the fiscal impact for abolishing averaging was included in the Treasurer's statement of 21 October 1999 in Table 1 relating to the fiscal impact of announced business tax reforms for which legislation was introduced on 21 October 1999.

Footnotes

[1] Treasurer, The New Business Tax System: Stage 2 Response, Press Release No.74, Attachment O.

[2] Totals compiled by the committee.

[3] Review of Business Taxation, A Tax System Redesigned, 1999, p. 733.

[4] Gravelle, in Submissions and Documents, p. 31.

[5] Review of Business Taxation, A Tax System Redesigned, 1999, p. 732.

[6] Financial Planning Association, in Submissions and Documents, p. 42.

[7] ASX, in Submissions and Documents, p. 68.

[8] Evidence, 12 November 1999, p. 213.

[9] Evidence, 11 November 1999, p. 103

[10] Alan Reynolds, A Study Commissioned by the Australian Stock Exchange Ltd for the Review of Business Taxation, July 1999, p. 39.

[11] Submissions and Documents, p. 72.

[12] Alan Reynolds, A Study Commissioned by the Australian Stock Exchange Ltd for the Review of Business Taxation, July 1999, p. 32.

[13] Evidence, 11 November 1999, p. 108.

[14] Evidence, 22 October 1999, p. 32.

[15] Submissions and Documents, p. 131.

[16] Evans, in Submissions and Documents, p. 133.

[17] ACTU, in Submissions and Documents, p. 82.

[18] ibid.

[19] ACOSS, in Submissions and Documents, p. 51.

[20] Evidence, 11 November 1999, p. 105

[21] Evidence, 11 November 1999, p. 105

[22] Mr Fitzpatrick, in Evidence, 12 November 1999, p. 230.

[23] Evidence, 12 November 1999, p. 230.

[24] ibid.

[25] Review of Business Taxation, A Platform for Consultation, Second Discussion Paper, 22 February 1999, p. 297.

[26] Review of Business Taxation, A Tax System Redesigned, 1999, p. 619.

[27] Securities Institute of Australia, Submissions to the Review of Business Taxation, 13 April 1999, Attachment: Report by Access Economics, Executive Summary, commencing p. iii.

[28] Submissions and Documents, Document 4.

[29] Submissions and Documents, p. 163.

[30] Submissions and Documents, p. 163.

[31] Evidence, 11 November 1999, p. 103.

[32] Review of Business Taxation, A Platform for Consultation, February 1999.