The role of inflation in determining the merits of different forms of capital gains taxation (CGT) is widely misunderstood. The 1999 CGT reform in Australia replaced an explicit inflation adjustment with a fixed nominal concession that was meant to approximate compensation for inflation. That concession was generous in a low-inflation world, but far from generous in a world where inflation is higher. 

This working paper finds the discount is not always more generous than the previous system and can produce very high effective rates of taxation on real capital gains because taxation is levied on both real and inflationary gains. 

The objective of tax reform should not be to maximise revenue. As much as possible, taxation should be efficient and minimise distortions at the least level of complexity. While the CGT discount is much less complex to administer, the indexation method, while a little more complex to administer, is a more rational and economically efficient way to tax capital gains, and should be available to taxpayers. 

Key findings

• The ‘discount’ is not a discount at all in environments of even modestly high inflation, producing effective tax on real capital gains often above 100%.
• One rationale of the prevailing 50% capital gains tax ‘discount’ is to provide a simple method of accounting for the effects of inflation for assets held longer than 12 months.
• Reducing the CGT discount from 50% to 33%, especially in today’s higher-inflation environment, would see many investors taxed on purely illusory gains.
• The economic cost of taxing inflation is significant, as it increases the effective tax rate on long-term capital formation, penalises investors who hold assets with moderate real returns, and exacerbates the ‘lock in’ effect whereby investors choose not to sell assets even though doing so would be in their own and the economy’s best interests.