It is becoming increasingly clear that the federal government will reduce or eliminate the capital gains tax discount in the forthcoming budget, but it is not clear how it intends to do it.

Until 1985, there was no broad-based capital gains tax In Australia and there was a tax avoidance industry of making income look like capital gains, thereby avoiding income tax. 

The introduction of a capital gains tax by the Hawke-Keating government put an end to that. 

If capital gains are taxed at the same rate as income, there is no point in trying to classify profit as one or the other.

In 1999, the Howard-Costello government introduced a 50 per cent discount to capital gains tax on assets that were held for more than 12 months. 

One of the stated objectives of the discount was to encourage investment in the housing market with the aim of making more houses available for renters.

It is not clear whether it ever achieved that purpose. What it did achieve was an increase in the proportion of houses owned by investors and a reduction in the proportion of houses owned by homeowners.

The concept of a capital gains tax discount for long term investments is a good one because it encourages investment over trading. Some countries have a discount which increases each year an investment is held, which is an even better system because it encourages long term investment.

The principal objective of these concessions in other countries is to increase long term investment in companies and thereby strengthen their economies. There is less need for this in Australia because we already have a tax-effective mechanism for investing in companies called superannuation.

In Australia, allowing a capital gains tax discount on residential investment properties has contributed to housing unaffordability. It is not the only factor, but it is a significant factor. If investors and would-be homeowners are competing to purchase properties, it follows that prices will be higher than if investors were not in the market.

Consequently, the capital gains tax discount on investment properties has been criticised by economists and housing advocates, and the government is now considering making changes to it.

If the government wants to raise as much revenue as possible, it will make the measure retrospective so that it applies to both past and future capital gains. It can then use the additional revenue to fund income tax cuts, which will advance its social agenda. 

That might be the course it takes. It will be hard on investors, but broadly fair across the tax base.

If the government’s primary objective is to take the strain off the housing market, it should eliminate the discount only for residential properties and leave it in place for other investments, such as shares, businesses and commercial properties. Within this option, it could retain the discount for investment in new apartments because that is a section of the market which is struggling with the costs of land acquisition and construction.

This option would, however, raise less revenue than a complete withdrawal of the discount, but the amount raised would still be substantial.

Then there is the issue of fairness. 

A fair system would remove the discount for new property purchases and leave it in place for existing investment properties. No-one would be disadvantaged and it would still achieve the purpose of taking investors out of the market. 

This option would, however, raise very little money. The government would only get the extra revenue from houses bought under the new system, there will be fewer people buying investment properties after the discount is removed and the tax won’t be payable until those houses are sold years into the future.

A similar measure, which would raise more revenue, would be the removal of the discount for capital gains which occur after the Budget, regardless of when the property was purchased. 

It would not be retrospective and the government would get the extra revenue from all investment property sales going forward.

Each of these options would have a positive effect on housing affordability, but there is a trade-off between fairness and revenue raising. 

As the change will be introduced as part of the Budget, it is likely that the Treasurer will opt for a version that raises a substantial amount of revenue. The opportunity to redistribute the increased capital gains tax revenue as income tax cuts will be very tempting.

The Greens and a number of independents appear to be on board with removing or reducing the discount. 

The Liberal Party has signalled that it will oppose any reduction in the discount on the basis that it would result in higher taxes. This approach is misconceived in a number of ways. 

First, the tax is not being increased, rather a concession is being eliminated. The purpose of tax concessions is to encourage behaviour or to lessen the load on the basis of fairness. 

Neither applies to investors in residential housing. The behaviour that is being incentivised is detrimental to home ownership and the investors are not in need of a handout, so they should be taxed at the full tax rate.

Second, the party of Robert Menzies, the champion of homeownership, should take ownership of the problem it created when it introduced the capital gains tax discount and support its removal.

Third, if the tax revenue from the removal of the discount is redistributed through income tax cuts, the Liberals will look very silly if they oppose the package on the basis of being the “low tax party”. 

They opposed the government’s income tax cut at the last election and look how that worked out.

Finally, there is the issue of intergenerational equity. 

The only segment of society that voted Liberal at the last election was the over 65s. The younger a person is, the less likely they are to vote Liberal. 

If the Liberals want to win more votes from the younger generations who are struggling to become homeowners, they need to support every measure that improves housing affordability.