The Federal Budget’s move from the 50 per cent property CGT discount to inflation indexation sounds, at first glance, like a tougher tax treatment for investors.
In some market conditions, it will be. But in a weak housing market with elevated inflation, the opposite can occur.
If property values grow slowly, or fall, while inflation remains high, indexation can significantly reduce the taxable gain.
That means over the next few years, if inflation remains elevated and price growth weakens, the new system could raise less tax from some property investors selling than the old 50 per cent discount would have.
The reason comes down to how the two systems work. Under the current system, investors who hold a property for more than 12 months receive a 50 per cent discount on the capital gain.
Under the new system, investors will instead have their cost base indexed to inflation, meaning they will only be taxed on the gain above inflation.
That is a significant change. It moves the system from taxing half the nominal gain to taxing the real gain.
The timing of the change also matters. If gains built up before the start date continue to receive the 50 per cent discount, then the new system will only apply gradually as post-change gains accumulate.
That means any revenue uplift is unlikely to be immediate. In a market where prices are weak, inflation is high and some investors choose to hold rather than sell, the near-term budget benefit could be much smaller than expected.
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In a strong housing market, indexation can raise more revenue. If property prices rise well ahead of inflation, indexation still leaves a large real gain to tax.
But this is not the environment Australia appears to be heading into. Price growth has been strong over the past year, with national house prices up 10.5 per cent annually and particularly strong gains in Perth, Brisbane, Adelaide and Darwin.
Sydney and Melbourne, however, are already much weaker, with annual house price growth of 2.7 per cent and 2.5 per cent respectively. The national figure is still positive, but momentum is clearly uneven.
The outlook is now likely to become weaker. The budget’s housing tax changes are designed to reduce investor demand for established property, which will weigh on prices. We do not know exactly how large that impact will be, but Morgan Stanley has reportedly predicted house prices could fall by as much as 10 per cent as investors reassess the after-tax return from residential property. Even if the decline is much smaller, price growth is likely to be weaker than it would otherwise have been.
There are other forces weighing on demand. The Reserve Bank has now lifted interest rates three times this year, taking the cash rate to 4.35 per cent.
Higher rates reduce borrowing capacity, increase holding costs and make property investment harder to justify.
Consumer confidence is also under pressure, with households dealing with higher petrol prices, higher food prices and broader uncertainty following the Middle East conflict.
The budget’s housing tax changes are designed to reduce investor demand for established property, which will weigh on prices.
This is already showing up in our data. Ray White open home attendance has fallen sharply, with the national four-week rolling average falling to 2.5 attendees per open home by late May. Sydney and Melbourne are now particularly soft, both sitting close to two attendees per open home.
At the same time, inflation remains high. The ABS reported annual inflation of 4.2 per cent in April, down from 4.6 per cent in March, but still well above the Reserve Bank’s target band. Trimmed mean inflation also remains above target, showing that this is not just a one-off fuel story.
For CGT, this matters enormously. If inflation is running at four or five per cent and property prices are growing at only one or two per cent, then the indexed cost base rises faster than the asset value. In that scenario, there may be little or no taxable real gain.
This is why the revenue impact of the CGT change is not straightforward. Removing the 50 per cent discount sounds like a tax increase.
But replacing it with indexation means the government’s revenue depends heavily on the gap between property price growth and inflation.
When that gap is large and positive, indexation raises more tax. When that gap is small, or negative, indexation raises less.
Our scenario modelling shows this clearly. For a property bought for $1.75 million and held for six years, indexation raises more tax than the 50 per cent discount when price growth is strong and inflation is low.
But when inflation is high and property price growth is weak, the opposite occurs. At annual inflation of five per cent and annual property price growth of five per cent, indexation raises around $89,000 less tax than the current discount system.
At inflation of four per cent and price growth of three per cent, it raises around $51,000 less. If prices fall, there is no capital gain to tax under either system.
Nerida Conisbee, Ray White Group Chief Economist
The weakest revenue outcome is not simply low growth; it is falling prices. If values decline, there is no capital gain to tax, regardless of whether the system uses a 50 per cent discount or inflation indexation.
That is an important point for the budget. A policy that relies on taxing capital gains is only a strong revenue measure when there are capital gains to tax.
There is also a behavioural issue. If prices soften, some investors may simply hold rather than sell, particularly where rental income remains strong.
That would further reduce near-term CGT receipts. The tax base depends not only on the size of the gain, but also on whether investors choose to transact.
In a weaker market, with policy uncertainty and higher interest rates, transaction volumes are likely to be lower than they otherwise would have been.
Over the next few years we are unlikely to be in the strong capital growth environment that would make indexation a powerful revenue raiser.
Prices have already risen strongly in many markets, but the combination of budget uncertainty, higher interest rates, weaker consumer confidence and reduced investor demand points to a softer period ahead.
If inflation remains elevated at the same time, more investors selling property could find that the new system produces a lower taxable gain than the old system would have.
The broader budget question is therefore whether the government is relying on revenue that may not arrive.
The policy may be defensible if the aim is to tax real gains rather than inflation. But it should not be assumed to raise more tax from property investors in the near term.
In the market conditions Australia now faces, the shift from the 50 per cent discount to indexation could reduce, rather than increase, near-term CGT revenue from property investors.
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