As tough as many critics of the new capital gains tax legislation consider it to be, compared with the rules for taxing fixed interest income it is extremely generous. Two features stand out: CGT tax only becomes payable at the time of sale and after 12 months ownership up till 1 July 2027 only 50% of the gain is taxable and after that date only the real gain above the rate of inflation is taxable.
Even in periods of modest inflation, taxing only real capital gains at the time of sale keeps their real value over time. Investing in interest bearing securities triggers income tax annually at marginal tax rates as the interest income adds to their account with no compensation for the decline in real value of the amount originally invested.
The annual income varies with the risks attached to the security bought. This increases the probability for low and medium risk assets that the after-tax return will be less than the prevailing rate of inflation. Given the need for liquidity, the harsh reality is that most if not all taxpayers will need to hold a variable but, in some cases, size-able percentage of their assets in interest bearing securities.
As in many other areas, some, usually but not always better off investors have attractive options available to minimize their personal name holdings of interest-bearing investments. Owning fixed interest investments in lowly taxed pension and superannuation funds is, for example, highly attractive for people over the age of 60 able to gain access to the funds at any time.
During working life owning investments in a partner’s name can provide the advantages of income splitting and achieve a lower tax rate. Similarly formalized interest-free loans to related parties with lower personal income tax rates helps lower effective tax rates. Over time lenders and financial institutions have also developed strategies including mortgage offset accounts and redraw facilities to help people with debts avoid paying tax on emergency and other cash reserves.
Offset account and redraw facilities do not usually receive the best before-tax return on the money invested because the lender always adjusts the available interest rates to allow for the taxation benefits of the structure. From an individual viewpoint, though not offered by any financial institution today, Keynes described traditional secured overdraft account as the cheapest, easiest, and most convenient way to manage borrowing costs while keeping access to cash reserves.
Given the long history of fixed interest income taxed with no allowance for inflation, radical change in policy is unlikely. Nevertheless, several changes could help in the future management of the $1 trillion federal government debt and similarly large state government borrowing. While Australia is unlikely to want to return to the compulsory 20/30 rules requiring superannuation funds to invest a significant percentage of their assets in government fixed interest securities, making it easier for risk adverse investors to invest in government bonds calls for thoughtful consideration.
Earlier governments, for example offered easily purchased and redeemable granny bonds to retired investors. Amongst other things, this minimized the need to shop around for the best return and simplified the investment and reinvestment process. Adding to their attractions by offering a competitive after-tax return (e.g., the RBA cash rate less say 1%p.a.) would allow retirees some inflation protection and simplify their investment options.
Currently, obtaining the best possible return for low-risk investments is not an easy option. Dealing with banks and financial institutions, especially with modest amounts of money, can be a complicated process, especially when interest rates are changing. In addition to retirees and others wanting to protect a nest egg, the current tax arrangements complicate life for one other group of taxpayers. This is younger people and others accumulating deposits to buy a home in most cases subject to a marginal tax rate of 32%.
The tax payable on their interest earnings means that their after-tax earnings do not exceed the rate of inflation and with rising house prices reduces their capacity to buy a house. Earlier government policies have included options to reduce their tax liabilities using lower superannuation tax rates complicating the arrangements. Specially taxed home deposit government fixed interest accounts (like the earlier granny bonds) may be a better option with say a maximum period of ten years (such as that of the life insurance and friendly society bonds used previously to reduce tax rates on accumulating savings).
The case for offering lower personal income tax rates on fixed interest income is strongest in cases where investors have limited alternative options to reduce the tax rate on fixed interest investments. Unlike many other countries, Australia has no restrictions on making gifts even to non-related parties or lending money (secured or unsecured) interest free to related or unrelated parties. This in effect gives maximum flexibility to income splitting and pursuing strategies such as investing assets in company and trust structures while keeping beneficial ownership.
Australia could always try to follow the practice of several other countries by requiring all loan transactions to be at a minimum commercial interest rate. While tax-free gifting of assets stays, administration of such a change would be difficult. This being the case, specific variations in the taxation of fixed interest income for selected categories of taxpayers as suggested above is likely to be the only practical choice.