One of the most vexing and contentious issues in taxation is the proper treatment of capital gains—the increase in value of an asset such as shares of company stock or a business. In principle, under an income tax, capital gains should be included in the tax base as they accrue. In practice, if they are taxed at all, capital gains are almost always taxed only when an asset is sold (or “realized”) and generally at lower rates than other income.

Australia follows the international norm. One-half of capital gains realized by individuals on assets held for at least one year is excluded from income, making the effective tax rate on long-term capital gains half the rate on other forms of income. Since the top tax rate on ordinary income is 46.5 percent, this makes the top capital gains tax rate 23.25 percent. (A third of gains on assets in superannuation funds is also excluded from income, producing a top rate of 10 per cent—two-thirds of the 15 percent flat tax rate on superannuation earnings.) Nonetheless, Australia’s rate is very high compared with New Zealand, which does not tax most capital gains, and higher than in most other industrialized countries.

The argument for concessional taxation is that capital gains are different from other forms of income. Since capital gains typically accrue on risky assets, taxing them deters risk-taking, to the detriment of the economy. Another argument posited in favor of lower tax is that capital gains are eroded by inflation. Gains on corporate shares and unit trusts also represent income that has already been subject to company-level tax, making individual level taxation an inefficient double tax (although Australia’s imputation credit system eliminates much of this distortion). And, finally, taxing capital gains discourages saving. 

Taxing gains upon realization creates special issues. It creates a strong incentive to hold onto appreciated assets to avoid the tax—the so-called “lock-in effect”—an inefficient distortion in financial markets. Moreover, capital losses are generally only deductible against capital gains. Allowing full deductibility of losses would create almost unlimited ability to shelter other income from tax since an investor could purchase offsetting short and long positions in assets and then realize the position with the loss to shelter other income while taking on no risk (or, indeed, making a meaningful investment). Even when such strategies are limited by statute, diversified investors could achieve similar results by selectively realizing assets with losses and holding those with gains. However, with loss limits, full taxation of gains may penalize capital gains compared with other less risky investments.