Robin Bowerman, Head of Retail at Vanguard Investments Australia.
Robin Bowerman, Head of Retail at Vanguard Investments Australia.

Henry speaks volumes on investor risk

KEN Henry has not uttered a word in public since Sunday but the statement he and his expert panel has made with the review of our tax system will be heard for years to come.

The release of the report into Australia’s Future Tax System was always going to be problematic for the federal government in an election year and the response has been roundly criticised for being timid because of the limited number of recommendations that have been actioned.

However, the success or otherwise of the Henry review will not be measured by this early test of political will.

This is a massive document – both in size and reach. Regardless of what is ultimately turned into tax law the Henry report will be the blueprint that tax changes for years to come will be checked against.

The economic environment that the Henry Review has been released publicly into could hardly have been more different to when the Government embarked on its tax reform journey. Strong budget surpluses have been blown away by the need to stimulate our economy through the global financial crisis and with the surpluses gone so has much of the government’s fiscal flexibility.

However, the Henry review never envisioned a round of quick fixes – rather a considerable transition period to avoid disrupting government revenue streams along with the inevitable business and individual impacts.

The cornerstone of the report – recommendation number one – is that revenue raising should be concentrated on four robust and efficient broad-based taxes:

•    Personal income
•    Business income
•    Economic rents from natural resources and land; and
•    Private consumption

So a key thrust of the report is specific taxes – e.g. on tobacco – should exist only where they improve social outcomes or market efficiency. Over time, the report envisages, a range of existing taxes would have no place in this broad-based framework and therefore should be abolished.

Naturally, much of the focus this week has been on the new resource rent tax and the increase of the super contributions to 12 percent because that is where the government has decided to act.

But one of the key recommendations of the Henry review relates to the tax on savings and how it distorts people’s savings and investing behavior.

In particular it focuses on the common practice of negatively gearing property and shares to take advantage of our tax rules. The detailed exploration of this in the report makes for interesting reading – and raises some challenging questions for investors.

There is no disputing the tax advantages that come from negatively gearing share or property investments – the fact that households held $700 billion of residential investment property (2005-06 figures) and that around 70 percent of individual investors in rental properties are in a net loss position is testament to the ability of the tax laws to influence investor behavior.

A big part of the appeal is the discounted capital gains tax rate – tax on capital gains is deferred until the asset is sold and if held for more than 12 months is entitled to a 50 percent discount.

“The current system for taxing assets that yield capital gains, in particular shares and rental properties, allows for interest to be deductible at the full marginal tax rate, while only half the capital gain is subject to tax.

“This encourages households to take on too much debt and risk when undertaking these investments,” the report says.

That resonates in our current white hot property market but also in the wake of the Storm financial planning collapse because of the reliance on extreme debt strategies.

So what is being proposed by the Henry review is a more consistent approach to taxing savings – with the specific recommendation being to apply a 40 percent discount to most interest income, net residential rental property income, capital gains and interest expenses.

The simple fact is that, as the Henry review points out, our tax system actively encourages risk-taking – perhaps to an excessive degree. More problematic is that it penalises investors who are more cautious and risk averse.

The Henry review was under no illusion that this has the potential to substantially disrupt the rental housing market for example so it is advocating the introduction only after reforms to housing supply and assistance.

Now accepted wisdom is that any government that meddles with negative gearing will quickly find itself contemplating life on the Opposition benches.

But the Henry review makes a strong case to correct this inequity in the tax system.

Doubtless we have not heard the last word on this issue.

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Robin Bowerman, Vanguard Investments Australia's Head of Retail, has more than two decades of experience in the finance industry as a writer, commentator and editor.

To receive this column by email, go to vanguard.com.au and subscribe to ‘Smart Investing’.


 



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