The government has unveiled significant changes to capital gains tax (CGT), which is justified as placing downward pressure on house prices. Unfortunately for us, this will undoubtedly result in most Australian small-cap investors paying increased tax.
This article will rely on the government’s Budget Papers as its primary source to discuss the impact of the fact that from 1 July 2027, “the government is replacing the 50 per cent capital gains tax discount with cost base indexation for CGT assets, from 1 July 2027.” For most of you reading this, this will mean you pay a higher tax rate on your investments.
However, this change also incentivizes some types of investments relative to others. And indeed, the secondary impact of these changes on the entrepreneurial and growth capital ecosystem is significantly more concerning than the extra tax bill itself.
To be clear, if it were only a dollar value impact on our after tax returns, that would be one thing, but the problem with these changes is that they could create a structural disincentive to invest in growth businesses. This, in turn, would amount to a multi-year headwind for growth investors, as the market and economy gradually increase the cost of capital for early-stage businesses.
Given the large amount of politicised misinformation coming from both opponents and supporters of the government, let me explain clearly why these changes are bad for growth stocks, using an example, below.
Imagine, for this thought experiment, that inflation is steady at 3% for 10 years.
If a conservative investor buys units in an ETF that increases from $100k in value to $200k, your gain before tax is $100k. Under the old rules, you apply a 50% discount, and pay your marginal tax rate on the taxable gain of $50,000. Assuming that in a year when they liquidate holdings, our investor will pay the top marginal rate, the tax under the old system would be $23.5k.
Under the new system, the gain before tax would also be $100k, but the taxable gain would be calculated by indexing the cost price to inflation (3% per year) to get an indexed cost price of $134.4k. Subtracting this from the sale price of $200k, we get a taxable gain of $65.6k. Assuming the same 47% top marginal rate, the tax paid under the new system is $30.8k.
That means for the conservative ETF investor who makes $100k profit before tax will pay $7.3k extra tax or an increase of 31%.
Now imagine that a growth stock investor invests $100k across five different growth stocks, $20k in each of them. At the end of 10 years, four of those five growth stocks have failed, and gone to zero. However, the fifth one has succeeded and the initial $20k investment is sold for $200k.
Like the conservative investor, the growth stock investor has made a before-tax profit of $100k over 10 years. This is exactly the same before tax profit over the same time period, as the conservative investor received.
In that scenario, the investor will receive a capital loss of $80k for the four stocks that went to zero. Then, they will receive a capital gain of $180k for the stocks they bought for $20k and sold for $200k.
Under the old system, you take the $180k capital gain, subtract the $80 capital loss, then halve the $100k remaining capital gain in accordance with the 50% discount. Thus, assuming the growth stock investor also pays the 47% top marginal rate, the tax under the old system would be $23.5k.
This makes sense: the conservative investor who makes $100k profit from an ETF pays $23.5k tax, and the growth investor who makes $100k profit from 5 small-cap growth stocks also pays $23.5k tax.
However, under the proposed new system, the $80k capital loss remains the same but the taxable profit on the one stock that went from $20k to $200k is very different. Instead of an equal treatment with the conservative investor, the growth investor will pay much more.
That’s because the indexed cost base is only applied to gains, not losses. The $20k invested in the winning stock will be indexed, and over ten years at 3% that means the indexed cost base will be about $26.9k. Subtracting this from the $200k sale proceeds, we get a taxable gain of about $173.1k.
Subtracting the $80k capital loss from the four stocks that went bust, we get a taxable capital gain of $93.1k.
Assuming the same 47% tax rate, our growth investor will pay a tax of about $43.75k on the total gain of $100k over ten years. This is a very significant 86% increase in the tax rate paid by the growth investor comparing the old system to the new.
Think about this and hold it in your mind.
The conservative investor in our example, who invests in a broad ETF, as the budget papers seem to assume all investors do, will have their CGT increased by about 31%. The growth investor in our example, who provides risk capital for earlier-stage companies that often need capital ahead of revenue so that they can hire employees, will pay 86% more tax.
The growth investor takes on more risk. Does more work in finding the stocks. Creates more value in the economy, and makes exactly the same pre-tax profit as the conservative investor. However, the growth investor will pay $43.75k tax, and the conservative investor will pay $30.8k.
This clearly disincentivizes risk-taking by investors.
If these tax changes are legislated as the government currently envisages, it will create an extremely powerful new disincentive to invest in growth stocks. The impacts in the long term will be detrimental to growth in the Australian economy.
I do not want to take action based on the assumption that these extremely detrimental changes will occur in the legislation because I hold out hope that sanity will prevail. It makes no sense why you would punish the kind of investing that is most beneficial to job creation, while encouraging investment in mature companies that are probably more interested in replacing employees with AI chatbots!
However, based on the political discourse, it seems that everyone in government is either genuinely or willfully ignorant to the fact that these changes impose truly extreme tax increases on people who invest in early-stage or fast-growing companies. Instead the government is disingenuously focussed on the conservative investors who will only face a modest increase in tax. You can see what I mean from the example in the government explainer, below:
How Should Stock Investors Respond to the CGT Changes?
Obviously, if these CGT changes are passed, it could approximately double the kind of before-tax investment returns required to justify investing in growth stocks, compared to more conservative investments such as index funds or (ironically) houses. All else being equal, this means growth stock prices will have to go down, in order to provide the required upside potential to attract new investors.
I am yet to take actions in my portfolio in response to this mooted change, because I want to see if the changes actually do occur as planned. I think there is some chance the government might amend their ambitions in response to people explaining how this badly impacts investment in growth businesses.
However, it is still necessary to examine how these changes would impact each of my recommendations. For example, some of the larger, higher-yielding (but lower growth) stocks I own and recommend might actually become more attractive to investors under the new tax regime.
Equally, some of the higher-risk, higher-reward growth stocks will become incrementally less attractive. On top of that, even the best growth stocks are likely to face headwinds if capital flees the sector in response to the very significant increase in potential tax.
On the other hand, investment companies will not face the same oppressive increase in taxes, so over time I expect that trading companies (which pay 25% to 30% tax on income ) will probably become more popular. This may somewhat mitigate the capital outflow from the small-cap sector.
My next article will examine how these changes impact each of our official recommendations, and how I intend to personally react to the changes, if they are implemented as currently intended.
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