"There is one clear asset that wins": Daniel Kelly and Chris Brycki look at the winners and losers of tax changes

Viola Private Wealth Chief Investment Officer Daniel Kelly has published a fascinating paper examining how Labor's proposed changes to capital gains tax and negative gearing could reshape after-tax returns across equities, fixed income, private markets and property.

"All else equal, income-producing assets are now relatively more attractive. The key word being relative," Kelly wrote.

The paper explores the second and third-order effects that could emerge if the changes are implemented, including higher rents, stronger incentives to own your home, and a gradual shift in capital away from growth assets and towards income-producing investments.

But while Kelly focuses primarily on how the numbers stack up, Stockspot founder Chris Brycki believes the bigger issue may be how investors respond.

Both arrive at a similar conclusion: tax changes don't simply alter tax bills. They change behaviour.

As investors begin thinking about what their portfolios may look like under a different tax regime, it's worth understanding both perspectives.

Growth still wins - just by less

The headline conclusion from Kelly's modelling is simple: growth assets are likely to generate lower after-tax returns under the proposed regime. But he stresses that doesn't automatically make them inferior investments.

"It is not true that, with the CGT discount removed, income assets now have higher total returns than growth assets, but given income was and is taxed at marginal rates and was not eligible for a 50% discount on returns, the removal of the favourable treatment of capital gains means they are now closer on an after-tax basis," he says.

Under the assumption of a simple structure and a marginal tax rate of 47%, Kelly compared the before and after-tax returns of major asset classes.

The key observations are:

• Asset classes that derive a larger share of their return from capital growth experience the greatest reduction in after-tax returns.
• Private equity, venture capital and hedge funds are among the hardest hit because most of their returns come from growth rather than income.
• Equities, property and infrastructure are affected to a lesser extent because part of their return is distributed as income.
• Growth-heavy assets become relatively less attractive on a risk-adjusted basis because investors are taking on similar levels of volatility for a smaller after-tax reward.

Interestingly, Kelly also looked at the after-tax return premium generated by each asset class relative to fixed income.

"On an after-tax basis under the old regime, hedge fund returns were 141% higher than fixed income. Under the new proposal, this premium drops to 111%, a decline of roughly 30 percentage points, or a 21% relative reduction. PE / VC fares the worst with a -26% relative drop," he said.

Let's take a closer look at equities

The chart below illustrates the sensitivity of after-tax equity returns under the proposed indexation-based tax regime.

The analysis assumes:

• Equities generate a 10% annual return
• 70% of that return comes from capital growth
• 30% comes from income
• The investor is on the top marginal tax rate of 47%

Under the current 50% CGT discount system, the after-tax return is 6.95%.

What happens next depends largely on inflation - the unpredictable variable at the centre of the proposal.

If inflation remains below 3%, investors are worse off because indexation shields less of their capital gains. If inflation rises above roughly 3.5%, the new system begins to work in the investor's favour.

"As you will note from the line however, that over an extended term, and assuming the Reserve Bank of Australia (RBA) can keep inflation within its target mandate of 2–3% per annum, the indexation method does produce worse investment outcomes," Kelly says.

The counter-argument: Why house prices may be the real winner

Yesterday, I wrote about a report from Macquarie arguing Australian property prices could effectively go nowhere in real terms for decades as the powerful tailwinds of falling interest rates and rising female workforce participation - which helped create more dual-income households - begin to fade.

But Kelly arrives at almost the exact opposite conclusion.

"There is one clear asset that wins under the new proposed regime, and that is the owner-occupied home. It would stand alone as the only remaining truly tax-protected asset in Australia," he says.

Kelly's thesis is that Australians may increasingly direct capital towards their principal place of residence, which remains one of the few assets capable of compounding completely tax-free.

It aligns with a broader view emerging in parts of the market that homeowners will be incentivised to maximise offset balances and undertake renovations that enhance the value of a tax-exempt asset.

"Assuming a 10% annualised growth rate, which is feasible for many more sought-after Australian suburbs, this would then have the strongest after-tax returns among all asset classes included in the table," Kelly said.

"This may then have the unintended effect of driving up property prices, given owner-occupiers are typically more emotionally driven purchasers rather than exhibiting the price-sensitive nature with which investors select assets."

Why tenants may end up paying the bill

On the landlord side of the ledger, Kelly argues that negative gearing and the 50% CGT discount effectively subsidised residential property investors.

If those benefits disappear, one of the easiest ways for landlords to restore acceptable returns is through higher rents.

"During the period between 1985 and 1987, when negative gearing was quarantined in Australia, capital city rents rose by 21.80%, or 10.36% p.a," Kelly said, adding that a similar policy shift in New Zealand saw rents rise 33% over five years.

All else equal, stronger rental growth can also support higher property values.

"Higher rents should generally flow through to increased Net Operating Income (NOI), and therefore higher valuations," he says.

"The most simplified valuation formula for property is: Value = NOI / Cap Rate. If cap rates were unchanged, a 20% increase in NOI would imply a 20% increase in value."

The upside for property owners and landlords, however, could become a major problem for aspiring homeowners.

Kelly argues the result could be a "three-way sucker punch" for first-home buyers.

• First, removing the CGT discount reduces the ability of growth assets such as shares and crypto to keep pace with rising house prices. 
• Second, higher rents make it harder to save for a deposit. 
• Third, if owner-occupied housing becomes even more attractive, buyers may face higher property prices at the exact moment their savings power is weakening.

The new tax shield?

Perhaps Kelly's most provocative observation relates to leverage.

"Under a regime where negative gearing has been removed for investment properties, debt-funded investments outside direct property become relatively more attractive because the tax treatment of the borrowing cost is preserved," he says.

Even where the loan is secured against a residential home or investment property, the deductibility should generally follow the use of the borrowed funds, not the security provided.

"As a result, if the debt is used to fund an investment, 100% of the interest cost remains deductible, meaning the investor retains the full debt tax shield," Kelly says.

"This makes debt-funded investment strategies more compelling on an after-tax basis relative to negatively geared property, where the ability to offset rental losses against other income has been removed."

Those most likely to be able to access these benefits are those who are already wealthy, with incomes sufficient to sustain the additional borrowing, material equity in properties that can be released.

Kelly is already considering how clients might position for this environment, including greater exposure to offshore assets such as private equity, where he believes structural tailwinds, including stronger innovation, lower inflation and higher economic growth, could support returns.

The other risk: changing investor behaviour

While Kelly focused on the mathematics of the proposal, Stockspot founder Chris Brycki is more concerned about the behavioural consequences, in addition to the potentially severe tax outcomes he outlined in his own analysis.

"Australia spent decades building a culture of long-term household investing," he says.

"If the system increasingly rewards income extraction over long-term capital growth, or rewards financial engineering over productive risk taking, that changes behaviour across the whole market."

If the changes proceed, Brycki expects several shifts at the margin:

• Higher allocations to franked income strategies
• Lower appetite for concentrated growth equities
• Reduced attractiveness of international equities and commodities
• Greater preference for assets with smoother nominal returns
• Potentially higher allocations to property and fixed income

"Whether those changes become modest or meaningful probably depends on the final design details and whether any amendments occur," he says.

Who gets hit the hardest?

Both Kelly's and Brycki's analysis point toward growth investors as the cohort most exposed to the proposed changes.

According to Brycki, the groups most likely to feel the impact are active DIY investors managing direct portfolios, active managed funds with higher turnover, and investors concentrated in growth assets or smaller companies.

"If you look at the ASX over the last 10 years, the dispersion between winners and losers has been enormous. You've had businesses like Goodman, Aristocrat and Pro Medicus compounding several hundred percent while others delivered flat real returns, and others like AMP are down 60%," he says.

"That asymmetry is how share markets naturally work. A relatively small number of big winners drive a huge share of long-term market return.

"So while high-conviction growth portfolios may experience the issue more severely, I don't think conservative investors are immune at all. Even diversified blue-chip portfolios can exhibit substantial dispersion over a decade or more."

REITs and high-yielding value strategies may fare relatively better because a larger proportion of their return comes through income rather than capital growth. But that is precisely the distortion Brycki worries about.

"The tax system starts influencing capital allocation decisions away from productive growth assets," he says.

Who benefits?

While much of the debate has focused on the potential losers, Brycki also believes some investment styles could become relative winners. Chief among them are broad index ETFs.

"I think broad index ETFs will be one of the main winners from these changes," he says.

"Their natural diversification and low turnover help reduce many of the tax distortions created by the new system."

Brycki argues index funds are less vulnerable to the dispersion problem he identified in his earlier analysis, where a handful of large winners can be offset by numerous losers. Their low turnover also means fewer capital gains are crystallised along the way.

Beyond index funds, he believes banks, REITs, infrastructure stocks and dividend-focused strategies could also enjoy a structural advantage because a larger proportion of their total return is delivered through income rather than long-term capital growth.

Will dividends come at the expense of growth?

But Brycki believes the implications could extend well beyond portfolio construction.

"Importantly, if a company distributes earnings through franked dividends, investors can use franking credits to reduce their effective tax rate. But if those same earnings are retained and reinvested for future growth, investors may eventually face the full 30% minimum CGT rate when they sell."

His concern is that the market may increasingly reward companies that pay out profits rather than reinvest them.

"Dividend payout ratios will rise and innovation, expansion and R&D risk becoming the first casualties of a tax system that pushes investors toward short-term income."

Once policymakers begin treating some forms of long-term investment as less economically valuable - and therefore deserving of materially higher taxation - Australia enters dangerous territory.

"My concern is this could gradually hollow out Australia's retail investing culture over time. Not overnight. But slowly, through incentives and behaviour change."

"And historically, countries that discourage broad household ownership of productive assets don't usually end up with stronger long-term economic outcomes."