Good reform of housing taxation should encapsulate the full spectrum of housing market distortions

Danika Wright (University of Sydney) provides an excellent overview of negative gearing in The Conversation and argues that it should not be analysed in isolation from capital gains and other special treatments of housing, such as stamp duty, land taxes and first-home-buyer exemptions.

Despite being widely described as a “tax rort for rich investors”, negative gearing is not a tax concession (a tax deduction as opposed to an exemption or rebate). It does, however, encourage over-investment and over-leveraging in Australia’s housing market, as the Financial System Inquiry Murray Report concluded.

Consequently, while not the only reason for increasing house prices and affordability issues in some locations, negative gearing has become a focal point in an election year for tax reform debate and a review of housing policy.

From Waleed Aly to the prime minister on his own blog, negative gearing is generating much talk without context.

Where does the idea come from?

Gearing describes the use of borrowing to finance an investment. When the interest costs of servicing that borrowing exceed the net income of the investment, it is said to be negatively geared.

The idea underlying negative gearing is relatively straightforward: when an individual (or business) incurs costs associated with generating income, those costs are tax-deductible from income.

As it is applied to investment properties in Australia, when interest costs of the mortgage exceed the net rental income of the property (that is, it is negatively geared) then the net loss on the investment property may be used by an individual to offset their ordinary wage income.

This is because, under the current rules in Australia, investment property losses are not “quarantined”. That is, the losses on an investment property are not only tax-deductible against the income from the investment property. As a result, the higher your total income, the greater the tax-minimisation benefit of negative gearing.

Quarantining losses is a major point of difference in the application of negative gearing in Australia to the rest of the world, and a key area that previous reforms in Australia have targeted.

International examples

Compared to the rest of the world, Australia’s negative gearing policy is one of the most generous to property investors.

Of OECD countries, New Zealand and Japan have the most similar treatment of negative gains to Australia. In these countries, negative gearing is allowed with relatively few restrictions.

On the other hand, the United Kingdom applies strict quarantining rules to loss-making properties. Investment property losses may be applied to the pool of income from investment properties and carried forward, but the losses may not be deducted against wages (i.e. non-passive income).

However, this summary should be treated with extreme caution. An international comparison of negative gearing treatment is incomplete without also examining the rules for capital gains and other housing market distinctions such as owner-occupier versus investment properties and new versus existing developments.

In the United States, while not a system to aspire to, even interest on owner-occupied housing is fully tax-deductible against ordinary income. By contrast, in Sweden, tax deductions from negative gearing of rental properties are permitted (although quarantined with income from other capital assets), but imputed rents from owner-occupied housing are taxed.

The net welfare gains are cumbersome to measure and entwined with government policy.

Previous attempts at reform

In 1984-85, major reform to negative gearing policy in Australia took place.

Prior to the Hawke government’s tax reforms, negative gearing rules quarantined investment property losses and allowed investors to carry these losses forward to offset future income when, or if, the property became positively geared.

In the space of six months, investment property losses quarantines were lifted (in order to boost the stock and affordability of rental housing) and then removed.

From property investors’ perspective, this final reform was severe: losses were quarantined on an asset-by-asset basis and could not be carried forward to offset future income.

Though this reform was not retrospective (that is, it would apply only to properties purchased after July 1985), it was largely criticised at the time and arguments that it caused rents to increase dramatically prevailed. While these analyses have been questioned in more recent debates, in September 1987 the reform was repealed and the system largely as it exists today was set.

The one major subsequent attempt at reform to negative gearing came in the 2010 Henry Tax Review. The primary recommendations for a “fairer” and more efficient housing market were for the removal, or reining in, of negative gearing. Specifically, negative gearing losses should be capped at 40%.

At the time of the report’s release, then-prime minster Julia Gillard chose to maintain the status quo with respect to negative gearing. Her response on ABC’s Q&A shows that negative gearing is a bilaterally difficult topic.

Where are we now?

With calls for negative gearing reform from a range of voters, economists and advocacy groups such as ACOSS, why has no major political party achieved significant reforms to negative gearing?

There is the elephant in the room: the majority of Australian voters have a direct interest in the stability of the housing market.

Beyond that, the added confusion is the conflict between what negative gearing policy aims to achieve and the reality.

It is true that negative gearing distorts the housing market. It encourages over-investment and over-leveraging in Australia’s residential real estate sector. And this is exactly what it was intended to do.

But when combined with the existing progressive income tax structure, the relative benefit to low-income versus high-income earners is easily muddied.

For over 30 years, negative gearing has been untouched under the primary political motivation – that it increases the housing supply and, importantly, the stock of rental housing. It has taken this long to conclude that the stated aim does not appear to have been achieved. Finding a better alternative is not going to happen overnight, no matter how persuasively Waleed Aly puts the case against it.

So what are the reform options?

The Turnbull government has ruled out changes to negative gearing in the pre-election budget. The government has walked away from earlier suggestions of capping the losses that may be claimed from negative gearing, or restricting the number of negatively geared properties in an individual’s portfolio.

By contrast, Labor’s policy has been placed on a pedestal by proponents of reform. Labor proposes to restrict the tax benefits of negative gearing to new properties only. In theory this would redirect housing investment (which currently is concentrated in existing properties) to housing construction and help to boost supply.

Labor’s proposal would be a further distortion. Taken to its limit, offering incentives for investment in new properties also encourages speculative developments. The policy risks unoccupied housing investments and the resulting “ghost towns”, without improving housing affordability.

Complicating this analysis, however, is the complexity of the tax system and housing market policy. Negative gearing should not be analysed in isolation from capital gains (on which the Grattan Institute has published a comprehensive report) and other special treatments of housing such as stamp duty, land taxes and first-home-buyer exemptions. Rather than take a sledgehammer to the current policy, a good reform should encapsulate this spectrum of housing market distortions.

This article is republished under creative commons licence.