Axe negative gearing for a healthier property market | Saul Eslake

Thanks to Ody for posting this on IC forum. I feel it is worth repeating here because of the current debate around negative gearing.

Axe negative gearing for a healthier property market
Apr 25, 2011: Saul Eslake

The property market would look a lot healthier without it, writes Saul Eslake.

For almost a quarter of a century, successive Australian governments have, with varying degrees of enthusiasm, sought to promote higher levels of participation in employment, and higher levels of personal saving.

These are both worthy objectives, ones which public policy should seek to promote. It’s therefore surprising that successive governments have not merely been content to maintain a tax system that taxes income from working and saving at higher rates than those at which it taxes income from borrowing and speculating, but have either increased the extent to which income from borrowing and speculating is treated more favourably by the tax system, or explicitly rejected sensible proposals to balance incentives between the two as Wayne Swan did in May last year when ruling out recommendations made by the Henry Review.

Under the taxation system, income from working – that is, wages and salaries – is taxed at higher marginal rates than any other kind of income: 31.5 per cent for most Australians with full-time jobs (earning between $37,000 and $80,000 a year), 38.5 per cent for those earning over $80,000 a year and 46.5 per cent for those earning over $180,000 a year.

Income from deposits in banks, building societies and credit unions is taxed at the same marginal rates.

For those contemplating entering, or re-entering, paid employment (say, after a period of caring for children or aged parents) the impact of tax on income from work can result in effective marginal tax rates of close to, or even over, 60 per cent, on what are quite modest levels of income. The Henry Review concluded that ”some people [are] likely to reduce their level of work as a result” of these very high effective marginal tax rates. This may be one reason why the workforce participation rates of women with children, and older people, are lower here than in other OECD countries.

By contrast, income from most forms of investment, other than interest-bearing deposits, is typically taxed at lower rates than similar amounts of income derived from working. Income from saving through superannuation funds, and from ”geared” investments (that is, the purchase of assets funded by borrowing) is especially lightly taxed.

The review calculated that, for a top-rate taxpayer, the real effective marginal tax rates (after taking account of inflation assumed to average 2.5 per cent per annum, and the time at which tax is payable) on income earned from superannuation savings or highly-geared property investments are actually negative, while the real effective marginal tax rate on interest income from deposits can be as high as 80 per cent.

Very few other ”advanced” economies are as generous in their tax treatment of geared investments as Australia is. In the United States, investors can only deduct interest incurred on borrowings undertaken to purchase property or shares up to the amount of income (dividends or rent) earned in any given financial year; any excess of interest expense over income (as in a ”negatively geared” investment) must be ”carried forward” as a deduction against the capital gains tax payable when the asset is eventually sold.

In Australia, by contrast, that excess can be deducted against a taxpayer’s other income (such as wages and salaries) thereby reducing the amount of tax otherwise payable on that other income.

The Howard government’s decision in 1999 to tax capital gains at half the rate applicable to wage and salary income, converted negative gearing from a vehicle allowing taxpayers to defer tax on their wage and salary income (until they sold the property or shares which they had purchased with borrowed money), into one allowing taxpayers to reduce their tax obligations (by, in effect, converting wage and salary income into capital gains taxed at half the normal rate) as well as deferring them.

As a result, ”negative gearing” has become much more widespread over the past decade, and much more costly in terms of the revenue thereby foregone. In 1998-99, when capital gains were last taxed at the same rate as other types of income (less an allowance for inflation), Australia had 1.3 million tax-paying landlords who in total made a taxable profit of almost $700 million.

By 2008-09, the latest year for which statistics are available, the number of landlords had risen to just under 1.7 million: but they collectively lost $6.5 billion, largely because the amount they paid out in interest rose almost fourfold (from just over $5 billion to almost $20 billion over this period), while the amount they collected in rent only slightly more than doubled (from $11 billion to $26 billion), as did other (non-interest) expenses. If all of the 1.1 million landlords who in total reported net losses in 2008-09 were in the 38 per cent income tax bracket, their ability to offset those losses against their other taxable income would have cost over $4.3 billion in revenue foregone; if, say, one fifth of them had been in the top tax bracket then the cost to revenue would have been over $4.6 billion.

This is a pretty large subsidy from people who are working and saving to people who are borrowing and speculating. And it’s hard to think of any worthwhile public policy purpose which is served by it. It certainly does nothing to increase the supply of housing, since the vast majority of landlords buy established properties: 92 per cent of all borrowing by residential property investors over the past decade has been for the purchase of established dwellings, as against 82 per cent of all borrowing by owner-occupiers.

For that reason, the availability of negative gearing contributes to upward pressure on the prices of established dwellings, and thus diminishes housing affordability for would-be home buyers.

Supporters of negative gearing argue that its abolition would lead to a ”landlords’ strike”, driving up rents and exacerbating the existing shortage of affordable rental housing. They point to ”what happened” when the Hawke government abolished negative gearing (only for property investment) in 1986, claiming that it led to a surge in rents, which prompted the reintroduction of negative gearing in 1988.

This assertion has attained the status of an urban myth. However it’s actually not true. If the abolition of ”negative gearing” had led to a ”landlords’ strike”, then rents should have risen everywhere (since ”negative gearing” had been available everywhere). In fact, rents (as measured in the consumer price index) actually only rose rapidly (at double-digit rates) in Sydney and Perth. And that was because rental vacancy rates were unusually low (in Sydney’s case, barely above 1 per cent) before negative gearing was abolished. In other state capitals (where vacancy rates were higher), growth in rentals was either unchanged or, in Melbourne, actually slowed.

Notwithstanding this history, suppose that a large number of landlords were to respond to the abolition of negative gearing by selling their properties. That would push down the prices of investment properties, making them more affordable to would-be home buyers, allowing more of them to become home owners, and thereby reducing the demand for rental properties in almost exactly the same proportion as the reduction in the supply of them. It’s actually quite difficult to think of anything that would do more to improve affordability conditions for would-be home buyers than the abolition of ”negative gearing”.

There’s absolutely no evidence to support the assertion made by proponents of the continued existence of ”negative gearing” that it results in more rental housing being available than would be the case were it to be abolished (even though the Henry Review appears to have swallowed this assertion). Most other ”advanced” economies don’t have ”negative gearing”: yet most other countries have higher rental vacancy rates than Australia does.

I’m not advocating that ”negative gearing” be abolished for property investments only, as happened between 1986 and 1988. That would be unfair to property investors. Personally, I think negative gearing should be abolished for all investors, so that interest expenses would only be deductible in any given year up to the amount of investment income earned in that year, with any excess ”carried forward” against the ultimate capital gains tax liability. But I’d settle for the review’s recommendation, which was that only 40 per cent of interest (and other expenses) associated with investments be allowed as a deduction, and that capital gains (and other forms of investment income, including interest on deposits) be taxed at 60 per cent (rather than 50 per cent as at present) of the rates applicable to the same amounts of wage and salary income.

This recommendation would not amount to the abolition of ”negative gearing”; it would just make it less generous. It would be likely, as the review suggested, ”to change investor demand towards housing with higher rental yields and longer investment horizons [and] may result in a more stable housing market, as the current incentive for investors to chase large capital gains in housing would be reduced”.

Sadly, these recommendations were among the 19 that the Treasurer explicitly ruled out when releasing the review last year. That makes it hard to believe that this government (or indeed any alternative government) is serious about increasing the incentives to work and save – or at least, about doing so without risking the votes of those who borrow and speculate, in effect subsidised by those who don’t, or can’t.

Saul Eslake is a Program Director with the Grattan Institute. The views expressed here are his own.

Saul’s suggestion of carrying forward losses rather than writing them off against other income is a good one. But I would go a lot further with tax reform:

  • a 10% flat rate of tax on all income;
  • 10% corporate tax rate;
  • 10% tax rate for super funds;
  • no capital gains discount and no inflation adjustment;

While a comprehensive 10% tax on all income and capital gains would raise a substantial sum, there is bound to be a shortfall compared to the current system. My solution would be a land tax (similar to local council rates), excise taxes (alcohol, petrol and tobacco), and a flat rate of GST on all goods (including basic foods and medicine) to balance the budget.

Some would argue that this would increase the tax burden for the poorest families, but that could easily be addressed through food stamps or “rent stamps” for families on welfare. Land tax is a highly progressive (the opposite of “regressive”) tax that is closely correlated to wealth rather than income. The overall aim would be to encourage GDP growth by removing the burden of a complex income tax system with high marginal rates that serve as a disincentive to create additional income. Simplicity would improve fairness, minimize avoidance and reduce the cost of reporting and administration.

….Don’t hold your breath.

13 thoughts on “Axe negative gearing for a healthier property market | Saul Eslake

  1. Greg M says:

    If legislation were enacted to ban corporate donations then attempts to subvert the policy should also be banned. Super PACs and any other individual or organisation engaging in commercial political advertising and fundraising would need to be banned. Where you draw the line is debatable but the spirit of the legislation should be to do away with the impression that wealthy individuals and corporations can have more influence over government than the people themselves.

  2. Greg M says:

    Great article, thanks for posting. More and more economists like Saul are speaking out against negative gearing and capital gains concessions, and for good reason.

    FWIW my recipe would look like this
    • c$20k tax free threshold & then a 10% flat rate of tax on all personal income up to c$100k & thereafter bump it to 15% or 20%
    • no capital gains discount and no inflation adjustment
    • A land tax which is needed to replace the grossly unfair real estate stamp duty.
    • As Saul writes “negative gearing should be abolished for all investors, so that interest expenses would only be deductible in any given year up to the amount of investment income earned in that year, with any excess ”carried forward” against the ultimate capital gains tax liability.”
    • Currency exchange tax on every single AUD sold initially at 1% and increasing to a final target of 10%
    • A target of 10% corporate tax rate.

    The big one for me is a currency exchange tax. Foreign companies aren’t paying their fair share of tax. They have an advantage over local manufacturers. A tax on every Aussie dollar sold would help redress this. For every 1% increase in exchange rate tax lower company tax by 2% and have the end goal of 10% for each.

    • ColinTwiggs says:

      Thanks for posting your suggestions Greg.

      My reason for suggesting a flat tax on every dollar of income (corporate and personal) was to avoid income-splitting, where income is either retained in a company, SMSF or Trust, if taxed at a lower rate, or channeled to individuals (e.g. children) with lower tax rates. Preventing this grossly complicates the Income Tax Act. Far easier to just have one rate and then compensate those few individuals whose income is below the threshold through other means (e.g. food or ‘rent’ stamps).

      Progressive rates of tax enhance the perception of unfairness and encourage tax avoidance. They also create an opportunity for income-splitting. Best to avoid this.

      A land tax, with relatively low rates, is highly progressive and far more effective at taxing the wealthy.

      I can’t see a currency tax working as it would affect all trade and not just offshore companies, and capital flows not just income. I do think that low tax jurisdictions are being abused by large international companies, especially Internet (e.g. Google) and big pharmaceuticals. A 10% tax could be levied on all good and services supplied from low tax jurisdictions (i.e. where there is no tax treaty).

      • ColinTwiggs says:

        P.S. I do think that a mining tax on non-renewable resources is a good idea, though politically difficult because of the damage that wealthy miners can do to politicians. But the proceeds should be channeled straight into a sovereign wealth fund as in Norway where they can only be used to fund infrastructure (and offshore investment) to later replace the hole left when the resources have expired. Australia has been particularly lax in this area, resulting in a bad case of ‘Dutch disease’ which destroyed local manufacturing. One day when the mines are gone, there will be nothing left to replace them. Norway is a prime example of how to deal with a resources boom but even Mongolia has done a better job.

      • Greg M says:

        Yeah, I get what your saying. Although as soon as you start to compensate lower income people you create more costly bureaucracy and with that the inefficiencies and people who want to meddle with the process. To me small government is good and the smaller the better. Far better to give people more independence than have them as welfare recipients. To address the income splitting you mention possibly it is better to have just the one 10% or 15% flat tax rate but I’d still like for a tax free threshold to be retained.

        Regarding the currency tax, I’d be very interested to see any study/report into the potential effect this would have on domestic business. It’s the absolute simplicity of it that appeals to me. Tax every dollar that leaves the country and compensate local business by reducing their tax rate. Straight away you collect revenue from the tax dodgers and give local business a boost at the same time.

        Totally agree with the mining tax. How about a flat 10% on the value of all raw resources that go offshore? As for wealthy miners doing damage to politicians, what options do we have? Initially at least I’d like to see political donations severely restricted and made completely transparent. Possibly an upper limit on how much individuals can donate and bar all businesses from making any donations.

      • ColinTwiggs says:

        Capping donations is important but what can be done about political advertising, like super PACs in the US and big mining or unions in Australia?

      • Greg M says:

        Quite shocked to see that Michael Kroger of all people agrees with severe restrictions on political donations.

    • ColinTwiggs says:

      Removing the discount on capital gains and reducing income tax to a flat rate of 10% would remove (most of) the motivation for negative gearing. Why spend money on an expensive structure (with increased risk) simply to defer income which will be taxed at the same low rate?

  3. ColinTwiggs says:

    P.S. Free education. I am all for reducing the exorbitant cost of education but human nature seems to be if you get something for free you don’t appreciate it. What of rewarding good grades with a fee rebate?

  4. ColinTwiggs says:

    Hi Frank,
    20% would be a huge hike for the bottom end of the tax scale. If you earn taxable income of $37,000 your current average rate is 9.7%. Close to 10%. If you earn $19,000 your average rate is zero. Hence the suggestion regarding food (and ‘rent’) stamps. Also, bear in mind that we already pay 10% GST.

    When it comes to Land Tax, don’t throw the baby out with the bathwater. It is easier to address cases of hardship (as with food stamps) directly, rather than abandon a highly effective and less onerous (than a 20% flat rate) tax.

    The objective is to create low, flat rate taxes that don’t act as a disincentive to income creation. Some would call this trickle-down economics. I call it removing impediments to growth.

    • frankaquin0 says:

      Yes – like I said I didn’t do any maths on it. More of a philosophical view (as in: three quarters for me and quarter for the King) kind of approach. As I’ve said repeatedly in previous responses I’m certainly no economist, and perhaps my preference to stay in surplus is old fashioned in these days of clever money management and incomprehensible derivatives. Not sure how food stamps work, but there is a welfare system already in place to reimburse the disadvantaged, and the Govt could always give money back to all of us if they acquire too much. What a day that would be!

      But I’m all for simplification: If you do your own tax (and notwithstanding the ATO’s very good effort in making e-tax as understandable as possible) you’ll know what a absolute dog’s breakfast it is. But if not, here is a paraphrased quote by Bernard Black from the comedy series “Black Books” that pretty-well sums it up. “If you live in a council flat beside a river but are not blind, did your non-returnable outgoings for the first half of the year exceed your deductions for quarterly VAT returns?”
      Mind you such nonsense keeps a lot of (non productive) tax people in business.
      Keep smiling 🙂

  5. frankaquin0 says:

    All good suggestions – shame no one in Canberra has the courage to do it. Personally (and without having done a shed of maths on the subject) I’d make it 20% flat rate on all income and corporate. Twenty (or even twenty five) percent seems a fair price to pay for maintaining a law-abiding, functioning, clean, decent society with a well-paid police force and free education right up to Bachelor level. I’d avoid the land tax idea because it would essentially evict fixed-income retirees from their hard-won inner suburb homes. GST is about right already. But like I said, it doesn’t matter; no one in Canberra has the courage.

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