Negative gearing is back on the table, with Jim Chalmers asking Treasury to model changes to property tax breaks. It’s not a new proposal for Labor, with tax reform a hot political issue in the 2019 election.
But at any mention of changes to negative gearing, landlords immediately voice concerns about losing income and having to sell up. Tenants raise issues about increasing rents. And first home buyers wonder if this will worsen their chances of getting into the market.
In this podcast episode, housing experts Brendan Coates and Matthew Bowes make the case for curbing negative gearing and the capital gains tax, a change which could raise billions for the federal Budget and boost home ownership.
Show notes
- Why negative gearing should be on the table
- On negative gearing and the 2019 federal election
- Hot Property: Negative gearing and capital gains tax reform report
Transcript
Kat Clay: Negative gearing is back on the table with Jim Chalmers asking Treasury to model changes to property tax breaks. It’s not a new proposal for Labor, with tax reform a hot political issue in the 2019 election. But at any mention of changes to negative gearing, landlords immediately voice concerns about losing income and having to sell up. Tenants raise issues about increasing rents. And first home buyers wonder if this will worsen their chances of getting into the market.
With the emotive nature of arguments around negative gearing, it is hard to get a sense check on whether this is a reform worth fighting for. If you’ve been following Grattan’s work for a while, it’s no surprise that we’ve been long term advocates for curbing negative gearing. So today I have housing experts, Brendan Coates and Matthew Bowes to make the case along with the data that backs this argument. So Matt, I’m just going to start with you what is actually negative gearing and how does it relate to capital gains tax?
Matthew Bowes: Very simply negative gearing is when investors are able to deduct the losses that they make on an investment property from other sources of income they receive. So, to break that down a bit. When someone buys an investment property and they rent it out, they’ll also have a number of expenses that they can claim as tax deductions.
And these are things like land tax, council rates, and strata fees, the cost of maintaining the property, but importantly also the interest on the mortgage that they may have taken out to purchase the property and also depreciation of the property as an asset. So, when it comes to tax time, if the expenses that they’re claiming are larger than their rental income, then they’re in what we call a net rent loss position.
And that loss can be pretty significant. So, you know, I think in 2021, 22 investors had around four to 5, 000 net rental loss on average, if they were negatively gearing. That’s a relatively significant net rental loss. And what our current tax system allows investors to do is deduct that against other sources of income they may have.
So, if you’re a lawyer, for instance, who makes money from your legal practice, but you also have an investment property, you can deduct losses you make from that property from the money you make from your practice. And that reduces the size of that loss to you. Now importantly, while negatively gearing the property does reduce the cost of making that loss for investors, it doesn’t remove it completely.
So, it kind of raises the question, why are these investors happy to make a loss on their property? And that answer relates to the other tax system feature that you were talking about, which is the capital gains tax discount. One of the reasons investors might hold onto a property that’s making a loss is because you anticipate that you’ll be able to make a large capital gain when you finally sell the property.
And in Australia, we do tax that capital gain that investors make, but we give them a 50 percent discount on that gain, which means we’re only taxing half of it. So this is a discount that applies to all types of assets that you might sell, but it really makes a difference for housing because they might want to hold onto a home that is in a net rental loss so that they can make a capital gain at the other end and claim that capital gains tax discount.
Kat Clay: So, if I’ve got this right essentially, they’re renting it at a loss so that they can reduce their capital gains tax at the end.
Matthew Bowes: Definitely the fact that they have the ability to get that capital gains tax discount at the end increases the incentive to try and hold on to a property and make that capital gain, even if they’re making a loss in the meantime.
Kat Clay: So why do we have negative gearing and CGT in the first place?
Matthew Bowes: There’s a lot of reasons that people raise why we might want to allow negative gearing in our tax system. And there’s also a lot of literature out there that looks at what an ideal tax system might look like from the perspective of economic efficiency. In the simplest terms, the reason we might want to make some allowance in our tax system for individuals who are making losses on an investment is because investments are risky.
So if we tax investors at progressive tax rates, so the higher their income, the higher the tax rate they have, on the profits that they receive from their investment, but we don’t provide any kind of deduction for losses that they make, then our tax system is kind of advantaging investors who are investing in safe assets that make small returns each year, rather than investors that might have more volatile returns that are negative in some years and positive in others.
And ideally, we don’t want our tax system to encourage people who invest in one kind of asset over another. We’d like investors to be making those decisions based upon the merits of the investment, not based upon the kind of taxes they might have to pay.
Brendan Coates: And just jumping in there actually on the capital gains tax discount, you know, we have a discount because, you know, tax theory will tell you that it’s better to tax the return to savings at a lower rate than it is to tax sort of our wage and salary income, which might sound counterintuitive, but it’s basically because over time, if you tax the return really heavily on those savings, then you’re taxing the cumulative gains over time from those returns being reinvested and the effective marginal tax rate in the long term can end up being 40, 50, 60, 70%, which then discourages savings and investment that we might want in the economy.
So that discount is there to essentially make sure that the return to savings isn’t taxed too much and also to compensate for inflation. But what Grattan Institute’s work has found in the past is that discount that 50 percent discount so you’re only taxing 50 percent of those gains, the tax that your marginal tax rate that 50 percent discount, you know, compared to history, it looks like it’s too high to compensate for inflation. And it’s the interaction of those two. The fact that you’re taxed on only half your gains, but you can deduct your losses in full against your wage and salary income makes negative gearing such an attractive prospect when it comes to property. It’s not just used for property, but because that’s the easiest place to get banks to blend your money to go and invest and speculate, that is the place where we see most of negative gearing being used.
Kat Clay: Okay, so I’m, I’m, look, I’m not the biggest tax expert, let’s face it, right? But like, I’m processing this in my head. And so is, is what you’re saying is essentially that there’s a tax imbalance here, like the profits are, you know, taxed at 50%, but then you can claim 100 percent of the losses on your tax. And so, it doesn’t quite add up with the maths at the day for the Australian taxpayer.
Brendan Coates: Yeah, that’s right.
Kat Clay: I’m a genius. Matt, what I do know is that, you know, Australia is quite generous here. We are a bit of an outlier when compared to other countries. What are other countries doing right now with this kind of tax?
Matthew Bowes: Yeah, that’s totally right. Australia does tax both capital gains and the way we treat rental losses is different to other countries. For instance, if you’re in the United States or the United Kingdom and you make a loss on your rental property, you can claim that deduction against similar sources of investment income, but you can’t claim it against unrelated wages or salary income.
Similarly in Canada, they limit the amount of expenses that you can claim as a deduction. So, you’re not allowed to deduct depreciation expenses. And that’s important because that’s an accounting expense that accounts for the cost of a property in the first place, but it’s not a cash payment you have as an investor, so it is an additional incentive for investors.
And when it comes to taxing capital gains, there’s a really wide variety of approaches. So, in New Zealand, they actually exempt capital gains completely. But more commonly in places like Japan and Sweden say they have a flat tax rate that applies to all capital gains regardless of your total income.
And in places like Norway, capital gains are just taxed at your marginal tax rate like any other type of income. So, there’s a wide variety of approaches, but there’s certainly a lot of countries that are similarly wealthy to Australia that provide much less generous concessions than we do.
Kat Clay: Just back on that question of the capital gains tax, I mean, why do we tax capital gains at a discounted rate?
Matthew Bowes: Yeah. So, I think this goes to, to some of the things that Brendan was talking about earlier. So, one of the reasons that you might want to tax capital gains at a different rate to labour income is because capital gains happen over a long period of time and investments compound over a long period of time.
And so, if you don’t provide some provision to account for the fact that compounding means that you could end up with a really high tax bill at the end, you are going to disincentivize investment. And that is really important for our economy. We need investment. In housing and in other types of businesses as well.
Kat Clay: So, one of the big questions, I mean, a lot of us have, and we kind of assume, is it true that these tax concessions benefit the wealthiest people in Australia?
Matthew Bowes: Yeah, definitely, Kat. So, there’s a couple of different sources that we can, can look at to try and look at who gets the benefits of these tax concessions. But just going back to the sort of first principles ultimately you need to have a lot of wealth to invest in property. You need to have the income to afford to pay a mortgage on an investment property.
So that would suggest generally you have to be higher income to be able to have an investment property and negatively gear it. And also, you need to be able to have a lot of wealth initially to make a large capital gain at a later time. So, both of these tax concessions are skewed. And then when we look at something like modelling done by the Parliamentary Budget Office recently from the Greens, they find that around 80 percent of the benefits of the capital gains tax discount go to the top 10 percent of individuals by taxable income.
When we look at negatively geared properties, the parliamentary budget office found that about 50 percent of the benefits of negative gearing go to the top 10 percent of people by taxable income. But importantly, some of those people don’t have such high taxable incomes because they’re negatively gearing.
Brendan Coates: And just to jump in there as well, like we can actually cut this by profession. So, there’s lots of talk that’s been out for a while that, you know, this is lots of nurses and teachers that are making use of these provisions because they’ve got an investment property. They’re deducting those losses in order to, you know, save for their retirement or for their kids future.
But when we look at the kind of occupations of those that most intensively use negative gearing, something like one in three surgeons are using negative gearing. And then the average benefit that they were getting a decade ago when we cut the numbers was about 4000 dollars per year, whereas only about 10 percent of nurses and teachers had negatively geared properties because they earn a lot less. And the average gains that they’re getting a were less than 1000 or in most cases less than 500 a year.
So, it’s a case that It’s wealthier cohorts that are doing this more. Most of the benefits go to the top wealthiest 20 percent of Australians. And so, if we’re in a world where we’re saying, well, we’re providing these concessions. Perhaps even to think about to boost housing supply or to support investors.
It doesn’t seem like this would be the best way to do it.
Kat Clay: Yeah, and look, plenty of people rent out their properties for different reasons, but you know, you’re right on the money that you do need to have a large capital in the first place to buy a property and then to have multiple properties or the capacity to rent and, you know, have another property on the side is, is a luxury many people can’t afford. So, Brendan, how do you propose that government should reform negative gearing and the capital gains tax discount?
Brendan Coates: Essentially, we would have the capital gains tax discount. It’s currently 50%. We would have that to 25%. And we would transition that in by phasing it down from 50 percent to 25 percent over five years. That would save the budget something like feel like 5 billion a year.
And then at the same time with negative gearing, we would move from a world of full deductibility where you can offset it those net rental losses against all your sources of income to what’s more common, which is partial deductibility, which means you can only offset them against other investment income, whether from other investments that you have or offset them against the capital gain tax that you would otherwise have to pay at the end when you eventually sort of sell that asset and realize the gain. And that would raise in the long term about another 2 billion dollars.
So we’re talking about 7 billion a year into government coffers by curbing these concessions that could be used either to provide support, to low income renters and others in other ways, or to basically repair the budget position so that we don’t need to raise other more economically costly taxes in order to balance the budget in the long term, particularly with the cost of an aging population.
Kat Clay: So, I mean, that’s no small number, seven billion dollars. That’s quite a lot in a budget that’s experiencing, a significant structural deficit. So, Brendan, one of the things that has been suggested with these kinds of reforms is that they’re grandfathered, so they’re only implemented from the point when they’re put in place.
What do you think about that? Is that a good idea?
Brendan Coates: It’s something that we tend to recommend against doing. So grandfathering is something typically a bad idea for a few reasons. One, it adds to complexity because it means that the tax treatment of investment property depends on when the property is purchased, and that just adds to complexity in the tax system, which is, you know, a cost to everyone spending more money on accountants.
It’s also means that we’re entrenching and kind of long-term intergenerational inequity story by essentially continuing to privilege certain forms of investments that tend to be held by older Australians.
And so that would substantially reduce the budget revenue that this thing, this, this change would collect in the short to medium term. In principle, it doesn’t really make a lot of sense to grandfather something like a negative gearing or a capital gains tax change when we don’t apply grandfathering to any other change in the tax system.
So, for example, changing the stage 3 tax cuts or any change to the personal income tax scales has an effect upon the investment returns of anyone who has a negatively geared property. We don’t think about that as warranting some sort of grandfathering for those properties. The same is if I hold BHP shares and the tax rate changes tomorrow.
We don’t worry about the fact that that will change the return on the investment. So, it’s a strange argument I find that there’s a request or an urge to grandfather in this particular case because there’s all these other changes in the tax system to which we don’t apply that test, and we really shouldn’t apply it here.
The best way to manage that transition is to gradually phase out both negative gearing and the capital gains tax discount. So essentially reduce the share of rental losses that can be deducted each year and phase that down over five years. Reduce step down the capital gains tax discount from 50 to 25 percent over five years.
That would be the approach that we would take to smooth out the transition and avoid unimpeded gains tax. Unexpected shocks for people without the need for grandfathering that ends up costing the budget billions of dollars for decades to come.
Kat Clay: Yeah, I mean, when you think about it, it’s not like you get a free pass on paying GST if you were born before GST was implemented.
Brendan Coates: No, but you do get a free pass on paying income tax if you happen to be over the age of 60 in most cases in Australia.
Kat Clay: Fair enough, although I’ll probably be working till I’m 80, so you know, that’s life. Why not then just abolish negative gearing and the capital gains tax altogether? Let’s just do away with them.
Brendan Coates: As we’ve talked about in the podcast so far, there are reasons why you want to allow deductibility of net investment losses against gains and other income. And there are reasons why we want to offer some kind of discount. So, abolishing both of those provisions completely, in our view, would be a step too far.
It would result in a less efficient tax system that’s less likely to support Australians to work, save and invest and ultimately, you know, would reduce the incomes and the prosperity of the Australian people in the long run. So, halving the discount on CGT, curbing negative gearing is the optimal tax approach to these kinds of investments in our view.
Matthew Bowes: One of the other things that’s worth keeping in mind is that we do have an additional capital gains tax concession for the family home. So, if you create a really large disparity between the capital gain that you can get on an investment and the capital gain you can get on the family home, it just really changes people’s incentives to invest in their owner-occupied properties rather than investment properties.
Kat Clay: Yeah, that was one of the questions I was actually going to ask is that if people can then just, if negative gearing is just going to be offset against investments, what’s to stop someone from just taking that whole 4, 000 offset and offsetting their share portfolio?
Brendan Coates: They can do that. But it’s just a lot harder because you can typically borrow a smaller share of the investment or asset value when you’re talking about negatively gearing. shares essentially than what you can when it comes to property. And so that’s why property ends up being the main investment because it’s the one asset from which banks will most easily and happily take security of the asset rather than you having to stump up a huge down payment or deposit on the home in order to secure the loan.
That’s much harder to do with shares, which are more volatile and repriced more often, which means the bank’s just not willing to lend as much of the purchase value of a set of BHP shares is what they are for an investment property.
Kat Clay: So, Brendan, I mean, some landlords say that these changes would actually hurt renters because the costs would need to be passed on to them, or that they would need to sell these properties, therefore reducing rental stock.
How do you see it affecting the rental market?
Brendan Coates: So, I think the first thing to keep in mind is that if someone who has negatively geared a property decides to sell up, whether it be because of these changes or anything else, that that property obviously does not disappear from the market. You know that home is available for someone else to purchase as a first home buyer or to be purchased by another investor.
If it’s purchased by a first home buyer, then by definition, you’ve got someone buying that home who has probably previously been in the rental market and the impact on the rental market the net balance of demand supply in the rental market is probably going to be pretty close to zero. So just investors selling up homes.
We’re seeing this quite a lot in Victoria at the moment, where investors have been selling more homes, that doesn’t necessarily lead to a net shortfall of rental housing. The bigger question is, what does it do to the incentives for people to buy new properties in the long run and therefore add to supply?
Now, most people who natively gear an investment property are not buying a new property because that tends to be riskier, or it has different risks attached. They tend to be buying an established home or established apartment. So not a lot of new properties are funded by negatively geared investors.
There is a concern that it will have some impact at the margin, but it’s likely to be very small because there’s been no shortage of capital being willing to invest in property for the last three decades and that it hasn’t changed. It doesn’t change anytime soon. So, we expect the impact on rents will be incredibly small and we’ll hopefully have more to say about that really soon.
Even work that’s been done by Deloitte for the Property Council, I believe, finds an increase in rents from a reduction supply of about 0. 5 increase in rents by 2030. So even in the property council’s own modelling, the effect appears to be pretty small, and we’d expect it to be much smaller still.
Kat Clay: So, on the flip side, I mean, how would it affect landlords?
Brendan Coates: Well, landlords would have a choice. They would be losing the benefit, those tax, that tax benefit of, of negative gearing and the CGT discount that would make investment property as an asset a little bit less attractive to them. Some of them may choose just to say, well, okay, this is still the right thing for me, particularly because, you know, if they sell, they have to pay agents fees to sell the property which are normally 1.5-2 percent of the property value.
So pretty sizable. Or if they do choose to sell, they may choose to invest their money elsewhere, whether it be shares or whether it be in a trust or another, another investment vehicle. I think the big question is kind of what happens to prices. And there, our research has been pretty clear for a long time that the effect on prices is really small. And the simple reason is that we’re talking about removing concessions that have a flow value each year of about 7 billion dollars. That’s been going to the, those negatively geared property investors and others. And if we remove that value of which not all of it’s actually in property, because not all of the capital gains discount applies to property investments and shares and everything else, then we’d expect, you know, property values would fall by between, one and 2 percent at most because the value of those concessions is so small in a 10. 9 trillion housing market. It’s just not big enough to care. There are estimates out there from others that suggest a larger impact on prices, but they just appear implausibly large to us because the actual pure value of the tax change and tax theory will tell you that’s what gets capitalized into property values is just not big enough to move the market, which is why we think the impact on prices is a small as we do.
Matthew Bowes: I think something that’s worth remembering is that about 70 percent of homes in Australia are owned by owner occupiers, so anything we do that impacts the residual amount of homes that are owned by investors is not impacting the majority of the market.
Kat Clay: That’s a really good point, Matt.
Brendan, what about people who are looking to buy?
Brendan Coates: Well, reforms to native gearing and the capital gains tax discount would be good news for them. As we’ve talked about, prices would fall, marginally at least. But on some of the modelling that’s been done by economists at the New South Wales Treasury, they estimate that reforming these concessions in similar ways to what we propose would actually see the home ownership rate rise for the first time in decades from 67 percent closer to 70 percent basically because those negatively geared investors that are currently outbidding first homebuyers at auctions, they wouldn’t bid as much for the property because they don’t get those benefits and instead more first homebuyers would actually win out at auctions.
This isn’t really a policy that’s a housing policy in most respects it is really a policy reform that’s about a better tax system. The exception, though, it is one of the most effective ways that a government could boost the rate of homeownership, which if governments want to do, then here is a prime example of how you can basically tilt the scales more towards for first time buyers in ways that are beneficial for the tax system overall.
And the beneficiaries of those that want to own their own home.
Kat Clay: This decision is on the political table at the moment, and it is a hard piece of reform to bring about. Negative gearing and the capital gains discount were two of the tax reforms on the table at the 2019 unlosable election alongside franking credits.
We’re quick to assume that it’s one of the reasons that Labor lost the election, but what did we see play out then and which voters do these changes really affect?
Brendan Coates: So, the conventional wisdom is, I think, as you say, that people assume that this played a part in Labor losing that 2019 election. It’s easy to forget they also took those changes to the 2016 election where they actually won seats off the then Coalition government, but not enough to form their own majority and form government.
But in 2019, we actually saw seats that the kind of seats that were more likely to be affected by the tax changes we’re suggesting. Wealthier, older electorates tended to swing towards Labor and the electorates that tended to swing towards the Coalition at the 2019 election tended to be those that were lower income, often younger, that really sort of puts paid to the idea that negative gearing and capital gains tax reform really affected or hurt Labor’s chances of winning that election.
And so if the government or the current Coalition, which is on the record and stating that it wants to boost home ownership, were to pick up our recommended reforms, there’s not a lot of evidence that would hurt either major party at the ballot box if they took those changes to the next federal election.
Kat Clay: Well, it will be fascinating to see this play out in the coming weeks and months as we continue on our pre-election discussions of the policy issues that will be important in next year’s federal election. I’d like to thank you so much, Brendan and Matt, for coming on the podcast, especially you, Matt, for your first podcast.
If you’d like to talk to us about these issues that we’ve discussed today, please find us on social media on X or Twitter at Grattaninst and all other social media channels at Grattan Institute. Likewise, if you’d like to read more about our housing research and our articles on negative gearing, I’ve put some links in the show notes so you can check them out as well.
As always, please do take care and thanks so much for listening.