A reply to Henry Ergas on negative gearing

by John Daley and Danielle Wood

The debate about negative gearing and capital gains tax shows no signs of disappearing. It’s a clear policy difference between the major parties in this year’s federal election. Such robust policy debates are part of a healthy democracy. People put forward policy positions, others challenge them, and the public can decide which set of arguments appeal most. Grattan Institute contributed with its report, Hot Property: Capital Gains Tax and Negative Gearing. Henry Ergas had a crack at some of the issues in his column in The Australian on May 2, so it’s worth understanding what’s at stake.

Ergas asserts that negative gearing is a normal part of a comprehensive income tax system. We didn’t ignore this point (as he claimed) – indeed we were explicit that “the ability to deduct expenses incurred in generating assessable income is part of the normal operation of the Australian tax system.” However, the report devotes more than a page to showing how this principle does not mean that all losses should be deductable against all income. Our system does not apply the principle universally. Among developed countries we studied, only Australia and New Zealand still apply this principle to allow the deduction of interest costs on investment from labour income.

In the absence of a fundamental principle, should negative gearing stay? Ergas believes we want to change rules on negative gearing and capital gains tax because of an “obsession” with income distribution. Yet even a cursory reading of our report would show that we do not see income redistribution as the primary reason for tax changes. Instead we argue for change on the basis that current arrangements encourage investment in less productive assets; encourage excessive leverage; force other, more distortionary, taxes to be higher; and undermine the integrity of the tax system. Indeed, we state that “the fact that negative gearing is regressive is not in itself an argument for change”.

Ironically, it is the defenders of negative gearing who have been most vociferous about the implications of negative gearing for wealth distribution. They claim that negative gearing should be maintained because it is primarily used by low and middle income earners – “teachers and nurses” – to get ahead. Our analysis of distribution seeks to correct this myth, pointing out that most benefits, by value, go to high income earners.

Another argument against change is that people would invest less as a result. Ergas claims that a reduction in the CGT discount to 25 per cent could produce an effective tax rate on real (inflation adjusted) capital gains of 70 per cent, discouraging many investors.

That number sounds scary. But as our report points out, real effective tax rates vary widely, depending on what you assume about inflation, returns, and how long you hold the asset. Based on average historical returns, under our regime a property investor in the top tax bracket that bought a house 15 years ago and sells today would face an effective tax rate on real returns of 41 per cent — less than the tax of 47 per cent they pay on their other income.

Even if we assume capital gains are much lower in future (say, 5 per cent a year rather than their historic 7 per cent) the real effective tax rate would be closer to 55 per cent on a house held for 15 years. Our report provides calculations of real effective tax rates under a range of different scenarios.

Finally, how much will changes to negative gearing and capital gains tax drag on the economy? Ergas’ favourite academic on this topic, Harvard’s Malcolm Feldstein, argues that there is an efficiency cost from higher taxes on savings because taxes reduce people’s future consumption, even if they don’t change the amount people save.

Few other economists agree that this should be considered a deadweight loss. And if we accept this broader definition, then the efficiency cost of other taxes, including taxes on labour income would be higher. Taxes on savings may still be relatively efficient.

So it is not surprising that in the interests of making our report readable we didn’t refer to Feldstein just to explain why we don’t adopt his particular approach. Presumably, for similar reasons, the 1000-page Henry Tax Review and the Government’s more recent tax discussion paper also did not find the room to quote the views of Ergas’ preferred tax academic. Instead, like them, we draw extensively on the international tax literature, including Nobel prize winners James Mirrlees and Peter Diamond.

Ergas is right about one thing. Our report states that investors account for more than half the new loans for housing, up from 29 per cent two decades ago. In a “gotcha” moment probably not worth the three paragraphs he dedicates to it, Ergas points out that the most recent data from February this year was 36 per cent – or 44 per cent using our approach of excluding loan refinancing for owner occupiers. We had referred to the figure from 2015, and missed the latest ABS release in the process of finalising the report. However, unlike Ergas, we also adjusted for refinancing – the numbers are distorted because investors are much less likely to refinance than owner-occupiers. We’ve updated the report accordingly.

But while dwelling on the revision, Ergas misses the more interesting and important point: why has the share of investor loans fallen so sharply after a two-decade upward march? The answer is regulatory intervention. After several years of warning about the risks to the financial system of growing lending to highly leveraged property investors encouraged by negative gearing tax breaks, the banking regulator APRA introduced new mortgage lending guidance for Australian banks. These changes have successfully reduced the investor share of new loans for housing. However, tackling lending excesses indirectly through regulation is second best to reforming the tax concessions that created the excesses in the first place.

Of course, there are other distortions in how we tax savings. Ergas argues that we should have spent more time questioning the wisdom of the longstanding policy not to tax capital gains on the family home. Our report does note this issue, but given the complex policy issues, puts it aside for another day. We set out to write a report on negative gearing and the capital gains tax discount, not a comprehensive review of the tax system.

So our case for restricting negative gearing and cutting the capital gains tax discount stands: there is no inviolate principle supporting the current arrangements; they distort where people invest; and they impose higher economic costs than the alternatives. We look forward to more carefully reasoned public debate about the topic.