Labor’s tax policy is courageous
Published by The Age, Tuesday 16 February
Credit where credit is due. Tax reform is always politically difficult. The losers always yell louder than any winners. So it’s unusual for a government, let alone an opposition, to embrace bold changes to the tax system. But that’s what Labor has done with its proposed changes to capital gains tax and negative gearing.
Labor has most of the policy fundamentals right.
As they stand, negative gearing and the capital gains tax discount are expensive, inefficient and unfair. These concessions have increased speculative activity in housing and reduced home ownership.
Negative gearing allows taxpayers to subtract the losses they make on investments (after costs including mortgage interest payments) from the taxes on their wage income. Negative gearing can be used for all types of investments, but is most commonly used for property. Of course, it only makes sense to lose on the running costs of an investment if you ultimately make a capital gain. But there are also tax advantages: taxpayers deduct the full amount of losses each year, but the 50 per cent capital gains tax discount means they only pay tax on half of any capital gains when they sell the asset.
An investor can use these tax concessions to avoid paying their fair share of income tax. Indeed, with the right investment strategy, a high-income earner can pay no tax on their investment profits and less tax on their income than if they had never purchased an investment property.
In order to get the biggest tax benefits, investors choose assets that pay more in the way of capital gains and less in terms of steady income. They also try to borrow as much as possible to invest. This all leads to the kind of leveraged and speculative investment we see in the Sydney property boom. Rapidly growing house prices benefit existing homeowners but accelerate falling rates of home ownership among younger age groups.
The property industry’s main argument against pulling up stumps on this rort is that “middle Australia” will lose out. But despite all the talk of nurses and police officers using negative gearing, our analysis shows the take-up is much greater (and the tax benefits much larger) among lawyers, finance managers, surgeons and anaesthetists.
This is also consistent with our broader analysis that suggests taxpayers with incomes over $80,000 – the top 20 per cent of income earners – claim almost 70 per cent of the tax benefits of negative gearing. And taxpayers with incomes of more than $80,000 capture 75 per cent of the capital gains.
If we really care about low and middle-income earners, the reducing income tax rates would be much fairer than allowing these overly generous tax concessions to remain in place.
So what is Labor proposing?
First, it will reduce the capital gains tax discount for individuals from 50 per cent to 25 per cent for investments held for more than one year. This would be a significant improvement in terms of economic efficiency and fairness.
The rationale for providing any discount for capital gains is to avoid taxing the component of asset returns that compensate investors for increases in prices. But 50 per cent discount overcompensates for the effects of inflation, particularly once you take into account the other tax benefits of capital gains: the ability to defer paying tax until you choose to sell the asset. And reducing the discount would reduce the tax bias towards more speculative investments and away from steady income sources such as rental income or bank interest that receive no adjustment for the effects of inflation.
Second, Labor proposes limiting negative gearing. Investors will no longer be able to deduct rental losses against their wage and salary income. But losses will be able to be carried forward and written off against other forms of investment income, including the capital gain from selling the asset. This is a sensible change that will continue to provide support for those wanting to borrow to make investments while reducing the incentive to do this just for the tax benefit.
Unsurprisingly with such a difficult change, Labor has made some concessions to political expediency.
Labor will grandfather the changes so that assets already purchased will continue to enjoy the existing tax concessions. Grandfathering will soften resistance to the reforms, but makes the system more complex and reduces the boost to the budget bottom line for the first few years.
And negative gearing will continue to be available for new properties. This should (but probably won’t) silence the cries from the property industry that the policy will restrict new housing supply. Fortunately, because investment in new property is only a small fraction of total property investment, the cost to the budget and the economy from this special treatment should not be large.
While we might quibble with the transition arrangements, Labor’s policy will still make a meaningful contribution to structural budget repair. The Parliamentary Budget Office estimates it could raise an addition $32 billion over the next decade. It will also increase rates of home ownership, reduce distortions in the investment market, and lead to tax system outcomes that match more closely the progressivity implied by income tax rates.
The Labor party should be commended for bringing bold policy change to the table. It remains to be seen whether the government will show similar courage and follow suit.