Published by The Sydney Morning Herald, Tuesday 17 March

Negative gearing is an untouchable of Australian tax policy. It survives because of persistent myths that it improves housing availability and reduces rents. It survives because 1.2 million taxpayers – mostly voters – use it to minimise their tax.

But negative gearing is expensive, inefficient, inequitable, and it reduces home ownership. For governments under severe budgetary pressure it should be near the top of the reform list.

Negative gearing allows tax payers to subtract the losses they make on investments from their taxable wage income. Of course, it only makes sense to lose on the running costs of an investment if you ultimately make a capital gain. The strategy is attractive because taxpayers can deduct the full amount of interest payments, but only pay tax on half of any capital gains.

More than 1.2 million Australian taxpayers own a negatively geared property, and they claimed $14 billion in net losses in 2011-12. The number of negatively geared individuals doubled in the 10 years after the capital gains tax discount was introduced in 1999, and they now cost the Commonwealth budget at least $4 billion a year.

Some claim that negative gearing encourages more homes to be built. If so, it is a very inefficient way to do it. Only 5 per cent of negatively geared properties are new homes; the rest are existing properties. Because negative gearing increases the price of homes it may encourage a little more building. But the big restraint on new building is not a lack of profitability in housing, but the availability of land and the vagaries of our planning systems.

Like most tax concessions on investment, negative gearing is biased to the wealthy. Most people with negatively geared residential property are in the top 40 per cent of income earners. The top 2 per cent of income earners claim half of all capital gains.

The most important argument against negative gearing is that it drives up house prices because it increases the after-tax returns to housing investors, and so prices are higher than they would be otherwise. This helps existing home-owners but accelerates falling rates of home ownership among younger age groups.

The belief that negative gearing keeps rents low seems to be a folk memory from when the Hawke Government temporarily abolished negative gearing in the 1980s. Rents rose rapidly in Sydney and Perth. But rents were stable in Melbourne and Brisbane and the rate of growth fell in Adelaide. In Sydney and Perth population growth and insufficient new housing, not tax policy, were pushing up rents. Economic theory predicts that abolishing negative gearing shouldn’t change rents. Every time an investor sells a property to a renter, there is one less rental property, and one less renter – in other words, no change to the balance between supply and demand of rental properties.

The best way to both reduce housing market distortions and lower the budgetary costs of negative gearing would be to remove the capital gains tax discount. This could net the Commonwealth up to $5 billion a year in extra revenue, while removing an incentive for house price speculation.

But if policy makers are unwilling to reform capital gains tax, reforming negative gearing would be a good alternative. The simplest mechanism, adopted by many countries, would be to allow investors to write off their losses only against capital gains. In the short term, the government would collect up to $4 billion in extra taxes from individuals, although this would fall to about $2 billion over time as taxpayers start to use their accumulated losses to reduce the tax payable on their capital gains.

Moving to limit negative gearing concessions will not be popular. More than a million taxpayers have structured their affairs to benefit from these concessions. But governments should resist the temptation to grandfather existing arrangements. This will only make the system more complex, discourage property sales, and entrench the advantages of taxpayers wealthy enough to already own an investment property.

Some transition is needed to reduce the risk of a rapid drop in house prices as investors rearrange their portfolios. It would be sensible to phase in the changes over five years so that investors could claim 80 per cent of losses in the first year, 60 per cent in the second, and so on.

Myths and taxpayer popularity are not good reasons to maintain expensive, inefficient, and inequitable tax arrangements that push home ownership further out of reach for young people. Negative gearing is a sacred cow that should be ritually slaughtered sooner rather than later.