27
Apr
2016

Sorry Malcolm, you are wrong on negative gearing

by John Daley


Published by Australian Financial Review, Wednesday 27 April

The Prime Minister, Malcolm Turnbull, yesterday wrote a detailed blogpost in reply to our report, Hot property: negative gearing and capital gains tax reform. It’s good that a Prime Minister engages with the detail of policy argument rather than responding with slogans. But none of his criticisms stick.

GENERALLY ACCEPTED PRINCIPLES

First, he argues that negative gearing is part of generally accepted principles for offsetting losses against gains. Negative gearing has indeed been permitted in Australia for over a century. But this “generally accepted principle” is not accepted in most developed countries, and it is far from being universally applied in our own tax and welfare system.

As our report documents, we could find no developed country save for New Zealand that allows taxpayers to deduct the interest costs of investment from their wage and salary income. And Australia imposes tight limits on claiming the losses from a business against labour income, as the Prime Minister notes. Losses from investment are also not counted when assessing income to determine eligibility for welfare payments.

HOUSING MARKET DISTORTIONS

Second, the Prime Minister argued that Grattan’s report contradicts itself in claiming that tax arrangements significantly distort the housing market, while calculating that changes will only reduce housing prices by about 2 per cent. The explanation is simple: a new tax regime will significantly affect on the mix of investment, but have less impact on the total.

Tax changes would lead to more home ownership, more investment in assets other than property, less investor leverage, and increased tax collections of about $5 billion a year. By themselves, tax changes cannot solve Australia’s problems of housing affordability, high private sector borrowing, and Commonwealth budget deficit. But they would all be steps in the right direction.

FAIRNESS

Third, the Prime Minister is concerned that changes will not be “fair” because they will lead to fewer middle-and-low-income earners borrowing to invest. This might well be true. But tax reform should proceed anyway. Although investors with only one asset will not be able to offset their losses against gains on other assets, overall the reforms will affect high incomes earners far more. The top 10 per cent of taxpayers before rental deductions get half of the benefits of negative gearing. By definition, they make losses on their collective investments. Reform cannot help but create a fairer system. And there will remain plenty of ways for low-income earners to invest without negatively gearing property.

CAPITAL GAINS DISCOUNT

Fourth, the Prime Minister is concerned that reducing the capital gains tax discount to 25 per cent would give Australia a high capital gains tax rate relative to comparable countries. He claims this would have “harmful impacts”. We don’t know what evidence he has in mind. But a substantial body of literature, including an OECD report, finds that tax rates have little impact on how much people on high incomes invest.

Even the government’s own Re:think paper on tax reform says that while “low-income individuals may respond to tax incentives with new saving, high-income individuals are more likely to divert savings to more tax-preferred savings”. It concludes that, “although taxes may affect the allocation of savings, they are unlikely to affect significantly the overall level of investment in the economy”.

CHOOSING ASSUMPTIONS

Fifth, the Prime Minister is concerned that with a reduced discount, the effective tax rate on real capital gains would be close to 70 per cent. This is an issue that our report works through in detail, and it all depends on what assumptions you make, bearing in mind that tax is not paid on capital gains until the asset is sold.

Under a capital gains discount of 25 per cent, as we propose, and with inflation at 2.5 per cent, an asset held for fifteen years with a 3 per cent nominal income return and 4 per cent capital return would pay a real effective tax rate of about 55 per cent if the taxpayer is one of the 3 per cent of Australians on the top marginal rate.

The effective tax rate would be much lower if capital growth is higher than 4 per cent – and capital growth on Australian property has averaged 7 per cent over the last 15 years (a table at the back of our report enables readers to mix and match assumptions).

INCREASED TAXES?

Finally, the Prime Minister is concerned that removing negative gearing would increase the effective income tax rate for wage and salary earners, reducing the incentives to work. But using negative gearing seems a strange way to solve this problem. Why would we try to reduce marginal income tax rates, but only for the minority of workers who happen to invest? What’s more, income tax rates need to be higher across the board to pay for the tax break we provide to one in 10 taxpayers.

The Prime Minister then uses our calculations to argue that removing negative gearing would reduce gross rental income by about 10 per cent. But he is looking at gross rental returns, which is the wrong number. Investors worry about their return after tax, including their capital gain. This return will fall by less.

Having made this error, the Prime Minister then simply asserts that this change in returns will increase rents. No study of the real world has ever found tax changes with this impact. Instead, in markets where property development is limited by planning permissions, changes in returns typically reduce property prices. Again, this is an issue that our report works through in detail. Nor is it plausible to claim, as the Prime Minister does, that the removal of negative gearing caused rental crises in the UK and US. Any number of countries that do not allow negative gearing have functional rental markets.

Engaging in detailed argument ultimately leads to better policy. We look forward to the Prime Minister arguing back – and maybe even changing his mind.