Discussion of gearing turns negative

The tax discussion table was quite large for a while. But the table is rapidly shrinking, with many issues now ruled out, most particularly a GST increase. Everyone is now scratching around for how else to fund tax cuts, which are clearly needed (see the arguments by the Centre for Independent Studies and the Government).

Negative gearing is now one of the few things left behind on the table.

The ALP has beat the Coalition to the punch, proposing a policy to quarantine negative gearing losses from established properties, while still permitting it for new properties.

There are several concerns with this proposal. First, it interferes with a core part of tax policy: expenses from earning income are deductible. However, there are already exceptions to this rule: capital losses aren’t able to be offset against other income, but must be carried forward. The ALP’s policy copies this approach to negative gearing. A second problem is that limiting tax deductions for interest payments ignores the fact that Australian banks will have to pay tax on interest they receive from investors.

A third problem is that investors will rush to buy properties before the start date of July 2017. A supposed concern, excessive purchases of housing by investors, will actually be made worse before the policy starts. Fourth, after the start date, investors who can negatively gear will be reluctant to sell, reducing market turnover. Fifth, once the policy is in place, existing houses are likely to be a bit cheaper which will be harmful to existing owners. Sixth, it will cause perhaps large increases in the price of new dwellings — an unwarranted windfall to developers, perhaps?

The overall impact on housing prices is unclear: while new dwellings probably increase in price, old ones will probably fall (this is an issue that confused the Assistant Treasurer on Wednesday).

There are a few irrelevant arguments in this debate: the ALP’s argument that negative gearing is massively skewed towards the rich; and the arguments of opponents that lots of nurses and police use negative gearing. This information shouldn’t determine tax policy. The impact on rents, while interesting, should also not be a major consideration.

Negative gearing is also affected by the so-called discount on capital gains taxation (CGT) of 50%. This is because the yearly losses as a result of negative gearing are offset by capital gains when an asset is sold.

It is often assumed that the CGT discount is concessional. However, the truth is more complicated. Looking at capital gains after both tax and inflation, the CGT discount actually means an asset is overtaxed if it has a capital gain less than twice the rate of inflation — ie around 4 to 6%. The asset is concessionally taxed only if capital gains are more than 4 to 6%.

Therefore, investing in growth assets (and engaging in negative gearing) is really worthwhile only if the asset’s capital gains are likely to be higher than 4-6% per year.

An alternate way of taxing capital gains existed before 1999, namely indexation, where only the real value of gains are taxed. The different effective tax rates for the two alternate tax systems are shown in the graph below for a taxpayer on the 32.5% tax rate, assuming inflation of 2% (which is around the current inflation rate).

The overtaxation problem highlighted in this graph could be fixed if indexation is reintroduced to replace the 50% discount.

However, replacing the discount with indexation would mean capital gains are effectively taxed the same as other income. This would run completely counter to the broad agreement amongst tax policy experts that that income from capital, including capital gains, should be taxed at a lower rate than other income: a lower tax rate will encourage investment which will cause future economic growth. This is an obvious reason to retain some CGT discount, whether or not indexation is reintroduced.

The ALP has proposed a reduction in the CGT discount. This will likely result in a further reduction in negative gearing, because the CGT discount is one driver of this investment strategy. However, the slashing of the CGT discount is likely to result in many more capital assets being overtaxed: in fact, all assets earning less than 8% will be overtaxed, assuming inflation is 2% (see gray line in the graph above).

So at the very least the ALP should be re-introducing indexation if they want to cut the CGT discount. With inflation at 2%, the taxation of assets earning capital gains of up to 8% would actually be lower under a policy of indexation with no discount, compared to the ALP’s policy.

This all suggests that the ALP’s proposals are not ideal; let us hope that the Coalition is using this time while the issues remain on the table to minimise the problems with anything they suggest.

Michael Potter is a Research Fellow in the Economics program at the Centre for Independent Studies