FEATURE UNTANGLING THE DEBATE OVER NEGATIVE GEARING There are more desirable ways to improve housing affordability than proposed changes to negative gearing, argues Gene Tunny n the lead-up to the 2016 federal election What is negative gearing? campaign, Prime Minister Malcolm Turnbull Negative gearing is when a taxpayer uses declared compared the Labor Opposition’s proposed losses from a rental property (or multiple properties) changes to negative gearing and capital gains tax to reduce their taxable income, including wage Ito a ‘big sledgehammer’ being taken to the property and salary income, thus receiving a reduction in market. The Opposition has proposed that negative taxes paid. Negative gearing is allowed in Australia, gearing—whereby losses on investment properties New Zealand and Sweden but is subject to a range can be deducted from other income for taxation of restrictions in the US and the UK, where rental purposes—should be restricted to new properties losses cannot be used to offset labour income.3 Such and that the discount on capital gains income be cut restrictions are generally seen as integrity measures from 50% to 25%.1 aimed at reducing tax evasion. The PM claimed that the proposed policy In Australia, a taxpayer is able to deduct a variety changes would have a major adverse impact on of rental expenses from their total income—in property prices. While Labor’s policy is motivated addition to interest payments on a loan used to by a desire to improve housing affordability, it would finance the property—including, among others, be politically unfavourable for the party if its policy depreciation, repairs and maintenance, utility did result in a large fall in property prices. Hence, bills, rates, insurance, management fees and (until Shadow Treasurer Chris Bowen has since seized on recently) travel expenses. advice from the Australian Treasury, released in early Assuming legitimate deductions 2018 under Freedom of Information (FOI), which are claimed and depreciation is appeared to contradict the PM, noting that Treasury accurately calculated, an investor referred to ‘a relatively modest downward impact on is still losing money on a rental property prices.’ 2 property in each year it is negatively The debate over negative gearing will no doubt geared, but the size of the loss is continue up until the next election in 2019, so it is reduced by being able to reduce important to assess where the truth lies. In this article, I argue that negative gearing is a logical feature of the tax system. Proposals to radically change it are Gene Tunny is the Principal of Adept Economics and misguided and will likely have adverse impacts on is a former Australian Treasury official. This article is the property market. Studies that purport to show partly based on a report he prepared in June 2016 for Walshs Financial Planning. The views expressed should large benefits from restricting or abolishing negative not necessarily be attributed to Walshs, and any errors gearing have major flaws and should not be used in or omissions are the author’s own. the policy debate. 8 POLICY • Vol. 34 No. 1 • Autumn 2018 GENE TUNNY total taxable income and receive a tax saving.4 What 2014-15, down around 7 percentage points from can make negative gearing pay off eventually is net the peak in 2007-08. To a substantial degree, this rental income, if and when a property becomes decline has been related to lower interest rates and positively geared, and the capital gain that is hence lower deductions for interest payments. ultimately realised on the property. According to ATO data, total net rent has Negative gearing has been a major topic of debate improved substantially in recent years, from -$8.4 in Australia for years now. Concerns about negative billion in 2011-12 to -$3.6 billion in 2014-15 gearing grew in the 2000s in line with the increase (Chart 2). This is most likely due to lower interest in the number of landlords in general—which grew rates and reductions in deductible interest payments. at more than twice the rate of population growth— Total declared rental losses fell from a peak of and negatively-geared landlords in particular (Chart $14.6 billion in 2011-12 to $11.1 billion in 2014- 1). While 51% of landlords declared net rental losses 15. The average rental loss has fallen from around in 1998-99, the share peaked at 69% in 2007-08. $11,000 to around $8,700 over this period. Given This upward trend in negatively-geared landlords recent restrictions on some deductions, discussed may have been driven by: in the next section, it is possible total rental losses will continue to fall. These recent trends mean the a) changes to capital gains tax in 1999-2000 potential revenue increase from the Opposition’s when a 50% discount on capital gains for policy, an estimated $32 billion over ten years, is taxation was adopted, replacing the previous likely reduced. inflation-adjustment of the cost-base method; b) greater availability of finance for investors, Rationale for negative gearing including interest-only loans; and Negative gearing is a logical feature of the tax c) an increase in mortgage interest rates of system, as it leads to consistent treatment of debt around 2 percentage points from 1998-99 to and equity regarding the financing of investments, 2007-08. a point made in 2015 by the Australian Treasury.5 After all, if an investor were to use additional equity After strong increases over the 2000s in the to purchase a property rather than debt, they would number of negatively-geared landlords and net forgo a rate of return on that equity and hence rental losses, there appears to have been a levelling would pay less in taxes. Negative gearing is not a off in negatively-geared landlords and substantial tax concession as such, and for this reason is not reductions in rental losses in recent years. The share included in the Treasury’s annual Tax Expenditure of landlords who are negatively geared was 62% in Statement. Chart 1. Landlords by net rental profit status Chart 2. Landlords by net rental profit status Source: ATO Taxation Statistics. Note: the number of landlords declaring a profit reported in the chart also includes a relatively small number of landlords who Source: ATO Taxation Statistics. Note: the number of landlords declaring a profit declare zero net rent. reported in the chart also includes a relatively small number of landlords who declare zero net rent. POLICY • Vol. 34 No. 1 • Autumn 2018 9 UNTANGLING THE DEBATE OVER NEGATIVE GEARING Given that a person’s income for tax purposes— ‘While negatively geared investors do typically have and the marginal tax rate they are liable to pay—is larger incomes it is also true that their spread of built up by adding up income from different sources, incomes covers low, middle and high incomes.’11 generally wage and salary income but also income Using ATO data, Phillips estimated that around from businesses and investments, it is natural that 25% of negatively geared investors are in the five deductible expenses are built up in the same way. lowest family income deciles.12 Negative gearing does not unfairly advantage While negative gearing is logical from a tax policy investors relative to people who only own an owner- perspective, and is not unfair, the Treasury does need occupied property, for which there is no deduction to be mindful of potential abuse of negative gearing of mortgage interest payments available. Economic through inappropriately claiming deductions. This theory and empirical evidence suggest owning your is why the 2017-18 Budget introduced changes to own home in Australia is very tax effective and a the deductibility of some items in rental properties, person should typically prefer an owner-occupied saving the government $800 million over the next property to ‘rentvesting’, whereby they rent their three financial years. Specifically, the ATO will place of residence and buy an investment property.6 no longer allow deductions for travel expenses The advantage of owner occupation comes through associated with inspecting and maintaining rental the implicit rental income of the property you live properties or collecting rent from tenants; nor in being exempt from taxation and capital gains on for depreciation of plant and equipment (e.g. the property also being exempt. dishwashers, ceiling fans) that were already in place Critics of negative gearing often note that when the property was purchased. negative gearing is disproportionately undertaken Although such integrity measures may result in by high-income earners. The Grattan Institute inefficiency by reducing the returns to large numbers has observed that ‘the top 10% of income earners of investors who were not claiming inappropriate before rental deductions receive almost 50% of the deductions, implementing such measures to prevent tax benefits of negative gearing.’7 It is misleading, abuses is a better approach than abolishing negative however to refer to tax benefits. As noted above, gearing entirely. negative gearing means an investor loses less money than they otherwise would because they are able to The impacts of negative gearing deduct expenses associated with earning that income. It is uncontroversial that negative gearing increases This is not illogical or improper. Furthermore, the house prices and lowers rents relative to what observation that the top 10% disproportionately they otherwise would be, as it increases the post- negatively gear is hardly surprising, given they tax return to investors in rental properties. So if are more likely to own investment properties and negative gearing were removed, prices would fall indeed multiple properties in many cases. The and rents would increase (relative to what they top 10% also pay around half of all income tax in otherwise would have been), and some households Australia.8 So it is unsurprising and not inequitable that previously rented may now find it economic to that the top 10% should receive around half of become owner occupiers.