There are 7 billion positive reasons why negative gearing needs to change

Negative gearing is back in the news. But reports that Treasury is modelling changes shouldn’t be a surprise, or something the government feels it needs to hide. The government and the bureaucracy should always be looking at economic reform opportunities, including how to improve our tax system.

Australia’s negative gearing rules (which allow people who borrow to invest in housing and use their losses to reduce tax on wages and salaries) are neither natural nor sacred. They go beyond the broadly accepted principle of offsetting investment losses against investment gains.

Just 18 per cent of lending to housing investors was for the construction of dwellings or for newly built dwellings.Credit: Louie Douvis

And the discount on capital gains tax that operates alongside negative gearing is only 25 years old. In fact, the number of Australians with negatively geared residential property investments only took off when the capital gains discount was changed in 1999 from taxing all real gains to taxing half of nominal gains.

These tax concessions – which are a form of expenditure from the public purse – now cost Australians billions of dollars each year. We should be asking if that is money well spent. What policy purpose are these measures serving and how well are they doing it?

The interaction of the capital gains tax discount and broad negative gearing rules have a peculiar effect on housing in Australia, encouraging speculative investment in housing rather than other forms of investment.

If the policy objective is to boost housing, these tax concessions aren’t great policy. They are an inefficient way of supporting the rental market and do little to support new housing development. Over the 12 months to July, just 18 per cent of the $122 billion in lending to housing investors was for the construction of dwellings or for newly built dwellings, whereas 75 per cent of lending was for the purchase of established dwellings.

Australia’s tax treatment of negative gearing is more generous than most comparable countries’. In the US and the UK, rental property expenses cannot be deducted against unrelated wage and salary income. In Canada, only cash expenses can be deducted against rental income, not depreciation expenses.

Australia’s taxes on capital gains are also more concessional than in many other OECD countries, although we are less of an outlier than in our approach to negative gearing.

Grattan Institute has long advocated for the federal government to curb negative gearing and reduce the capital gains tax discount. The government should limit negative gearing by not allowing losses on passive investments to be written off against unrelated labour income (wages and salaries).

But losses on passive investment should still be allowed to be written off against all current-year and future positive investment income, including interest, rental income, and capital gains. The 50 per cent capital gains tax discount for individuals and trusts should be reduced to 25 per cent.

Both changes should be phased in over five years. The proportion of losses that can be written off against wages should be reduced by 20 percentage points each year. And the value of the capital gains tax discount should be reduced by 5 percentage points each year.

Using so-called grandfathering arrangements – allowing existing investors to keep their tax benefits – is an alternative approach. But it creates other problems, particularly for changes to capital gains tax. Grandfathering any changes exacerbates intergenerational inequality, and it would also discourage people who hold a property under the prior, more generous, tax rules from selling.

In our view, limiting negative gearing and reducing the capital gains tax discount is better understood as good tax reform, rather than a focus for housing policy.

We estimate that our proposed changes to negative gearing would be worth at least $2 billion a year in revenue, and the reduction in the capital gains tax discount would be worth about $5 billion a year. Curbing these “leakages” would broaden the income tax base and, over time, reduce our reliance on bracket creep to do the heavy lifting on budget repair.

Cutting back on poorly justified tax expenditures would help to close the government’s structural budget deficit, which is currently about 1 to 1.5 per cent of GDP, and it would make our tax system more equitable.

Our proposed changes would also have some positive impact on the housing market. Our modelling suggests property prices might fall by about 2 per cent. This is a minuscule effect when prices have risen by about 50 per cent over the past five years. But these changes would help more renters to become home owners because they would be bidding against fewer investors at auctions. Modelling of similar reforms to our proposal suggests the home ownership rate would rise from 67 per cent to 70 per cent.

Curbing negative gearing and CGT discounts is not radical. These are exactly the type of sensible reforms that ought to be on the table ahead of the next federal election.

Dr Aruna Sathanapally is chief executive of the Grattan Institute; Trent Wiltshire is deputy director of the institute’s economic prosperity program.