Why negative gearing has ground down every politician who tries it

In the United States, political leaders describe any move to change social security as the “third rail” – touch the subway line carrying electricity to passing trains and, electorally, you’re fried.

Australia’s third rail is negative gearing, which has claimed a variety of treasurers, opposition leaders and even prime ministers who have even canvassed changing a tax arrangement that is given near magical qualities by its supporters while being described by detractors as a blight on the tax system and property market.

Prime Minister Anthony Albanese and Treasurer Jim Chalmers may find themselves in the same predicament as Paul Keating, Joe Hockey, Scott Morrison and Bill Shorten, after revelations in this masthead of Treasury modelling of changes to negative gearing rules.

Negative gearing and capital gains tax … a problem for a succession of prime ministers, opposition leaders and treasurers.Credit:

At the heart of their issue is one long-standing feature of Australia’s rental property system and a more recent tax concession that promised billions for business but turned into a boon for property speculators.

Landlords can claim deductions for everything from mortgage interest to the cost of cleaners against the rent on their properties.

Losses, under a feature introduced by the Lyons government in 1936 to boost the nation’s housing supply, were able to be claimed against a landlord’s income from any source. Those people who happened to lose money were negatively geared.

It had no immediate impact, but after World War II the country went on a home-building binge – although much of that was due to government housing construction rather than private sector rentals.

By 1985, the Australian tax system was creaking under distortions that meant ordinary taxpayers carried the federal budget. Keating undertook what remains the broadest overhaul of the system and introduced a capital gains tax. He also ended the ability of landlords to claim interest deductions against their tax, in effect ending negative gearing in its then form.

Negative gearing supporters, led by the city’s influential property lobby and Sydney Labor MPs whose constituents argued Keating’s tax change was the reason for soaring rents across the city, rebelled. By 1987, Keating backed down and restored negative gearing to its 1936 version.

A mythology around negative gearing emerged from those events. For a nationwide policy, its impact seemed indiscriminate. Rents lifted in Sydney (which was going through a population surge) and Perth, where vacancy rates were between 1 and 2 per cent, but fell in Melbourne, Brisbane, Adelaide, Canberra and Hobart.

At the same time, the Reserve Bank aggressively lifted interest rates.

Keating’s capital gains tax (and fringe benefits tax) helped pay for major changes to personal income tax, including a cut in the top rate from 60¢ in the dollar to 49¢.

Labor’s capital gains tax system indexed the cost of an asset to inflation to ensure that the part of a capital gain due solely to inflation was not taxed.

In 1999, then-treasurer Peter Costello received the Ralph review into business taxation. It argued a more generous capital gains tax arrangement would encourage investors to sink their cash into Australian businesses and make them more productive.

The proposal was to halve capital gains tax on all investments – such as shares – if owned for at least 12 months. Neither the inquiry nor the Ralph report worried that the new concession would suck cash into the property market. But that is exactly what happened.

Ahead of the change, the nation’s landlords were evenly split between those who lost money (negatively geared) and those who turned a profit (positively geared).

By 2003-04, about 60 per cent of landlords were negatively geared. By 2008-09 the proportion had reached 68 per cent.

Despite this increase in loss-making landlords, there was no commensurate surge in the number of new homes. First-time buyers found themselves being outbid by negatively geared investors for existing properties.

During COVID-19, the balance between negatively and positively geared landlords returned, but this was solely due to the collapse in official interest rates. The imbalance will return due to the increase in the cash rate from May 2022.

The intersection of negative gearing with the capital gains tax concession, while not the driving force of the 30-year surge in property prices, certainly failed to bring it to heel.

Sydney’s median house price was $272,500 before 1999’s capital gains tax changes. Today it is $1.5 million. If it had kept track with inflation, the median price would be about $540,000.

Tax experts and economists quickly became aware of the problems caused by the tax situation.

The 2009 Henry tax review argued the concession had failed to channel money into businesses while increasing risk across the economy.

“The existing tax system is also likely to encourage excessive leveraging in pursuit of tax-preferred income. Where capital inflow is used to finance less productive assets, this can also affect long-term macroeconomic stability,” it argued.

It advocated the introduction of a 40 per cent discount on all net rental income and losses plus capital gains.

“Savings would be allocated more productively, distortions to rental property and other markets would be reduced, and household investment and financing choices would better suit their circumstances and risk preferences,” it found.

The Reserve Bank was also worried. Its concerns went not specifically to housing prices, but that the tax system could become a threat to the financial system.

Internal documents relating to the bank’s submission to the 2014 Murray review of the financial system revealed its fears that negative gearing and the capital gains tax concession were a dangerous economic cocktail.

The policy mix “could encourage leveraged and speculative investment in housing” and lead to investors “bidding up housing prices”.

“Any change which discourages negative gearing may be a good thing from a financial stability perspective,” it bluntly noted.

The Reserve Bank canvassed capping the interest that could be claimed as a tax deduction under negative gearing and reducing the capital gains tax concession.

In his final speech to parliament in 2015, former treasurer Hockey backed negative gearing reform as part of a broader overhaul of the tax system to enable a cut in the top personal marginal rate to 40 per cent.

“Negative gearing should be skewed towards new housing so that there is an incentive to add to the housing stock rather than an incentive to speculate on existing property,” he said.

Bill Shorten and wife Chloe on the night of the 2019 election. Labor’s negative gearing and capital gains tax policies were critical issues.Credit: Alex Ellinghausen

Former Labor leader Shorten would go to the 2016 and 2019 elections with plans to restrict negative gearing to new homes while cutting the capital gains tax concession.

As treasurer, Morrison would concede there were “excesses” around negative gearing, with his department looking at possible changes, but he and then-prime minister Malcolm Turnbull would decide to target Shorten’s proposals.

Proponents of negative gearing argue it spurs new home construction. Albanese said his biggest concern was that any changes could reduce housing supply.

But independent economist Saul Eslake said since the United States abolished its version of negative gearing in 1986, rental vacancy rates had averaged 8 per cent and never been below 5.6 per cent.

Australia’s rental vacancy rate has averaged 2.6 per cent since the mid-1980s and has never been higher than 4.4 per cent.

“So much for the proposition that negative gearing is ‘essential’ to ensure an adequate supply of rental housing,” he notes.

Apart from the tax benefit, negatively geared investors hope their concessionally taxed capital gain will more than offset accumulated losses.

But research last year by property service companies LongView and PEXA revealed for most landlords, the dream of a fantastic capital gain is just that – a dream.

Between 1990 and 2020, they found an after-tax median rate of return of about 6.5 per cent. Superannuation funds, by contrast, averaged 7.4 per cent over the same period.

In other words, rather than dealing with estate agents, tenants and broken dishwashers, most negatively geared landlords would be better off sinking cash into super.

Another issue is that Australia has too many individual landlords and few for-profit or non-profits that own and manage properties.

As long-term renters know, the quality of landlords and estate agents can vary wildly. As the LongView and PEXA research noted, “Australia is unusually bad for renters”, with problems in everything from owning a pet to getting a landlord to clean mould from a kitchen.

Independent economist and former Housing Industry Association chief economist Harley Dale noted that while most involved in negative gearing were high-income earners, it had become an aspiration for many others.

“The nature of negative gearing policy is that it favours higher income earners, but along the way since the mid-1980s, middle Australia developed a different view. They view it as a one-to-two-home investment for their children’s future,” he said.

Eslake said claims that supply would collapse due to changes to negative gearing did not stand up to scrutiny as investors were actually creating additional demand by outbidding a prospective owner-occupier.

“While scaling back negative gearing almost certainly will reduce the supply of rental housing, it will reduce the demand for rental housing by exactly the same amount,” he said.

“In fact, if negative gearing is abolished or scaled back for investors in established housing but retained for new housing, it is plausible that there would actually be an increase in investment in new rental housing.”

No matter the economic arguments around negative gearing and capital gains tax, the issue remains mired in politics. Something Albanese and Chalmers are discovering, just like their political predecessors.

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