Negative gearing isn’t the cause of our housing crisis, so curbing it isn’t the solution

In light of reports the Albanese government may curb negative gearing and capital gains tax concessions, it’s worth reflecting on the problem we are trying to solve. This is especially true given negative gearing is among the most misunderstood features of our tax system. It is widely perceived as a tax rort that has blown up our housing market. The objective truth is it is nothing of the sort.

So what is the problem?

Negative gearing can be a gambleCredit: Simon Letch

In addition to taxing wages, governments also tax investment returns. Most cash returns are taxed at the same rate as wages — this includes interest and dividend income or rent from an investment property.

Some returns are taxed less — for instance, super returns are taxed at 15 per cent. And the return we receive because an investment rises in value (the capital gain) is also taxed at a lower rate — for most investments, at half the rate on wages. And we pay no tax at all on the capital gain on the family home. And on it goes.

What should be clear is that the tax you pay depends wildly on how you choose to invest. On the face of it, this is bad policy, distorting investment decisions, raising the prices of some assets and lowering others — ultimately resulting in too little of some assets, and too much of others. And I’m yet even to mention negative gearing! This is revealing of the role negative gearing plays in the dysfunction of our tax system (spoiler: not much, if any).

To understand the role negative gearing plays, we need to understand two basic principles of good tax design.

The first is the deductibility of costs. A “neutral” tax on an investment (one that doesn’t distort investment) allows deductions for costs. For example, a business can deduct the wages it pays. If it were denied this, then it would be less likely to hire employees, which is clearly bad.

The same principle applies to housing. A property investor should be able to deduct the cost of their investment, including interest. If that were denied, then a variety of negative consequences would result, such as fewer houses being built, less land being developed, less physical investment being put into the property, etc.

The second principle is refundability. A “neutral” tax system works as follows. If an investment makes a return with a tax liability of $100, then the investor should pay the government $100. But if an investment generates a loss of the same size, then the government should pay the investor $100.

The alternative is to honour the refunds owed on these losses only in the future when the investment generates a return and thus a tax bill against which the loss can be credited. But this is like imposing a whole other tax on the investor — the money they are owed should be in their hands earning a return for them.

So how do our property investment tax arrangements work?

Any rent received is taxed at the same rate as wages. And interest and other expenses are deducted from that rental income. If the expenses are higher than the income, then there is a loss with an associated tax refund due.

Ideally, this would be refunded to the investor. But this is not what happens. Instead, only if the investor has a separate income tax liability, say from wages, will the money they are owed be credited back to them, offsetting that tax liability.

This is all negative gearing is. Properly understood, it is perfectly reasonable. But there is a different problem. And it’s that property investment also generates a capital gain when house prices rise. And, as noted earlier, capital gains are taxed at half the rate that applies to wages. And therein lies the problem.

When you invest in a house, your expenses are deducted at your marginal rate (up to 47 per cent), and while rent gets taxed at that rate, the capital gain is taxed at only half. That is, our tax system treats the upside and downside of property investment wildly differently, distorting investment in favour of property. That’s clearly bad.

But it has nothing to do with negative gearing. Attempting to curb the actual problem we face by curbing negative gearing would only move the tax system further away from how we want it to function, which is not to distort investment.

Instead, the appropriate solution is to apply the same tax rate to all forms of investment income and deductions, and for any net tax liability to then be creditable against other taxes owed. This is how taxes work in the Nordic countries, and represents the kind of principled improvement to our tax system we actually need.

It would be a tax reform worthy of Hawke and Keating, or Howard and Costello. Rather than the unprincipled hacks I fear may be coming down the pike.

Steven Hamilton is assistant professor of economics at the George Washington University in Washington, DC, and visiting fellow at the Tax and Transfer Policy Institute at the ANU.