Warning extra long post!
TL/DR – I think negative gearing is a bad policy
On Friday Tom Whitty wrote an opinion piece in The Age expressing frustration about housing affordability, a frustration I share. You can read his article here http://www.theage.com.au/comment/sick-and-tired-of-chasing-dreams-of-finding-a-home-20130404-2h9i4.html.
Among the things he blamed was the policy of negative gearing. I wrote a research paper on negative gearing last semester and I thought it would be an opportune time to post it.
The version I’ve posted below doesn’t include references but of course the version I submitted did. If you’d like to know what my references are, or if you think you have been referenced without proper attribution and aren’t happy about it please let me know.
VERY IMPORTANT – You do not have permission to use this essay (or any part of it) without my prior approval, ESPECIALLY for academic purposes. That is true for all my posts but even more so for this one.
P.S. I’ve got a bit behind with my studies but I’ll be back soon with more posts about source, witholding rules, double tax agreements and more fun international taxation stuff.
Looked at from the perspective of simplicity, equity and efficiency, critically evaluate the entitlement of taxpayers to negatively gear the cost in acquiring assets and particularly immovable assets
This paper evaluates Australia’s relatively generous approach to negative gearing from the perspective of simplicity, equity and efficiency. These three criteria of a good tax system are explained and their interaction explored. Negative gearing itself– its operation, popularity, history and legal basis – is then also explained. This is followed by a critical discussion of negative gearing’s impact on house prices, housing stock and the economy as a whole. This impact is evaluated in terms of the three key criteria, with the author concluding that current arrangements, while simple, are neither equitable nor efficient. Options to improve the system are briefly mentioned.
It’s official – Australia is a nation of loss-making landlords. ATO statistics show that in 2009-10 1,751,679 people (roughly one in seven taxpayers) were property investors. Of those, 62% or 1,110,922 were negatively geared. These figures are higher than almost all other comparable countries on a per-capita basis. This is in no small part due to Australia’s tax system which allows losses to offset income from other sources without restriction. Australia’s approach is almost unique in the OECD in this regard. Virtually every other country – including the United States, United Kingdom, Canada, France, Germany and Japan – deny or restrict negative gearing losses.
Australia’s generous approach has been heavily criticised by many in the academic community. Evans polled 13 academics from legal, economics and accounting backgrounds and found that negative gearing ranked second (behind the CGT discount) as the tax expenditure they most want removed. At the same time, the concession has attained the status of ‘sacred cow’ amongst the rest of the community. Recognising this, Wayne Swan has been at pains to assure people that reform to negative gearing would not be implemented at any stage.
The author is not under the same political constraints as the treasurer. With that in mind, this paper seeks to critically evaluate, from the perspective of simplicity, equity and efficiency, the entitlement of taxpayers to negatively gear immovable assets, particularly residential accommodation. The paper is structured in four unequal parts. The first part examines and explains the terms simplicity, equity and efficiency – frequently cited as the three criteria of a good tax system. The second part examines and explains negative gearing itself. The third and largest part of the paper critically evaluates negative gearing and its impact from the perspective of the aforementioned three criteria. Finally, possible alternatives are briefly mentioned. The author is of the view that negative gearing offends the principles of equity and efficiency and is in need of significant reform.
Part One – An overview of simplicity, equity and efficiency
In order to critically evaluate negative gearing from the perspective of simplicity, equity and efficiency, it is first necessary to consider each principle and their interaction from a theoretical perspective. It will be shown that it is not always possible to satisfy all criteria simultaneously. Having done that, the paper will apply this theory to the case of negative gearing.
The principle of simplicity is not as straightforward as its name would suggest. Generally speaking, a tax is simple if the relevant law can be easily understood and the correct liability accurately determined. Tram-Nam argues that simplicity encompasses three essential elements – clarity, consistency and certainty. Clarity is achieved if the legislation and associated rulings are written in clear language and structured in a logical manner. Legislation is consistent (internally and with other laws) if it deals with similar issues in a similar manner rather than an arbitrary or contradictory fashion. Finally, a taxpayer should be certain of the liability relating to their particular situation.
Complexity is often measured by reference to administration costs on the one hand, and compliance costs on the other. Administration costs focus on government and include processing and scrutinising tax returns, educating taxpayers, issuing rulings and resolving disputes. Compliance costs focus on taxpayers and include the time, money and stress of taxation compliance. Regardless of how one categorises or measures complexity, all agree that the tax system should be kept as simple as possible. This is because complexity can lead to inefficient economic decisions and inadvertent over- or under-payment of tax. It can also lead to mistrust of the system and erode perceptions of its fairness. This mistrust can severely damage the workings of a self-assessment system that relies heavily on the ability and willingness of taxpayers to comply. Of course some degree of complexity is an unavoidable consequence of a developed economy. However, a good tax system is one that limits complexity to levels appropriate for the taxpayer affected.
The principle that a good tax system is fair is a practical as well as moral necessity. A system that is perceived to be inequitable by the tax-paying public is unlikely to enjoy widespread support. However, there are differing views on what is fair. For some, fairness means that taxes collected reflect the benefits received from those taxes. For others, an equitable system is one that rewards, rather than redistributes, earnings from effort and ability. This ‘entitlement to earnings’ perspective can be contrasted with an ‘ability to pay’ approach. This third approach views fairness from a social-equality or needs perspective. The principle of equity is frequently subdivided into horizontal and vertical equity.
Horizontal equity is about treating people in equal positions equally. Difficulty lies in determining whether people are in equal positions. Of course no two people are exactly alike in all respects. Choosing what is relevant is highly contentious and involves challenging judgments. For example, two taxpayers may have similar incomes but dissimilar essential outgoings. They may have spouses with widely differing incomes. They may have the same total income over time, distributed across different periods. A system based on the concept of taxable income is only fair if taxable income is an appropriate measure of a taxpayer’s economic wellbeing.
Vertical equity is about treating people in different positions differently. A tax system is said to be progressive if it imposes a heavier burden as income rises. It is said to be regressive if the opposite is true. Difficulty lies in determining the appropriate degree of unequal treatment. Such questions of distributive justice require particularly challenging social, political and ethical judgments.
Narrowly interpreted, efficiency involves the minimisation of administrative costs. It requires that waste is minimised when transferring resources from the private sector to the public. However, efficiency also encompasses the concept of neutrality. Neutrality seeks to minimise, as far as possible, the influence of the tax system on economic decisions. This approach is based on the presumption that the free market promotes the best use of national resources by allocating them towards their most highly valued uses. By doing so, the market maximises efficiency, taxpayer welfare and long-term economic growth. If, left alone, individuals and businesses will act in a way that maximises growth, an ideal tax system is one that leaves taxpayers alone. Therefore, from the perspective of efficiency, the tax system shouldn’t influence the costs (and therefore attractiveness) of alternate goods, investments or activities. It shouldn’t favour one industry or mode of investment over another. It shouldn’t factor in economic decision making.
Relationship between the three
Efficiency will often concord with horizontal equity but conflict with vertical equity. Both efficiency and horizontal equity hold that a tax should apply equivalent treatment to transactions that, although different in form, achieve the same economic result. Efficiency, because to do so would distort economic activity. Horizontal equity, because to do so would impose different tax liabilities on taxpayers with the same level of economic income.Vertical equity requires those on higher incomes to pay higher amounts of tax. This can limit efficiency as higher taxes may reduce incentives to work, save or consume.
Often, attempts to improve equity come at the expense of simplicity. In pursuit of fairness the tax law may seek to allow for a multitude of differences in people’s individual circumstances. In doing so it is often necessary to make numerous fine distinctions between what is and isn’t liable, leading to voluminous and complicated legislation. Ironically, this complexity is often regressive in its impact, falling most heavily on people least able to access professional help.
In most cases, the principles of efficiency and simplicity can exist in harmony. A system that focuses on economic substance over legal form should be both simple and efficient. If the law is well understood it allows taxpayers to better anticipate the tax consequences of their choices. This certainty should encourage innovation, optimal decision making and measured risk-taking. Furthermore, a simple tax will minimise the diversion of resources away from productive activities and towards tax planning and compliance.
Having explined the concepts of simplicty, equity and efficiency, this paper now turns to the issue of negative gearing.
Part Two – Negative gearing explained
Where an investor partly finances the purchase of an asset by borrowings, that asset is said to be geared. When the level of borrowing is such that interest on the loan is greater than the income generated, the asset is said to be negatively geared. Investors who negatively gear must meet the interest payments from savings or other sources of income. They hope to eventually be compensated for this with a large profit upon sale of the asset. Therefore, negative gearing is only attractive as an investment strategy if property prices are rising. Though data is not yet available, it would not be surprising if the Global Financial Crisis and Australia’s recently stagnant property market have dampened taxpayer enthusiasm for negative gearing.
Negative gearing is often partly motivated by tax considerations. Interest payments are deductible where the asset is used to produce assessable income. These deductions can be used to offset income from all sources, not just the asset it helped finance. Upon sale of the asset, gains or losses will generally be taxed on capital account. Therefore, provided they have been held for longer than 12 months, they will be eligible for the CGT discount. It is these dual benefits of reducing as well as deferring tax that makes negative gearing so attractive from a tax perspective.
It is therefore unsurprising that negative gearing is popular with Australian taxpayers. In 1998-9 Australia had 1.3 million taxpaying landlords who in total made a taxable profit of almost $700m. By 2008-9 the number had risen to 1.7 million and their losses had skyrocketed to $6.5b, largely because interest payments rose almost fourfold. Australia has significantly more landlords per capita than North America and the United Kingdom.
Negative gearing is most popular with wealthier households. Almost 40% of households in the top income quintile take advantage of negative gearing, compared with less than 5% in the lowest income quintile.Negative gearing can benefit all income levels and many Australians who take advantage of the concession are not wealthy. However, analysis of negative gearing shows that the benefits flow disproportionately to high-income households. There are two reasons for this. First, wealthier households have greater ability to carry the rental loss whilst waiting to crystallise the capital gain. Second, because the benefit is in the form of a tax deduction, negative gearing is worth more to taxpayers on higher tax brackets.Negative gearing is therefore vertically inequitable. It is also horizontally inequitable in the sense that taxpayers who use other forms of savings receive less favourable tax treatment.
It should be remembered that negative gearing and the CGT discount can theoretically apply to all forms of income-producing assets. However, residential property has practical advantages that make it better suited to negative gearing than almost all other forms of investment. The level of debt financing that can be obtained for residential property is likely to be higher than for investment in business operations because it provides better security for the lender. The level of access to finance may also be greater than for equities because property is seen to be less volatile, though this point is contended. Furthermore, individual investment in housing will typically gain access to the CGT discount upon disposal, but many business assets (such as depreciating assets and all assets held in a corporate structure) will not. These things suggest that negative gearing causes inefficiencies in Australia’s tax system.
Negative gearing has been subject to judicial scrutiny. Generally, in cases where there is an imbalance between outgoings and assessable income, the courts have been prepared to consider the subjective purpose of the taxpayer in determining whether the outgoings are deductible. Such a situation occurred in Fletcher’s Case. However, it is thought that the application of Fletcher’s case is limited to circumstances involving non-commercial terms or where there is little or no prospect of eventually returning a profit. In Janmor the Commissioner attempted to deny a deduction for interest in excess of the rent received, but the Full Federal Court held that high gearing alone does not deprive interest payments of their deductibility, nor require any deeper enquiry into why the expenditure was incurred. The legitimacy of negative gearing was again confirmed by the High Court in Hart’s case.
The Commissioner now accepts that, ”in the commonly encountered kinds of circumstances where assets are negatively geared, a commonsense or practical weighing of all the factors surrounding the acquisition could be expected to lead to the conclusion that the relevant interest expenses is properly to be characterised as genuinely, and not colourably, incurred in gaining or producing the assessable income”. If there is to be any change to the law on negative gearing, it will require specific legislative amendment.
Such a legislative amendment did occur in the 1980s. In June 1985 a Draft White Paper on ‘Reform of the Australian Tax System’ recommended quarantining measures. To implement its recommendations the government introduced Division 3(G) into the Tax Act. It effectively abolished negative gearing for real estate purchased after 17 July 1985. In introducing the new law Minister Hurford said “the government takes the view that the general taxpaying community should not be obliged effectively to subsidise the acquisition of investments by a particular group of taxpayers in this way. Competition for the purchase of residential property between these investors has been reflected in increased prices, to the detriment of ordinary homebuyers”. However, the provisions were repealed in their entirety less than two years later. Officially, the government referred to “uniformity of tax treatment of interest costs for all types of investment”. Unofficially, an impending federal election likely played a role.
Some have argued that legislative restrictions on negative gearing should be introduced. Having explained negative gearing, this paper now turns to a critical evaluation, from a perspective of simplicity, equity and efficiency, of such arguments.
Part Three – Negative gearing evaluated
Many of the arguments in relation to negative gearing are founded upon two assumptions. Firstly that negative gearing increases house prices and secondly that negative gearing increases housing supply. Because of the critical nature of these assumptions, this paper now considers each of them in turn.
Negative gearing and house prices
Numerous individuals and organisations, from the Australian Council of Social Services (ACOSS) to the Construction Forestry Mining and Energy Union, have claimed that negative gearing increases house prices. The Government also made this claim in 1985 when it introduced legislation to quarantine interest deductions. Negative gearing makes property ownership more attractive to investors than it would be if interest deductions were quarantined. By making property ownership more attractive, negative gearing increases demand for investment properties. If the supply of properties cannot meet this demand, the value of the tax subsidy is capitalised into house prices. CPA Australia writes that tax concessions such as negative gearing need only translate into increased house prices “if the supply of housing is completely inelastic (it does not respond to house price increases). However, in Australian cities the number of new dwellings is not very responsive to house prices…thus most of the general income tax concessions may be expected to translate to higher house prices”. The effect of negative gearing on the supply of dwellings will be discussed later in this paper.
If it is true that negative gearing increases house prices, then it offends the principles of efficiency, vertical equity and horizontal equity. By subsidising property ownership and increasing demand, negative gearing influences economic decisions and distorts the free operation of the market. While tax expenditures benefiting renters provide them with an annual subsidy of approximately $1,000 per household, concessions to investors (of which negative gearing is one) provide an average annual subsidy approximately four times larger.Therefore, current taxation arrangements are horizontally inequitable towards people who chose to live in rented housing as it leaves renters relatively less well-off. Furthermore, since many people who rent do so because they cannot afford to buy, negative gearing is vertically inequitable. Rising house prices may benefit those already in the housing market but it can crowd out potential first home buyers. The broad effect of rising house prices is a redistribution of wealth to those who own real estate (typically older and wealthier Australians) from those who do not (typically younger and poorer Australians).
However, not everyone accepts that negative gearing is a major cause of Australia’s housing affordability problem. In rejecting the Productivity Commission’s findings, the government pointed out that housing-booms have also occurred in countries with widely differing policies on negative gearing. At the same time, despite also being able to access negative gearing, Australian share prices have often moved in a different direction to house prices. Various other variables have been suggested as being more influential in raising demand. Among these are increasing real incomes, population growth and low inflation. Many have also noted the increased willingness of financial institutions to provide cheap finance to investors (prior to the GFC). It appears that whilst it makes intuitive sense for negative gearing to have at least some influence on house prices, further research is required to quantify its effect relative to other variables.
Negative gearing and housing supply
It has also been alleged, for example by Master Builders Australia and the Property Council of Australia, that negative gearing increases the supply of rental properties by encouraging new housing construction. Support for this view is given in a 1989 Reserve Bank study that found lowering of tax incentives available to real estate investors leads to a decrease in the construction of real estate. Further support, at least according to the Housing Industry Association and the Real Estate Institute of Australia, comes from the period in the 1980s when negative gearing was abolished. During this period there was a downtown in housing construction.
However, Saul Eslake has highlighted that this downturn was confined to Sydney and Perth, suggesting that abolition of negative gearing was not the cause. A study by Babcock and Browett supports this view. It concluded that factors other than negative gearing – rising interest rates and a share market boom – caused the decline in rental housing investment, while the reversal of those trends caused the subsequent property boom that followed the reintroduction of negative gearing. Other studies, such as one done by Jim O’Donnell, have also countered the view that negative gearing leads to an increase in the number of dwellings.
One might think that as negative gearing increases demand for investment properties, supply would increase to meet this demand. However Australia has significant supply-side constraints, reducing the elasticity of housing supply and therefore its ability to respond to changing demand. These constraints include planning policies that are too restrictive, complex and costly and a shortage of skilled labour in the construction industry. Partly as a result, landlords are mainly buying existing properties, rather than building new dwellings. Therefore it appears that negative gearing does little to increase the supply of rental dwellings.
If negative gearing does not raise the supply of rental stock, this casts doubt on the assertion that negative gearing helps to cut the cost of renting. That claim has frequently been offered by industry groups such as the Property Council of Australia and Master Builders Australia to support negative gearing. It also has found some degree of favour amongst some academics. If true, negative gearing would improve the vertical equity of Australia’s tax system, since many renters are from low-income and disadvantaged groups in the community. There is unfortunately a shortage of rental dwellings affordable to such lower-income households.However, according to ACOSS, negative gearing encourages investment at the top end of the market (and is therefore unlikely to significantly benefit low-income tenants) because that is where the anticipated capital gains are greatest.
The contention that negative gearing lowers rents appears to be founded upon two questionable arguments. The first argument is that negative gearing increases the supply of rental accommodation more than it increases demand. As discussed earlier, supply-side constraints on Australia’s property market render this claim doubtful. The second argument is that negative gearing lowers the costs for landlords and that some of these savings will be passed on to renters. It is doubtful that landlords would have the altruism to pass on the benefits of negative gearing to tenants or if they even could, if they are already capitalised into the price of the property. Furthermore, even if negative gearing does help to make renting more affordable, there are better ways to achieve this result.
Negative gearing and the economy
Critics argue that negative gearing has distorted investment away from more productive avenues. By encouraging borrowing to invest in assets that appreciate in value without productive effort, negative gearing simultaneously discourages investment in other, potentially more socially-and economically-productive areas. A dollar invested in negatively-geared rental property is a dollar not invested elsewhere. This money could be invested in areas such as plant and equipment, human capital and research and development. The Reserve Bank of Australia, CPA Australia, the Australian Council of Social Services Professors Frank Stillwell and Judy Yates and Saul Eslake have all voiced concern about this.
It is not the author’s intention to suggest that negatively geared investment in property does not add value to the economy. There are many thousands who are employed, directly or indirectly, by industries that benefit from negative gearing. However, with few exceptions, it is the market that should determine where investment is directed. It offends the principle of efficiency for the government to encourage investment in one sector of the economy over others. Different forms of savings should be taxed as consistently as possible.
However, Henry has demonstrated that different investments face widely different effective tax rates, depending on the financing choices of the investor. He describes this as “amongst the greatest tax induced biases to the savings choices of households”. By favouring one form of savings income over another, the tax system alters the allocation of the nation’s capital. Productivity and efficiency is reduced, Henry explains, if tax-induced distortions lead to a misallocation of resources, with savings directed towards less productive investment opportunities.Statistics show that when negative gearing in rental properties increases, investment in private fixed capital decreases. A potential consequence of this is that businesses must rely more on overseas finance, exacerbating Australia’s foreign debt burden. It should be noted that, without denying that negative gearing is inefficient, some authors have questioned the extent of the distortion it causes.
Of course negative gearing doesn’t only affect where Australian’s invest their savings, it also affects how they finance their investment. In buoyant economic conditions, investment gains are magnified by borrowing. Furthermore, negative gearing’s tax benefits ensure that effective marginal tax rates go down as gearing goes up. On the other hand, during economic downturns, investment losses are also magnified. Negative gearing, therefore, appears to have pro-cyclical effects, amplifying the volatility of capital markets. The dangers of excessive levels of debt have been made all too apparent over these past five years. Easing the tax concessions offered by negative gearing should moderate asset price inflation during economic booms, reducing the risk that asset bubbles form in the first place.
Part Four – Negative gearing alternatives
It appears that removing or restricting negative gearing would improve the equity and efficiency of Australia’s tax system (though the extent of the gains are unclear). However, any change would neccesarily come at the expense of simplicity. Current arrangements perform well on this criteria. Unlike a sole-trader operating a ‘non-commercial’ business, property owners do not need to consider any further rules or criteria regarding their eligibility to claim losses. Furthermore, any change to a system that has remained largely untouched (save for that brief period in the 1980s) inevitably adds complexity and confusion. Alhough a detailed discussion of how negative gearing might be reformed is beyond the scope of this paper, it is worthwhile to briefly mention some of the proposals that have been put forward.
Some proposals, in an attempt to improve the equity of the system, have the potential to cause significant complexity. For example, Nick Renton wants to ensure that a deduction is not denied in cases of unintentional losses.[ Some, such as the Housing Justice Roundtable have suggested a higher deduction for ‘affordable housing’ and a lower deduction for expensive properties. Eslake would like interest expenses to only be deductibe up to the amount of investment income, with any excess carried forward against the ultimate capital gain. Though I find this proposal to be an improvement on current arrangements and relatively simple, I see the core of the problem as the mismatch between the treatment of income and capital. If the system taxed gains in full as they accrued, negative gearing would not be problematic. However, such a system is practically and politically unfeasable. In light of this I favour Henry’s proposal of taxing interest income, net residential income and capital gains at an even 40% discount.
This paper sought to critically evaluate the entitlement of taxpayers to negatively gear the cost of investments, especialy investmets in residential accomodation. It concluded that unrestricted access to this entitlement was simple but offended the tax design principles of equity and efficiency. Despite this, any reform to negative gearing is politically improbable. However, two developments have posed their own challenges to negative gearing. Firstly, with the outlook for capital growth subdued, the financial impetus behind negative gearing is far less certain. Secondly, as increasing numbers of baby-boomers retire, fewer taxpayers will have labour income to offset rental losses against. It may be that economics and demographics succeed where politics could not.