On Thursday the 11th of June, the McKell Institute released a report titled Switching Gears. It’s a document which looks at five different policy options in relation to negative gearing and perhaps most disappointingly, it does not give strategic planning policy much of a look in. First and foremost, the McKell Institute are a NSW independent, not-for-profit, public policy institute dedicated to developing practical policy ideas and contributing to public debate and unfortunately much of the report views the issues with the existing negative gearing system through Sydney-coloured glasses – a quick word search of the document shows 53 references to Sydney and only 3 to Melbourne. In saying that however, I welcome its favoured policy response of grandfathering existing negative gearing arrangements and the allowance of new negative gearing only for new housing stock.
The topic of negative gearing is forever in the media spotlight, its a topic discussed with almost all of my clients and for most of us, its hard to determine who we should listen to. So before we dive right into the thick of the Switching Gears report, lets first take a brief look at the history of Negative Gearing. In July 1985, the Hawke/Keating government quarantined negative gearing after it was only introduced six months prior. Negative gearing refers to a form of financing whereby an investor borrows money to buy an asset, but the income generated by that asset does not cover the interest on the loan. The loss is then deducted against other sources of income, for example labour income. The tax advantage is more attractive to those on higher incomes due to the greater savings accrued through a reduction in income taxed in higher tax brackets. In theory, the incentive encourages investment by reducing the impact of losses in the earlier years of a purchase, at least until an increase in earning (or rent) and/or a decrease in borrowing costs switches the investment from being negatively geared to positively geared. Negative gearing by property investors reduced personal income tax revenue in Australia by $600 million in the 2001-02 tax year, $3.9 billion in 2004-05 and $13.2 billion in 2010-11. When the asset is sold, it is likely to have increased somewhat in capital value, providing gains to the investor. The Government recovers some of this through its Capital Gains Tax (CGT), though the revenue raised through this measure was substantially reduced when the Howard Government introduced provisions that halved the rate of tax on capital gains in 1998.
Now for the Switching Gears report. This report has been designed to drive the creation of new housing and deliver a $29.3 billion benefit to the budgetS bottom line over a decade as well as trying to break the current political impasse by providing a range of politically pragmatic proposals that would reform negative gearing without abolishing it outright. The report attempts to identify opportunities that would restructure negative gearing in a way that allows tax expenditure to be more directly targeted towards the creation of new housing supply. Such reforms would help tackle Australia’s housing affordability issues while also delivering a notable improvement in the federal budget. The report considers five different policy options for negative gearing, ranging from the status quo to immediate abolition of the current system. Lets take a look at the five scenario’s that I’ve listed below.
Business as usual: Under this scenario all current provisions relating to negative gearing would be retained. This option is expected to cost approximately $51 billion over 10 years.
Grandfather existing negatively geared properties: Under this scenario, existing investors taking advantage of negative gearing would be allowed to continue to do so for the existing properties they own. This option is reported to have a very broad range of impact on the budget ranging from $19.3 billion through to $38.7 billion.
Grandfather existing negatively geared properties plus new participants would have access to negative gearing for up to $1 million of property: Here, scenario 2 is augmented with a provision of newly negatively geared properties, but with a cap on the amount for new properties. Budget impact is greatly reduced and over 10 years the impact would be a total of $4.7 billion.
Grandfather existing negatively geared properties plus new negative gearing only for new construction: Under this scenario the only new negative gearing that would be permitted would be for new construction. This would put the 10 year benefit at $29.3 billion.
Abolish negative gearing immediately: Under the final scenario they consider, the current tax deductibility of losses on investment properties being completely abolished. This is the most radical policy proposal of the five considered. A naïve account of the budget impact of such a policy is that the existing $3.9 billion in net deductions would become an immediate improvement in the budgets bottom line. However, faced with the loss of valuable tax deductions, investors would have a strong incentive to move to other asset classes where tax losses could continue to be offset against their income.
Negative gearing was introduced with the purpose of providing a level playing field for all classes of assets in which individual Australian tax payers may invest. Over time, however, developments in capital markets such as financial innovation and lower real interest rates affecting returns to deposit savings, combined with the structure of the Australian banking system, and also the economic psychology of investors, have shifted the playing field. Making all investments equal from a taxation perspective does not make sense if there exists other forces that systematically advantage one asset class. With this in mind, of the five scenarios considered here, the one which shows the highest likelihood of being effective in doing so, while minimising the negative consequences is Scenario 4. Grandfathering existing negative gearing but only allowing new negative gearing for new construction. This would help tackle the serious issue of constrained housing supply, allow for a smooth transition for existing investors, and have important indirect benefits in the housing construction sector. It would also have a material and positive impact on the federal budget which could easily be more than $5 billion over 5 years. The federal opposition is considering changes to capital gains tax rules as well as negative gearing if elected, but remains tight-lipped about the policy it will adopt before the next election. The Shadow treasurer Chris Bowen has welcomed the McKell Institute’s proposal to limit home buyers’ use of negative gearing to new properties only, but declined to say whether it will be adopted as opposition policy.
I guess we’ll have to wait until the next election to see the outcome but in the meantime, investors may also be interested to know that the property sector has called for an end to stamp duty, saying it has destroyed the home ownership dreams of some people. As pressure mounts inside the Federal Government to address housing affordability, the Property Council of Australia noted that while the Perth median house price increased by 442% over two decades, stamp duty rose by 740%. Nationally, homeowners have faced tax increases of 800% at the expense of affordability since 1995. Interesting times ahead.