Age: The great Aussie dream II

The great Aussie dream II

By Tim Colebatch and Malcolm Maiden
October 31, 2005

THE CASE FOR

THERE'S no doubt that Australians invest a disproportionate amount in
investment housing, and no doubt also that they would invest less if
negative gearing on housing investments were outlawed.

Investment in housing would be even lower if the government ended the
capital gains tax concession that has halved the capital gains tax
payable on housing investments since 1999.

Whether investment would actually become better balanced and the
economy better off is another thing entirely.

Negative gearing - which allows taxpayers to deduct borrowing costs
that support an income-producing investment from not only the income
the asset generates, but other income including salaries - is
popularly associated with housing investment, but it is far more
pervasive than that. It applies to almost all geared investments in
this country (the major exception is farms), and in an important sense
underwrites them, by recognising that investment returns tend to
increase over time. In the early years (what companies investing in new
businesses call the establishment phase) costs can exceed income,
producing a loss. The tax system supports business investors through
this period allowing the loss to be deducted from other income.

Importantly, the concession cannot be claimed if investors are
intentionally setting out to produce losses.

If that is occurring, as some claim, there is a problem with the
enforcement of the law - and the Tax Office has in fact announced
that this year it is cracking down on deductions claimed against rental
income.

The story is similar with capital gains tax. The halving of the CGT
rate in 1999 coincided with a sharp acceleration in housing investment,
and in the opinion of the Productivity Commission in its report on
housing affordability last year, combined with the negative gearing
concession to propel it.

There is, however, a particular problem with the lower CGT rate
introduced six years ago. The higher CGT rate was aligned with the top
marginal tax rate, and that meant that negative gearing deferred tax,
but did not avoid it.

Negative gearing reduced the investor's tax bill, most often at the top
marginal personal tax rate, but the value the deduction created was
built into house prices (they rose) - and they were eventually taxed,
at the top marginal rate, when the asset changed hands.

Now, CGT is half the top marginal rate. This means that only half the
gain negative gearing creates is being captured when the asset is sold
- and that is why the CGT change has super-charged the housing
investment market.

Those who propose different, harsher negative gearing or capital gains
tax regimes for housing are proposing that the Australian system be
deliberately and massively weighted against investment in a single
asset class.

Several difficult questions would be raised. Where would investors turn
to, for example? And what impact would shutting off housing investment
have on long term household savings, given that the preponderance of
housing investment is in a single home or apartment, and intended to
provide a retirement asset and income stream?

The complete removal of negative gearing and the imposition of higher
CGT would probably not only deflect investment, but deter it. Given the
huge importance of the housing sector in this economy, and the
political importance attached to home ownership, even second homes,
this is a prospect that no government can embrace easily.

Less aggressive attacks would aim to more subtly deflect investment and
not kill it, and there is a precedent, in Treasurer Peter Costello's
1999 crackdown requiring that individual investors' farm losses can
only be written off against farm income.

Housing investment losses could be tied in the same way to future
housing investment income, and that system is in place elsewhere,
including Britain.

A realignment of capital gains tax, back up to the top marginal rate as
far as housing investment is concerned, would be another option.

Even then however, there would be unquantifiable risks. There can be no
doubt that investors would switch their attention to other assets if
the tax system was altered so that it discriminated against housing
investment. Indeed, that would be why the change was made. But the
government would have no control over where the migrating investors go.

The most obvious, available and welcoming home for the money a
crackdown tipped out of housing is, of course, another market that is
liable to speculative excess: the sharemarket.

- Malcolm Maiden

THE CASE AGAINST

IN 1990, 7.5 per cent of Australian taxpayers owned rental property. By
2003, 14.3 per cent were rental landlords. And a very unsuccessful
business it was.

In 2002-03, 60 per cent of owners told the taxman they had lost money
on renting. As a result, they had to write $5 billion off their taxable
income.

And since half those losses were run up by people facing marginal tax
rates of 42 or 47 per cent, that cost revenue close to $2 billion.

Put this in perspective. Australia has had 20 years of wrenching policy
reforms to make the economy operate on market principles. One of these
is that the state should not subsidise commercial activity.

The aim of these reforms is to raise Australians' productivity, output
and incomes, by ensuring that investment flows where it yields the
greatest return - not in subsidies, but through the market.

So why is the government encouraging us to make unprofitable
investments in rental housing, write off the losses against tax, and
then pay only half-tax on capital gains?

Those who defend negative gearing hoist the flag of principle.

It is a principle of tax policy, they argue, that the costs of
commercial activity should be written off against a taxpayer's income,
even if the costs exceed the income that activity produces.

If rental losses could be written off only against rental income, they
argue, this would create a distortion in the tax system, leading to an
exodus from property to equities.

But that is neither the principle nor the reality.

Professor Cameron Rider, director of taxation studies at the University
of Melbourne law school, pointed out last year to the Productivity
Commission's inquiry into first home ownership, that the tax laws and
the High Court agree that net losses can be deducted only where there
is reasonable expectation that the investment will yield a net income
flow over its life.

That was the principle adopted by Treasurer Peter Costello in his 1999
reforms to tax treatment of losses from non-commercial activities. In
fact the distortion is that, for political reasons, Costello then
exempted investments in rental property and shares from his own law.

Tax policy is full of conflicting principles in constant collision.
Good tax policy is driven by pragmatic judgement as to where to draw
the line. Costello's 1999 reforms, for example, cracked down on the
Collins Street farmers by ruling that farm losses could be deducted
only against farm income. It was a good call, and one he should now
extend to rental losses.

Look again at the statistics. In the nine years to 2003, the number of
people paying tax rose 13 per cent, but those declaring rental losses
grew by 69 per cent.

In 2002-03, 10 per cent of taxpayers wrote off rental losses against
tax. In nine years, rental costs claimed against tax shot up by 125 per
cent, and tax commissioner Michael Carmody says that in 2003-04 they
rose almost 20 per cent.

Since 2002, loans to investors have almost doubled, interest rates have
jumped 125 basis points, while rents have only edged up. You can bet
that negative gearing is now costing the rest of us $3-$4 billion a
year.

The question should be: does this work to boost our economy, or shrink
it? The answer is obvious. Would we be better off phasing it out, and
using that $3 billion plus to cut tax rates for all taxpayers? The
answer is obvious.

- Tim Colebatch

TOMORROW
Mark Coultan in New York looks at how property investment is treated in
the world's biggest economy.

WEDNESDAY
Tax analyst Max Newnham tells you how to negatively gear an investment.