Why anyone who talks about tax breaks but won't touch negative gearing isn't serious about reform

The Barangaroo development in Sydney. Photo: Cameron Spencer/Getty Images

When I studied graduate public finance, one of my lecturers was Martin Feldstein. Feldstein was the chair of the Council of Economic Advisers under Ronald Reagan, and not exactly regarded as one of Harvard’s most progressive economists.

There were a range of issues on which I disagreed with Feldstein, but one idea that made a lot of sense was the principle that public finance reformers should look not only at spending levels and tax rates, but also at tax expenditures. In the United States, Feldstein argues, such tax loopholes have proliferated. He argues that ‘Congress should review these tax expenditures and eliminate those that the country cannot afford.’ Such an approach, Feldstein points out, raises revenue more efficiently than increasing tax rates. In economic jargon, closing loopholes has a lower deadweight loss than raising rates.

As their name suggests, tax expenditures look a lot like budgetary expenditures. If the government gives you a dollar for doing something with public value, we put it on the revenue side of the ledger. If the government takes a dollar off your tax for doing the same thing, we put it on the tax side. But the practical effect is pretty similar. As Feldstein points out, winding back tax expenditures can be framed as either a revenue increase or a spending cut.

Yet it turns out that tax expenditures tend to be much less fair than budgetary expenditures. When we assist older Australians through the pension, the money goes disproportionately to the poorest. But when we assist older Australians via superannuation tax breaks, the benefits go disproportionately to the most affluent.

When it comes to personal income deductions, a conversation about tax expenditures is really a conversation about negative gearing. Rental deductions account for more than half of all personal deductions. So anyone who tells you they’re serious about cutting tax breaks, but won’t touch negative gearing, isn’t serious about broad-based tax reform.

The current tax treatment gives investors an advantage over first home buyers. That advantage was reflected recently when the value of loans for investment housing outstripped owner-occupier housing for the first time.

Measured by house price to income ratios, Sydney is now the second most unaffordable city in the world – after Hong Kong. Melbourne comes in fourth. Sydney’s median house price is now over $1 million.

Who is missing out? Young Australians are much less likely to own a home as they were in the early 1980s, with homeownership rates for 25-34 year olds falling from 62 per cent to 48 per cent.

Lower income Australians are hit too. In the mid-1970s, there was no difference in the home ownership rates of those in the top income quintile and the bottom income quintile. Today, the most affluent are 15 percent more likely to own their home than the least well off.
For younger and poorer Australians, it’s like the ladder of opportunity is being pulled up.

The list of those who have raised concerns about the impact of negative gearing and the capital gains tax discount on the housing market are Saul Eslake, Cassandra Goldie, Chris Richardson, Peter Morgan, John Daley, Joe Hockey and Jeff Kennett. Hardly a squadron of socialists.
Those arguing against Labor’s reforms have trotted out a range of misleading points.

First, they argue that 67 per cent of taxpayers who claim negative gearing earn a taxable income of less than $80,000.

The key phrase is ‘taxable income’ – in other words, income after taking account of negative gearing. As my colleague Chris Bowen has pointed out, if you take this figure seriously, you also need to realise that 64,000 Australians on taxable incomes of zero have investment properties. It’s not that they have no income – if they did, they wouldn’t be making mortgage repayments. It’s that they managed to use negative gearing to reduce their tax obligation to zero.

In fact, negative gearing disproportionately benefits the more affluent. Most of the benefits of negative gearing go to the top tenth of income-earners. For example, surgeons claim 100 times the benefit that cleaners do, and 16 times the benefit received by nurses.
Second, critics of Labor’s plan also claim that negative gearing keeps rent prices lower than they’d otherwise have been. The basis for this claim is a Sydney-centric view of rents. In the years from 1985 to 1987 that negative gearing was stopped by the Hawke Government, rents did rise in Sydney and Perth. Yet the rate of growth in rental prices slowed in Melbourne, and all other capital cities had no change in the growth of rental prices.

The rent rises in Sydney and Perth rental prices are more likely to be attributable to unusually low vacancy rates in those cities prior to the implementation of the policy.

A third canard is that negative gearing boosts housing supply. This misses the fact that 93 per cent of property lending goes to established housing. If the aim of negative gearing is to boost housing supply, this is a policy with a 93 percent failure rate. That’s why Labor’s plan would restrict new claims for negative gearing to new homes, starting from July 2017.

Existing investors can sleep easy with Labor’s policy. Our plan will ‘grandfather’ negative gearing – allowing it to remain on investments made before 1 July 2017 – and restrict negative gearing to new housing on and after that date.

Labor’s policy will also ‘grandfather’ the capital gains tax discount. The existing treatment will remain for assets purchased prior to 1 July 2017; assets bought on or after that date will receive a 25 per cent discount instead of 50 per cent.

This policy does not hurt current investors as there is no retrospectivity.

As for the ‘analysis’ released this week by BIS Shrapnel, the less said the better. Suffice to point out that the study models a policy that is quite different from Labor’s. For example, BIS assumes that negative gearing remains for shares, that there are no changes to capital gains tax, and that the policy starts in 2016. Its conclusions flow from the assumption that investors would raise rents – even although the report admits that there was no nationwide rise in rents in 1985-87.

This plan announced by Bill Shorten, Chris Bowen and Katy Gallagher improves the fairness of tax concessions and boosts housing supply. But it also improves budget sustainability. We all know that it’s vital to close the gap between what the federal government raises and what it spends. This gap currently sits at around 1½ percent of GDP.

Taking tax expenditures seriously isn’t a left-wing idea or a right-wing idea. It’s a practical, sensible way to approach economic policy. Closing tax breaks isn’t pain-free – anyone who remembers the fights that surrounded the introduction of fringe benefits tax can tell you that. But it’s the right thing to do for a more efficient and a more equitable tax system.

* Andrew Leigh is the Shadow Assistant Treasurer. This is an edited extract of a speech delivered to the Tax Institute’s National Convention.

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