Monday, March 7, 2016
A comment on negative gearing in the Australian property market
Background for non-Australians
In Australia you can deduct losses that you might make in renting a house against your ordinary (wages) income. This includes interest losses.
This is widely thought of as a tax incentive or even a tax rort. The aggregate amount of losses taken against tax is about 1% of GDP which is - to be blunt - a very large number. Negative gearing is widespread and part of our culture.
Moreover it is widely considered to be beneficial to have tax losses. I have had taxi drivers patiently explain that it is better not to pay principal on loans to buy investment properties (ie buy-to-let properties) because you want to keep the tax deductions as large as possible.
The Labor Party has promised to "abolish negative gearing". This has been a policy agenda for fringe groups (notably affordable housing activists) for some time.
Is negative gearing even a tax concession?
I sometimes express my view that negative gearing is not a tax concession and I am howled down by the consensus in this country. [This is despite doing an honours thesis on tax policy and working for five years in the Tax Policy Division of the Australian Treasury.]
But lets lay out the argument.
Imagine I have two business enterprises. One works well and the other one fails.
One makes $120. The other loses $100. My net gain is $20. If the tax rate is 30% I will pay $6 tax on on the net gain.
Now suppose that I can't deduct the losses against the profits. Then my loss will cost me $100. But my gain will be taxed at 30% and I will gain only $84 after tax. I will be $16 out of pocket.
If you do not allow losses to be taken against profits then you introduce an incentive against risk taking. Quarantining losses is expensive from a tax-policy perspective. Taken to its limit quarantining is a tax policy against innovation. [The benchmark for the taxation system is one that does not discriminate in taxation by how you make your income. Its a benchmark which implies tax policy should not in the benchmark case "pick winners".]
There is a case for quarantining losses - and it is done all over the place in tax policy - but almost everywhere the case for quarantining is anti-avoidance. The most famous example is that offshore losses tend to be quarantined against offshore income. The reasons are (a) the offshore losses are hard to audit and (b) the offshore income that it is quarantined against might not have hit the domestic tax base anyway.
Risks from not quarantining
If you do not quarantine losses you can wind up with completely anomalous situations. For example Australian once had a 150 percent R&D tax concession. If something were certified as R&D all inputs to the process were entitled to a 150 percent tax deduction. Then some enterprising minerals processing company did some tweaking of their processing technology. It was legitimate R&D whilst they were measuring the efficiency of their processes. All inputs to that process (ie the minerals they bought) were deductible at 150%. The output only taxable at 100 percent.
They bought say $10 million of minerals, processed them and sold $11 million worth of metals. But they got a net tax deduction of $4 million even though the activity was profitable and the real amount spent on R&D (ie the amount spent tweaking equipment) was tiny.
Done on this scale the concession could - and did - produce tax losses for the mining company in the hundreds of millions of dollars. There was almost no limit to how large the tax losses could be.
If these losses were not quarantined somehow they could erode the entire corporate tax base.
But the issue here was a "clever avoidance scheme", not that quarantining is of a benefit in itself.
And if you take the typical negative gearing case in Australia (a doctor or middle-income professional) buys a property and makes a real loss it is pretty hard to see how this is a "clever avoidance scheme". Its just a loss.
And real losses are normally deductible.
Countries that ban negative gearing
It is commonly asserted that other countries do not allow negative gearing - and that is true. In some countries capital income is always and everywhere quarantined from wages income. (Scandinavia is a key example where taxes on wages can be much higher than taxes on capital and quarantining is enforced against all businesses not just property investment.)
It seems the Australian Treasury agrees with my view that negative gearing is not a tax concession
The Australian Treasury (for foreigners the main economic policy advice department of the Australian Government) publishes a "Tax Expenditure Statement" which estimates how much various tax concessions cost on the basis that money spent via a tax expenditure is economically similar to money a government might spend directly if it taxed the income and then gave it back through grants or similar.
The tax expenditure statement gives a list of major tax concessions and lists two big housing related expenditures. First the imputed rent that you might receive owing your own house is not taxed even though it might conceptually be thought of as part of your income. Second the capital gains you might make selling your primary residence is not taxed (though it would be taxed if it were an investment property).
They do not list negative gearing as a tax expenditure. The list of big tax expenditures can be found on page 8 of the Tax Expenditure Statement.
But everyone thinks that negative gearing is a concession
Its pretty clear the view that negative gearing is not a tax concession is a minority view in Australia (though it is a view held fairly widely by senior tax people I have known and seems to be held by the Commonwealth Treasury).
The general consensus that negative gearing is a tax concession and that the smart money should and do take advantage of it.
And you find negative gearing all over the income spectrum including some high income earners (but very few mega-high income earners).
I find negative gearing intellectually amusing. It is not a tax concession but after much marketing by the Property Council, various spruikers and the otherwise ill informed negative gearing has been in part responsible for pushing house prices in Australia to ridiculous levels.
People will not only make investments when you give them a real tax concession - they will do so when they think they are getting a concession even if they are not. [We have likewise observed that it is easier to defraud people if they think they are getting a tax concession - witness forestry schemes in Australia.]
Implementing the Labor Party no-negative-gearing pledge
The Labor Party is careful not to ban negative gearing for existing property investments. If they did there would be squeals about retrospectivity. Also there would be dumping of property on the market by people who were no longer entitled to their tax concessions.
But they do plan to ban negative gearing prospectively. So I will throw up a simple example that shows the implementation difficulties.
Imagine a house that is positively geared. Rent is $800 a week and all outgoings are $700 a week.
But the tenant trashes it. (This happens, not often but it happens.) There is $10,000 worth of maintenance.
The landlord is out-of-pocket. Even after than $5000 net rent they collect in the year they are out of pocket.
Does the Labour Party have an argument for quarantining that loss that is not an argument for quarantining all business income against wages income? If so I have not heard it.
PS. I am not averse generally to the Scandinavian idea of income quarantining. However in that case all income from capital is separate for tax purposes from income from wages. I have not heard a good case for selective quarantining that is not an anti-avoidance case.
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