Homelessness, housing affordability and unsound public policy - Part 2

In my previous article I wrote about housing affordability and the first homebuyer’s scheme as an example of unsound public policy that exacerbates the housing affordability problem. In this article, I shall turn my attention towards tax concessions and consider their impact on housing affordability.

What are these tax concessions?

The two main tax concessions at play in the housing market are negative gearing and the capital gains tax (CGT) discount. For those unfamiliar with accountancy or tax law – negative gearing allows for people to borrow heavily (gear) to purchase assets and claim any losses as deductions from taxable income. The CGT discount allows individuals to pay tax on only 50 per cent of any capital gains if they have held the asset for over 12 months. The combination of these two policies renders it difficult to lose in property investment as any losses one incurs while holding the asset can be deducted from taxable income and then when the asset is finally sold there is a 50% CGT deduction.

What is the impact of these tax concessions?

From the description of these taxation arrangements it hardly takes a genius to work out that they increase demand for residential property, thereby pushing up prices and contributing to a lack of housing affordability in Australia. The Grattan Institute in their report Renovating Housing Policy noted this, stating that:

‘The combination of capital gains tax rule changes in 1999 and negative gearing has strongly increased demand for investment properties. Investors compete directly with potential homebuyers … This makes it harder for first home buyers to secure a property.’

Prominent economist Saul Eslake commented that these policies encourage speculation in the property market as opposed to hard work and savings. He derided negative gearing as essentially a giant subsidy from those who are working hard to landlords who are making a short-term loss but will eventually make a large capital gain when they sell.

Based on their analysis of ABS data the Grattan Institute estimated the cost of this support to residential property investors at $6.8 billion per year. Eslake estimated the revenue forgone from negative gearing alone at approximately $4.8 billion. It is worth noting however, that abolishing these tax concessions will not necessarily equate to extra revenue in the value of the tax concessions. This is because, as the Henry Tax Review noted, changing taxation settings changes behaviour. Thus abolishing these rules would lead to less property investment and hence less income or capital gains to tax. Nevertheless, the money wasted on these policies can be put to better use than to price the less fortunate out of the housing market.

Obviously we should abolish these tax concessions then, right?

Before resting my case, it is worth taking a look at the arguments against removing these tax concessions.

One of the main arguments that exponents of negative gearing offer is that it increases the supply of dwellings available in the private residential tenancy market thereby assisting those who cannot afford to buy and reducing strain on government housing. This is the argument offered by the Property Council of Australia.

The Grattan Institute acknowledges that it is difficult to find direct evidence for or against this argument given the complexity of the housing market and the multiple variables at play. However, they use ABS data to show that only 5 per cent of money loaned for housing investment was used to construct new dwellings. This indicates that despite these favourable tax arrangements, investors are doing little to increase overall housing supply. This can be seen on the graph below:

(Source: Macrobusiness)

The main piece of evidence that proponents of negative gearing cite is what happened when the Hawke-Keating Government quarantined negative gearing from July 1985 to September 1987. Their version of history is that people stopped investing in rental property, causing a shortage in the private rental market and consequently higher rents.

This view has been challenged by economist Saul Eslake, who points out that rents only rose rapidly in Sydney and Perth, remained the same in the other capital cities and even declined in Melbourne. One would expect rents to rise rapidly in all capital cities if negative gearing really did support the private rental market to the extent claimed. However, this is not borne out by history.

The reason Saul Eslake offers for the growth in rental price experienced in Sydney and Perth is that the rental vacancy rates in those two cities were unusually low (barely above 1% in Sydney’s case) in the period just before the Hawke/Keating government abolished negative gearing. All this can be seen in the graphs below:

(Source: Address to the 122nd Annual Henry George Commemorative Dinner by Saul Eslake, 2013 http://www.prosper.org.au/2013/09/03/saul-eslake-50-years-of-housing-failure/)

A Final Word

We know from recently released cabinet papers that the Hawke-Keating Government constantly had unions, business lobbies and other special interests in its consideration as it sought to implement its reform agenda. For better or worse, all governments consider the political ramifications of decisions as well as their economic costs and benefits. Unfortunately, in the case of negative gearing and the CGT discount the political costs would be high if they were abolished and thus it is not viable to expect a government to take robust action on these fronts.

Despite the cynical political motives, governments should implement policies that promote housing affordability and home ownership. Policies should not push up prices to benefit the haves at the expense of the have-nots. Home ownership is of critical importance to GDP growth, productivity and overall social cohesion. For these reasons home ownership is known as the Great Australian Dream, and this is a dream that governments should support.

Even with the political realities in mind, there are still a host of potential reforms open to governments. The government could reign in negative gearing and the CGT discount by the extent recommended by the Henry Tax Review. Additionally, they could offer more favourable tax settings for investors creating new dwellings. There are also a plethora of other options recommended in the Grattan Institute Report. Beyond the CGT discount and negative gearing, there are plenty of reforms required; such as creating more consistent planning, zoning and building regulations and reducing unnecessary red tape identified by COAG in their report of Housing Supply and Affordability and replacing archaic and inefficient taxes such as stamp duty. In many ways negative gearing and the CGT discount are just the tip of the iceberg when it comes to housing policy reform but they are a prime example of unsound policy.