Why does negative gearing get a bad rap?

Negative gearing is blamed for pricing first home buyers out of the housing market, for asset price bubbles (notably, again, housing), lost Budget revenue, and benefiting the rich. The Financial System Inquiry interim report apparently agrees. Most recently, this debate has been re-activated by the Housing Industry Association and (again) by Saul Eslake.

Is negative gearing a tax concession?

Recent commentary seems quite unburdened by reference to long-established tax design principles. Treasury's Tax Expenditures Statement (2013) defines the personal income tax benchmark from which concessions are measured as including all nominal income, less all nominal expenses incurred in earning income. (We can debate inflation adjustment of the income tax base and tax rates later).

Interest costs of borrowing to purchase income-generating assets (whether housing or other assets) should be allowed as deductible expenses, even if (as with negative gearing) they exceed income (eg, from rent) generated by the asset.

Negative gearing isn't a tax concession. It's a proper part of the income tax base.

So what's the problem? There are several income tax concessions. Capital gains (CG) are taxed under CGT when realized, not as they accrue, offering tax deferral benefits. 'Trading' capital gains aside, the applicable CGT is discounted between 33.33% (super funds accumulation phase), 50% (most non-super capital gains) and 100% (the family home and super funds pension phase). Super contributions and earnings aren't taxed the same as income either.

See Chart for some of these.

These concessions rise with income, and are zero or negative below the tax-free threshold. This reflects fixed percentage capital gains tax discounts, and fixed super contributions and earnings taxes, relative to 'progressive' personal tax rates on wages, interest and dividends. Additional tax advantages arising from ability to defer realisation of capital gains aren't shown.

So why would governments ban negative gearing under an income tax?

In short, tax revenue. Current borrowing cost tax deductions come before capital gains realisations. Banning them boosts tax today. The price of the ban is increased tax distortions, and thus less revenue, over time.

All governments are inherently risk-averse revenue raisers. They want to maximize tax revenue ASAP, while shifting revenue risks to the taxpayer.

Want proof? Contrary to basic tax design principles, expenses incurred in earning assessable income are often denied, quarantined or delayed rather than being allowed – as they should be – as comprehensive deductions up-front. Governments never share income risk in proportion to income tax rates imposed. (The treatment of losses under the poorly designed, and ultimately ill-fated, RSPT was another example.)

Beyond CGT and super tax concessions, current concerns about housing and other asset 'bubbles' reflect much wider forces associated with quantitative easing and near-zero interest rates overseas (and, as a result, low interest rates in Australia). Globally, low interest rates are driving the search for higher yields via investment in other assets. This drives asset prices up, reduces their yields, and increases asset valuation risk (ie, generates asset price 'bubbles').

Increasing housing loan valuation ratios, plus state restrictions and levies on new land supply, don't help.

So banning negative gearing as a knee-jerk response to a feared housing bubble is really bad tax policy.

Sensible tax reforms should be dealt with holistically in the Government's forthcoming tax review.

There are two obvious options.

First, eliminate all (properly defined) income tax concessions, using the revenue to lower income tax rates across the board. This promotes comprehensive, consistent, and simpler income tax.

Much better than that option, shift revenue reliance away from income, towards comprehensive tax on expenditure and consumption. An expenditure tax base is discussed in the Treasury's Tax Expenditures Statement as an appropriate benchmark for taxing saving generally.

Both options reduce or eliminate incentives to negatively gear investments to exploit CGT and other concessions. The second also removes the double taxation of income from saving under income taxes.

Sure, each involves significant transition issues. They would need to be 'sold' effectively to voters, too.

What about negative gearing?

To the extent we retain income tax, don't ban it. Insofar as we move to a consumption or expenditure tax, it becomes irrelevant.