Mythical beasts and public policy
Federal Treasurer Scott Morrison recently derided the ALP’s Positive Plan to Help Housing Affordability as “selling a unicorn”.
Colourful language, but what is happening in policy terms?
Even though unicorns do not exist,[1] tax and housing policies do.
And it is legitimate for any political party to propose changes to policy. Indeed, negative gearing has been considered politically untouchable ever since 1987 and the ALP may have done the Government a huge favour by putting this risky proposition into play.
In 1985, the Hawke Government slashed the tax benefits of negative gearing by limiting the offsets to income derived from the investment property, and not allowing offsets against other income such as wages. The outcry from the vested interests in the housing, real estate and construction sectors, sustained political pressure from the Liberal Opposition and a looming NSW State election made it too much to bear politically. Another myth grew up: that without negative gearing rents would skyrocket because investors would pull out of the housing market.[2] The reforms were reversed in 1987.[3] Ever since, the received wisdom is that negative gearing is untouchable. Watch the pressure from vested interest stakeholders in opposition to the ALP policy.[4]
In 1999, the Ralph Committee recommended wholesale reform of the tax system, including a new simplified method for calculating capital gains tax liability, the discount.[5] The recommendation was legislated by the Howard government.
The Henry Review in 2009 also proposed reform of negative gearing by reducing the discount to 40% but also not taxing 40% of the income.[6] The Rudd Government did not implement Henry’s capital gains tax recommendations.[7]
The Abbott Government released a tax discussion paper in 2015 under the twee title Re:think.[8] While it raises issues about the capital gains tax discount, no firm proposals have been floated so far.
The ALP’s policy proposal would:
- limit negative gearing to new housing prospectively from 1 July 2017, leaving existing investments undisturbed;
- preserve negative gearing for other investments such as shares;
- halve the capital gains discount from 50% to 25%, also effective prospectively from 1 July 2017;
- exempt superannuation funds and small business from the changes.[9]
Negative gearing is a legitimate investment strategy independently of the tax system. As a strategy it relies on the value of the investment property increasing over time, and being sold for more than it cost to buy it, including the cost of borrowing (interest). It is a bet on capital gain – being able to sell the property for more than it cost to buy it.
A rental property is negatively geared if it is purchased with the assistance of borrowed funds and the net rental income, after deducting other expenses, is less than the interest on the borrowings.[10
Negative gearing is a strategy of borrowing to invest in an asset which generates income, but not enough to cover the investor’s costs (including interest and depreciation). Although this results in a loss for the investor, the loss can be used to reduce other taxable income, lowering the investor’s tax liability. A deliberate negative gearing strategy relies on an expectation that gains from selling the asset at a higher price will be greater, in after-tax terms, than the earlier losses.[11]
What is the capital gains discount?
A capital gain or capital loss on an asset is the difference between what it cost you and what you receive when you dispose of it. You pay tax on your capital gains. It forms part of your income tax and is not considered a separate tax … [12]
Example: Kevin bought an investment house three years ago for $400,000. After allowable capital deductions he sells it with a capital gain of $100,000. Under the discount method, only $50,000 is counted as taxable income.
The discount method of calculating capital gains tax liability does not apply to companies. The discount is 50% for individuals and trusts, and 33⅓% for certain superannuation funds. There are some complicated rules about how a capital gain is calculated and the discount applied. The ATO has a guide to the discount method.[13]
The tax benefits of negative gearing apply to any property that is income producing and not just rental property, such as shares (where the income is the dividend paid).
The budget cost
Negative gearing and the capital gains discount have a cost to the Commonwealth revenue. They operate just like a subsidy paid to encourage desirable behaviour. Here, the tax benefits effectively subsidise capital speculation, although the policy justification is to encourage investment in housing.
That investment incentive is achieved (in part) by allowing interest costs that exceed net income to be offset against other income (such as wages). The discount allows individual taxpayers to halve tax liability on capital gain for properties held for at least a year.
The Grattan Institute estimated the cost of the two subsidies in the housing market on 2012 data to be at least $6.8 billion annually.[14] The ALP policy suggests the cost to the revenue is $10 billion annually.[15] The Parliamentary Budget Office compiled a range of estimates of the budget impact of negative gearing, ranging from $0.9 billion to more than $5 billion pa.
ALP policy under political attack
The Turnbull government’s initial response from both Morrison and the Prime Minister was to attack.
Mr Turnbull was reported as saying the policy “should put concern into the minds of every single house owner … the consequence of it will be a decline in property prices, every home owner in Australia has a lot to fear from Bill Shorten”.[16]
He said in Parliament:[17]
Labor’s policy would mean that a significant number of these investors would withdraw from the market for existing houses. It would push down existing house prices. It would result in a reduction of the amount of property available for tenants to rent.
The Treasurer’s line of attack invoked the mythical unicorn. The following exchange took place on ABC’s AM program on 18 February 2016:[18]
MICHAEL BRISSENDEN: Okay, it’s also projected to save $7 billion a year after about 10 years. This is a …
SCOTT MORRISON: Yeah, that’s a unicorn. That’s a unicorn policy. I mean, I’ve heard this, I’ve heard this that over 10 years and over 15 years and all the rest of it. … You’ve got to deal with the budget and the forward estimates in a budget, and this $100 billion and all the rest of it they go on about, they are selling a unicorn to the Australian people.
Morrison’s unicorn theme was played out repeatedly that day, to the extent he was asked by Neal Mitchell on 3AW the next morning:
can we shoot the bloody unicorn? Can we ban the unicorn today?[19]
The policy problem
The policy problem behind all this is housing affordability.
House prices have grown faster than income in Australia, as with other countries. The IMF data is shown in the figure below.[20]
According to the IMF:[21]
Price-to-income ratios have risen across all measures in Australia and are now near historic highs. However, international comparisons of price-to-income ratios suggest that Australia is broadly in line with comparator countries.
The real estate industry, politicians and welfare bodies all speak in terms of a housing affordability crisis.[22]
There is a shared policy goal between the two major political blocs to improve the housing prospects of Australian, particularly those entering the housing market for the first time.
The Liberal Party’s electoral platform for the 2013 election promised, under the heading “Improving housing affordability – supporting housing development”:
We will improve housing affordability and encourage high levels of home ownership. We will work closely with the States and territories … to reduce red tape holding up the supply of housing and construction and to increase land release for new homes.[23]
Labor’s new policy is explicitly labelled “housing affordability”.
One way of understanding the policy problem is to look at the ratio of earnings to house prices, as shown in the following figure.[24]
The debt to income ratio is also a good indicator:[25]
These two data sets give a slightly different picture of the ‘crisis’. Hmm.
A second policy objective is about the overall budgetary position of the federal government. Negative gearing tax benefits come at a cost to the tax take. The much vaunted “budget crisis” (language that, like the unicorn, has been given a rest) might be addressed in part by reducing the subsidies through the tax system.[26]
Again both sides of politics agree that the budget should be strong, balanced or even in surplus. The disagreements tend to be about means not ends.
The unicorn?
Labor’s policy commitment includes a timetable for the budget impacts that runs well outside the ‘normal’ budget cycle, which includes the budget year and the three years following in “forward estimates”.[27] The estimate in the policy is for improvement in the budget only in the last year of forward estimates. However, the policy also forecasts budget improvement of $100 billion over 10 years.
How can we know what will happen in the Commonwealth budget on such a long timeframe? While we can predict with confidence on very short timeframes, the probability of unexpected events changing the real outcome from the predicted one grows rapidly as we contemplate longer and longer times.
But there is a conundrum here. Public policy does not operate in 3 or 4 year cycles. It is funded that way,yes, but almost all policy operates in very long terms. An education policy is at least about the lifetime of the young person starting school, to acquire knowledge and skills for living, working and being healthy. Policies about the Great Barrier Reef are about the Reef in geological time, not just for the benefit of President Obama’s daughters, but for humans and sea-life well beyond our life time.
And housing policy is not just about affordability to nice young people looking for a home now, but for the generations that will follow and live in the houses and communities built or preserved by the policies we make today: 10 years; 30 years; 50 years; 100 years.[28]
The unicorn reference derides the policy precisely because it is long term. It may make for a neat headline. It may even be good short-term politics. But the snappy one-liner has serious implications for long-term thinking and policy objectives that are intended to act in the future in a meaningful way.
The real damage to good policy is the exclusion of important policy tools on the basis of political differentiation. The unicorn sledge effectively takes capital gains tax reform off the table. The Turnbull Government might just have thrown away a once-in-a-generation reform opportunity for the sake of a cheap shot, and leaving the impression it can achieve good outcomes despite discarding legitimate tools.
Who is trying to sell unicorns now?
Postscript
Richard Holden and Saul Eslake in the Australian Financial Review of 17/4/2014 (p. 54) also invoked the myth theme on negative gearing:
.
Their myth also springs from Mr Morrison’s agile mind – mythical negative gearing by mythical nurses and police officers.
Added 13 March 2016 12:15pm
Entry amended 21 April 2016 to correct typographical error and improve expression
[1] … or do they? See www.craigslist.org/about/best/nhm/4218208723.html
[2] Holden, R. (2015) Switching Gears | Reforming negative gearing to solve our housing affordability crisis. Sydney: McKell Institute; ABC (2016) “Fact check: Did abolishing negative gearing push up rents?” www.abc.net.au/news/2015-05-06/hockey-negative-gearing/6431100
[3] Murphy, D. (2013) “Cabinet Papers 1986-87: Negative gearing almost axed.” Sydney Morning Herald, 28 December 2013: www.smh.com.au/federal-politics/political-news/cabinet-papers-198687-negative-gearing-almost-axed-20131228-3011r.html
[4] eg www.dontplaywithproperty.org.au (Property Council of Australia)
[5] Review of Business Taxation (1999). A Tax System Redesigned, More Certain, Equitable and Durable, Report. See diagram at p. 606
[6] Commonwealth of Australia (2009) Australia’s Future Tax System – Report: taxreview.treasury.gov.au – see p. xxiii, 70, 415-420; recommendations 14 and 15
[7] Swan, W. & Rudd, K. (2010) “Stronger, fairer, simpler: a tax plan for our future”, Media release: ministers.treasury.gov.au/DisplayDocs.aspx?doc=pressreleases/2010/028.htm&pageID=003&min=wms&Year; Crikey (2010) “The Henry review: reviewed” www.crikey.com.au/2010/05/03/the-henry-review-reviewed/
[8] Commonwealth of Australian (2015) Re:think: Tax discussion paper. bettertax.gov.au/publications/discussion-paper/
[9] Australian Labor Party (nd) Positive Plan to Help Housing Affordability www.alp.org.au/negativegearing
[10] Australian Taxation Office (2014) Rental Properties 2014: Guide for rental property owners. Canberra: Commonwealth of Australia, p 24
[11] Dale, T. (2015) Budget impacts of negative gearing. Canberra: Parliamentary Budget Office: http://www.aph.gov.au/About_Parliament/Parliamentary_Departments/Parliamentary_Library/ FlagPost/2015/August/Budget-impact-negative-gearing
[12] https://www.ato.gov.au/General/Capital-gains-tax/
[13] https://www.ato.gov.au/General/Capital-gains-tax/In-detail/Calculating-a-capital-gain-or-loss/The-discount-method-of-calculating-your-capital-gain/. For a detailed background and analysis of the discount and its origins in 1999 see Kenny, P. (2005) “Australia’s Capital Gains Tax Discount: More Certain, Equitable And Durable?” [2005] JlATaxTA 11; (2005) 1(2) Journal of The Australasian Tax Teachers Association 38
[14] Kelly, J-F., Hunter, J., Harrison, C., & Donegan, P. (2013) Renovating Housing Policy, Grattan Institute, Melbourne, p. 25
[15] the policy also estimates the CGT discount alone will rise from $4.2 billion in 2014-14 to $8.6 billion in 2018-2018, a growth rate of 8% pa
[16] Massola, J. (2016) “Malcolm Turnbull warns property values will fall under Labor negative gearing policy”. Sydney Morning Herald, 19 February 2016
[17] Hansard 3 March 2016, 53 (proof)
[18] http://www.abc.net.au/am/content/2016/s4408837.htm
[19] transcript conveniently reproduced on the Treasurer’s website: http://sjm.ministers.treasury.gov.au/transcript/020-2016/
[20] http://www.imf.org/external/research/housing/images/pricetoincome_lg.jpg
[21] IMF Country Report No. 15/275. Australia: Selected Issues. September 2015, p. 5
[22] eg Cummings, C. (2016) “AVJennings say Australia’s housing sector is in a crisis”. Sydney Morning Herald, 8 February 2016; Duke, J. (2015) “Affordable housing at crisis point: Clover Moore” http://www.domain.com.au/news/affordable-housing-at-crisis-point-clover-moore-20150313-143hsw/; Australian Council of Social Services (2013) “United call for action on housing affordability crisis”, http://www.acoss.org.au/media_release/united_ call_for_action_on_housing_affordability_crisis/; Ludlam, S. (2016) Housing in crisis: http://scott-ludlam.greensmps.org.au/housing-crisis
[23] Liberal Party of Australian (2013) Real solutions for all Australians. Barton ACT: Liberal Party of Australia, p. 42
[24] Murphy, J. (2015) “Why house prices don’t need to be a consistent multiple of income” 8 August 2015, http://www.news.com.au/finance/real-estate/why-house-prices-dont-need-to-be-a-consistent-multiple-of-income/news-story/b717202becf54b9a65f1abbc49b6a1f7
[25] Joyce, C. (2014) “Australia’s house prices ‘flashing red’, debt to income ratio at record levels”. Sydney Morning Herald, 4 April 2014
[26] but only so long as policy changes did not negatively impact the budget in other ways such as by increasing welfare housing demand or damaging investment confidence, reducing building activity and therefore reducing tax revenues from the housing construction sector
[27] http://www.budget.gov.au/2015-16/content/glossary.htm
[28] Camden’s Cottage, built 1816 is Australia’s oldest existing residential property: http://www.nationalparks.nsw.gov.au/visit-a-park/parks/Cadmans-Cottage-Historic-Site;