Abolishing negative gearing would harm landlords while doing nothing to make housing more affordable, writes IPA Adjunct Fellow Sinclair Davidson.
A spectre haunts Australia. The horrible thought, that somewhere, somehow, somebody is using private initiative and taking on personal risk—not to mention responsibility—to get ahead in life. Once again, there seems to be a moral panic over so-called ‘negative gearing’. This time the panic is related to housing affordability.
The housing market in Australia is in disequilibrium. Demand for housing strongly outpaces the supply of housing. As any high school economics student could tell you, that means the price of housing should increase. This in turn means people should economise on housing (kids move back home, for example) and that the supply of housing should expand. It is really not that hard. The economy has been so badly mismanaged that at a time when there is a massive housing shortage, housing construction companies are going out of business.
Australian political elites, however, seem to have formed the view that increasing taxes on landlords will solve the problem. Add to that the always popular view that negative gearing is somehow a rort and, once again, we see the political drums beating for ‘someone to do something’ about negative gearing.
WHAT IS NEGATIVE GEARING?
A standard principle of taxation is that expenditure incurred in the production of taxable income is deductable for tax purposes. This is the ‘ability to pay principle’ at work, which is something Scottish economist and philosopher Adam Smith spoke about as long ago as 1776.
Imagine you run a small business and pay rent on your premises and wages to your employees. For tax purposes, you deduct those expenses from your sales revenue to calculate taxable income and then pay tax on the residual. Being a landlord is no different. You deduct all expenses from your rental revenue when calculating your tax liability. The complication arises when businesses make a loss. For many businesses, this means they ‘carry-forward’ the loss. This means the business can deduct this year’s losses from next year’s profits and reduce their tax liability. Some tax regimes also allow ‘carrybacks’—this lets the business deduct current year losses from previous years’ profits, thereby reducing their tax liability and they get a refund of prior taxes paid.
Some businesses, however, are diversified. One part of the business might be profitable, while another might be unprofitable. When doing their taxes the losses on the unprofitable component are subtracted from the profitable component, thereby reducing their tax liability. The important point is that making a loss reduces your tax liability, either in the future or the present.
If you are in the business of being a landlord, one of the biggest expenses that can be deducted is the interest paid to buy the property being rented. Many landlords operate at a loss—especially in the early years of their business operations—thereby reducing their tax liabilities. These losses can be offset against other income. If the landlord is an unincorporated business, they can offset their rental losses against other personal income such as their salaries. Some tax regimes restrict individuals from deducting investment losses from other income, allowing individuals to only deduct investment losses from investment income. This is a complication of the tax system that makes little sense. After all, governments often claim a dollar is a dollar, when collecting tax. Similarly, a dollar is a dollar when claiming a deduction.
The implied criticism is that people become landlords in order to engage in tax minimisation and not for ‘genuine’ investment purposes. So, people who want to change the negative gearing laws in Australia want to change a situation that applies to every other form of business in Australia.
We often hear the argument that Australia is the only country in the world that allows negative gearing. That is simply not true. Australia is the only country in the world that calls it ‘negative gearing’. What is true is that many landlords in Australia are unincorporated businesses—private individuals taking on a lot of risk. In other countries, landlords tend to be incorporated. All that means in practice is that some private or public company gets to deduct their interest expense from rental revenue and thereby reduce their tax liability.
THE LANDLORD BUSINESS
Imagine wanting to start your own business as an investor. You save up $50,000 and go to the bank to borrow more capital. If you want to invest in the stock market, the bank might lend you another $50,000 (if you are lucky). If, however, you want to become a landlord, they will likely lend you another $500,000.
Negative gearing allows landlords to charge lower rents.
Already we can see the benefit of being a landlord: your ability to borrow (the technical terms are ‘gearing’ or ‘leverage’) is much higher. Imagine then that you buy a property and let it out. In the process you would have incurred several expenses. You may have improved the property (capital expenditure), you would have had to advertise the property, get an agent to manage the property, and so on. All these expenses are tax deductable.
Economists would say landlords are ‘price takers’. The prices they can charge for their property are set in local housing markets. The prices they pay for finance are set in global financial markets. They have some control over who their tenants might be, but even that is being progressively regulated away. This is a very risky business proposition.
In the early stages of any business, expenses are likely to be greater than the revenue and most businesses incur losses. Over time, however, businesses usually begin to earn a profit and become liable for taxation. Landlords are no different. In the early days of their business, they have a highly leveraged asset, that over time becomes less leveraged as the mortgage is paid off. Eventually they own a property outright and have no interest expense to deduct. Even if they dispose of the property, it being an investment, they are liable for capital gains tax. What little academic research that has been undertaken demonstrates that landlords consider both rental income and capital gains when making property investments.
Landlords—like every other business—are taxed over the life of their business. The timing of the tax being paid might not suit political elites, but this is true of all forms of taxation. Political elites always want to spend our money in the present, and delaying tax payments into the future is an inconvenience to those elites.
LANDLORDS ARE NOT ‘FAT CATS’
Many people have an image of landlords as ‘fat cats’; indeed it is implicit in the imagery of the game ‘Monopoly’. In that game, people buy properties and have to pay rent if they land on someone else’s property, with the game ending when tenants lose all their money, or one person owns all the property. It is an enjoyable game for children—adults, too—but it is a very misleading indication of how the property market actually works and who landlords tend to be.
In Australia, landlords tend to be unincorporated businesses. That means the landlord is not protected by limited liability and their own home is at risk if the business fails. According to ATO data, in the late 1970s there were about 270,000 landlords in Australia. By 2021 that number had increased to 2.3 million. About 15 per cent of Australian taxpayers declare receiving some rental income. To put that figure in context, about 19 per cent of Australian taxpayers declare receiving a franked dividend. That number is down from about 30 per cent in 2000. Most Australians ‘invest’ via superannuation; there are 21 million superannuation accounts, with some people having more than one account.
The important issue is: does negative gearing drive up housing prices? Combining ATO data on the number of landlords and ABS data on housing prices, we can see there appears to be no relationship between the number of landlords and housing prices over the last 20 years or so.
In a very sophisticated econometric model presented to the RBA in 2017, a group of economists from Melbourne University argued that the complete elimination of negative gearing would reduce housing prices by 1.7 per cent, while increasing rents by 2.4 per cent. The academic literature tends to suggest that removing negative gearing results in increased rents. This is the historical record, too. In 1985 the Hawke government restricted negative gearing (investment losses could only be offset against investment income) which resulted in huge rent increases (mostly in Sydney) and the restrictions were removed in 1987.
Theory and evidence are entirely consistent. Negative gearing allows landlords to charge lower rents. Risks are being shared with the taxpayer, and this is true of all businesses. Taxpayers gain when landlords make a profit and lose when landlords make a loss. Where the taxpayers gain the most is from the capital gains tax paid when the property is sold. The timing of all of that may not suit political elites, but that should be no reason to reevaluate tax policy. The fact is, according to ATO data for 2020/21, more than 50 per cent of landlords across Australia were profitable. That number has increased from about 30 per cent in 2007/08. Far from being some sort of tax rort, landlords are making a positive contribution to Australian tax revenue.
The average landlord (50th per centile) has a taxable income somewhere between $65,000 and $80,000. The ATO provides job descriptions for individuals across the taxable income distribution. People with taxable incomes in that range have job descriptions like ‘Nurse, disability and rehabilitation’, ‘School teacher, remedial’, ‘Welfare officer’, ‘School teacher of the sight impaired’, and ‘Speech pathologist’. Landlords in the 75th per centile (with a taxable income of $120,000 to $150,000) have job descriptions like ‘Medical officer, resident’, ‘Detective, police’, ‘Coal miner’, ‘Driver, train or locomotive’, and ‘Medical practitioner, general practice’. These are not professionals that most people would consider to be ‘fat cats’.
JUST A NEW TAX
Australia always seems to be just one more tax away from utopia. Policy elites are continuing to argue for more taxes and regulations to solve this or that problem. What is missing from these proposals is usually some explanation as to how this new tax will solve the problem and who will be paying the new tax. Proposals to eliminate negative gearing are just a new tax. Proposals to change the capital gains regime as it applies to residential property investment are also just a new tax.
People with jobs like ‘disability nurse’, ‘general practitioner’, ‘police detective’, and ‘train driver’ are the landlords of Australia. It is these people who will bear the brunt of the new tax. Their tenants too, will pay higher rents. Housing prices might fall by as much as 1.7 per cent, if the highly theoretical, assumption-laden academic research is to be believed.
Fiddling with taxation is easy, lazy policy. There is no evidence to support the notion that the abolition of negative gearing would ease the cost-of-living crisis. If anything, the evidence points to increased taxation resulting in higher rents not lower rents. And it is unclear if it would have any material impact on housing affordability.
This article from the Winter 2024 edition of the IPA Review is written by IPA Adjunct Fellow Sinclair Davidson.
