Few Australian housing policies are more contentious than negative gearing.

Despite the publicity it has received and its popularity with government and property investors, little analysis of negative gearing can be found within easy reach, with much of it accessible only in academic journals. Only an occasional fragment is found in the mainstream media.

Australia’s policy on negative gearing is considered a sacred cow by investors and politicians, with Prime Minister Julia Gillard, Treasurer Wayne Swan and Federal Housing and Homelessness Minister Brendan O'Connor ruling out changes to this policy. The reason for this obstinacy is that negative gearing allows a property investor to deduct losses against the investor’s personal tax liability at their marginal tax rate (MTR), a tax-minimisation strategy adopted by 1,110,922 taxpayers who vote. Property is run at a net loss when interest payments and property-related expenses like repairs and maintenance exceed rental income.

The strong Australian economy has not experienced a recession since the early 1990s. This, along with reduced personal tax burdens, real rising incomes, extensive property subsidies and tax breaks, and rapid increases in property values, delivered an economic environment conducive to negative gearing. From 1996 to 2010, housing prices surged by 130%, adjusted for inflation and quality.

The present housing and rental affordability crisis is placing tremendous financial stress on many Australians as housing and rental prices have outpaced wages, and provided the spark for the public to question the validity of subsidising investors, whether they choose to gamble on making a return by selling property at a higher price or eventually becoming cash-flow positive when rents rise to exceed outgoings.

Despite the fact that negative gearing has existed for a long time, much assertion but surprisingly little evidence has been made to justify this policy across all classes of investment, whether it be shares, business, or property investment. The supporters of negative gearing provide negligible evidence to show that is it a sound policy.

Deductibility and tax minimisation under negative gearing

It is common sense that both businesses and investors should be allowed to deduct the costs directly incurred in making an income, but labour is unable to do so. A salaried employee incurs substantial costs in the course of earning a wage (for instance, accommodation, travelling to and from the workplace, and childcare) but government policy bars deduction of these costs against wages.

There is a double standard in operation here. From a distributional or equity perspective, this policy is biased towards the wealthy, as business and investment capital ownership is concentrated into this class, which relies proportionately less upon wages.

The disparity between wage earners and investors is exacerbated when negative gearing is considered. The net income loss from an investment property reduces the investor’s personal tax liability, even though that loss was generated elsewhere. Earning a wage and earning income from an investment are two separate activities and should be treated as such. Business commentator Alan Kohler accurately summarised the inconsistency between investment and employment:

Five years ago Treasurer Peter Costello told Australians: “Work for a living and we’ll tax you at close to 50 cents in the dollar; speculate and we’ll only take 25 cents. Not only that but, as a special deal – while stocks last – we’ll pay half your speculating costs.”

To sum up this line of reasoning, investors are unduly advantaged by the present taxation arrangements relative to labour. Investment capital is overwhelmingly concentrated in the wealthiest households, who deduct investments costs against income generated, have the highest personal incomes and thus MTRs, can deduct investment losses against their personal tax liability (negative gearing), can carry forward losses and lower their effective MTRs.

Clearly, the tax system is biased towards the rich in terms of cost deduction and tax liability minimisation. Some of this bias can be reduced by maintaining consistency: labour should be allowed to deduct costs against wages but disallow negative gearing for investors.

Increasing the rental stock and lowering rents

This is the primary argument in favour of negative gearing: that it provides an incentive to investors to purchase property for rent, thus increasing the supply of rental properties as a proportion of the total housing stock. As the reasoning goes, negative gearing holds rental prices down, benefiting tenants.

The evidence shows otherwise. 92% of residential property investment is for the purchase of existing dwellings rather than those newly constructed, meaning that former owner-occupiers and tenants have to purchase or rent elsewhere, respectively, thus resulting in little to no net increase in the supply of rental dwellings.

In the long term, it makes little sense for the supply of rental properties to increase compared to the total residential stock unless there is a profound upward swing in housing prices, with investors spurred into the market on expectations of making a substantial profit through realising capital gains upon sale. Accordingly, there is little incentive when long term data from Australia and other countries shows that housing prices track inflation, despite numerous and ongoing booms and busts.

Negative gearing is also badly targeted as high-income professionals and millionaires also allegedly receive lower rents. If policymakers are concerned about rental affordability, there are other options to pursue. The obvious candidate is the Centrelink Commonwealth Rent Assistance (CRA) scheme, a subsidy provided to low-income tenants.

The effects of quarantining negative gearing in the 1980s

The favourite scare story promulgated by the housing lobby is that when the Hawke/Keating government quarantined negative gearing during 1985-87, it caused rental prices to surge, quickly leading to its reinstatement. Fortunately, not only did the evidence refute this urban myth, it showed that negative gearing can be safely quarantined, if not abolished.

Rents rose in Perth and Sydney only, remained steady in Melbourne and Canberra, and fell in Brisbane, Adelaide, Hobart and Darwin. If the lobby was correct, quarantining should have adversely affected all capital city rental markets equally, not just two out of eight (even when factoring in a lagged response). There were confounding factors at work: rising interest rates, introduction of capital gains tax and a stock market bubble.

Oddly enough, while the lobby claims that quarantining will increase rents, the inverse is not considered: rents have escalated from 2006 onwards while negative gearing was in effect. Perhaps they could claim that rents would have been higher otherwise. This, however, is an ad infinitum argument; that is, negative gearing is not generous enough, so by increasing the scope of tax deductibility, it can serve to further constrain rents.

How much does negative gearing cost?

ATO data provides an estimate of the cost of negative gearing. In 1993-94 it was $850 million, fluctuating around the $1 billion mark over the next several years. As investors piled into the market, the cost rapidly escalated to a peak of $3.8 billion in 2007-08 before falling to $2.9 billion in 2009-10. Over the last seventeen years, negative gearing has cost taxpayers an inflation-adjusted $33.5 billion (2012 dollars).

What to do?

Policy outcomes can be enhanced by quarantining negative gearing deductions to the purchase of newly constructed properties, but not for established properties. It would be even better to remove it, as it makes little sense to subsidise property investors, regardless of the reasons for investment when there are better policies for helping low-income tenants.

Also, the negative gearing debate presupposes the existence of income taxation, which has no justification when evidence suggests that substantial amounts of tax revenue can be raised from far more efficient bases. Productive individuals and business already bear the brunt of income tax, which is merely one of 125 burdensome taxes.

According to the property lobby, it’s too dangerous to reform negative gearing, let alone abolish it. Fortunately, there’s no requirement for anyone to believe the lobby, given the weight of evidence against their assertions and the fact that they have enough conflicts of interest to fill a book.