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While negative gearing is often cited as the key tax concession on rental property investments, it is in fact only attractive to the extent that investors benefit from capital gains, and those capital gains are subject to a significantly lower tax rate.

What the present negative gearing tax arrangements do is encourage investors to leverage the purchase of housing in order to convert ordinary income, such as rents and salaries that are taxed at marginal income tax rates, into capital gains that are leniently taxed at much lower rates of tax. These lower rates of tax on capital gains have two sources. One is the 50% discount, which only requires investors to add 50% of capital gains to assessable income. The other is deferral of capital gains tax until an asset is sold.

Table 1 quantifies the capital gains tax concession by supposing that all capital gains are taxed as they accrue, and then calculating that effective rate of tax on capital gains that leaves the taxpayer’s after-tax wealth the same as under current CGT arrangements. This effective rate of capital gains tax can be compared to the investor’s marginal tax rate on wages, salaries and investment income.  We consider an investor paying the top 45% marginal rate on wages, salaries or investment income, and calculate the effective rate at alternative rates of house price inflation (see table 1).

So, for example, at an annual rate of increase in house prices of 3.5%, and after holding a property investment for 15 years, the investor is paying roughly 19 cents tax on every dollar of capital gains, less than half the 45 cents in the dollar that is paid on their salary. If realisation of capital gains is postponed the value of the tax concession increases. Consider, for example, a 25 year holding period. The effective rate on annual capital gains declines further to 17 cents on every dollar of capital gains.

But there is a second very important pattern evident in table 1. As house price inflation accelerates the effective rate on capital gains also declines. With a 25 year holding period but house price inflation of 4.5% per annum the investor pays 15.4 cents in the dollar, and when inflation reaches 5% (s)he is now paying 14.7 cents, or less than one-third the 45 cents in the dollar paid on salary income.

These calculations give us an insight into how significant rental property investments can be as a tax shelter. But they also show that current tax arrangements are pro-cyclical. When times are good, during the upswing of a house price cycle, our capital gains tax arrangements throw fuel on the fire. When times are bad, and price appreciation slows, they help starve the fire of oxygen. Housing markets are consequently more volatile.

These pro-cyclical tax arrangements have been in place since 1999. Before the 1999 Ralph Review real (inflation adjusted) capital gains were taxed at the investor’s marginal rate.  The effective rates of capital gains tax listed in table 2 are those calculated under the previous CGT arrangements. At an assumed annual rate of consumer price inflation equal to 2.5% and house prices edging ahead at 3%, an investor holding rental property for 15 years pays tax of only 8 cents on a dollar of accrued capital gain. But at an annual house price inflation rate of 5%, the investor is now paying a much steeper 21 cents. The previous arrangements were counter cyclical

Table 1: Capital gains tax (CGT) concession under current and previous CGT regimes1

CURRENT CAPITAL GAINS TAX REGIME: EFFECTIVE MARGINAL CAPITAL GAINS TAX RATES
Holding period

House price

inflation

5 10 15 20 25
0.025 0.224 0.214 0.204 0.194 0.185
0.03 0.222 0.209 0.198 0.187 0.177
0.035 0.220 0.205 0.192 0.180 0.168
0.04 0.218 0.202 0.187 0.173 0.161
0.045 0.216 0.198 0.182 0.167 0.154
0.05 0.214 0.194 0.177 0.161 0.147
 PREVIOUS CAPITAL GAINS TAX REGIME: EFFECTIVE MARGINAL CAPITAL GAINS TAX RATES
Holding period

House price

inflation

5 10 15 20 25
0.025 0.000 0.000 0.000 0.000 0.000
0.03 0.078 0.077 0.077 0.076 0.076
0.035 0.133 0.131 0.129 0.127 0.125
0.04 0.173 0.169 0.166 0.162 0.159
0.045 0.203 0.198 0.192 0.187 0.182
0.05 0.227 0.220 0.212 0.204 0.197

More volatile markets amplify investment risk. And the high levels of debt that negatively geared investors take on add to these risks. According to the 2014 wave of the Household Income and Labour Dynamics Survey (HILDA), 1 in 6 Australian households have invested in a rental property. For leveraged investors the average debt secured against their residential property is $388,590, or 2.3 times their average household income. The OECD reports that our household sector has average outstanding debt that is now roughly 2.5 times GDP, a significant lift from 1999 levels when debt was 1.5 times GDP.

Low interest rates have encouraged and supported these high levels of borrowing. But they are also inflated by the debt bias in property tax arrangements. We do not know whether the levels of repayment and investment risk accompanying these high levels of debt will prove sustainable. But these risks matter, as is evidenced by the attention that monetary authorities now give to house prices. As Professor Ross Garnaut has pointed out in “Dog Days: Australia after the Boom” (p100), worries about a house price bubble can deter the RBA from cutting interest rates when this is needed on other grounds.

Our tax treatment of property needs reform not least because it poses a threat to the long term heath of the national economy. Instability in housing markets was central to the Global Financial Crisis. Governments round the world are reining in property tax concessions as the lessons from the Global Financial Crisis are learnt.  We should be replacing pro-cyclical, debt biased fiscal settings through reforms that strengthen the resilience of our housing markets. Curbs on negative gearing accompanied by a return to the pre-1999 capital gains tax arrangements would be an important first step in that direction.

The views in this article are those of the authors and do not represent the views of Curtin University and/or Bankwest or any of their affiliates.

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