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Perhaps the most woefully misunderstood economic issue of the election campaign has been negative gearing.

I’ve been baffled by the number of times I’ve read commentary by otherwise thoughtful people describing negative gearing as a distortion to the property market—as a rort we need to crack down on.

But as someone who knows a bit about the economics of taxation, I can say that couldn’t be further from the truth.

Negative gearing is a natural, orthodox, and proper feature of any market for investment. And allowing negative gearing to be tax deductible is an essential component of an efficient tax system.

Negative gearing isn’t a bank account in the Cayman Islands

Negative gearing is a funny term. If you search online, you won’t find it in the lexicons of other countries. Not because it’s not allowed. But because it makes it sound grander than it really is. In reality, negative gearing is nothing special—it’s really rather boring and conventional.

If it didn’t have a fancy name, perhaps so many column inches wouldn’t have been wasted writing about it. And maybe we wouldn’t have cast it as a villain that must be slain at all costs.

When you buy an asset, you bear costs (like interest) in exchange for two types of return: cash (like rent) and a rise in value (called a capital gain). To tax this investment, we should add up the rent and capital gain over the life of the asset and deduct the interest and maintenance expenses.

The capital gain might not be realised for years, so this might come out negative in the meantime as the interest and other expenses exceed the rent received (this is all “negative gearing” really is).

And this doesn’t make you some wild speculator. With a 20% deposit, a 4% interest rate, and the 3% annual rental yields seen in Sydney recently, you’d be running a loss on an investment property.

An investor should be able to deduct this loss against their other income or carry it forward to subsequent years if they have no income this year.

This is a completely orthodox, boring, vanilla way to tax investment.

Negative gearing isn’t a distortion (but cracking down on it is)

A critical feature of investment taxation is to allow investors to fully deduct their costs. That ensures the tax rate applies equally to the upside and downside of investment. If not, then taxes will depress investment. That’s taxation 101.

Outlawing negative gearing prevents investors from claiming against these future gains their short-term losses. That distorts down the return on investment—so too the level of investment—to below where it would be without taxes. Inevitably, that reduces prices.

To lean against a fall in housing investment, the Labor proposal allows investors in new housing to continue to benefit from negative gearing, outlawing it only for existing houses. But it’s naïve to think that will quarantine the distortion.

Housing investment doesn’t just come in the form of new houses. It also includes renovations and extensions to existing homes, and other investments like blinds and flooring. If you run a loss on an existing property, the after-tax cost of these investments would rise, so investors would do less of them.

And the markets for new and existing houses are inextricably linked. By distorting down investment in existing houses, you inevitably distort up investment in new houses. That means even higher prices for new houses, and new houses built that shouldn’t be.

Some have argued that negative gearing unfairly favors investors over owner-occupiers. It’s true that owner-occupiers don’t get access to negative gearing. But more importantly, they don’t pay any tax whatsoever on the return to investing in their own home—the capital gain and the imputed rent (the rent they save by owning instead of renting).

Because of this, the after-tax return on a given housing investment is in fact radically higher for an owner-occupier than an investor of the same means. Cracking down on negative gearing makes this gap even wider.

Negative gearing isn’t the right target to make housing affordable

Some have blamed negative gearing for house prices that are far higher than they should be. While there’s no good evidence on that, it’s surely true that prices are higher with negative gearing than without it.

But rather than the root cause of the housing affordability crisis, negative gearing is really more of a catalyst.

The real culprit is the generous 50% discount on the taxation of capital gains. Because capital gains are taxed at half the normal rate, investors prefer more of their return in capital gain than in cash. Which makes negative gearing more attractive than it otherwise would be.

Reducing the capital gains tax concession was recommended by the Henry Tax Review, and has been adopted by Labor. And the contributing role of state and local governments in releasing and rezoning land for housing has been called out by many. They’re the right ways to address our distorted housing market.

The focus of taxation when it comes to housing should be on neutrality—that decisions of whether to invest in housing are just as they would be if there were no taxes.

Every time a politician introduces another hack into the tax treatment of housing, investment decisions are distorted. Prices are pushed up or down. Some win, some lose. But the goal of tax policy should be neither to support nor depress house prices, but rather to let the market evolve on its own.

And that kind of neutral tax policy would unquestionably accommodate negative gearing.

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