Allowing negative gearing losses on passive investments to be used as a deduction against other income is a major assault on the equity and fairness of Australia's income tax system.
The assault on equity is compounded by the fact that Australia's capital gains tax only taxes half the gain made on the sale of assets when held by individuals, and through trusts, for 12 months or more - so called discount capital gains.
The unfairness is further compounded by the fact that Australia's tax system only taxes capital gains when the asset is sold. It would however be hard to implement a capital gains tax that taxes gains before the point of sale.
Another major aspect of the unfairness is that negative gearing is uncapped, and not targeted. That is, it does not matter how large the loss is on the passive investment, the whole loss can be used against other income, for example salary.
There are two assaults on equity here. First, taxpayers who can afford to carry a bigger nominal negative gearing loss on their passive investments obtain a bigger nominal tax break from the income tax.
In other words, the uncapped nature of negative gearing means that taxpayers with higher incomes can extract a larger tax break because they have a higher 'other income'. People with higher incomes are very likely to have higher levels of wealth than those on lower incomes.
Secondly, the so-called 'upside down effect' that is caused by open ended deductions is also prevalent in the case of negative gearing. That is, allowing a taxpayer on say the 30 per cent tax rate bracket a $100 deduction provides a tax break of $30, but the same $100 deduction for a taxpayer on the 45 per cent tax rate bracket gives rise to a tax break of $45. On this simple example, the tax break for the higher income earner is 150 per cent of that of the lower income earner.
In many other areas, this upside down effect - a bigger benefit from a given deduction, is countered by using tax offsets (rebates) instead of deductions. Yet, in the area of negative gearing, no regime exists to target or 'equalise' the benefits across taxpayers.
The equity problems of continuing to allow negative gearing would not be quite as bad if Australia taxed the whole of a capital gain made on the sale of investment assets by individuals. But this is not the case. But even getting rid of the discount capital gains, the uncapped nature of negative gearing and the upside down effect is still an assault on the equity of the income tax system.
Subject to the qualification for so-called small (marginal) businesses, negative gearing is permitted for taxpayers operating a business (ie loss on a business can be used immediately as a deduction against other income). But operating a business is commercially and economically quite different to holding a passive investment.
Risk taking through the creation and expansion of businesses is central to promotion of economic growth and jobs. This can hardly be said for most passive investments. (Losses from a 'small business' are quarantined. (Negative gearing not permitted)).
If the government is going to cut back on negative gearing, it must not introduce quarantining (abolish negative gearing) immediately. That is, there should be a phased introduction of quarantining over a transition period, say three to five years, so that there is less chance of widespread, knee-jerk, reactions to tax changes.
For example, let taxpayers use 75 per cent of their loss in the first year after introduction of quarantining, 50 per cent in the next year, until no usage (full quarantining/abolition of negative gearing). This means it is less likely that affected taxpayers will look to an alternative investment in the short term.
It also gives affected taxpayers time to adjust to the new tax environment, a fairness thing in itself. Given the 'retrospective' nature of the change, a degree of fairness here is also important.
The other thing that must happen on the abolition of negative gearing is that quarantining is also introduced for close substitutes to rental property investments.
The problem with the abolition of negative gearing (quarantining) back in 1985 was that the then government Hawke Labor Government failed to also stamp out negative gearing on close alternatives to property investments such as shares, and units in property trusts).
This meant that affected taxpayers had an immediate alternative investment where negative gearing was permitted, and the shift across was relatively costless.
The current Labor Government is unlikely to make the same mistake. Indeed, the Government now requires the add-back of negative gearing losses on financial assets, as well as rental properties, in calculating income under various social benefit programs, and in calculating income for payment of certain social levies.
As for the claim that restricting negative gearing would stifle the flow of new homes and further push up house prices, two point should be made.
First, if negative gearing is abolished for investments that are close substitutes to housing, then taxpayers may very well stay with the housing investment option because the alternative investment does not have the negative gearing advantage over housing. That is, income tax becomes less of an issue on investment choice.
Secondly, there are numerous other factors at play in investment choice decisions, such as returns on investment, the speed at which an asset can be sold, other government imposts such as land tax and local rates. In other words, attributing cause and effect to the relationship between abolition of negative gearing and the reduction in residential housing stocks is probably stretching credibility.
Rules would have to be introduced to distinguish a passive investment from a 'business activity'. This is not a problem. The Income Tax Act does this efficiently in many other areas.
