As I mentioned a while back, I’m planning a series of posts on tax policy. Since debate about “negative gearing” has been spurred by the suggestion that Labor might restrict it, this seems like a good time to cover the topic.
I’ll give my summary upfront, then go on. The problem is not negative gearing in itself but its interaction with the concessional treatment of capital gains. There are a variety of solutions, but the best is probably to “quarantine” business losses for individuals, at least with respect to housing investments, and allow them only to be used as an offset against capital gains.
First, where does the term “negative gearing” come from? “Gearing”, in this context, refers to the ratio of debt to equity in the financing of an investment. Roughly speaking, the gearing ratio will be reflected in the ratio of interest payments to equity returns (income net of operating expenses and interest) . But what if the investment has so much debt that interest payments are higher than income net of operating expenses. Then the standard debt/equity measure of gearing is large and positive, but the second interest/equity returns measure is negative. Hence, the term.
Under the ordinary rules of taxation, interest and other expenses can be deducted from the earnings of a business enterprise before paying tax. So, there’s nothing special about the deductibility of interest in the case of negative gearing. But in the ordinary course of things, a business that makes continuous losses will close down. So, the investor has made a mistake, reducing their taxable income, and some of that loss takes the form of a reduction in tax paid. This is a substantial benefit for people on the top marginal rate of taxation, but much smaller for those on low incomes. In particular, while investment property has many characteristics that might make it attractive for retirees, the deductibility of operating losses is not one of them, since only a tiny fraction of retirees are on the top marginal rate.
The problem for revenue emerges when the investment is held for the purpose of generating a capital gain, as is the case with most investment in rental housing and many small businesses. In an ideal system of taxation of current income, capital gains would be taxed, at the full rate, as they accrued, and operating losses would automatically be set against them. Under our system, however, capital gains are taxed only when the asset in question is sold, and only half the capital gain is taxable. Not only that, but investors can time the capital gain for a year when their income, and therefore their marginal rate of taxation is low. So, there is a strong incentive to put money into investments that generate capital gains rather than those that generate income throughout their lives.
There are a variety of ways this might be fixed, such as eliminating the concessional treatment of capital gains. But the simplest (adopted, I think, in the US) is to “quarantine” business losses like this so that they can not be offset against income from other sources. When the asset is sold, the accumulated deductions can be offset against capital gains, and anything left over deducted from income.
It’s encouraging to see that Labor appears willing to tackle the problem. Overall, reining in negative gearing should improve tax and housing policy, especially given the evidence that speculative investors make bad landlords (H/T Nancy Wallace). However, a more comprehensive reform addressing issues like transfer duties land tax exemptions for homeowners would be even better.