While affordability, measured by how much households spend of incomes on loans, has hovered between 20 and 30 per cent and remains well-below record peaks, younger buys need more of their incomes to build up a deposit, the bank says in its submission.

Politically the issue is alive, with Labor indicating over recent months that it will consider the capital gains tax discount for investors who negatively gear as it prepares its own housing affordability policy.

David Murray, a former Commonwealth Bank chief and head of the Abbott government's financial system inquiry, has called for capital gains tax and negative gearing to be looked at as part of any changes. "You have to look at them all," he said in June.

Similarly, the head of the government's audit commission, businessman Tony Shepherd has recommended lifting the capital gains tax rate to a person's income tax rate.

"I can't see any reason to treat capital gains any different from income gains," he said last month. "And I think it does in fact probably lead to a greater emphasis in some respects on negative gearing."​

Others calling for a review of negative gearing include the Grattan Institute's John Daley and prominent economist Saul Eslake.

While real estate industry groups are vehemently opposed to watering down negative gearing, the Reserve Bank's submission represents the most high-level official challenge to the current system.

Capital tax breaks blamed


Reserve Bank officials have struggled this year to balance the need for additional official interest rate cuts – largely to maintain downward pressure on the Australian dollar in order to benefit the broader economy – against the threat of a property bubble.

The Reserve Bank questioned the federal government's 1999 decision to halve capital gains tax on investment properties, as well as the 2003 move that allowed for the first time super funds to borrow – both decisions taken during the John Howard's prime ministership.

Both measures are having the affect of encouraging more people to invest in property over other assets, the Reserve Bank suggests.

"Since property can usually be purchased using higher leverage than other assets that produce capital gains, property is especially affected by this feature of the tax system," the Reserve Bank said in its submission.

In addition, the bank points out that many self-managed super funds have taken advantage of the borrowing rules to speculate on property.

"At the margin, this has increased the population of potential investors," it said, adding that while the stock of housing owned by self managed funds is small, it has grown quickly – a trend that Reserve Bank officials have previously warned may be increasing risks across the financial system.

Hockey defends principle

The Australian Prudential Regulation Authority is currently actively engaged in using regulations to suppress investor buying in key parts of Sydney's market, an official market intervention unseen since the 1970s.


Treasurer Joe Hockey, who delivered a wide ranging speech on tax reform on Wednesday, echoed the Reserve Bank's concerns about how capital gains tax operates, describing it as an "in-built structural challenge."

"For example, you're allowed to negatively gear a $1 million 40-year-old unit in the middle of Melbourne, but you may not be able to negatively gear a business employing 10 people that is exporting and engaged in productive activities," Mr Hockey said.

"Do you address the issue of negative gearing on that property or the negative gearing on the business?"

Mr Hockey said a key principle was ensuring that people be able to deduct expenses of a business or investment against their primary income.

"By removing negative gearing on real estate, as some are suggesting … they are creating an exception to a standing rule in taxation law. And that is that you can deduct the cost of the loss against another form of income, that would be creating another exemption," he said.

Business Council of Australia chief executive officer Jennifer Westacott said broader tax reform meant keeping all options on the table, particularly in the lead-up to next week's federal and state leader's retreat.

"It will require a level of bipartisanship we have not seen for a long time, and for state and territory governments to sign up to achieving the optimal tax system for the country while making their own tax arrangements more competitive," she said.

First-time buyers hurt


The Reserve Bank's submission highlights that Australia's tax system effectively disadvantages renters over owners, particularly those with little or no debt.

While mortgage interest repayments cannot be deducted – as is the case in countries such as the US – taxpayers are not subject to taxation on so-called "imputed rent," which is what a homeowner would pay if they were renting their home. This exists in Switzerland, and has the effect of reducing home ownership rates, the Reserve Bank said.

The bank concludes its submission by suggesting the current tax system is effectively cutting first-time buyers out of the market.

"Given the value Australian (and other) households place on home ownership, policy should not unduly advantage property investors at the expense of prospective owner-occupier home buyers.

"Financial stability considerations would suggest that tax and regulatory frameworks should avoid encouraging over-leveraging into property, whether by owner-occupiers or investors."

Negative gearing allows investors to reduce their taxable income from wages by deducting expenses incurred from owning an investment property, including interest payments, and then only pay 50 per cent tax when the capital gains are realised.