By Leith van Onselen

The final report of the Murray Financial System Inquiry, released in December, was critical of Australia’s tax incentives that enable investors to claim losses from their investments against unrelated wage/salary income.

Specifically, the report noted that the extreme growth in mortgage debt had been driven, to a large extent, by the favourable tax treatment provided to housing, and recommended that the Abbott Government’s White Paper on tax explicitly seek to remove these tax concessions, specifically capital gains tax and negative gearing concessions:

Capital gains tax concessions for assets held longer than a year provide incentives to invest in assets for which anticipated capital gains are a larger component of returns. Reducing these concessions would lead to a more efficient allocation of funding in the economy… For assets that generate capital gains, the tax treatment encourages leveraged investment, which is a potential source of financial system instability. Investors are attracted by the asymmetry in the tax treatment of expenses and capital gains, where individuals can deduct the full interest costs of borrowing (and other expenses) from taxable income, but only half of their long-term capital gains are taxed. The tax treatment of investor housing, in particular, tends to encourage leveraged and speculative investment in housing…

Now, David Murray has urged the government to replace negative gearing of property with “neutral gearing”, in order to take some heat out of the property investment market. From The AFR:

…given that “housing tends to be more of an issue” – since most people use negative gearing tax breaks for rental property – there was a case for restricting it to “neutral gearing”. That is where a property has the same amount of money being paid in interest as is received in rent. “I tend to think if real estate is a favoured asset it gets more than its fair share as a consequence of negative gearing,” Mr Murray said. “I’d be more inclined to go to neutral gearing than to get rid of it.”

Murray’s approach is sound, and more or less aligns with the approaches proposed previously by Saul Eslake and yours truly. That is, investors could deduct interest expenses up to the amount of net income generated by that investment in any given income year, but would have to carry forward any excess interest expense as a deduction against the capital gains tax liability when the asset is ultimately sold.

This is the way the tax law works in the US and the UK, and is also similar to the scheme introduced temporarily by the Hawke/Keating Government in 1985 (repealed in 1987).

Under such a system, negatively geared investors would lose the right to deduct excess expenses at double the rate at which the capital gain produced by that same investment is taxed (since capital gains are taxed at half the marginal rate applicable to other income, provided the asset is held for more than 12 months).

It would also take some steam out of the property market, reduce systemic risk for the financial system and the economy, improve allocative efficiency (since less capital would flow to unproductive houses), and save the Budget money.

Put simply, reforms of this nature are a ‘no brainer’.

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