With investor demand surging, and steep rises in Sydney and Melbourne property prices, RBA governor Glenn Stevens last week noted it was "perfectly sound and sensible to ask ourselves whether we might at least lean on that a bit." In its Stability Review last week, the RBA pointed out investors are more inclined to take out interest-only loans, because the interest costs on investment property are tax deductible. But Saul Eslake, chief economist at Bank of America Merrill Lynch says the central bank has made "a very compelling case for the government to consider ending negative gearing for new investors." He accepts that it is not politically feasible to abolish negative gearing entirely because around 15 per cent of voters are currently taking advantage of negative gearing - a tax regime that allows them to buy assets and deduct the interest costs against other income. But he says that it would be easy for Canberra to decide that any new investment past a certain date would not be eligible for negative gearing.

Eslake argues that the Reserve Bank has three options for tackling the "unbalanced" housing market. "They can let the market run, which history has shown is not a good option. Or they can lift interest rates which will cruel the rest of the economy to stop an alleged risk in the housing market. "The third option is to introduce new macro prudential rules to limit how much the banks lend to certain types of borrower. But the risk here is that the new rules either don't work or that they hurt the wrong people, such as first home buyers." In contrast, if Canberra decided to curtail negative gearing, it would reduce borrowing by investors, which would mean that investors either paid less for properties or did not buy as many. Eslake says that some supporters of negative gearing argue that it gives investors the same tax treatment as business.

"This is a nonsense argument", he says. "Unlike investors, businesses don't get a 50 per cent discount on any profits they make when it comes to capital gains tax." Supporters also run the argument that scrapping negative gearing will lead to a steep jump in rents, as happened after former Treasurer Paul Keating decided to abolish negative gearing in 1985. "Actually if you look at what happened, rents went up in Sydney and Perth, but they didn't rise in any other market", Eslake says. "And that was because in 1986-7, Sydney and Perth had vacancy rates of less than 2 per cent. And so rents would have gone up anyway." In addition, some argue that abolishing negative gearing would create a shortage of rental properties because landlords would simply dump their portfolios.

"But other people will buy properties off the landlords, and so they will move from being renters to being home owners. "So there will be a drop in the demand for rental properties, which will balance out the effect of less supply." In its Stability Review last week, the RBA pointed out investors are more inclined to take out interest-only loans, because the interest costs on investment property are tax deductible. According to the report, "in Australia, around 64 per cent of loan approvals to investors are interest-only loans compared with 31 per cent to owner-occupiers." The problem is that if investors are only paying interest and are not reducing the principal on their loan, there is a risk that they will be in negative equity (which the loan balance is higher than the value of the property) if housing prices fall.

The RBA also noted that owning investment properties appeals to higher income earners. Investor households with incomes in the top 20 per cent of the income distribution owe 60 per cent of all investor housing debt, and more than one quarter of all the country's housing debt. In contrast, households in the bottom 20 per cent of income distribution account for a mere 2 per cent of investor housing debt. Follow BusinessDay on Twitter