Some thoughts on Changes to Negative Gearing and the Capital Gains Tax Discount
With the recently announced federal budget illustrating changes to negative gearing and the capital gains tax discount, there has been significant coverage and controversy. The proposal is to limit negative gearing after the budget announcement to new property builds and, regarding the CGT discount, to return to the prior indexation method by July next year, with a minimum CGT tax rate on real gains of 30%. If one’s marginal tax rate is higher than 30%, then that will be the tax rate on real capital gains.
Under the former status quo - the pre-budget negative gearing and CGT discount arrangements - the investor can purchase an asset for which the expenses (interest, annual running costs) exceeds the yield (rent, dividends), reduce the negative carry cost via the tax deduction, and then sell at a higher price with a 50% tax discount on the capital gain. Obviously, this provided a great incentive to speculate on secondary markets which do not directly add to GDP. Asset flipping on secondary markets may change who owns assets and who receives interest, rents, and dividends, but it does not directly increase either of these forms of income such that the GDP of the nation is higher.
The argument that changing these tax concessions will raise the rents that the tenants must pay illustrates a misunderstanding of asset price setting. The landlord charges the rent that the market would bear. Being able to write-off annual losses via negative gearing does not reduce the rent that landlords will charge. Rather, this tax benefit is capitalised in asset prices via the discount rate effect. Suppose the mortgage rate is 6% and the rental yield is 3% such that the negative carry is 3% per year, and suppose the investor earns a high income and has a marginal tax rate of 50%. This means that the negative carry cost is 1.5% after-tax. If this tax benefit is removed for existing property, then the yield will need to rise to 4.5% for the landlord to be at the same ‘affordability’ as before. No doubt, this will be confused with the policy change causing actual rents to rise. But this rise in yields will be through a reduction in asset prices, just as a higher discount rate on bonds does not raise the interest payments of fixed coupon bonds but, rather, leads to a fall in their prices which causes the yield to rise to the market interest rate.
Already, this channel appears to be having an effect as new investors’ borrowing capacity on existing real estate is being slashed. Suppose the investor can afford $60,000 in annual interest payments. At a 6% interest rate, the landlord can afford to borrow $1 million. Now with negative gearing being removed adding the equivalent of a 1.5% interest rate hike, that $60,000 annual interest at 7.5% implies a borrowing capacity of $800,000, a $200,000 reduction in borrowing capacity. Since mortgages finance property purchases at the margin, and asset prices are set at the margin, this can flow through to a sharp reduction in demand for purchasing property.
What of the argument that landlords will raise rents by selling their properties? If they sell to other landlords, there is no change in the supply of rental dwellings. If they sell to those seeking to buy a home to live in, this reduces rental demand by the same amount. What these tax changes do, especially as they are still available for investors seeking to construct new property and therefore add to dwelling supply, GDP, and the capital stock, is reduce the incentive to speculate on secondary markets. The 50% CGT discount rewarded short-termism over long-term investment, especially as the longer the time horizon the more that inflation has an impact on the price of an asset, while in the short-term, the 50% discount compensates well above short-term inflation.
Investors, compared to those who receive their income through wages, also get a much better deal. Unrealised capital gains can continue compounding tax-free. The investor has flexibility on when to pay CGT. Those who own securities such as shares and bonds can also sell only a fraction, and therefore pay a fractional tax, to realise the economic equivalent of a capital gain. The wage earner gets no such flexibility, and since secondary market asset churn does not directly add to GDP, the economic merit of the argument for concessional tax treatment only applies to those who invest constructing new assets which, in principle, can increase the national wealth rather than merely change the distribution of it.
Thanks. I need to re-read this. But, I thought I ought to point out my understanding that the 50% discount rule only applies to investment after 12 months, ie, not short term in the the sense of less than 12 months.
Although most consider negative gearing as a separate tax section. It is really just a part of the 'Deductions' section. Hence, it isn't explicitly about the losses on the actual property, its actually part of the whole income related costs and expenses. Whether a rental loss occurs or not, it still reduces the tax paid on total gross income, ie, reducing taxable income. in that sense it is not necessarily about rental loss. I want to see change in the deductions system. But because most, including economists, are unaware of the point above, they harp on about negative gearing, and meanwhile the multimillionaires will continue to pay minimal tax, and the low top tax rate encourages outrageous salary packages for CEO, etc that increase inequality.