The Henry Review reviewed: part 2

In part 1 of our review of the Henry Review, we looked at tax and owner-occupied housing. This time we're looking at tax and rental housing – but before we do, a bit of news.

You'll recall the Federal Government's promise to convene a tax summit, at which the Henry Review may get a second lease on life. Now a date has been set – 4-5 October 2011 – for what's to be called the National Tax Forum. Pencil it in, readers! You can get up to speed and keep up to date by checking out the excellent TaxWatch website – and, of course, the Brown Couch's own continuing review of the Henry Review.

(Ken Henry (at right), with Treasury officials in sportive mood.)

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In a universe parallel to our own, the story of rental housing and tax might be a simple one: rental properties are valued as assets that produce a valuable service – housing – and owned by persons with the necessary skills to make a viable business out of providing this service; the revenue of the business covers its costs and provides an income for the owner, which is taxed, and if the assets increase in value, the gain is taxed too.

For a picture of how differently things go in our own universe, consider the following charts. The first shows the number of persons who have become landlords (or more precisely, persons who declare rental income in their tax returns) – which grew strongly over the last decade-and-a-half. It also shows the proportion of them declaring a rental loss – and this grew strongly too.

(Source: ATO Tax Stats Chapter 2 – Personal Tax, various years)

And let's look at their losses, in dollar terms. In 2008-09, the most recent year for which we have figures, Australia's landlords took in rent revenues of more than $26 billion – but after their costs, ended up losing $6.5 billion. Since the turn of the century – the last time they actually made money from rents – the nation's landlords have lost more than $36 billion.

(Source: ATO Tax Stats Chapter 2 – Personal Tax, various years)

And these were rental property's boom years (that uptick in 2008-09 is the result of some landlords bailing out in the GFC). What's going on?

Negative gearing, that's what's going on. Negative gearing is financial alchemy, turning losses into gains – or rather, at an elemental level, turning income into capital.

More prosaically, negative gearing is the name given to the situation where an investor borrows to buy an asset and the interest they pay is greater than the revenue generated by the asset. They get into this situation with the hope or expectation that for all the losses they have to wear along the way there will be a greater payoff at the end – that is, through an increase in the value of the asset.

Other names can be given to this strategy: 'speculation', or 'gambling.' The Henry Review calls it another form of savings, like putting money in the bank is savings, and putting money into owner-occupied housing is savings. This is, in our view, an undeserved compliment to negatively geared rental property speculation, but it does give us some common points of reference with the 'bank saver' and 'owner-occupied housing saver' from part 1 of our review and a way of thinking about how negative gearing works, so once again we'll work with Henry on this.

Here's how the alchemy works. Start with the negatively geared landlord's gross income: rental income from the property, and income from other sources – namely work. All the rental income goes on interest and other deductible costs, and a far bit of their other income – in total, $6.5 billion of it – goes on those costs too. There's no tax payable on the rental income (because in net terms, it is wiped out by costs) and – under a provision of Australian tax law that is almost unique internationally – there's no tax payable on that other bit of the landlord's income too.

By contrast, our bank saver only puts their money away after the tax office has run its eye over all the saver's income and taxed it accordingly; likewise our owner-occupied housing saver puts their money into the house after it has been taxed. With the negatively geared rental property saver, the money is put towards the cost of the loan before it is taxed, thus reducing taxable income and possibly even the rate of tax. It is as if the income they spend on interest etc melts into air, before the taxman's very eyes.

Or so it seems. It reappears as the value of the property it has bought increases, transmuted into capital. And when the property is sold and the capital gain is realised, it does get taxed (contrast the income from the owner-occupied saver's capital gain, which is not taxed at all) – but it gets taxed at half the rate applicable to income from work.

Now, there's a golden rule to be observed here: the negatively geared rental property saver makes a profit only the after-tax capital gain pay-off at the end of their speculative adventure is more than the total income lost to interest etc along the way. Satisfaction of this rule is helped a lot, of course, by only half-taxing the capital gain, and by the fact that the landlord paid no tax on the income that was spent on interest, and may have paid a lower rate of tax on the rest of their income.

And it has also been helped a lot by the fact that they are using, as the crucible of their alchemy, the housing market. A person can (and quite a few people do) negatively gear other assets, such as shares, but when it's housing, they're trading in a market alongside owner-occupiers who, as we've seen, don't pay tax on capital gains and so are encouraged to put any money they have to spare into housing. Thus the tax-preferencing of owner-occupation is also an encouragement to speculation by landlords, and encouragement to speculation is encouragement to further speculation, even to the extent that the speculators begin squeezing out the owner-occupiers – which, prior to the GFC at least, is precisely what was happening in the Australian housing market, as evinced by declining rates of home ownership.

Henry presents a neat graph showing the results of the different tax treatment for each of the savings strategies we've discussed (it also includes superannuation, domestic shares and foreign shares). The results are presented in terms of effective marginal tax rates – in other words, how much each additional dollar of income from these savings actually gets taxed, with reference to the various marginal tax rates that apply to incomes generally.

(Click on the image for a better view. Graph based on Treasury assumptions of 6 per cent nominal return; 2.5 per cent inflation; for rental property, 50 per cent of the return is attributable to capital gain and 50 per cent to rental income and the rental property is held for 7 years then sold; shares are held for 7 years then sold; superannuation is held for 25 years and the individual is eligible for a tax-free payout at the end of the period.)

On these assumptions, pity the tenant diligently putting their spare dollars away into a bank account, rather than borrowing and spending on a house.

In a second graph of effective marginal tax rates, Henry zeroes in on the rental property saver category and shows how crucial negative gearing is to the success of their strategy. More than that – it shows how crucial is the level of gearing (that is, the proportion of borrowed money in the landlord's purchase of the property).

(Click on the image for a better view. Graph based on Treasury assumptions of 6 per cent nominal return; 2.5 per cent inflation; for rental property, 50 per cent of the return is attributable to capital gain and 50 per cent to rental income and the rental property is held for seven years then sold; tax on debt provider disregarded.)

The more debt, the more income melts into air, the more tax is reduced – all subject, though, to the golden rule above. 'This creates', Henry says, with some understatement, 'significant distortions in how rental properties, in particular, are financed and for the rental property market.'

And how! Just look at the huge growth in the debts of landlords (and, for good measure, owner-occupiers):

(Click on the image for a better view. Source: RBA Table D2)

All that money, pumped into higher prices.

(Australian capital city house prices, index. ABS cat no 641601 and 641603)

And look, too, at how landlords spend their borrowed money: pursuing gains in tried and tested housing markets, on established houses and flats. These speculators barely build any new stock.

(Click on the image for a better view. Source: RBA Table D6 - note lending commitments are not aggregated, unlike debts in Table D2).

So how to address the sources of these distortions in tax system? One way would be to put an end to the Australian oddity and allow interest etc to be tax deductible only against rental income. This way no more of a landlord's income from work and other sources would disappear before it is taxed, and the golden rule of profiting from rental property would apply a sterner test of value. This is TaxWatch's preferred reform, and as we saw in the articles referred to here, Saul Eslake advocates it too.

The Henry Review proposes something different. In keeping with his theme of making the tax treatment of the various forms of saving more consistent, Henry would reduce the favourable treatment of capital gains by lowering the capital gains tax discount from 50 per cent to 40 per cent. He'd also even up the treatment of rental income, by applying a 40 per cent discount to it (net of interest etc), too (as he would to interest income from bank savings, as we saw in part one). Negatively geared landlords could still deduct interest costs from their non-rent income, but the effect of applying the discount on a net rental income basis would reduce the extent to which interest costs reach into non-rental income and reduce taxable income.

Henry indicates the results in a chart contrasting the current approach to his proposed one, again in terms of effective marginal tax rates and using the same assumptions as before.

(Click for a better view.)

This is, so to speak, a proposal for watering down the alchemy of negative gearing. It is, to use Henrian understatement, a mild reform.

Next: housing transfers – that is, rent rebates in social housing, and rent assistance in private rental.