Where do the parties stand on housing: part 5 – Saul Eslake (a non-party)

Yesterday we commended the Greens for their housing policy, including their 'Better Deal for Renters'. Today we commend Saul Eslake, whose natural habitat is the big end of town, on his  outline for a better housing policy – different from, but complementary to that of the Greens – and his critique of Australia's '50 years of housing failure'.

Please follow that link to Prosper Australia – it is essential reading.

Australia's two major parties do have a housing policy, despite their silence on the subject at election time. Their longstanding mutual policy is, tragically, to treat housing not as the seat of security and comfort that is the right of every citizen, but rather as a get-richer-quick scheme. In recent years, it has become a shady adjunct to retirement incomes policy, transferring the future incomes of younger households to older households for their present consumption.

There are plenty of people in both the major parties who would dispute this, because they genuinely don't see housing this way, and regard making housing less accessible and more expensive by deliberate policy as unconscionable. On their terms, then, faced with a 50-year track record of failure, they must change their parties' housing policies.

Negative gearing fail

It was unedifying spectacle all round. Yesterday, after Shadow Treasurer Joe Hockey indicated to media that a Coalition government would conduct a review of tax policy, including the tax treatment of negative gearing, Treasurer Wayne Swan hurried to assure the negative gearers that a Labor government would not touch it:

'We ruled out any change to the existing arrangements in our response to the Henry (tax) report.'

Whereupon the Shadow Treasurer hurried to get the initial media reports retracted and assured the negative gearers that nothing would be changed, at least not in a Coalition government's first term.

While the Treasurer and Shadow Treasurer hasten to do nothing about negative gearing, the public discussion about this wretched bit of policy will proceed. And it has proceeded. Almost three years since we found we had to tell tenants and policy makers that negative gearing was not their friend, we find that more and more people we speak with harbour no illusions about it: it does no good, only bad, to our housing system, to our government finances, and to the fairness of our society.

On the bad it does to our housing system: it distorts the rental sector to the disadvantage of low-income renters in particular, by facilitating speculative purchases of higher value/higher rent properties, shuffling the relatively affordable stock out of rental, and doing next to nothing for new supply. 

On the bad it does to government finances: in 2010-11 (the most recent year for which figures are available), Australia's negatively-geared landlords posted a net loss of $12 billion on their rental properties, which they deducted from their non-rental incomes at tax time. As result, about $4 billion that would otherwise have been collected in tax wasn't.

And so to just one example – in the media today – of the bad that negative gearing policy does to fairness. While it forgoes the billions that it might otherwise have collected in tax from negatively geared landlords, the Federal Government goes about looking for 'savings' in its expenditures – such as on social security payments to people doing it really tough. Earlier this year, the Government withdrew from some 84 000 single parents their entitlement to Parenting Payment, and put them on the significantly lower Newstart allowance instead. The Salvation Army has noticed many of them have had to turn to it for help. The Salvos quote one of them:

'Since I have been put on Newstart, I am unable to afford the rent I signed a contract on, and have had to break my lease and move into a caravan, making my life very hard. I am forced to live substandard.'

This person has been let down not just by an increasingly mean social security system, but by an unaffordable, distorted rental market too.

The Henry Review review: part 4

Now we draw to a close our review of the Henry Review and, in particular, what it had to say about housing.

We'll do so with a summary of what it had to say about (1) the taxation of owner-occupied housing, (2) the taxation of rental housing, and (3) the provision of housing assistance in the forms of Rent Assistance and social housing.

In relation to each, we'll also note the response of the Government, and add a few words of our own.

*

1. Taxation of owner-occupied housing.

Henry says: let's keep the preferential tax treatment of owner-occupied housing. In particular, let's keep exemption of owner-occupied housing from capital gains tax. (And let's not even consider the taxation of imputed rents – that is to say, the value of the housing services that owner-occupied housing produces and that is consumed directly by the owner.)

But, let's include owner-occupied housing in a reformed land tax regime.

And let's think about a bequest tax.

The Government said: we 'will not... at any stage... introduce land tax on the family home – this is a state tax and thus an issue for the States.' (And it goes without saying that we agree with Henry on keeping the exemption from capital gains tax.)

And we will not introduce a bequest tax at any stage, either.

The Brown Couch says: first of all, a general note: this was, literally, the Government's response to so much of the Henry Review's recommendations. Its press release of 2 May reads: 'In the interests of business and community certainty, the Government advises that it will not implement the following policies at any stage.' Thereafter follows nineteen dot points, of which land tax and the bequest tax are just two. We'll encounter a few more of these 'not at any stage' dot points.

As for the substance of the recommendations and the response: the preferential tax treatment of owner-occupied housing is a core component in the Australian house price bubble-making machine.

Now, this machine runs on a volatile blend of animal spirits and debt. It seems that at the moment, supplies of this fuel amongst Australian households may have been tapped dry: housing credit growth has stopped, and prices are flat and falling. We've heard from respectable commentators – that is to say, commentators who have long argued for reform of the taxation of housing to improve affordability – that including owner-occupied housing in the capital gains tax regime at this stage may be revenue-negative, because the gains aren't there at the moment and, as a necessary corollary, you'd also have to allow deductions for owner-occupiers' interest payments. And the latter aspect could well give a fillip to borrowing – at this stage. But, at some stage, there must come a time to start dismantling the house price bubble-making machine, including the tax-preferencing of owner-occupied housing.

Land tax reform, however, is something we could proceed on now – and the fact that it is a tax levied by the States does not mean that the Commonwealth cannot act on it. In particular, the Commonwealth should look at how it distributes, through the Grants Commission, its tax revenues to the States, and calculate the distribution on the basis that each States' own tax base will include a reformed land tax.

And the bequest tax – or unearned wealth tax, as we like to call it – let's do it!

2. Taxation of rental housing.

Henry says: investing in rental housing, shares, putting money in the bank – it's all saving, isn't it, so let's tax these different ways of saving more consistently. Let's tax the income from savings (whether it's rent, dividends, interest or capital gain) at a 40 per cent discount. In relation to rental housing, this means slightly more tax on capital gains, reduced tax for landlords who have a positive net rental income, and reduced losses deducted against other forms of income for landlords who have a negative net rental income – thus watering down the encouragement that Australia's unique negative gearing provisions give to big-borrowing landlords.

The Government said: we will not reduce the capital gains discount, or apply a discount to negative gearing deductions.

The Brown Couch says: negative gearing is financial alchemy, and when it's conducted in the crucible of the housing market, which is already subject to the tax preferencing of owner-occupation, you get a very volatile, bubbly brew. The reforms Henry recommends are mild; for a stronger reform, try quarantining rental losses from being deducted against other forms of income at all.

3. Housing assistance.

Henry says: as a form of housing assistance, Rent Assistance ticks a lot of an economist's boxes. We just need to lift the thresholds at which Rent Assistance maxes out.

Social housing, on the other hand, presents problems – but many of them are fixable, if you extend market rents and Rent Assistance to social housing tenants. For tenants with very high needs, there should also be a new additional payment, that goes to their landlord.

The Government said: we will not ask the States to charge market rents [subject to Rent Assistance] to social housing tenants.

The Brown Couch says: Like Henry says, lift the caps on Rent Assistance. And Henry makes some strong arguments about the problems with social housing's income-related rents. There's a number of forces converging on social housing rent policy that will change its shape – what do tenants and their advocates want to make of this?

*

Thus ends our review of the Review. We look forward to the National Tax Forum on 4-5 October this year, and recommend you keep an eye on TaxWatch in preparation.

A final couple of observations: all those 'not at any stage' dot points happened not just one year ago now, but one prime minister ago, one hung parliament ago. And, having retired from the Treasury, Dr Ken Henry has recently taken up a part time job in the office of the Prime Minister. He won't be doing the photocopying and making the coffee.

The Henry Review reviewed: part 3

The Henry Review was more than a review about Australia's tax system: it was a review about Australia's tax and transfer system, so as well as looking at the money the Government takes in, it also looked at the payments, subsidies and other forms of financial assistance that the Government pays out to individuals.

We'll consider what Henry says about housing transfers – in particular, Rent Assistance and public housing – below.

(Ken Henry contemplates the effective marginal tax rates associated with public housing rent rebate policies)

But first, a final word on what Henry says about tax.

We've noted in the previous two parts of our review that the taxation of income from savings (which, on Henry's definitions, includes property speculation) is a focus of the Henry Review, and in his recommendations Henry develops the theme of treating different means of savings more consistently, particularly by taxing most forms of savings income at a 40 per cent discount to the saver's other income.

As always, the question arises: if you tax savings incomes less heavily than labour incomes, who benefits? Virtually by definition, the wealthy benefit.

Henry gives an indication of just how skewed is this benefit in the preliminary discussion paper to the Review, which shows just how skewed is the distribution of wealth – and hence, the distribution of labour incomes and capital incomes (ie what we've been calling savings incomes: interest, net capital gains, net rent, dividends and trust incomes).

In 2005-06, the bottom 50 per cent of Australian taxpayers received 17.6 per cent of total labour incomes, and 15.8 per cent of total capital incomes. On the other hand, the top 10 percent (keep in mind, this is a much smaller group) received 28 per cent of labour incomes, and 53 per cent of capital incomes.

To really make the point, an even smaller group – the top one per cent of tax payers – received 5.3 per cent of labour incomes, and 28.5 per cent of capital incomes.

In other words, the better off you are, the stronger the mix in your income of capital income to labour income. And Henry would generally tax capital incomes lightly, and labour incomes relatively heavily.

Henry doesn't give a strong justification of of this basic bias in the tax regime he proposes. He does, however, make a suggestion that would go a little way towards mitigating it: a bequest tax. The tax Henry has in mind would apply only to inheritances above a 'substantial threshold', so as to fall on the wealthiest 10 per cent of households, and then apply simply as a low flat rate.

'You mean "death duties"!' gasp the decadent bourgeoisie. That appellation is fine by us here at the Brown Couch, though a bequest tax could probably be even more accurately called an 'unearned wealth tax'.

It should be noted that the Henry Review does not go so far as to positively recommend a bequest tax – it just spells out the benefits of one, then invites a community discussion of the issue. Good luck with that.

*

On to housing transfers.

First up, Henry gives a strong statement – albeit in the peculiar language of economists – of support for housing assistance:

A key function of national government is the prevention of capability deprivation — that is, the absence of fundamental capabilities that enable people to participate fully in society. Income support is a major mechanism for achieving this end. It provides people with resources to maintain an adequate standard of living and supports their participation in the community, including the workforce.... There is a further need for specific housing assistance in recognition of the special role it plays in supporting wellbeing.

And in similar terms, Henry states his general principle for the provision of housing assistance:

Housing assistance should be provided in a way that is equitable, does minimum harm to participation incentives and gives recipients choice in the housing they occupy.

Now we turn to the actual lie of the land. In Australia, Henry observes, 'there are two major forms of housing assistance available to low-income earners: Rent Assistance and public housing. A person can access only one or the other.'

The implication is that there is a great divide in Australian housing assistance policy. There is, but with respect, Henry doesn't quite define the divide exactly right. Rather than 'public housing' he really ought to have referred to 'social housing', which is a larger category that also includes community housing organisations. True, it's only a slightly larger category: in 2008, there were about 30 000 community housing tenancies, compared with 330 000 public housing tenancies (and, for the record, about 940 000 Rent Assistance recipients). Still, I don't think this is nit-picking, and we'll return to the complicating factor of the community housing organisations further below. Henry notes their existence, but otherwise he refers to public housing.

So how does that general principle of housing assistance go, either side of the great divide?

Rent Assistance
Rent Assistance is paid by Centrelink to recipients of other Centrelink payments (eg Age Pension, Disability Support Pension, Newstart), and recipients of Family Tax Benefit Part A (where paid at more than the base rate), where the recipient pays more than a certain threshold amount of rent. These thresholds vary according to the recipient's household type (ie single or couple, and number of kids). The amount of Rent Assistance paid is 75 cents for every dollar of rent above the threshold, subject to a maximum amount, or cap. These caps also vary according to household type.

Generally speaking, Henry likes Rent Assistance. For Henry, it's equitable, in that it is well-targeted to need (the thresholds rule out about 40 per cent of Centrelink recipients, who pay no or low rents). It's okay in terms of work participation, because the amount paid is independent of the amount of the recipient's other Centrelink payment. This means, for example, that the recipient who does some work and earns a bit of money might have their Newstart payment reduced, but not their Rent Assistance – which is less of a discouragement to working than if both the Newstart and the Rent Assistance were hit at once. It also means that the rate at which income support is withdrawn is the same for renters and owner-occupiers – which is important in terms of equity.

And, in terms of choice, Rent Assistance recipients can choose which houses to apply for, and when to move. Henry also observes that because Rent Assistance works as a 'co-payment' - that is, you and the Government go 25/75 in paying the rent above the threshold amount – there is an incentive for receipients to economise and choose lower cost rental housing (about 30 per cent of Rent Assistance recipients receive less than the maximum amount).

For Henry, the main problem with Rent Assistance is one we've discussed before on the Brown Couch: the amounts at which it's capped are too low. Henry's solution is the same as we discussed: lift the caps. In particular, Henry would set the cap for each of the various household types at the 25th percentile rent for a dwelling of suitable size. (In other words, take all rental dwellings of the same size, rank them according to the amount of rent: the 25th percentile is more expensive than 25 per cent of dwellings, and cheaper than 75 per cent.) And looking ahead, Henry recommends that the caps should rise in line with rents, rather than the CPI, as is currently the case.

As we discussed previously, one possible objection to increasing the maximum amounts of Rent Assistance is that this may cause rents to rise – that is, landlords will simply eat up the increase. Henry doubts this would be a problem, noting that Rent Assistance recipients comprise a minority of the market... and anyway, would it be such a bad thing if the rents paid by Rent Assistance recipients increased? This would be (in economist-speak), 'a market signal to suppliers of rental housing to shift toward provision of the type of housing demanded by Rent Assistance recipients. Suppressing price signals is not conducive to promoting increasing supply over the long term.'

That's how much Henry likes Rent Assistance. What about public housing?

Public housing

Says Henry:

Public housing is a significant mechanism for providing housing to disadvantaged groups. It has become the primary source of housing for people who cannot access appropriate or adequate housing in the private market such as people with a mental illness and Indigenous Australians who still too often face discrimination in the housing market. Social housing (public housing and community housing) provides a valuable stock of houses in the context of Australia's housing supply difficulties, and in some areas such as remote Indigenous communities is the only viable source of housing.

(You can feel a 'however' coming, can't you?)

However, there are a number of areas where social housing is not adequately supporting the Australian households that rely upon it for adequate housing.

Thereinafter, Henry conducts a thorough demolition of the way public housing delivers housing assistance – particularly the way it delivers rebated rents (in most cases, rebated to 25 per cent of household income) to tenants of certain publicly-owned dwellings.

This is, Henry says, inequitable. Public housing rent rebates deliver a much greater level of assistance to public housing tenants than Rent Assistance delivers to tenants of like means in private rental. And within the public housing system, the level of assistance is inequitable because it is the same, regardless of the relative amenity of the particular dwelling with which it comes (that is, person pays the same rent, whether they're in a roomy house by the beach, or a pokey bedsit in the sticks), and regardless of any other costs (transport, etc) that go with that. It is also inequitable because it is the same for those in greatest need (eg those who were previously homeless, those whose health is at risk) as for those who are not but who are on a low income. Rather, public housing differentiates between these levels of need by giving preferential placement to those in greatest need on its waiting list.

Which leads us to work disincentives. The waiting list is the site of a major discouragement to work, because to stay on the list you've got to stay poor. Henry refers to research that reports that rates of unemployment are 11 per cent higher for men, and 5 per cent higher for women, when they are on the public housing waiting list, compared to when they are in public housing.

But when in public housing, these persons face another round of work disincentives. As Henry points out, public housing's income-related rents mean that if you do some work and earn a little money, your rent goes up, while your Centrelink payment goes down. In terms of effective marginal tax rates, public housing's 25-per-cent-of-income-rents straightforwardly add 25 per centage points on top of the effective marginal tax rates ordinarily associated with increasing work and incomes.

This too is something we've discussed on the Brown Couch before, and illustrated in the following charts. Each gives the effective marginal tax rates faced by one of three typical public housing households, based on their Centrelink payments and Family Tax Benefits being withdrawn, and their rent, income tax and Medicare levy being increased, as their income from employment increases. (The data is from 2008, but the general shape of things will be similar today).

(Click on each for a better view)

Our focus then was on the effect of a variation on income-related rents that's peculiar to New South Wales: the moderate income rates, which slide your rent up to 30 per cent of household income and stack on even higher effective marginal tax rates. Henry doesn't mention this particular policy: for him the underlying policy of 25 per cent income-related rents is bad enough.

As for choice: public housing tenants don't really get a choice about their housing. Receipt of a public housing rent rebate is tied to occupation of a public housing dwelling, and they get the dwelling that's offered to them – and they better take it lest they spend even longer on the waiting list or, worse, get kicked off the list. Once in public housing, a person can move around and take their assistance with them, but here too public housing's systems make a mess of persons' choices.

For one thing, public housing authorities place restrictions on moving around (eg you have to be eligible, as if you're on the waiting list). Another thing: because the rent is the same regardless of amenity and location, tenants have, as Henry puts it, 'an incentive to maximise their "in-kind subsidy" — that is, they try to stay in larger and better houses than they would normally occupy if they had to pay directly for their housing.' And public housing landlords lose the benefit of receiving 'effective price signals' about what sort of housing stock tenants would really prefer to occupy, and so labour with a public housing stock that is poorly matched to public housing households.

It is, as I said, a demolition job. There are a couple of points at which Henry probably overdoes it. The fact that unemployment is higher on the waiting list than in public housing may be attributed, as Henry does, to the work disincentive effect of having to maintain eligibility, but you could also make the case that unemployment is lower in public housing because the relative stability and security of the tenure helps get people work-ready and back into employment. (The authors of the research cited by Henry suggest both factors are at work).

Henry also suggests that income-related rents may contribute to 'intergenerational poverty' in public housing, because they assume a contribution from children's incomes. He does not, however, consider that the children of tenants in private rental housing might also make such contributions, and in larger amounts, considering the generally lower level of assistance that Rent Assistance provides. If there's a problem of intergenerational poverty in public housing, it is not so directly the result of including children's incomes in the calculation of income-related rents.

Still, even if you're a committed defender of public housing and income-related rents, Henry's is a critique that you'll have to come to grips with.

So how would Henry cure the ills of public housing? Firstly, with the benefits of Rent Assistance. Henry proposes that public housing tenants should receive Rent Assistance and pay market rents to their public housing landlords:

As recipients of social housing would receive Rent Assistance, the amount they pay to their landlord should reflect the market rent of a dwelling. A dwelling's rent reflects the range of benefits it provides, such as the building's size and quality and the location's proximity to employment, services or nearby amenities. Charging market rents would allow recipients to make trade-offs between these aspects of housing and other elements of their consumption. It would also provide signals to social housing providers about the housing that is valued by their clients. In combination, Rent Assistance based on market rents should encourage the provision of social housing that is of value to tenants.

Henry allows a couple of qualifications on this. First, there would have to be 'carefully targeted transition arrangements, to prevent households from being forced into housing stress or pulling up roots and moving away from support networks. Secondly, there are some locations – particularly remote Indigenous communities – where there really is no housing 'market' and hence no 'market rents', and yet other locations – particularly mining towns – where even a reformed Rent Assistance (ie with higher caps) won't get low-income households anywhere near an affordable rent. In these locations, some limiting of public housing rents with reference to tenant incomes would be okay.

Secondly, in respect of 'high needs' clients, Henry recommends that there should be a new additional payment, made by the Commonwealth Government, reflecting the higher costs of housing such persons, which would go to their public housing landlord – or indeed, if they were to move, to another social housing landlord. (Henry specifies 'social housing', because that's where so many of the 'high needs' tenants are, but expressly leaves open the prospect of the additional payment being made available to private landlords.)

You'll notice that the term 'social housing', as distinct from 'public housing', has crept into the account; it does so in the Henry Review's recommendations, too. Let's turn briefly now to those other social housing landlords, the community housing organisations, and the way they complicate the picture of housing assistance in Australia.

Community housing

Let's be clear: the way it currently works places community housing, in very large part, on the same side as public housing in the great housing assistance divide. Most community housing tenants pay income-related rents, at a rate of 25 per cent of their household income, on very similar terms to public housing tenants, with all the implications for inequity, work disincentives and interference with choice that go with that.

However, by a peculiar dispensation of the Government, community housing tenants do receive Rent Assistance. They do so, however, on terms that avail them of none of the benefits that Henry identifies in Rent Assistance.

Here's how Rent Assistance works in community housing. The community housing organisation effectively says to a tenant: we do income-related rents, so give us 25 per cent of your income, not including Rent Assistance. Now, if that was your rent, you'd get so much Rent Assistance (according to Centrelink's usual thresholds). Let's count that Rent Assistance as income for our income-related rent purposes. This additional income means the rent will go up (by a small amount), and as your rent has gone up, so has your entitlement to Rent Assistance (by an even smaller amount). Repeat until the increasingly tiny increases approach their mathematical limit. Now give us all of the Rent Assistance.'*

So, the community housing organisation maximises and captures all of the tenant's Rent Assistance. The tenant has no incentive (or opportunity) to economise on their housing costs, and the community housing landlord receives no 'market signals' about their housing stock. Rent Assistance is becomes just another an operating subsidy to community housing orgainsation, albeit one that is directed through the bank ccounts of individual tenants, who bears all the risks associated with making sure Centrelink pays it in the amount expected by their landlord.

That's not the only potential problem with this odd arrangement. Community housing is the only growing part of the social housing sector, and this growth is increasingly being achieved through private financing – particularly debt financing. Community housing organisations are relying on those Rent Assistance payments to pay mortgages.

And they're involved in other financial innovations, too, such as the National Rental Affordability Scheme, which has created partnerships between community housing organisations and private investors that are supposed to turn a profit, within the strictures of a requirement that tenants pay not more than 80 per cent of the market rent. This too, raises questions about revenues, rent setting and housing assistance.

All of this is to say that housing assistance policy as we know it is under challenge on a number of fronts. The Henry Review indicates a number of them:

• efficacy – in particular, Rent Assistance as it is currently capped is often not effective in producing affordability;
• equity – in particular, income-related rents in social housing deliver to similar persons a higher level of assistance than Rent Assistance, and without regard to differences in need or the amenity of the dwelling also provided;
• work participation – in particular, the waiting list for social housing creates a work disincentive, and so do income-related rents and the high effective marginal tax rates to which they contribute.

And we've identified another: the financing of social housing – in particular, the new private debt and equity arrangements into which community housing organisations are getting, and the implications of these for reveues, rent setting and housing assistance.

These four fronts of pressure will change the shape of housing assistance policy. Henry's own vision of the new shape is an enhanced Rent Assistance, extended to social housing tenants, and supplemented by a new housing payment for persons with high needs. What do tenants and their advocates in the community sector think?

Next: a summing up of the Henry Review, and the Government's response.

____________________________________________________

* For the mathematically inclined, this iterative process can be reduced to a fairly simple formula.

RC = 4TC-3LT

where:
RC is rent charged to the tenant - that is, what they are actually expected to pay;
TC is the 'tenant's contribution' - that is, 25 per cent of the tenant's household income, excluding Rent Assistance;
LT is the lower Rent Assistance threshold.

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.)

*

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.

The Henry Review reviewed: part 1

This time last year, we were all waiting, with bated breath, for the report of the review into ‘Australia’s Future Tax System’ or, as it is known after its principal author, the Henry Review.

(Dr Ken Henry (at right), with an anonymous adviser)

The Henry Review was, after all, established as a ‘root and branch’ review of Australia’s tax system, ‘the most comprehensive examination of the tax system in over 50 years’, that would help set the tax reform agenda for years to come. And, making it even more compelling, the review was expressly directed to look at, amongst other things, the connection between taxation and housing affordability.

The review was completed on time at the end of 2009, and the report handed to the government. And we waited.

Next thing, in May the Government releases the report, the day before the Budget. From the Henry Review’s 138 recommendations the Government plucks two – reforms to superannuation and, fatefully, the mining tax. Twenty million dollars worth of PR hell breaks loose. Exit Rudd, under whom the government had ‘lost its way’; enter Gillard, who then leads it to the election and into minority government.

And what of the Henry Review? In their deal for supporting the Government, the three independents and the Greens MP, not being ones to let a ‘root and branch’ tax review go to waste, secured a commitment for a ‘tax summit’ to discuss the Henry Review, to be convened by mid-2011.

So it's a good time to look again, and in more detail, at the Henry Review. In a series of blog posts here on the Brown Couch, we'll look particularly at what the Henry Review says about tax and owner-occupied housing; tax and rental housing; and 'housing transfers' – that is, Rent Assistance and social housing rent rebates. And we'll look, too, at what the Government said in response.

First, tax and owner-occupied housing.

*

Home ownership. The Great Australian Dream. The Great Australian Tax Shelter, more like it. Over the years we've established various ways of taxing property – in particular, taxing income from capital gains, and land tax – and we've always made sure to leave owner-occupied housing untaxed. That's not to say, however, that housing is unaffected by these arrangements: on the contrary, by leaving owner-occupied housing out, it becomes tax-preferenced. This means that if you have money to spare and are looking for a place to store it where neither it nor any increase in value are taxed, look no further than spending it on your own housing.

And as you spend on your housing, others are similarly motivated to spend on housing, so prices rise. And as prices rise and the gains go untaxed, so the motivation to spend on housing increases. Even before we get to other tax lurks like negative gearing and the matter of spending on other people's housing (ie rental housing) – and we will get to this, in part 2 of the review – we can see how the tax-preferred status of owner-occupied housing is a basic driver in Australia's house-price inflation machine.

The Henry Review doesn't use the term 'tax shelter' to describe owner-occupied housing; it prefers to call owner-occupied housing a 'savings vehicle'. After rightly acknowledging that owner-occupied housing provides good things like actual shelter and a sense of security, the Henry Review says of its 'savings vehicle' aspect:

As well as providing vital services to individuals and communities, housing also forms a large share of Australia's savings. Houses are built to last — many people work hard to pay off their house during middle age, in order to ensure they have access to accommodation with no cash payment obligations when they are old. As a form of savings, housing has additional benefits over other savings vehicles because it not only acts as a store of value, but also reduces exposure to fluctuations in rental costs. In particular, those on fixed incomes are insulated from housing cost fluctuations, ensuring that other necessities like food or energy are affordable and they are protected from the risk of poverty.
Australia currently has one of the highest rates of home ownership in the OECD. In total, 68 per cent of Australians own or are buying the home they live in, compared to an OECD weighted average of 63 per cent. For those aged over 65 years old, the rate is 82 per cent, which is among the highest in developed countries.... These high levels of home ownership often reflect strong personal preferences for home ownership over other forms of housing tenure, as well as deliberate government policies to enable owner-occupied housing.
The Review's recommendations are intended to support this policy goal. There is a strong case for continuing Australia's approach of ensuring that owning their own home is within the reach of ordinary families. The role of owner-occupied housing as the key source of voluntary retirement savings is a major reason for continuing to exempt it from income taxation.

For the breath-bated reader who may have been looking for a bit more 'root and branch' reform than the Henry Review is willing to recommend, a few points in response to this passage jostle to be made. Does the 'strong personal preference' for owner-occupied housing really need any more encouragement from tax policy? Does the tax preferencing of owner-occupation actually 'enable owner-occupied housing' – keeping in mind our brief sketch of how it contributes to house price inflation and the fact that rates of owner-occupation for younger households have declined significantly over the last decade and a half, and that the rate generally has declined in recent years?

(Rates of owner-occupation and renting (%). ABS, Australian Social Trends Data Cube: Housing. Cat no 4102.0.

For present purposes, let's put those points to one side and work with Henry on this idea of owner-occupied housing as saving – because it is through the prism of savings that Henry does come up with recommendations that partly address the tax-preferencing of owner-occupied housing.

Tax, owner-occupied housing and savings

The taxation of savings is one of the main focuses of the Henry Review, and more consistent tax treatment of different ways of saving is a major theme of its recommendations. As the Henry review drily observes, 'the tax outcomes for different types of savings vary considerably and have evolved in an ad hoc manner.'

Consider the differences between saving by putting money into owner-occupation and saving by putting it in the bank.

For the owner-occupied housing saver, the main pay-off from this strategy is the prospect of a capital gain – that is, that some other person will come along later and pay more for the house than it cost the saver. The cost, of course, is the purchase price, plus all the interest that the 'saver' pays on the loan along the way. Under our current tax system, the pay-off is not taxed – and as we've seen, Henry would keep it that way.

For the bank saver, the pay-off is the compound interest paid to them by the bank. They face costs too: the bank saver, not being an owner-occupier, pays rent (and 'tax tranquille' of rent inflation). Under our current tax system, the interest pay-off is income that gets added to whatever other income the saver earns from work and so is taxed at the highest marginal tax rate applicable to the individual saver.

Now this is what Henry proposes to change. The Henry Review recommends that interest, as income from savings, should be taxed at a discounted rate – in fact, a 40 per cent discount on the tax rate applicable to the bank saver's other income.

OK, that's something – but it's still some way off the 100 per cent discount enjoyed by the owner-occupied housing saver.

And it also leaves unaddressed another way in which the owner-occupied housing saver's strategy pays off. The capital gain is one pay-off; another is the valuable product – that is, the 'vital service' of shelter – produced by the housing along the way. If this product was sold by the owner-occupier to some other person – that is, rented out – the proceeds would be taxed as income; however, the owner-occupied saver chooses to consume this valuable product themselves. When kept for one's self this pay-off is known as 'imputed rent', and it could be taxed like other forms of income from saving – but it currently isn't, and Henry doesn't propose to change that either.

So Henry's proposed 40 per cent discount on tax on interest income goes part of the way towards consistent tax treatment of income from savings; but the refusal to consider taxation of imputed rents takes a small step away from consistency. However, Henry proposes one more move on the tax-preferenced status of owner-occupied housing that brings the balance a little closer again to consistency. This move is in relation to land tax.

Land tax

Like most economists – and indeed, the Tenants' Union of NSW – Henry likes the idea of land tax (it's levied on an asset that by its nature cannot be removed from the jurisdiction or from supply; it gets at increases in value that arise through no work or productivity on the part of the owner), but laments the way States levy it. In particular, the exemption of land used for owner-occupied housing is a major problem, because it narrows the tax base – land used for owner-occupied housing would otherwise account for 60 per cent of the value of the land tax base – and because the burden ultimately falls on renters. To be clear, it's landlords who are presented with the land tax bill, but as Henry observes:

it is likely that, in the long run, much of the burden of the tax is shifted to renters, as rents adjust to ensure that investors achieve an adequate return. This may be inequitable, as renters generally have low income and wealth.

It would be far better, says Henry, to have a broad-based land tax – including on land used for owner-occupied housing – levied at rates varying according to the value of land per square metre (and not, as is currently the case, the total value of the owner's holdings, which discourages institutions from investing in rental housing on a large scale). To avoid hardship, low-income owner-occupiers would be allowed to defer their land tax liability, and a range of alternative mechanisms for smoothing the introduction of a broad-based land tax are offered. And while States are at it, they should abolish their inefficient stamp duties too.

So, summing up: the Henry Review proposes to retain the current practice of not taxing the pay-offs of owner-occupied housing (capital gains, and imputed rent) as income, but would go part – and only part – of the way to reducing owner-occupied housing's tax-preferenced status relatively by reducing tax on income from other forms of savings, such as interest on bank deposits. The Henry Review proposes a further move towards better balanced taxation, by reforming land tax, particularly to include owner-occupied housing.

If the savings income proposals are a bit of a compromise, the land tax proposals are strong – and backed up by detailed options for implementation and quite strongly worded recommendations. Each set of proposals represent an advance on current arrangements.

Next: taxation and rental housing.

PART 2

PART 3

PART 4