REINING IN TAX EXPENDITURES
Tax Institute National Convention, Melbourne
4 MARCH 2016
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When I studied graduate public finance, one of my lecturers was Martin Feldstein. Feldstein was the chair of the Council of Economic Advisers under Ronald Reagan, and not exactly regarded as one of Harvard’s most progressive economists.
But as you know, there’s a surprising amount you can learn from someone of a different ideological persuasion. I liked Feldstein’s style – a meld of maths and war stories. Every now and then one of my classmates, Jason Furman, would get into a furious back-and-forth argument with Feldstein. At the time, it seemed a little impertinent. Less so now that Furman is serving as President Obama’s chair of the Council of Economic Advisers.
There were a range of issues on which I disagreed with Feldstein, but one idea that made a lot of sense was the principle that public finance reformers should look not only at spending levels and tax rates, but also at tax expenditures. In the United States, Feldstein argues, such tax loopholes have proliferated. He argues that ‘Congress should review these tax expenditures and eliminate those that the country cannot afford.’ Such an approach, Feldstein points out, raises revenue more efficiently than increasing tax rates. In economic jargon, closing loopholes has a lower deadweight loss than raising rates.
As their name suggests, tax expenditures look a lot like budgetary expenditures. If the government gives you a dollar for doing something with public value, we put it on the revenue side of the ledger. If the government takes a dollar off your tax for doing the same thing, we put it on the tax side. But the practical effect is pretty similar. As Feldstein points out, winding back tax expenditures can be framed as either a revenue increase or a spending cut.
Yet it turns out that tax expenditures tend to be much less fair than budgetary expenditures. When we assist older Australians through the pension, the money goes disproportionately to the poorest. But when we assist older Australians via superannuation tax breaks, the benefits go disproportionately to the most affluent.
The same holds for social spending. Work by the Australian National University’s Peter Whiteford shows that a dollar spent in the Australian social safety net does more to reduce inequality than would be the case in any other advanced nation. Across-the-board cuts to our social safety net therefore worsen inequality more in Australia than would be the case in any other nation.
Of course, where we find needless spending, we should cut it. Labor has committed to scrapping the Emissions Reduction Fund, not restoring the Baby Bonus, and not spending millions on an expensive marriage equality plebiscite. But we also have to recognise that government is a smaller share of the economy in Australia than in most advanced nations. Putting all tiers together, government in Australia accounts for about one-third of the economy – much less than the 40-50 percent that you see in much of Western Europe.
Labor believes we have to take a thoughtful approach to tax expenditures. Labor in government means-tested the Private Health Insurance rebate, one of the fastest-growing tax concessions in the budget. Last year, we announced a policy to rein in superannuation tax concessions, bringing down the Higher Income Superannuation Charge threshold from $300,000 to $250,000; restoring a 15 percent tax rate for earnings over $75,000 a year in the pension phase.
But when it comes to personal income deductions, a conversation about tax expenditures is really a conversation about negative gearing. Rental deductions account for more than half of all personal deductions. So anyone who tells you they’re serious about cutting tax breaks, but won’t touch negative gearing, isn’t serious about broad-based tax reform.
Today, I want to lay out the economic argument for winding back negative gearing and the capital gains tax discount. This argument stems from a question all policy makers should ask themselves about tax reform: what is the intended outcome of a tax policy and what are its implications for tax integrity?
Let’s start with how we got here.
This is a tale bookended by two reviews: the Ralph Review in 1998 and the Murray Review in 2015.
Commissioned by the Howard Government, the Ralph Review concluded that modifications to the capital gains tax system could ‘improve the operation of Australian capital markets and help support a stronger investment culture amongst ordinary Australians’.
The Ralph Review also stated ‘Australia taxes capital gains more harshly than most other comparable countries and certainly more harshly than other countries in our region competing for international investment’.
It was somewhat of an oversight that the Review, at this point, did not note that investors will also look to factors beyond a headline rate of taxation, such as a country’s policies impacting on human capital, including health and education policies. An even greater oversight was that the Ralph Review did not mention real estate. Instead, it foresaw that cutting the capital gains tax would lead to a surge in sharemarket investment, ‘particularly in innovative, high-growth companies’.
The Howard Government proceeded with the Ralph Review’s recommendation of replacing indexation of capital gains tax with a 50 percent discount. It was generous at the inflation rates of the day – even more so given that inflation has fallen in the years since then.
Reducing complexity and increasing investment were the ostensible aims. But the result was to give Australia a uniquely generous set of arrangements for housing investors.
The result can be seen by looking at a graph of net rental income across the decades. Prior to the introduction of the capital gains tax discount, net rental income was positive – typically about a billion dollars a year. Since 2001, not a single year has had positive net rental income according to Australian Taxation Office data. Most years have had net rental losses between $4 billion and $10 billion. Put another way, our tax system would be billions of dollars better off if we simply took landlords out of the tax system altogether.
17 years later, the Financial System Inquiry – the Murray Review – commissioned by the current government came to a different conclusion from the Ralph Review.
Under the title ‘Major Tax Distortions’, the Murray Review stated:
- 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.
The current tax treatment gives investors an advantage over first home buyers. That advantage was reflected recently when the value of loans for investment housing outstripped owner-occupier housing for the first time.
It’s worth remembering that while 120,000 people become new home owners per year, there are currently 8 million adults (in 5 million households) who already own property.
The effects on housing affordability are unavoidable. Nationally, median house prices grew an average of 4.3 per cent annually between 1995 and 2012. Between 1970 and 1996, the average annual median house price rise was 0.8 per cent.
Throughout the 1990s, inflation, rents, and house prices tracked along roughly in step with one another. After the introduction of the capital gains tax discount, the growth of house prices dramatically surged ahead of inflation.
Measured by house price to income ratios, Sydney is now the second most unaffordable city in the world – after Hong Kong. Melbourne comes in fourth. Sydney’s median house price is now over $1 million.
Who is missing out? Young Australians are much less likely to own a home as they were in the early 1980s, with homeownership rates for 25-34 year olds falling from 62 per cent to 48 per cent.
Lower income Australians are hit too. In the mid-1970s, there was no difference in the home ownership rates of those in the top income quintile and the bottom income quintile. Today, the most affluent are 15 percent more likely to own their home than the least well off.
For younger and poorer Australians, it’s like the ladder of opportunity is being pulled up.
The list of those who have raised concerns about the impact of negative gearing and the capital gains tax discount on the housing market are Saul Eslake, Cassandra Goldie, Chris Richardson, Peter Morgan, John Daley, Joe Hockey and Jeff Kennett. Hardly a squadron of socialists.
The Reserve Bank of Australia, not usually inclined to intervene in policy debates, has noted that there is a case for reviewing negative gearing.
Those arguing against Labor’s reforms have trotted out a range of misleading points.
First, they argue that 67 per cent of taxpayers who claim negative gearing earn a taxable income of less than $80,000.
The key phrase is ‘taxable income’ – in other words, income after taking account of negative gearing. As my colleague Chris Bowen has pointed out, if you take this figure seriously, you also need to realise that 64,000 Australians on taxable incomes of zero have investment properties. It’s not that they have no income – if they did, they wouldn’t be making mortgage repayments. It’s that they managed to use negative gearing to reduce their tax obligation to zero.
In fact, negative gearing disproportionately benefits the more affluent. Most of the benefits of negative gearing go to the top tenth of income-earners. For example, surgeons claim 100 times the benefit that cleaners do, and 16 times the benefit received by nurses.
Second, critics of Labor’s plan also claim that negative gearing keeps rent prices lower than they’d otherwise have been. The basis for this claim is a Sydney-centric view of rents. In the years from 1985 to 1987 that negative gearing was stopped by the Hawke Government, rents did rise in Sydney and Perth. Yet the rate of growth in rental prices slowed in Melbourne, and all other capital cities had no change in the growth of rental prices.
The rent rises in Sydney and Perth rental prices are more likely to be attributable to unusually low vacancy rates in those cities prior to the implementation of the policy.
A third canard is that negative gearing boosts housing supply. This misses the fact that 93 per cent of property lending goes to established housing. If the aim of negative gearing is to boost housing supply, this is a policy with a 93 percent failure rate. That’s why Labor’s plan would restrict new claims for negative gearing to new homes, starting from July 2017.
Existing investors can sleep easy with Labor’s policy. Our plan will ‘grandfather’ negative gearing – allowing it to remain on investments made before 1 July 2017 – and restrict negative gearing to new housing on and after that date.
Labor’s policy will also ‘grandfather’ the capital gains tax discount. The existing treatment will remain for assets purchased prior to 1 July 2017; assets bought on or after that date will receive a 25 per cent discount instead of 50 per cent.
This policy does not hurt current investors as there is no retrospectivity.
As for the ‘analysis’ released yesterday by BIS Shrapnel, the less said the better. Suffice to point out that the study models a policy that is quite different from Labor’s. For example, BIS assumes that negative gearing remains for shares, that there are no changes to capital gains tax, and that the policy starts in 2016. Its conclusions flow from the assumption that investors would raise rents – even although the report admits that there was no nationwide rise in rents in 1985-87.
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This plan announced by Bill Shorten, Chris Bowen and Katy Gallagher improves the fairness of tax concessions and boosts housing supply. But it also improves budget sustainability. We all know that it’s vital to close the gap between what the federal government raises and what it spends. This gap currently sits at around 1½ percent of GDP.
Over the next decade, Labor’s policy on negative gearing and capital gains tax will add $32 billion to the budget bottom line. Together with the other measures we have announced, Labor’s savings now amount to $100 billion over the decade. Importantly, none of our measures will slow growth or worsen inequality.
Let’s give the final word to Martin Feldstein, who wrote of the US budget situation:
‘It is possible to increase revenue without raising marginal tax rates. The key is to limit the reductions in tax revenue that result from the use of tax rules that substitute for direct government spending.’
Taking tax expenditures seriously isn’t a left-wing idea or a right-wing idea. It’s a practical, sensible way to approach economic policy. Closing tax breaks isn’t pain-free – anyone who remembers the fights that surrounded the introduction of fringe benefits tax can tell you that. But it’s the right thing to do for a more efficient and a more equitable tax system.