Capital gains cracks return to haunt Labor

Labor’s obsession with negative gearing and capital gains tax changes has reared its head yet again. The latest version has all the hallmarks of the government’s previous dissembling over the Stage 3 Tax Cuts.

The government has “no plans” to make changes — just like they didn’t plan to change Stage 3. Until they did.

They have merely asked Treasury to work on potential changes. It is hard to see any prospect that those changes might cut taxes and incentivise investment in housing supply.

No; it’s always about cutting concessions and increasing taxes. However, you should rest assured that Labor doesn’t plan on taking the changes to the next election.

A cynic might suggest the party doesn’t want to offer voters the choice because tinkering with taxes like these was a big factor in Labor’s 2019 election defeat.

Even the government has now admitted that negative gearing and capital gains tax changes would do little for housing affordability.

Study after study has demonstrated that the effect on affordability would be mixed — house prices would fall slightly while rents would rise over time — but the change would be very minor (less than 5%).

These policies are only billed as the answer to housing affordability issues because it’s an easier sell than the real reasons: a relentless desire to gobble up more taxpayers’ funds and the intense bitterness of envy.

The latter is the easiest to identify, but the hardest to address as its basis is irrational.

Despite the diverse nature of those who invest in property, they are one of the most vilified groups in society. Contrast the general community support for small business with the contempt for landlords, especially on social media.

On a larger scale, even left-leaning housing supply advocates shy away from allowing large-scale property development, preferring instead ineffectual — but morally pure — policies to boost supply centred on social housing.

Of course, this also displays the lack of basic economic understanding of the general public: liberalising rules restricting supply will lower developer profit margins through greater competition.

Envy is potent though. It resonates especially with those who think people mostly get ahead by exploiting people or rigging the system; why shouldn’t those hated landlords pay more tax? It’s not fair that they own two or more houses and I own none!

But ‘fairness’ is a loaded word here, and there is more than one dimension of it at play. In fact, one of the strongest arguments for retaining negative gearing is based in fairness.

First, it is always worth making clear negative gearing is not exclusively applied to property investment. It applies to any investment where the expenses incurred are temporarily greater than the income earned.

If you run a small business in your spare time, any losses made in that business can be deducted against your salary. No-one complains about this type of negative gearing, though.

Nevertheless, you might ask why someone should be able to deduct losses from one business against a completely different source of income?

One simple reason is that either an individual is a single entity for tax purposes — which means you pool all your income and all your expenses together — or they aren’t, and all sources of income and expenses should be considered separately.

The tax system shouldn’t just arbitrarily categorise income and expenses in whatever way maximises government revenue.

A tax system should be rational and reasonable; it’s not heads the government wins, tails the taxpayers lose.

In that sense, negative gearing is the lesser of two evils. Overall tax revenue is far higher because secondary income sources are taxed at marginal rates.

Capital gains tax discounts are also about fairness. In this case, the fairness comes from recognising the impact of inflation and the difference between nominal and real returns.

Revenue-hungry governments love inflation because it reduces the impact of their debt burden. As the current government has discovered, inflation generates heaps of extra revenue from bracket creep (another deeply unfair tax policy).

However, inflation erodes profit. An investment that makes a nominal return of 2.5% is just keeping pace with inflation: it makes no profit in the real sense.

It’s ironic that multiple antonyms for the word ‘real’ apply in this context: both ‘nominal’ and ‘fake’.

If tax should only be applied to a profit — which seems like a fairly reasonable starting point — then it should only apply to real profit. Not nominal / fake profits

It is important to note that the nominal vs real distinction is not the only reason for the capital gains tax discount.

And again it has to be pointed out that capital gains tax applies far beyond property. There are at least two other important reasons why this discount exists (remembering that capital gains were untaxed until 1985 and the discount replaced concessions for indexation and averaging).

First, capital gains are the by-product of something very good for the economy: productive investment. Our economic wellbeing is totally dependent on the level of productive investment in the economy.

Taxing capital gains less than income provides an incentive to people to take risks and invest.

Second, money that is invested to generate capital gains at some point must first have been income and therefore already taxed once.

Think of the classic case of a share investment portfolio: income earned (and taxed) as wages is invested in shares to generate a future return.

Remember that inputs are typically not taxed, only outputs. That is why businesses can offset the GST they pay on inputs.

Having already taxed the input once as wages, it is only fair to recognise that in some way in the final tax bill.

The concession the Prime Minister made — that diluting negative gearing and the capital gains discount will do very little to improve housing affordability — should mean they are debated as tax policy changes without the fig leaf of housing affordability.

As the changes would be bad tax policy, they should be rejected.

Simon Cowan is Research Director at the Centre for Independent Studies.

Photo by Expect Best.