Forget trying to curb demand, build more houses

Debates about housing affordability continue to point to negative gearing as a factor putting upward pressure on house prices. However, negative gearing has been in place for decades and through many up and downs in house prices. The fact that people want to invest in housing should not be a problem for housing affordability.

The real problem is the increasing inability of the supply-side of housing markets to accommodate the demand for both owner-occupied and investment property without upward pressure on prices. Public policy needs to focus on boosting supply rather than suppressing or diverting demand.

The deductibility of mortgage interest against other income for investments in housing is first and foremost an issue of tax policy. Housing is not the only asset class for which interest on borrowing to invest is deductible against other income.

There are legitimate questions over how the tax system treats income derived from saving and investment, including rental income. It is widely acknowledged that the tax system penalises some forms of saving (for example, interest on saving deposits), while rewarding others (some concessional superannuation contributions).

Ideally, the tax system would more equally reward all forms of saving and investment in order to encourage capital accumulation, including much-needed additions to the housing stock to accommodate a growing population.

The Henry review argued for a more consistent treatment of income derived from saving, which would have seen a 40 per cent discount applied to the taxation of capital gains, interest and net rental income.

This proposal was a somewhat less generous, but still concessional, treatment of investment income derived from property, consistent with the review's objective of reducing the overall tax burden on saving.

However, the Henry review was very explicit about the need to free-up the supply-side of the housing market before any such reform was attempted.

Henry's final report noted that "changing the taxation of investment properties could have an adverse impact in the short to medium term on the housing market, reducing net rental losses and capital gains tax concessions may in the short-term reduce residential property investment. In a market facing supply constraints, these reforms could place further pressure on the availability of affordable rental accommodation."

Other proposals for making the tax treatment of investment property less generous include quarantining deductibility to income derived from the investment only or requiring losses to be carried forward to offset future capital gains tax liabilities.

The concessional tax treatment of saving via owner-occupied and investment property adds to demand by making both a more attractive vehicle for saving relative to other asset classes, but is also positive for housing supply.

It is sometimes noted that demand from property investors is largely met through existing rather than newly built dwellings. This reflects the fact that the flow of new houses is small relative to the existing dwelling stock. But it is about as relevant as noting that investors in the stockmarket mostly buy already held rather than newly issued shares. It is only supply-side constraints that prevent demand for existing dwellings from inducing new construction.

The short- to medium-term impact on the rental market from less generous tax treatment of investment property highlighted by the Henry review could be mitigated to the extent that any fall in prices induces more renters to become owner-occupiers.

However, substitution between investors and owner-occupiers is unlikely to offer much relief in terms of overall housing affordability, especially if there is also a negative supply response.

Public policy should aim to improve incentives for increasing housing supply. While saving via housing is concessionally taxed, this does not mean that there is no tax burden on housing as such.

The tax burden on new housing includes direct levies such as the goods and services tax, stamp duty, land tax and council rates, as well as a variety of indirect taxes on inputs into housing, development and infrastructure levies.

There are also hidden taxes from unnecessarily complex and expensive planning and approval processes.

The Centre for International Economics has estimated that as much as 44 per cent of the price of a new home in Sydney is accounted for by explicit and implicit local, state and federal taxes.

The animus directed against negative gearing is as much an objection to the tax deduction as its supposed implications for housing affordability. Few people seem to object to an investor buying a property outright or having rental income in excess of deductions, making them a net taxpayer in relation to the investment.

Those who negatively gear ultimately rely on taxable capital gains to make up for net losses on rental income incurred over the life of the investment. Unless capital gains exceed borrowing and other costs, negative gearing is a losing investment strategy.

Like all leveraged investments, negative gearing is risky, not a one-way bet. Property investors specialise in bearing risks that many owner-occupiers and renters are either unwilling or unable to take.

Improving housing affordability ultimately depends on building more and cheaper houses, not on suppressing or diverting the demand for housing.

Stephen Kirchner is a research fellow at The Centre for Independent Studies.