Australia's Joe Hockey Responds to the Criticism Surrounding Negative Gearing

Negative gearing is a very controversial issue. The latest round of debate stems from the actual Reserve Bank’s submission towards the House of Representative Standing Committee on Economics concerning the enquiry into home ownership. The Bank believed that “there is a case for reviewing negative gearing.”

Treasurer Joe Hockey quickly responded to again rule out any kind of change of the tax coverage on negative gearing. In particular, reports show that he claimed which removing negative gearing would create “an exception to a standing rule in taxation law.”

Is unfavorable gearing in accordance with well-established tax rules? A fundamental principle in the tax law is that a taxpayer should be able to subtract expenses only if incurring the expenses to generate assessable income.

This is why an employee can only deduct expenses adequately related to work. For example, the funeral director at exotic Queensland would be able to deduct the price of his black jacket (but not his black trousers) because the ATO believes that no rational person – except a funeral director – would wear a dark jacket in such a hot location.

Should mortgage interest on an expense property be deductible? Expense properties generate two kinds of earnings: rental income and funds gains (if any). Because capital gains on investment property can enjoy a 50% tax discount after holding the home for at least a year, strictly speaking just 50% of the interest expenses associated with the capital gain should be deductible.

In practice, it is impossible to predict whether there will eventually be the capital gain, and impossible to predict the amount of the acquire. This presents the key difficulty in the design of the tax policy on negative gearing.

Allowing full deduction of the interest costs every year effectively allows deductions of expenses that may be incurred to generate the tax free portion of the capital gain (if any kind of), and therefore may violate the essential tax principle for breaks. However, how can the Australian Tax Office (ATO) determine how much of the interest expenses should be disallowed every year before the investment rentals are actually sold?

Many countries solve this issue by quarantining losses on investment properties. It means that losses generated from negative gearing can’t offset against other causes of income, for example, salaries or even business income. Instead, the losses can carry forward to future years to offset against earnings from the investment properties.

This policy is fair in the sense the same tax principle with regard to deductions applies to both taxpayers with and without negative gearing. Many countries adopt this quarantine policy, including major developed countries such as the US, the UK, Portugal, and Japan.

Some countries have even stricter tax rules on investment properties. For example, China allows a fixed 20% deduction of the rental income, and also the Netherlands tax property investors on the deemed yield rate of 4% on the value of the properties. In other words, these countries do not let deduction of any tax losses on investment properties at all.

Australia’s current tax coverage on negative gearing seems overly generous when compared to both groups of countries. More importantly, it is not fair to taxpayers who do not have negative gearing. The policy effectively financial assistance negative geared property investors with the tax system.

The Reserve Bank concluded its submission towards the enquiry into home ownership by rightly stating, “policy should not unnecessarily advantage property investors at the expense of prospective owner-occupier home buyers … tax and regulatory frameworks should avoid encouraging over-leveraging into property.”

Of course, the actual negative gearing issue is complex and highly political. The ATO’utes Tax Statistics for 2012-13 demonstrated that taxpayers claimed a total of $12 million tax losses from investment properties, and almost 1.3 million taxpayers had negative gearing.

The sheer number of citizens currently enjoying the benefit of negative gearing dictates that it will demand powerful political will and management before a politician is willing in order to propose changes to the current tax rule on negative gearing.

Even if the government is bold sufficient to change the rule, they must consider transition rules to cater for the existing taxpayers that have negative gearing. This is a story for another day.

Why negative gearing is not a fair tax policy is republished with permission from The Conversation