Illustration: John Spooner

Illustration: John Spooner

IMAGINE that you have just become treasurer or finance minister in the government of a newly independent nation. Imagine also that, for some reason, you wanted to create a tax system that encouraged the accumulation of wealth through borrowing and speculating, as opposed to working and saving.

So you hire a consultant, who, based on your previous experience, you anticipate will hand you a voluminous report and a large bill after a period of extensive research, consultation with interested stakeholders and all the other things that consultants do. But, to your astonishment, the consultant comes back the very next day and simply hands you a copy of the Australian Income Tax Assessment Act, and tells you to forget the bill.

Why the treasurer of some hypothetical government in a far-away country would actually want a tax system that encouraged borrowing and speculating, and penalised working and saving, is, of course, rather hard to imagine.

Yet that is precisely what Australia's income tax system does: it imposes the highest rates on wage and salary income - that is, income from working - and on income from the most common forms of saving (bank, building society and credit union deposits).

By contrast, Australia's tax system taxes income from investments (other than deposits) at substantially lower rates than identical amounts of income derived from working. And if those investments are funded wholly or partially by debt, it provides a subsidy that reduces even further the amount of tax payable on the income from those investments.

For most people on relatively high salaries, tax rates aren't as high as they used to be, as a result of the substantial increases in the thresholds at which the top rate becomes payable that were implemented during the last term of the Howard government.

However, for people lower down the income scale, the interaction of the income tax system with the income tests on various forms of social security payments can result in them facing effective marginal tax rates considerably above those paid by those on the highest incomes. These high effective marginal tax rates can - and according to at least some research do - adversely affect the willingness of some people, especially women with children, to enter paid employment.

By contrast, the Australian income tax system provides substantial incentives for people to borrow money to acquire property, shares or other assets with a value they expect will appreciate over time. Unlike most other countries, it has always been possible in Australia to deduct any excess of interest payments on loans taken out to fund an investment over the income produced by that investment to reduce the tax payable on wage or salary income.

Since the Howard government's decision in 1999 to tax capital gains at half the rate applicable to the same amount of wage and salary income, a decision that was supported by the then opposition, ''negative gearing'' has become a means not only of deferring tax, but also permanently reducing it.

In 1998-99, when capital gains were last taxed at the same rate as other types of income (less an allowance for inflation), Australia had 1.3 million tax-paying landlords who in total made a taxable profit of almost $700 million. By 2007-08, the latest year for which statistics are available, the number of tax-paying landlords had risen to 1.7 million, but they collectively lost more than $8.6 billion, largely because the amount they paid out in interest rose more than fourfold (from about $5 billion to more than $20 billion over this period), while the amount they collected in rent ''only'' slightly more than doubled (from $11 billion to $24 billion), as did other (non-interest) expenses.

If all the 1.2 million landlords who reported net losses in 2007-08 were in the 38 per cent income tax bracket, their ability to offset those losses against their other taxable income would have cost more than $4.8 billion in revenue forgone; if (say) a fifth of them had been in the top tax bracket, then the cost to revenue would have been more than $5 billion.


And it's hard to think of any worthwhile public policy purpose that is served by this subsidy. It does nothing to increase the supply of housing, since the vast majority of landlords buy established properties. Precisely for that reason, it contributes to upward pressure on the prices of established dwellings, thereby diminishing housing affordability for would-be home buyers.

It's also hard to reconcile this subsidy with the government's stated aim of increasing participation in the workforce, especially when abolishing it could help pay for reducing some of the high effective marginal tax rates faced by those contemplating moving from taxpayer-funded benefits into paid employment.

The revenue forgone through negative gearing could alternatively be used to build nearly 20,000 new ''affordable'' homes each year, making substantial inroads into the massive shortage of affordable housing.

Supporters of negative gearing argue that its abolition would lead to a ''landlords' strike'', driving up rents and exacerbating the shortage of affordable rental housing. They point to ''what happened'' when the Hawke government abolished negative gearing (only for property investment) in 1986, claiming that it led to a surge in rents, which prompted the reintroduction of negative gearing in 1988.

This assertion has attained the status of an urban myth, but it isn't true. Rents (as measured in the consumer price index) did rise rapidly (at double-digit annual rates) in Sydney and Perth, but that was because in those two cities, rental vacancy rates were unusually low before negative gearing was abolished. In other state capitals (where vacancy rates were higher), growth in rentals was either unchanged or, in Melbourne, actually slowed.

Suppose, however, that a large number of landlords were to respond to the abolition of ''negative gearing'' by selling their properties. That would push down the prices of investment properties, making them more affordable to would-be home buyers, thereby reducing the demand for rental properties in almost exactly the same proportion as the reduction in their supply.

And that, of course, is the reason why negative gearing will forever remain untouched - because the negative reaction and loss of votes from people who would experience declines in the value of their properties would outweigh the positive reaction from people who would benefit from lower property prices and would change their votes accordingly.

It's something to remember next time you hear a politician saying he or she is committed to improving housing affordability, or increasing participation in the workforce, or both.

Saul Eslake is a program director with the Grattan Institute.