Humans vs Houses: Australia’s perverse tax system

I often joke that my investment property earns more than I do. Thinking more about this lead me to the realisation that my investment property has a privileged position in the tax system when compared to a measly old human being.

Below I summarise some of the main tax considerations from the perspective of being a human making wages, or from the perspective of an investment property (okay, fine, the property owner).

After making this comparison, our current system appears to be designed exclusively for the betterment of the property community, rather than the people community. It’s unreal. The whole thing is back to front, with all that green showing investment property to be a clear tax winner.

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Let us take a closer look at the marginal effects of a dollar increase in income for a one-income family, with two school-age children earning $100,000. They are an above-median household, and a prime candidate property investor. You know. To secure the children’s future. We’ll call them the ‘Battler’ family, because in Australia if you aren’t on the property ladder, making money is a battle.

An extra dollar in wage income for the Battler family over a year attracts income tax, along with a loss of family tax and medicare benefits that together account for 60c of that extra dollar. So 40c in the pocket. The graph below, from David Plunkett, shows the effective marginal tax rates (EMTR) for this family currently in Australia, with every household earning under $125,000 having about a 60% EMTR.

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Let us examine the case when the Battler family instead makes their extra dollar from capital gains on their investment property. Using round numbers, they buy a $500,000 home with an annual rental income of $20,000, and annual rates, maintenance and other costs of $6,000. They finance this purchase with an interest only loan attracting a $25,000 annual interest bill.

They make a loss of $11,000 over the year they own the property. Of that loss they are out of pocket only $4,400, because they have reduced their taxable income and avoided $4,400 in tax, and gained $2,200 in family tax and medicare benefits.

After one year they sell with a price after selling costs of $511,001, making $1 net over the year from the property investment project.

It’s a risky way to make $1, compared to getting a rounding-error sized pay rise. But we want to compare dollar-for-dollar the tax incentives for earning wages or earning capital gains though property speculation.

So what did the battlers get out of their $1 gain from property investment? First we factor in the 50% capital gains tax discount because they owned the property for more than a year. So they only need add $6,500.50 of the capital gains to their taxable income. With a 60% EMTR that means they keep $9,100.20 in the hand (the tax-free $6,500.50 half, plus 40% of the remaining $6,500.50).

Subtracting last year’s net loss of $4,400 gives a total net gain of $4,700.20. I summarise how this arises from the benefits tax treatment of both the losses and the gains from investment property in the table below.

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With these types of advantages to making your money from lazy capital gains on investment property, rather than working for a living, it is no surprise that we have become a nation of property speculators.

We can also work backwards to see in this example case how much of a loss on property the advantageous tax treatment will cover. To break even after tax all the Battler family need to do is make $4,400 after tax on the sale, which would be situation if the capital gains were $6,286, or a sale price after selling costs of $506,286. Under this situation the property investment has made a loss of $4,714 over the year (an $11,000 income loss and a $6,286 capital gain after 12 months), yet the tax system has bailed out that loss for the family through negative gearing and the capital gains tax exemption. Add another 57c or so to the project income – so it makes a $4,713.43 loss – and you are back to the same net outcome as making an extra dollar through wage income; a 40c gain.

Policy for an even playing field
We can use this example to also see the immediate impact from tax policy changes targeting investment property. If we eliminate the capital gains tax discount and quarantine losses against property incomes, we get a different story, which is in the table below.

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Here the $11,000 loss rolls over to be deducted from the future income of the property, in this case the capital gains on sale, making the net capital gain of $1. Because none of this gain is subject to the CGT discount, it all adds to personal income and is taxed at the marginal rate, along with the losses in other welfare benefits. After tax both the $1 from investment property and the $1 from the wage income now provide the same benefit.

It is certainly now time for the government to end these tax concessions for investment property. Raising the GST, the current government’s preferred tax policy, is probably the worst choice in terms of both equity and efficiency compared to the low-hating fruit of removing these property tax advantages which currently cost the budget about $11 billion a year. Obviously removing them would change incentives, reduce prices, and so forth, meaning that actual budget gains from their removal will be lower. But even so, the shift of incentives across the economy would be hugely advantageous in terms of both efficiency, and equity, as these tax incentives primarily benefit the wealthy.

Comments

  1. brettnicholsonMEMBER

    So a Q for you H&H
    This strategy has worked for 25 years
    – de reg of the banking system
    – availability of credit
    – advantageous tax system
    – interest rates falling towards zero over 25 years
    – AUD LOWER maybe more last 2 years effect
    – bye bye Chinese buyers – Melb East I guess
    So now what ???

    Interest rates at lows
    Credit tightening
    Medium income falling
    Budget crisis – therefore possible reversal of the tax adv

    You would have to say the party is over – why buy a news agency when you can buy a home and kick back and get rich

    I’d say we are at the turning point now –

    • We are at a turning point in that the ATO is slugging wages with more audits and fines to cover the losses on housing.

      Yet we think the ATO is going to save us from illegal foreign property investors.

      God help us.

      • More audit on wages by the ATO is a wasted resource. There are very little opportunity for wage earners to cheat on tax, whereas the are order of magnitude more fines that could be levied of they audited property investments.

    • Yeah – good luck buying a news agent – they’ve been snapped up by foreign buyers or foreign speaking local buyers & staffed with the like so good luck if you’re a citizen & fancy working in a newsagent, bakery, supermarket, Telstra shop, real estate, Darwin port etc – they’re the only ones who can afford to live in this country.(anecdotal of course re newsagent – Hall St Bondi has tidy up, new owners / operator & staff – they were beaming – couldn’t understand a word but figure they’re happy taking it off the hands of baby boomer vendors & securing citizenship for a dozen family members now eligible for Australian welfare)

  2. For a real eye opener do the same analysis but for an employee of a startup on a ESOP (employee stock options plan) under the old Labor rules.
    I did exactly this a few years ago and presented it to a couple of influential pollies ….believe it or not they justified ass raping the startup employees because in their honest opinions Options were UNEARNED income (windfall gains) I tried to politely point out that Investment property was truly unearned income but they wouldn’t have a bar of it…one was hard yakka, the other was money for old rope. Personally I had no argument with the categories but for whatever reason we couldn’t agree on the binning algorithm.

    • And this is why our productivity sucks.

      Productivity, competitiveness, agility and innovation all took a back seat (and were often intentionally sacrificed) to the all consuming housing market over the past 15 years.
      We only got away without foe so long thanks to our spectacularly expensive dirt. But it’s time to pay the piper. …

    • This is why my boss decided to become a property developer instead of focusing on his computer business, and made millions more.

  3. What brought it home for me was when Joe Hockey was asked on Q&A whether a person over 60 should pay tax on $100k of Super investment returns, and he replied: “Well, but it’s THEIR money.” How ridiculous! Surely, if a guy goes out and earns $100k at his job, there woild be an even greater reason to describe it as THEIR money.

  4. Cameron, can you please flesh out the FTB and Medicare benefits on the negatively geared property. My understanding was FTB was calculated on “Adjusted Taxable Income”, which adds back investment losses.

  5. Tassie TomMEMBER

    That effective marginal tax rate graph has blown my mind – I knew it was bad but I didn’t know it was THAT bad!

    I have previously suggested an alternative tax structure: 1) Everyone receives welfare (including pensioners – no more pension age, and children under 16 get half), 2) Everyone pays a flat tax of, say 35% on everything earned (investment income including bank deposits is deducted by CPI of investment capital, but this deduction is no longer applied to CGT deduction against CPI), and 3) Everyone pays a flat-rate wealth tax of say 1%pa on total wealth. I’d split the wealth tax into a LVT component (against which debt is not deductible, and possibly payable to the states), and a “rest of wealth” component (which debt against land can be applied against, but which cannot be below zero).

    My alternative tax structure looks positively fair and equitable against the EMTR graph.

    Before someone replies with “You ignorant plebiscites don’t understand capital, capital is mobile, you can’t tax wealth or capital will move elsewhere” – I say “garbage”. You can’t move land or the structures on it. You can’t move ore and resource deposits. You can move cash and equity investments, but there are systems already in place that can be a) refined and b) enforced to capture this. Otherwise every senior Australian would have their assets hidden off shore so that they pass the assets test for the full rate pension.

    The fact that I might be on $300,000 and my brother might be on $80,000, and if we both earn $100 in overtime I end up taking home more than he does – there’s something wrong.

  6. re capital gains: isn’t a fundamental difference that gains in value for humans can never be realised at time 0, because rights to future wages always belong to the worker and therefore can’t be traded in an asset market for labour returns. In that sense, the biggest distortion is between capital gains and capital income. ie. if 100% of capital income is taxable at marginal rates 100% of capital gains should also be taxable at marginal rates. Then humans are automatically better off v property investors. Cost of commuting should clearly be deductible imo. It’s an obvious inconsistency

  7. Ah, yes. Another Fox trying to deflect attention from the Hen-house by skirting the obvious point to be addressed “Negative Gearing”.
    This article conveniently(?) leaves out the addendum to the same article published on “fresh economic thinking” which Cameron ends with:

    Because many claim that negative gearing is a ‘natural result of the tax system’, we can leave this alone and simply concentrate on the capital gains tax discount. In this case, the table below shows how the tax benefits from negative gearing remain, yet the capital gains taxes completely offset the tax benefits from the losses made, resulting in the same net outcome.

    When you vigorously argue for changes to NG, Cameron, then perhaps you will be worth listening to.

    • Tassie TomMEMBER

      If there was no CGT discount at all then NG would be largely neutered.

      I’m not sure exactly how the interplay between a CPI adjustment to base capital and NG would play out. On one hand any 100% deduction against income for net property losses Vs <100% of marginal tax on capital gains will reduce tax payable for the same money in the pocket. On the other hand the favourite strategy of reducing the capital base by depreciating the investment property, thereby maximising net property losses and also maximising capital gain which is concessional – this strategy will partially backfire because as the base capital is reduced then the CPI indexation to capital will also be less.

      People will still be attracted to NG because it reduces the immediate tax payable, and even though the same amount of tax is deferred (unless one's marginal tax rate is about to drop, ie, approaching retirement), people will still do it.

      I guess I'm sticking up for Cameron – if he is attacking the CGT discount and he is successful then he is 80% of the way there.

      • The Negative Gearing system has to be changed for the very reason you touch on “People will still be attracted to NG because it reduces the immediate tax payable”, and it’s actually more corrosive than that! NG will be ‘sold’ by any vested interest as “the tax-man will help you pay off your investment”. Most ‘investors’ don’t have the time or the knowledge to think it through as you have done, so they take it at face-value. Until such times as it’s made obvious that the ‘benefit’ is not there, then it will be sold as if it is.
        Until people who do know better, like Cameron, start to recognise that economics is as much about perception, emotion and knowledge as it is about maths (although I’m sure some do, and that’s why we are all in the pickle that we are!) then it will be hard to change community thinking – let alone Government thinking!

      • @ Janet – all of that is completely true.

        If you need any evidence that tax deferral is swallowed by the punter in the absence of overall tax benefit, look no further than managed investment schemes in forestry, viticulture, almonds, and olives between about 1995 and 2005.

  8. That 50% cgt exemption is before taking inflation into account.

    The real exemption after inflation is much less, and in the case of long term investment might be no exemption at all.

      • And every time there’s a flip, the flipper looks to recoup the transaction costs. More upward price pressure.

      • The more houses you flip, the more likely it is that the ATO will see you as a speculator and you won’t get the CGT discount anyway.

  9. The only reason that NG “works” is because of the CGT discount if you make a gain or if you can play silly buggers around marginal tax rates (which is hard if you earn more than a couple of hundred thousand dollars a year).

    So can you please do some analysis of what happens when there is a capital loss versus a wage cut (or cut in rental income). I think you’ll find that the opposite happens ie that you are substantially worse off under your investment property because the losses cannot be offset against other income.

    Also, the analysis you have done above applies just as equally to other investments so it is not houses that have special advantage.

    Finally, I note that the Greens paper yesterday on this stuff assumed that any NG losses in a year could NOT be carried forward to offset against future income or capital gains.

    • NG “works” because capital growth in property has been stupid for decades.

      Take that away – eg: most property only appreciates with CPI like it should – and even with the CGT discount it barely makes sense because it takes so long for there to be any serious benefits from paying your tenant every week to live in your property.