Australia's Future Tax System

Final Report: Detailed Analysis

Chapter E: Enhancing social and market outcomes

E4. Housing affordability

E4–3 The effect of the tax system on housing affordability

Many taxes influence the housing market. The personal tax system affects the affordability of rental housing through the assessment of income from investment in residential rental properties, offsetting expenses (such as interest costs) and capital gains. The housing market is also affected by the exemption of owner-occupied housing from the personal income tax and the capital gains tax system, stamp duties on housing transactions, GST on the price of supplying new housing, council rates and land taxes.

Prices send a signal to direct resources within an economy. Resources are directed to where they are most valuable when price signals reflect real preferences and resource constraints rather than tax policy settings, which of themselves contain no information about the type or location of dwellings Australians want to live in. Where taxes add to the volatility of demand or restrict the supply of housing, they reduce the efficient operation of the housing market. The general efficiency principle of tax policy, involves minimising its impact on economic activity. Similarly, when the tax system affects housing prices it can also affect fairness, for example, if the tax system makes it difficult for disadvantaged groups to afford housing.

However, other public policy objectives are of relevance for the taxation of housing. The role of housing as a lifetime savings vehicle that provides security in retirement means the income from owner-occupied housing should not be taxed. However, the Review is proposing to tax rental properties in a way that is more consistent with other forms of investment, reducing biases in housing investment and savings portfolios. As a result, these different tax treatments will affect the cost of housing for renters compared to homeowners.

Effect of proposed reforms on supply and demand for housing

Outlined below are a number of proposed reforms to the tax system that would reduce the impact of the tax system on house prices. These reforms are described in more detail in Section C2 (Land tax and conveyance stamp duty) and Section A1 (Personal income tax). In concert with other reforms to improve housing supply, they should improve housing affordability by making housing supply more responsive to demand.

Removing stamp duty

Removing stamp duties would improve the supply of housing, as well as reducing a range of other adverse impacts on the housing market.

By suppressing the number of transactions undertaken in the housing market, stamp duties reduce the effective supply of housing.16 More transactions means a better matching of people to housing, which in turn means a given housing stock can effectively house more people. By adding to the cost of moving to a larger house, stamp duty encourages people to renovate rather than re-locate. This means that more investment is channelled into making existing housing larger than into more affordable and newer housing. These impacts on the supply of housing are on top of the personal costs of stamp duty, which arise when people live in houses that are ill-suited to their needs.

As a turnover tax, stamp duties can also discourage the development of new housing stock. Stamp duties are paid twice in the supply chain of new housing construction: when the developer buys the property from its initial owners and when the final owner buys the land. Stamp duties impose their highest effective tax rate when a property is held for a short period (see Section C2 Land tax and conveyance stamp duty). As a result, they fall heavily on people who hold property over short time periods while it is developed (or redeveloped) into housing. As the liability from a land tax is independent of holding periods, replacing stamp duty would support new housing supply.

As well as taxing turnover, stamp duties are also a tax on the buildings (or improved value) including in housing. Compared to a tax on land only, stamp duties discourage the construction of new dwellings, which is likely to reduce supply and increase cost of housing.

Land tax

Using the size of holdings and the use of land to determine land tax liabilities has adverse impacts on the housing market. Reforms to levy land tax on all land, based on its value, should reduce these effects.

Apart from the ACT, all States that levy land tax calculate it on the basis of aggregate land holdings. In combination with progressive rate scales, this approach creates a significant bias against large-scale land holdings. In combination with the negative gearing tax advantage available to individual investors, this is a major reason for the residential property market being dominated by small-scale investors.

Policies that discourage large-scale investors from participating in the housing market are likely to have adverse effects on the supply of rental housing and its affordability for tenants. By favouring small investors, housing investment forgoes the potential for lower costs from economies of scale in housing supply. For example, small landlords effectively share the services of tenancy management by purchasing them from property agents. Large scale housing investors may be able to bring the supervision of tenancy arrangements 'in house', reducing their cost and the cost of housing overall. Further, large-scale investors are more likely to invest over longer time horizons, as they are less likely to face cash-flow problems or the need for portfolio diversification that can force sales by small-scale investors. For long-term investors, longer leases would also reduce negotiation costs and provide certainty of income. Such arrangements would be particularly beneficial to some tenants who currently face high costs from insecure tenure, such as many elderly people and low-income families. The security of tenure provided by longer leases would have positive effects for tenants' social integration and for high levels of social capital within communities.

Improvements to housing investment arising from the removal of the aggregation basis for land tax would likely develop over a reasonably long time period in light of the range of other factors affecting housing supply.

The current exemptions from land tax mean that the tax is unlikely to be fully capitalised into land values (see Section C2 Land tax and conveyance stamp duty). This results in the burden of the tax falling on the users of land, greatly reducing the efficiency of the tax. This is particularly relevant for the housing market. When developers purchase land that was exempt because it was used in primary production and will become exempt in the future (as owner-occupied property), little of the tax will be reflected in lower land values. The exemption is likely to add to holding costs of supplying new housing. Similarly, the burden of the current land tax on investment property is likely to fall predominantly on renters through higher rent. Broadening the land tax would therefore improve housing affordability.

Changes to the taxation of investment properties

The current personal income tax system favourably treats capital gains and amplifies this benefit when investments are geared. By discounting net rental income at the same rate as capital gains, the tax treatment of investor housing will be less responsive to gearing levels and capital gains, creating a more neutral treatment of different forms of savings (see A1 Personal income tax).

The proposed reforms would reduce the bias in favour of the capital gain generated in rental properties by treating it more neutrally compared to rental yield. Over the long term, this is likely to change investor demand toward housing with higher rental yields and longer investment horizons. This may also result in a more stable housing market, as the current incentive for investors to chase large capital gains in housing would be reduced. Finance for investment in rental property appears to be more volatile than that for owner-occupiers (see Chart E4–4). The Productivity Commission (2004) and Reserve Bank of Australia (2003) have suggested that favourable taxation settings can contribute to volatility of the housing market.

Chart E4–4: Volatility of housing finance from investors and owner-occupiers

Chart E4–4: Volatility of housing finance from investors and owner-occupiers

Source: ABS(2009j).

However, changing the taxation of investment properties could have an adverse impact in the short to medium term on the housing market. Investment returns in the Australian residential housing market are likely driven by capital gains rather than by rental yield. As such, 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 within the private rental market. These reforms therefore should only be adopted following reforms to the supply of housing and reforms to housing assistance (see Section F5 Housing assistance). The design of these reforms differs from the previous amendment to taxation of rental properties, see Box E4–2.

Box E4–1: Changes to tax treatment of negative gearing, 1985 and recommended

The effect of applying the recommended savings income discount to net rental income would be that a negatively geared investor would still be able to offset net rental losses against other income, including labour income. While the extent of the offset would be reduced, negatively geared investors would continue to access ongoing deductions that they might value for cash flow reasons.

Under the savings income discount, there would also be a generally better outcome for rental property investors that finance out of equity. The more neutral treatment would reduce the crowding out of other potential investors in rental housing by those undertaking negative gearing, and improve the long-term stability of the housing market.

Accordingly, this is quite a different approach to that adopted in 1985 (and reversed in 1987). In 1985 the tax benefits of negative gearing became restricted through the introduction of quarantining measures for excess deductions. As such, negatively geared investors could not access the entire net rental loss in the income year it was incurred, rather, excess interest in any year was carried forward and offset against future rental income or any gains taxable under capital gains tax from the sale of such investments.

In terms of rent setting, a more neutral taxation of investment housing would reduce the tax on some investors, while increase it for highly geared investors (see Chart E4–5). The long-term impact on rents would depend on how these different investors respond and their relative prominence in the rental housing market. Currently, investors with no or low levels of gearing form the minority of the market, so the current tax advantages available to highly geared investment can operate as a subsidy to renters by placing downward pressure on rents.

Chart E4–5: Real effective marginal tax rates on rental property, by gearing ratio

Chart E4–5: Real effective marginal tax rates on rental property, by gearing ratio

Assumptions: Individual on 31.5 per cent marginal tax rate. 6 per cent nominal return, 2.5 per cent inflation. For rental property, 50 per cent of the return is attributable to capital gain, 50 per cent attributable to rental income and the rental property is held for seven years then sold. Tax on debt provider disregarded.

Source: Treasury estimates.

This implicit subsidy is sometimes cited as a reason to sustain a non-neutral tax treatment. However, while some benefit may accrue to renters through lower rents, the tax advantage is neither transparent nor well-targeted to improve affordability for low-income renters. Further, providing assistance through subsidised geared investment can have other impacts on the availability of rental housing that may not be in the best interests of tenants. Recent work by Wood and Ong (2009) found that negatively geared investors were around half as likely to hold their property after five years as investors who were not negatively geared. For tenants, having landlords who are more likely to sell reduces the security of their tenure. In contrast to negative gearing, the proposed reforms to housing assistance are targeted to those who need assistance, making them a more effective and equitable means of subsidising low-income renters.

Overall impact on the housing market

While these reforms will address significant biases that the tax system introduces into the housing market, the overall impact on housing affordability depends on other factors, such as interest rates and land release policies. A range of other policies are likely to have a more significant impact on housing supply than tax settings.

The tax system is unlikely to be an effective instrument to move housing prices toward a particular desired level and the tax system is not the appropriate tool for addressing the impact of other policies on housing affordability.

Finding

Though the Review's proposed reforms to taxes, in particular stamp duty and land tax, could play significant roles in addressing housing affordability, other policies are likely to have a more pronounced impact on the responsiveness of housing supply.


16 For example, Leigh (2009) estimates that a 10 per cent increase in stamp duty costs reduces the total number of transactions by 4 to 5 per cent if the increase is sustained over a three year period.