Semester 1/2017 LEGL 602: Negative Gearing and Capital Gains Essay

This essay analyzes the Australian Labor Party's policy proposal on negative gearing and capital gains, addressing its significance, key stakeholders, and impact on various groups. It examines the winners and losers under this policy, considering distortions in the housing market and its effects on different income brackets. The essay further explores the implications for accounting/tax practices and their clients, detailing potential tax savings and complexities. Finally, it discusses the compliance impact on the Australian Tax Office (ATO), considering the treatment of property investments and potential inconsistencies within the tax system. The assignment draws upon the provided text to analyze the nuances of the negative gearing policy, its effects on stakeholders and the potential implications of the policy if it becomes law.

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Q.1 Why is this tax policy issue significant?
This tax policy is significant since the implementation of such a policy will help the labours to a
great extent. Accordingly, they can avail the benefit of such policy as a result of which their net
tax liability will be directly affected. They are of opinion that such policy if implemented will
lead to an increase in their disposable income i.e., the proportion of the salary amount they
possess for spending towards essential commodity (Austill, 2018).
To understand why negative gearing is a detrimental tax policy one needs to understand how it
works and how that compares to most other tax systems:
In Australia, an investor who incurs an “operating loss” on an investment property (total
expenses exceed the rental income in a given year) can deduct this loss from his/her current
income. Notice that this cannot be done for any other business: an operating loss in any business
is carried forward and offset against future profits before additional profits get taxed. (This is a
point that proponents of negative gearing don’t seem to want to understand.)Negative gearing is
incredibly costly in terms of government revenue lost and is one of the largest government
handouts that is in no way targeted to a particular group that needs government support
(Australian Government, 2017).
Q.2. Who are the key stakeholders and how does this policy affect them?
The key stakeholders likely to affect or influence by this policy includes labor working at
different levels and whose income consists of capital gains. Besides, income tax officers
(assessing officers) are also key stakeholders. Key stakeholders include all those persons whose
will be influenced or get affected either positively or negatively. As such, it is important to
identify key stakeholders so that the success or failure of the concerned policy can be determined

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with ease. This is because key stakeholders are the appropriate person who can give unbiased
opinion and views in relation to any particular policy (Australian taxation office, 2018). It can be
said that this policy will yield positive result or benefit to labor’s working in different business
organizations. On the other hand, it will decrease the net tax liability of workers lowering the
income tax revenue to the Australian Taxation Officer. Thus, it can be said that income tax
collection agency will not get benefit from such policy. Apart from income tax authorities and
labor, it can be also observed that business organization in which such labors are working will
also get influenced.
Labour would limit negative gearing to newly built properties. This means that investing in new
properties becomes (at the margin, and for some) more attractive than purchasing an existing
property, which may increase the supply of newly built properties (primarily apartments) in the
rental market rather than bidding up the prices of existing buildings and apartments(Australian
Government, 2017). Contrary to the opinion, the absence of negative gearing does not mean that
the cost of a mortgage cannot be deducted from the income an investment generates. It still can
(as a carry-forward).
Without negative gearing (as for example in the US tax system and most other countries), the
operating loss would be carried forward as the property investment is treated separate from
current income (as so-called “passive income”). Later, either when the property generates
positive operating income or at the time of sale, the carry-forward loss is deducted from the
proceeds and capital gains taxes are only incurred on the proceeds from the sale net of all
expenses and losses along the way. Labor income in such a system will be taxed according to its
respective tax bracket, i.e., at 45% in this case.

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Q.3. who are the winners and losers in relation to this tax policy?
The effect of the ability to deduct losses from current income depends on the owner’s income
bracket: for an investor in the highest income bracket ($180k+) income is taxed at the margin at
45% (plus Medicare levy and budget repair levy). Thus, $1000 of “negatively geared” operating
loss saves the investor $450 in income tax(Austill.,2018). Notice that the investor then still is left
with a net loss of $550. Of course the investor expects to earn this loss back in the long run,
primarily through the appreciation of the property, which is taxed at the time of sale at a
concessionary capital gains tax rate (CGT) of 22.5%, provided s/he is still in the top income
bracket at the time of sale—potentially less if s/he is retired or otherwise in a lower income
bracket at the time of sale. So when the operating loss is later recovered as a $1000 capital gain,
the investor only pays $225 in tax and has in effect converted his or her income tax rate from
45% (the intended marginal income tax rate) into the long-term capital gains tax rate of 22.5%
for the amount of the $1000. In addition the investor benefits from deferring the tax liability until
the sale of the property, which amounts to an interest free loan in the amount of the original tax
due, worth [(1+r)T−1]×$450[(1+r)T−1]×$450, or $280 (for an interest rate of 5% and 10 years
until selling the property).
 Distortion of the housing market, in a couple of ways:
a. Those who benefit the most from negative gearing at the margin (i.e., high-
income, mortgage financed investors) are willing to pay a higher price for a given property that
others who don’t benefit (i.e., someone who wants to occupy the property themselves—which
does not attract the negative-gearing benefit—or someone in a lower income bracket).
Beneficiaries of negative-gearing can, therefore, out-bid the non-beneficiary at an auction, all
else equal(Australian taxation office, 2018).

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b. Investment in housing is tax-favoured relative to other productive investments. —
This may, in fact, be an intended or at least desirable consequence as it could potentially increase
the housing stock. The problem is that empirically a lot of the negatively-geared funds are spent
on existing properties, driving up the price of existing housing (thus making them “less
affordable” to the nation-negative-gears, point a. above) rather than encouraging new housing.
c. Other forms of investment (e.g., venture capital or otherwise productive
investment) may be in shorter supply than without the negative-gearing policy.
Since housing prices are higher than they otherwise would be, everyone who owns their own
home feels better about their asset position (without necessarily having more purchasing power
since when they sell they’d have to buy another property that is also inflated or become renters),
and everyone who doesn’t own a home feels poorer.
All of these are negative consequences. On the positive side is that some (on average rich)
people get a tax break.
So Labour’s proposal is to limit negative gearing (from now on) to new properties so as to get rid
of most of the above negative consequences while at the same time direct more investments into
new properties. The current distributional inequities would not be addressed since those who
already benefit from negatively geared properties would be grandfathered and continue to be
able to effectively halve their marginal income tax rate to the extent of their annual operating
losses. Their benefit may be reduced at the time of sale if housing prices grow more slowly as a
result of reducing the distortion on investment(Australian Government, 2017).
Negative Gearing allows investors to deduct 50% of expenses on business that is taxed at 25%.
Also, in Australia investment into the home are not taxes deductible. As a result, property
investors are given an advantage over first home buyers. Several other factors are also important:

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 Relatively high taxes, with top marginal tax reaching over 50% if levies are added.
 Fringe Benefits Tax that makes provision of benefits taxed at top rate. With exception of
superannuation (pension plan), employees are paid what they earned in money rather than
benefits(Koen& Holloway, 2014).
 Individual rather than family taxation, resulting in high salary earners paying high taxes
even if they have a lot of dependents. Negative gearingoffers an opportunity to reduce the tax.
Q.4. Assuming that you work for an accounting/tax practice, what would be implication for
taxpayer firm and its clients if the tax policy becomes law?
For instance, If assesse claims 10,000 tax loss each year for 5 years, that adds up to 50,000
offsets against other income, and saves paying tax on 50,000, maybe saving 9,500 in tax for 19%
bracket taxpayers (Koen & Holloway, 2014).
Assume assessesell the property, after 5 years, and make 20,000 profit. The tax man adds that
50,000 back and recalculates tax payer profit at 70,000 on the sale, and that will be at the higher
tax bracket, or maybe 32.5%, so 16,250 in tax to pay on that original 50,000 (Which saved
assesseonly 9,500 originally). Fortunately, with the 50% CGT break, it gets reduced to 8,150 tax
to pay. Total saving after 5 years is therefore only 1,450, or 290 per year. About what
assessemight have paid an accountant to do it. Figures differ for different examples of course,
but that shows the general idea (Lai & Kelley, 2012).
So what assesse need to notice about negative gearing are the following things:
 The benefit of effectively halving the marginal income tax rate is highest the higher tax
payer income bracket and is maximal for those with incomes above $180k and those who can
defer selling the property until retirement. Hence the observation those high-income earners
benefit most from negative gearing. This does not rule out that “teacher and nurses” use negative

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gearing, it just means that the benefit to them is much smaller than it is for the investment banker
or doctor. This results in higher wealth and income inequality.
 The benefit accrues only to mortgage-financed investments, as self-financed property
does not incur operating losses and hence yields no income reduction. The policy thus favours
leveraged investments, thus increasing the risks to investors should interest rates rise or property
markets ever tank. (Both are likely to happen simultaneously, by the way.)
 As a result of excess borrowing, bank balances have a high proportion of mortgage
assets, putting lots of eggs into the Australian housing basket and thus increasing the “systemic
risk” for the financial system (Mrkvicka, et. al., 2016).
Q. 5 Assuming that you work for the Australian Tax Office, what impact would the tax
policy have on compliance work of the ATO?
The intention is to treat property investment on the same basis as all other investments. For all
other business investments, costs are deductible. So for example, if assesseborrows money to
invest in bank stocks, the interest charges for the money assesseborrow are a tax deduction. If the
taxpayer didn't have "negative gearing" on property purchases, it would be the only type of
business investment which did not allow negative gearing.
If the taxpayer didn't have negative gearing for property purchases, then the tax system will have
potential inconsistencies and opportunities for "rorting". Consider the case for listed property
trusts, which invest in commercial and sometimes residential real estate. If the taxpayer didn't
have negative gearing, then presumably interest payments on debt used to purchase property trust
stocks would not be deductible, and any interest payments on debts would have to be separately
calculated. (And for that matter, the value of listed property stocks would plummet).

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This is a lot harder issue than most people realize. They think the issue is solely about residential
investments by mum and dad investors. The problem arises when these investments are then
wrapped into a business structure (eg as Pty Ltd). If taxpayer doesn't apply the same rules to
businesses, then Mum and Dad investors will restructure this as a business investment through a
Pty Ltd structure. If taxpayer applies the same rules to businesses, tax player opens a major can
of worms (Ostertagová, 2014). It rewards people who already own houses by making it easier for
them to buy a second one. It punishes renters on low or even average incomes by forcing them
(us) to compete in the market with people who have a taxation advantage by virtue of already
owning one or more houses. This pushes up house prices up and locks many people out of ever
owning a house for their family.
With statements like: “Traditionally, taxpayers have been allowed to negatively-gear their
investment properties“, it appears that Australia may have always added all income and losses
together to get a final taxable figure. But it should be remembered that all these losses claimed
each year get clawed back on the sale of the property. And then get taxed (Shazmeen, et. al.,
2013).
Because the loss is able to be written off as a tax offset against personal income tax. Also, the
income from leases on the properties is taxed at a lower rate than personal income tax. So
basically assessee can pay less tax by buying a second house. This is why people owning
"investment properties" (more than one house, which they lease to tenants) is so common. Once
assesseowns a house, the assessee can use the equity to buy another house and rent it at a price
that won't cover the mortgage. The loss can be used as a tax offset against tax payer personal
income tax and the money paid to assesse by the tenants is taxed at a lower rate than income tax,

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so you're effectively getting a second house for free (so long as assessehas a good enough job to
earn enough tax to offset, and assesse have tenants).

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References
Austill. (2018) INCOME TAX ASSESSMENT ACT 1997 - SECT 82.135 Payments that are not
employment termination payments. [Online]. Available at:
http://www5.austlii.edu.au/au/legis/cth/consol_act/itaa1997240/s82.135.html [Accessed: 5th
September 2018].
Australian Government. (2017) Fringe Benefits Tax (FBT. [Online]. Available at:
https://www.business.gov.au/info/run/tax/fringe-benefits-tax [Accessed: 5th September 2018].
Australian taxation office, (2018) Amounts not included as income. [Online] Available at:
https://www.ato.gov.au/Individuals/Income-and-deductions/Income-you-must-declare/Amounts-
not-included-as-income/ [Accessed 5th September 2018].
Australian taxation office, (2018). Capital gains tax. [Online] Available at:
https://www.ato.gov.au/General/Capital-gains-tax/ [Accessed: 27th August 2018].
Koen, R. and Holloway, J., (2014) Application of multiple regression analysis to forecasting
South Africa's electricity demand.Journal of Energy in Southern Africa, 25(4), pp.48-58.
Lai, K. and Kelley, K., (2012) Accuracy in parameter estimation for ANCOVA and ANOVA
contrasts: Sample size planning via narrow confidence intervals. British Journal of Mathematical
and Statistical Psychology, 65(2), pp.350-370.
Mrkvicka, T., Hahn, U. and Myllymaki, M., (2016) A one-way ANOVA test for functional data
with graphical interpretation.Functional ANOVA test.
Ostertagová, E., Ostertag, O. and Kováč, J., (2014) Methodology and application of the kruskal-
wallis test. In Applied Mechanics and Materials, 611, pp.115-120.

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Shazmeen, S.F., Baig, M.M.A. and Pawar, M.R., (2013) Regression Analysis and Statistical
Approach on Socio-Economic Data.International Journal of Advanced Computer Research, 3(3),
p.347.