Negative gearing and house prices, plus a case study of the 1980s

The government is limiting negative gearing for investment properties to new homes from July next year, returning to cost-base indexation for the taxation of capital gains, and imposing a minimum tax rate of 30% for inflation-indexed gains. 

The government does not think these measures will raise much revenue or have much of an economic effect. However, negatively-geared investor loans for existing properties account for an estimated 20% of all new home loans, such that house prices – which had broadly stalled prior to the announced changes – could fall by 4-9% and credit growth should slow from 7½% to about 4½%.  Policy rules point to tighter monetary policy, but tax changes could result in a lower peak in the cash rate.  

The only comparable tax changes where in the mid 1980s, when negative gearing was all but scrapped and capital gains were taxed for the first time, with the changes to negative gearing reversed under political pressure after only two years. House prices fell in real terms, while real rents rose, real credit growth slowed sharply and new home loans slumped. However, many of these trends commenced prior to the tax changes when the RBA was aggressively raising interest rates.

Major changes to the taxation of the housing market.

The government has legislated two major tax changes that will significantly affect the housing market, which were announced in the May Budget and take effect in July 2027.

1. Significant limits to negative gearing for investment properties.
   Negative gearing – which allows interest payments to be deducted from total taxable income – will be limited to investments in new homes. Existing investments will be exempt from these changes, while interest payments on existing homes purchased between last month and July 2027 can only be deducted from income from residential properties (albeit where there is a carry-forward of losses).
2. A return to inflation indexation of the capital gains tax base and the imposition of a 30% minimum tax rate on capital gains.
   Capital gains – net of any current losses or past capital losses that have been carried forward – are currently halved under a concessional 50% discount and added to total taxable income. The 50% discount will be replaced by the cost-based indexation of capital gains, which is a return to pre-1999 arrangements. A minimum tax rate of 30% will be imposed on inflation-adjusted capital gains.

The government thinks the changes won’t raise much revenue and won’t have much impact on the economy.

The government does not expect that the two changes will raise much revenue, with the main budget saving coming from planned reforms to the National Disability Insurance, which are recycled into more spending on hospitals, defence, an income tax cut, health and other expenditure.

Instead, the treasurer hopes that the budget will “encourag[e] investment in new housing supply” and “[provide] a fair go for first home buyers”. History suggests that these worthy aims will probably not be realised. No government has succeeded with either goal because they are unwilling to pay off the states to reform the supply of housing to allow it to catch up with demand, while repeatedly turning to subsidies to first home-buyers that end up capitalised in higher house prices.

In terms of the economic impact, Treasury’s modelling claims the tax changes will:

• Reverse the decline in the home ownership rate for owner-occupiers over the past 10 years by boosting the number of owner-occupiers by 75,000 over the next ten years;
• Temporarily reduce house price growth by about 2pp over a couple of years, which will have a “small [negative] impact on housing supply”; and
• Raise rents by about $2 per week, which is a forecast rounding error compared with the median weekly rental rate of about $670 per week.

The tax changes affect a material share of the housing market.

While not expected to raise much revenue, the new policies will affect a material share of the housing market given private rentals account for about one-quarter of the stock of homes.

• Private rental properties – which encompass the homes affected by the tax changes – account for 24% of the total number of homes in Australia, including vacant properties.
• Home ownership has declined, but still dominates the housing market, accounting for 66% of homes (this includes the 9% of homes that are empty).
• Public rental properties account for 3% of homes, although this greatly understates the role of government in the housing market because about half of all renting households receive Commonwealth rent assistance.
• The remainder of 7% of homes includes hotels, aged care, hospitals, etc., as well as homes where details are not available.

In the private rental market, more than half of investment properties are negatively geared. The split between taxpayers with a rental property who are negatively geared and those who are either neutrally or positively geared was 54%/46% in 2023-24, based on Tax Office data. More recently, the split has probably shifted to about 60%/40% given the share of negatively-geared properties is largely driven by the level of mortgage rates.

Investors do buy new homes, which can still be negatively geared, but have favoured existing homes over recent years. The split of investor loans in dollar terms between new and existing homes is currently 18% new / 82% existing. This means that new investor loans for existing properties account for one-third of all new owner-occupier and investor loans.

On the strong assumption that 60% of investor loans for existing homes are negatively geared, this would amount to about 50% of new investor loans, or around 20% of all new home loans.

The tax changes could reduce house prices by 4-9% over the next couple of years.

Home prices – which have been at an extreme for some time as a multiple of household income – have recently stalled at the national level as the RBA has raised rates, taking back all of last year’s rate cuts.

The government’s new policies are likely to weigh on prices, although estimating the economic impact of the tax changes is very difficult. This is because macro models do not adequately incorporate taxes and the only comparable changes to the tax treatment of the housing occurred over forty years ago.

One approach is to broadly equate the tax change to an increase in mortgage rates, taking a leaf from research by Trent Saunders at CBA. The estimated increase in the mortgage rate can then be combined with results from the RBA’s Saunders-Tulip model of the housing market to back out a potential impact on house prices.

On this basis, the tax changes equate to an increase in investor mortgage rates for negatively-geared properties of about 2-2¾%, depending on the tax bracket of the investor. This is calculated by backing out the increase in the mortgage rate required to raise loan repayments by the same amount as the lost tax concession on Cotality-derived estimates of an average national property worth $1 million with a 3.6% rental rate and relying on the APRA estimate of an investor mortgage rate of 6.4% (the latter assumes that the latest rate rise was fully passed on to new borrowers).

Given that negatively-geared investors account for about 20% of new home loans, this broadly equates to a rounded increase in the mortgage rate on all new home loans of about 50bp.

The Saunders-Tulip model suggests a rate rise of this magnitude would lower real house prices by about 3-5% over one year and by a cumulative 4-9% over two years, with the range reflecting uncertainty over whether the changes are truly permanent.

As a crosscheck, a second much simpler and mechanical approach relies on balance sheet data. The stock of all residential mortgages is $2.6 trillion and estimated negatively-geared new investor loans for existing homes was an annualised $80 billion in Q1. Mortgages are currently growing at an annual rate of 7½%, so the tax changes could take just over 3pp off growth by ending the demand for these loans, which could be interpreted as an upper bound for the impact on growth in house prices.

House price declines could see a lower peak in the cash rate.

Policy rules currently point to a peak in the cash rate of about 4¾-5% given high inflation and unemployment that is still below the estimated NAIRU. A material decline in house prices could see a lower peak in the cash rate, although it should be stressed that the circa 50bp estimate of the increase in the overall mortgage rate does not equate to a cash rate increase of 50bp. This is because other channels of the transmission mechanism of monetary policy are not affected by the tax changes.

In addition, there is the possibility that banks partly counter the tax changes by lowering mortgage rates for owner-occupier loans and investor loans for new homes to make up for lost revenue. APRA publishes the best data on mortgage rates actually paid by borrowers with a lag, although there are unconfirmed reports that banks have recently trimmed owner-occupier rates.

Haven’t we seen this movie before? What happened in the 1980s?

The only other time that the taxation of housing and capital gains was changed in such a significant way was in 1985. That was when recommendations made in the Hawke-Keating government’s White Paper on tax reform were adopted, with the notable exception of a GST, which was not introduced until 2000.

1. Negative gearing on investment properties was all but scrapped.
   Negative gearing was heavily curtailed for both new and existing homes by not allowing interest payments to be deducted from total taxable income and restricting deductions to income from residential properties (albeit where there was a carry-forward of losses).
2. Capital gains on assets bought after 1985 were taxed for the first time.
   Assets bought before 1985 remained exempt from tax, but inflation-adjusted capital gains on assets bought after 1985 were taxed when the assets were sold. Capital losses could not be deducted from taxable income. Instead, they could be deducted from any other current or future capital gains. This arrangement prevailed until it was replaced in late 1999 by the above-mentioned 50% discount on capital gains tax liabilities.

The economic impact of the tax changes is still debated today, with most focus on higher surveyed rents, particularly in Sydney and Perth. These rent rises, or more perhaps effective political campaigning by the housing industry, caused the government to completely the reverse changes to negative gearing in 1987, although the new capital gains tax was retained.

While the rental market share of the housing stock in the 1980s is similar in size to today, the impact of the tax changes is hard to disentangle from the impact of higher interest rates, which look to have been the driving force behind the weaker housing market on many metrics.

• The RBA raised the cash rate from 10% to 18% over 1983-85 (or 2% to 10% in real terms). However, the mortgage rate – where a ceiling was in place until 1986 – rose by much less, up from 12% to 16%, and the increase in the real mortgage rate was only 1pp given high inflation at the time.

With this key caveat in mind:

• House prices fell in real terms across the country, although they were weakening prior to the tax changes.
  National house prices declined by about 4% in real terms over the period, with similar declines across the country. Prices were weaker prior to the tax changes, likely reflecting the impact of higher interest rates.

• Rents rose in real terms, although it is not clear whether tax changes were responsible.
  Nationally, rents rose by about 7% in real terms, with some lag, given that the CPI measures the stock of rents and not every lease is regularly updated. The increase was not uniform, rather driven by Sydney and Perth, which raises questions about whether the tax changes were behind the increases. Vacancy rates were extremely low in both cities, and were extremely low in Sydney well before the tax changes.

• Credit growth slowed sharply in real terms, cooling before the tax changes, while much the same fall in new owner-occupier and investor home loans suggests interest rates were more the driver.
  Annualised growth in stock of residential mortgages halved from 18% to 9%, with the slowdown in real terms from 12% to -1% commencing well before the announcement of the tax changes. The value of new investor and owner-occupier loans both fell by about 30%. The fact that owner-occupier loans – which were not affected by the tax changes – fell at the same rate suggests that higher interest rates had a greater role than tax policy.