Tax reform
The shitstorm
A set of minor tax reforms that remove perverse incentives in the housing market and that correct distortions introduced 27 years ago has precipitated a hysterical reaction from the ill-informed, from partisan media, and from those who shamelessly defend the right for the privileged to avoid paying tax.
Judging from the howls from real-estate agents, investment advisors, journalists employed by right-wing media, and those who claim to speak for business interests, the government – this horrible Labor government – has betrayed its promises to the Australian community. It has made a fundamental intervention in the economy upsetting the market order and replacing it with a set of far-left high-tax socialist interventions that will cripple any hope of restoring growth and productivity. We can expect a flight of capital, the loss of entrepreneurial talent, and the abandonment of any opportunity for ordinary Australians to accumulate wealth.
Writing in the Saturday Paper on June 6, just after the budget – “We will hammer you”: News Corp’s budget campaign – Stephen Long describes the scare campaigns mounted by partisan media, particularly the lies about a “death tax”.
Long doesn’t confine his criticism to the Murdoch media, which is known to be partisan. More seriously the ABC, which claims to be free of partisan bias, has misrepresented the changes. For example, in its post-budget summary of “winners” and “losers”. it categorically stated that investors would be the losers, oblivious to the fact that restoration of indexation would actually lower the amount of capital gains tax paid by many investors, particularly patient investors who are not chasing speculative profits. Many ABC journalists, explaining the budget, referred only to the withdrawal of the 50 percent discount without mentioning the restoration of indexation. This sloppy reporting contributed to the idea that the government is being unfair on investors.
Martin McKenzie-Murray, writing in the Saturday Paper three weeks later – Inside the tax reform “shitstorm” – describes the hysterical campaign that developed, contrasting it with the modesty of the actual changes.
The changes are described in detail in a well-crafted article by Tom Crowley describing details of the reforms with 9 graphs. To summarize even more concisely, there are two main intentions in the reforms.
One is to remove a distortion in the tax system that allowed housing “investors” to effectively double-count interest payments as a tax deduction, tilting incentives towards speculation in established real-estate and away from real wealth-creating investment.
The other is to restore the principle that capital gains tax should be paid only on real gains in value, rather than the illusory gains of inflation. The changes ioduced by the Howard government in 1999, without consultation, had resulted in a tax system that undertaxed investments with short-term gains in value, while overtaxing investments with more modest long-term performance.
Both reforms are directed at restoring neutrality to the tax system, ensuring that income earned through labour is taxed in the same way as income realized through asset-price appreciation.
The din of complaints was so strong that it was hard to distinguish real complaints from partisan misinformation campaigns. Part of the fuss was over “startups” – companies that started with a low or zero capital base, which meant that indexation would be irrelevant. A series of work-arounds for small businesses seems to have compensated – in fact over-compensated – for these problems.
The government is probably hoping that the shitstorm will soon pass. In fact, if the share market and housing bubbles deflate, or if they rise only slowly, investors may be quite pleased to see that indexation has been restored.
But such has been the vehemence of the reaction that politicians, in government or aspiring to government, must be wondering if they can bear the political cost of economic reform. If it’s been so hard for a government with a whopping parliamentary majority and confronted by a mortally wounded opposition, economic reform must surely be impossible for governments or opposition parties in more normal times.
That’s the topic of a discussion on The Economy Stupid, where Peter Martin interviews Guardian economics editor Patrick Commins and former ACCC head Graeme Samuel on the question Is tax reform even possible anymore? Martin’s guests are reasonably positive about the path the government has taken to achieve reform, in spite of the messy compromises relating to startups. Samuel is not surprised by the squeals of complaint, hinting that the volume of complaints is a good indicator that the government is on track to real reform in the public interest.
That is certainly the way this reform has played out. But have those who claim to speak for “business interests”, with hysterical campaigns and exaggerations, done themselves and the interests they claim to represent any favour?
Housing and other assets
The reforms are contributing to a small but real reduction in housing prices. We should celebrate this minor victory over inflation.
“Jim’s tax hit wipes $300m from Qld’s housing market” (Courier Mail)
“Australian house prices drop: Matt Canavan demands PM sack Jim Chalmers” (news.com)
“House price fall could slice $100,000 from your home’s value “ (Sydney Morning Herald”)
Really? Has there been an earthquake, a series of fires, storms bringing trees crashing down on houses?
No. Our houses are undamaged.
A normal depreciating asset: Chalmers doesn’t set its value
These headlines refer to the news that over the last three months house prices have fallen by 0.6 percent, or probably by about 4.5 percent in inflation-adjusted terms. According to the Cotality home value index, in the latest quarter to June nominal dwelling prices have actually fallen in Sydney, Melbourne and Canberra, and in other state capitals price rises have been 0.7 percent or less. This means that house prices are not keeping up with inflation elsewhere in the economy: they are falling in real terms. In the last few weeks auction clearance rates in Sydney and Melbourne, and in Australia generally, have fallen. That is taken as an early sign of softening in dwelling markets.
No one can give a categorical reason for this softening in the market. It may be the accumulated result of three interest rate rises so far this year. It may result from banks’ tightening lending standards. It may simply be a “regression to the mean” as prices in different regional markets even out: there is evidence that while prices are falling in Sydney prices in the rest of New South Wales are still rising, for instance. It may have something to do with lower rates of net migration. It may result from the government’s initiatives, which have only just been legislated but were announced on May 7.
Or, more generally, it’s simply an example of an asset bubble bursting – tulips in Amsterdam in 1630, Melbourne property in the 1890s, shares worldwide in 1929.
Housing “investors” – they should have seen it coming
It is close to a universal law of systems, including financial systems, that positive feedback loops always end in deflation. Unfortunately it is confirmed that naïve investors don’t learn from history. The longer a boom has gone on, the more confident people become about it continuing. Encouraged by the tax deductibility of interest payments (“negative gearing”) some have loaded themselves with high debt to finance what they reasonably fear will be assets declining in value.
Had they familiarized themselves with a little history, rather than the blurbs of real-estate spruikers, they might have been more cautious with their money. Those who have speculated in the real estate market deserve no more sympathy or political support than those who made the wrong bets at Randwick and Flemington. In any event the 10 percent of Australians who own “investment” properties tend to be older people (>60) and in the top income quintile, according to Reserve Bank research.
The other 90 percent – some better off, none worse off
But for the 90 percent of Australians who don’t own “investment” properties, falling prices don’t matter, and they are advantageous for those entering the property market and for those trading up, as many young people do once they have a foothold.
If you own and live in a house or apartment, its value in terms of shelter and convenience remains unchanged by changes in the market value. If you own or are paying off a house it’s a normal depreciating asset, generally running down between long-term renovations.
The political problem, however, is that if people feel disadvantaged by falling house prices, they are likely to blame the government as the most evident party-pooper.
That’s because some people have come to see their own houses – the ones they live in – as financial assets. It’s an irrational perception, but many are gripped by a belief that when the market value of their house rises, their wealth rises, even though it’s only inflation. We generally welcome lower prices when they occur, particularly for things we really need, like food and gasoline. But many people don’t extend that logic to housing.
Some highly-indebted households may fear that they are facing negative equity, but banks are unlikely to foreclose because they are content to see rising nominal incomes slowly reduce the burden of their debt.
Holders of self-managed superannuation funds
One of the last-minute deals shepherded through the Senate by the Greens has been to prohibit self-managed superannuation funds from borrowing to invest in housing. To hear the squeals from the finance sector one would think that the government has just imposed a huge impediment on those saving for retirement. Claire Armstrong explains the changes, and the petulant protests, in a post on the ABC website.
It’s an extraordinary complaint. Speculators with some spare cash outside superannuation may still borrow to invest: it’s their right to gamble on horses, poker machines, Bitcoin, IT shares or houses in Sydney. But the intention of superannuation – encapsulated in law as the “sole purpose test” – is to provide people with an income in retirement.
Those who have studied the behaviour of personal investors know that people who borrow to invest in order to build up their life savings, particularly in times of rising asset prices, often lose everything. To hear so-called financial advisors complaining about this restriction, designed to protect naïve investors, brings into question the competency of those offering advice to self-managed-superannuation fund holders. It is to the Greens’ credit that they closed this dangerous exemption, and to the government’s discredit that they overlooked it in their original bill.
Other investors and their hangers-on
If the reforms are effective in reducing demand for “investment” housing, and dampening speculation in other high-growth assets, there will be some losers in the finance sector. These are the businesses that prosper from asset turnover – real-estate agents, mortgage brokers, so-called “wealth managers”, and the finance sector generally.
Another category of losers, whose complaints will be less strident, are state governments, that have been so dependent on real-estate stamp duties.
As pointed out in the preceding post there is also a general belief that those who invest in the share market will lose out, even though the return of indexation means that many share market investors will actually face lower capital gains assessments when they eventually sell their shares.
The Howard changes that abolished indexation and replaced it with a 50 percent discount was certainly favourable to those who bought shares that rose steeply in market value, and comparatively unfavourable to those who held shares in established companies that tended to pay dividends and stabilized in real value. The Howard changes favoured speculators – successful speculators anyway – while they applied comparatively high taxes on those who made long-term investments in established companies. The former investors tend to have high turnover in the market, to the benefit of stockbrokers and investment advisors, while the latter tend to hold shares for a long time.
When the Howard government changed the capital gains tax provisions in 1999, it did so under pressure from the finance sector. Their argument was that the economy needed more “financial dynamism” – that is, more turnover of assets. At the time Australia was in the mid-years of a share market boom, that was to power on until the global financial crisis of 2008. In such bull markets a spirit of irrational exuberance prevails: investors behave as if the boom will never end, and they come to confuse the market value of assets, such as shares and houses – with real wealth.
The present times are not dissimilar. The share market has been in boom conditions for the last ten years, interrupted only by the small inconvenience of the Covid pandemic, and now there are early signs that the Australian share market is cooling: over the last 12 months the ASX 200 index has moved by only 2.1 percent. If that is the typical capital gain of a share portfolio, it means share prices are rising more slowly than inflation. As a result the 50 percent discount method will result in a higher taxation base than would have been the case if indexation had been retained. How many investors will realize this, and how many investment advisors will point this out to their clients? It’s a fair bet that the deceitful story about Labor discouraging investment will persist.
How to deflate a bubble – try to hold nominal values
Some asset bubbles burst like balloons, which means that almost every investor gets burnt. Others deflate slowly. For the sake of financial stability, the government clearly doesn’t want to see an 1890 or 1929 crash in housing or in other assets. Also, because many people assign an irrational meaning to the market value of their houses, the government tries to pretend that it doesn’t want to see house prices fall, when in fact that is a prime purpose of their reforms.
Mike Seccombe explains this awkwardness in his Saturday Paper article Are Labor’s housing reforms working? (The print edition has a better headline “The correction we have to have”.) The government knows that many people would be spooked by falling nominal house prices. In fact in Victoria the Liberal Party in opposition is promising that if it is elected it will enact policies intended to
That is why, as Seccombe explains, the ideal political outcome would be for nominal house prices to freeze for 10 to 15 years, while nominal incomes rise. At present the price of a typical home is about 8 times median income (10 times in Sydney). A back-of the-envelope calculation suggests that, based on the budget projections of 4.5 percent annual nominal wage growth, over 10 years wages will rise by 55 percent. That would bring the price of a typical house down to about 5 times median income. Over 15 years nominal incomes would nearly double, bringing the price of a typical house down to about 4 times median income, which was around the level at the turn of this century. This may be too slow: we probably need to see nominal house prices drop if we are to see significant progress in affordability in the short to medium term. Without a boost in supply, there is only so much that can be done by clearing the market of speculators.
In fact, the fear of a public backlash against falling house prices may be overstated: home owners are not as irrational as politicians assume. A Resolve Political Monitor survey, reported by Shane Wright of the Sydney Morning Herald, suggests that Australian home owners are comfortable with the idea of a fall in house prices. Among the 1800 people surveyed, 54 percent were in favour of lower house prices, with only 11 percent opposed. Unsurprisingly 60 percent of those aged 18 to 34 were in favour of lower prices. But surprisingly support for lower prices was much the same for outright owners, mortgage holders and renters. We might have reached the point where most people are coming to believe that the housing bubble is not good for Australia, and to look with scepticism at values set in a bubble.
We may all be amenable to a more rapid fall in house prices – that is a nominal fall in house prices – if we take Seccombe’s advice:
The lesson is that solving the housing crisis will likely require more than change to the tax laws. It will require us to buy into a different narrative, such as existed decades ago, in which houses were homes, not positional goods or investment vehicles.