An independent assessment on negative gearing

Labor claims its "reforms" to "negative gearing" would do wonders to make home ownership more affordable for our kids. But Malcolm Turnbull says vote for high-taxing Labor and the value of your home will crash, while rents soar.

Many voters have strong views for or against negative gearing. But when rival politicians fall to arguing about their policies, most of us find we don't know enough to decide who's right.

We need someone we can trust to act as a kind of umpire, pronouncing on who has the better case. So we're fortunate to have John Daley and Danielle Wood, of the independent Grattan Institute, issuing a report on the topic.

For defenders of negative gearing, it's bad news. The pair explain that there's a good case for acting against the practice, dismissing alarmist claims it would disrupt the property market.

For opponents of negative gearing, however, the news isn't as good as it seems. Since the resulting reduction in house prices isn't likely to be great, acting against the practice wouldn't do much to make home ownership more affordable.

Investment in a rental property is negatively geared when so much of the cost of the property has been borrowed that the interest bill and other expenses exceed the earnings from rent.

Why would anyone deliberately structure an investment to run at a loss? Partly because they can deduct that loss from their income from other sources, thus reducing their tax.

But that means they're still out of pocket for the remaining half or more of the loss. Why do that? Because they're hoping eventually to sell the place at a big capital gain, which should more than make up for the after-tax losses they've incurred.

That's been more likely since 1999, when the Howard government introduced a 50 per cent discount on the rate of tax on capital gains.

Daley and Wood disprove the dishonest claims that negative gearing is used by many people on modest incomes to get ahead. There may be a few of them, but the statistics show high income earners claim the lion's share of the benefits.

The authors say there's no point of principle that supports our longstanding practice of allowing losses on property investments to be charged against wage income for tax purposes.

Very few other countries do this. It makes the housing market more volatile and reduces home ownership. It diverts capital from more productive investments while doing little to increase the supply of homes.

They propose allowing losses on property investments to be deducted only against income from other investments, not against wages. This would save the budget $2 billion a year in the short term, falling to $1.6 billion a year as behaviour changes.

But much of the attraction of negative gearing comes from its connection with the 50 per cent discount on the taxing of capital gains.

They say there is a case for taxing capital gains more lightly than other income – mainly because much of the seeming gain comes just from the effect of inflation, which makes it illusory – but this doesn't justify a discount as great as 50 per cent.

Allowing such a high discount (as well as allowing rental losses to be deducted against wage income) greatly reduces the government's tax collections, meaning it has to rely more heavily on other taxes. Those other taxes often do more to distort economic behaviour than taxing saving does.

In any case, empirical evidence shows people on high incomes save almost as much regardless of the tax rate. Measures intended to encourage saving mainly influence the vehicle through which wealthy people save – superannuation or property or a bank account, for instance.

As well, the high discount on capital gains tax creates opportunities for artificial transactions to reduce tax and encourages investors to focus too much on speculative investment – sit back and wait for capital gains to accrue – rather than investment that earns annual income by producing goods and services.

Daley and Wood propose halving the capital gains discount to 25 per cent. This would save the budget about $3.7 billion a year.

These policy proposals may sound the same as Labor's, but there are important differences. Labor promises that, for new investments undertaken from July 1 next year, deduction of losses against wage income will be permitted only for investments in newly built homes.

Investments made before then will be unaffected, while losses on new investments in shares or existing properties may still be deducted against other investment income.

Labor promises to cut the capital gains discount to 25 per cent for all assets bought after July 1, 2017. All investments made before then will be unaffected.

Daley and Wood criticise both proposals. Retaining existing negative gearing rules for prospective investments in newly built homes adds a new distortion that would, they believe, do little to increase the supply of homes.

And they criticise Labor's plan to "grandfather" existing investments – for both negative gearing and the capital gains discount – leaving them unaffected by the change.

A better way to minimise disruption to the market and to the expectations of existing investors would be to apply the changes to everyone, but phase them in equally over 10 years.

If only making up our mind on the other election issues we'll face could be so easy.

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Is the world ruled by ideas or by interests?

Most economists believe John Maynard Keynes (rhymes with "brains" not "beans") was the greatest economist of the 20th century. But his most famous quote is one I've never been sure I agree with.

He claimed that "the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.

"Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

"Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."

One man who definitely agrees is Barry Schwartz, a professor of psychology at Swarthmore College in Pennsylvania. He writes in his book Why We Work that, where once our ideas about human nature may have come from our parents, our community leaders and our religious texts, these days they come mostly from social science.

"In addition to creating things, science creates concepts, ways of understanding the world and our place in it, that have an enormous effect on how we think and act," Schwartz says.

"If we understand birth defects as acts of God, we pray. If we understand them as acts of chance, we grit our teeth and roll the dice. If we understand them as the product of prenatal neglect, we take better care of pregnant women."

Schwartz says that because ideas aren't objects, to be seen, purchased and touched, they can suffuse through the culture and have profound effects on people before they are even noticed.

And ideas, unlike things, can have profound effects on people even if those ideas are false.

I don't doubt that, in this, both Schwartz and Keynes are right. The social world is far too complex for any of us to really understand how it works. So we observe what's happening and then come up with theories - "models" - about how it works.

Those theories inevitably influence the way we think about the world, the way we react to it and the way we try to get some control over it.

But the world is so complex that we can have lots of different theories about it, or different aspects of it. Many of those theories will have an element of truth and an element of error.

We probably should have a toolbox full of theories, choosing to use the one that best fits the particular issue we're focusing on.

But human nature - our limited cognitive processing power - leads us to simplify things, settling on the one that seems to work best and apply to most circumstances. We remember it, and forget the others.

Often, of course, we don't do a lot of thinking about which theory is best, we just go along with the one most of the people around us seem to believe.

It's also true that the theories and models we rely on, consciously or unconsciously, become, as the sociologists say, "performative" - if enough people believe the world works in certain way and act on that belief, to some extent the world does start to work that way.

There are limits to this, of course. For a few decades economists allowed their dominant model - their group's way of thinking - to convince them the deregulation of the banks had brought us to the era of Great Moderation, of low inflation and unemployment with ever rising prosperity.

Their model blinded them to the global financial crisis that was coming and the years of economic malfunction that would follow.

There could be no more costly demonstration of the inadequacy of their theory about how the world worked.

So no argument: ideas have a huge effect on the world - for good or ill. But does that mean "the world is ruled by little else"?

I doubt it. The main rival for that title is the thing economists exalt above all else: self-interest. What happened to the rich and powerful, don't they have any influence on how the world is ruled?

The more I observe our politics, the more I see it as an unending battle between powerful interest groups. The political parties, contending for their own share of power, negotiate their way around the most powerful of the various interest groups.

The problem is the power democracy still gives to ordinary punters. Should I try to win votes by promising a royal commission, or should I keep in with the banks - and their generous donations to election funds - by promising to bash them with a feather?

So, do ideas really trump vested interests? Surely we're ruled by some combination of the two.

But the more I understand the weaknesses in the economists' dominant ideas about how the economy works and should work, the more I see what a bad predictor their model is, the more I wonder how such a flawed theory remains so dominant, largely impervious even to stuff-ups as monumental as the Great Recession.

Then a terrible thought strikes: maybe their ideas remain so influential in politics and the community because they happen to suit the interests of the rich and powerful.

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