The wrong way to fix housing affordability

It was reported on Tuesday that the NSW Government has made a submission to the Federal Senate enquiry on housing affordability.

Their argument? According to the report in the Australian Financial Review:

“NSW Treasury’s submission argues the CGT discount places upward pressure on house prices by increasing investor demand, exacerbating housing inequality and making it harder for first home buyers to enter the market.”

And some other data from the submission itself:

“Lending to investors [in NSW] was not that much larger than to first home buyers in 1994 but is now substantially higher, with lending to investors growing to $53 billion (972 per cent) compared to lending to first home buyers growing to $17 billion (392 per cent).”

The latter data is pretty stark, and highlights the growth of property investment and, indirectly, the reduction in the percentage of young people who are able to afford a home in NSW.

The data, directionally at least, is likely to be similar across the country.

Given the importance of housing affordability and the potential for tax changes, I thought I’d address both, here.

First to housing affordability.

It is axiomatic that anything which makes an activity less profitable (after tax) is likely to result in less of that activity.

So it’s likely that reducing the CGT discount (one suggestion supported by the Greens who are chairing the enquiry, as well as many other commentators and experts, and implied by the NSW Government submission) will make housing relatively less attractive as an investment option.

That would mean less competition among buyers, and less pressure on prices, improving affordability compared to the alternative of keeping the current discount in place.

By much?

No. In all likelihood only by a tiny amount.

Why? Well, remember that tax is paid on profits (in this case capital gains), and while it would reduce the after-tax profit, the activity itself would still generate gains for those investors (if there’s no gain, there’s no tax to pay, whatever the rate).

Sure, some might choose to invest elsewhere with a better after-tax return, but that cohort is probably small (the copper and office worker buying a negatively geared unit today are unlikely to all of a sudden start speculating on pork belly futures, instead).

Overall? It’d probably help affordability. A bit.

And that’s better than nothing, right? Yeah… if our sights are truly set that low.

Remember, housing affordability has plummeted (or housing unaffordability has skyrocketed) over the past forty years, using almost (probably every) available metric.

If prices came down (or the rate of increase slowed) by a few percentage points, that’d be welcome, but would be like the proverbial alcoholic who cut back from a bottle of whisky a day to 95% of a bottle instead – better, but not exactly fixing the problem.

So, what would actually make a difference?

I’ve written about it before, but the only way to make a real difference is to meaningfully – and quickly – address the supply/demand (im)balance.

In short, here’s the two line comparison:

– If there are 10 dwellings and 11 households, prices will rise, probably strongly.

– If there are 10 dwellings and 9 households, prices will fall, probably significantly.

The numbers aren’t that stark in reality… but that provides a directionally useful summary.

So the first step must be to meaningfully and quickly lower the rate of population growth. Not on any racial or other xenophobic grounds – both are despicable – just in numerical terms, overall.

That allows the (necessarily much slower, due to construction lead times) supply growth time to catch up.

I’d then address the one area of tax I think has a much bigger impact than CGT: negative gearing.

If I was a betting man, I’d give you good odds that somewhere north of 75% (and maybe over 90%!) of investment property purchases start with the simple question to the accountant: “How can I pay less tax?”.

Indeed, I’ve never heard anyone cite the CGT discount as the reason for investing in property, but countless who’ve cited negative gearing as a key reason they bought.

The other issue? Lending. Whenever rates drop, as they have recently, the borrowing power of potential buyers increases (the same repayment per month, at a lower interest rate, means they buyer can borrow more). Sounds good at the time, but what follows is that everyone does just that, and prices rise, leading to 30 years of higher repayments – at variable interest rates… and no improvement in affordability via lower interest rates.

A change in the rules enforced by the banking regulator, APRA, could stop that impact in its tracks.

And then, maybe, I’d rank CGT changes next, in terms of likely impact on affordability.

Maybe.

By all means, we can discuss it, but remember the proverbial alcoholic, and all of the things governments (and oppositions) are not doing, while they’re debating changing CGT.

Which is a lovely segue (you didn’t even notice, did you?), to the tax itself.

See, before you think ‘ah, Phillips is just feathering his own nest, by trying to argue against higher taxes on investments’, I’d go even further. Just not for ‘affordability’ reasons.

I’d return CGT to its pre-1999 regime of indexation, rather than the arbitrary 50% (or proposed 25%) discount.

Kids, sit back for a little (short) history.

Before 1985, capital gains were tax free. Great for investors, but it was a huge free kick for those with capital, compared to workers, who paid full-freight on their incomes. Yes, a reward for investing, but those who couldn’t or didn’t invest ran the risk of being left behind, and creating a widening wealth gap.

So, in 1985, the then-government introduced capital gains tax. But, because assets were usually held for a long time (compared to labour income, which was received concurrently with the work being done), the government realised that if general inflation led to asset prices increasing, taxpayers would essentially be taxed on that inflation when property or share prices rose.

To combat that, the investor was allowed to index the cost base of their asset before calculating the taxable gain. Okay, that’s a word salad; here’s what it looked like:

You bought $100 worth of shares, and sold them 5 years later for $150. Inflation over that time was 15%, in total, so rather than paying tax on a $50 gain ($150 – $100), you were allowed to index your cost base by inflation, meaning you paid tax on a $35 gain (the $100 cost became $115 for tax purposes, after accounting for inflation).

In that way, you were paying tax on the real (after-inflation) gain, not just the nominal one.

That’s how it worked for 14 years before, in 1999, the then-government decided to make it ‘simpler’.

From that point, any asset sold within a year of purchase would be taxed at the taxpayer’s marginal rate. And anything held for longer than a year wouldn’t have its cost base indexed, but instead would have only half of the gain taxed, with the other half being tax-free. Hence the ‘50% discount’ on capital gains we know today.

Is it simpler? Yep. Before 1999, the ATO used to publish tables so taxpayers could work out the indexation factors, and this change simply meant you either paid full-freight, or half of that rate, based on a simple date calculation.

Does that simplification justify the change? No, not really. Even less so now we have the internet (it was only a handful of years old in 1999) and the tools to do these things easily. Even at the time it was barely justifiable on those grounds, though. Did the simplicity justify giving up so much potential medium- and long-term tax revenue? No.

Frankly, it was almost certainly just vote-buying, with a veneer of ‘simplification’.

(And if you think I’m being political, I’m not. Every government, of every stripe, buys votes all the time. It happened to be the Liberal Party in 1999, and it was Labor with the student debt reduction at the last election. I’m an equal-opportunity critic!)

Okay, so how do the different potential tax treatments – the current 50% discount, the original indexation approach, and the mooted 25% discount – impact investors?

The short answer is ‘it depends’.

On? On the interplay between inflation and asset price growth.

In a world where growth is high, but inflation is low, the 50% discount is far more generous than indexation. Why? Because inflation doesn’t catch up to the size of the discount.

In a world where growth is lower and inflation is higher, the 50% discount still wins, but not by as much.

And the mooted 25% discount? In the first scenario, the 25% discount is still more generous than indexation.

But, in the latter (lower growth, higher inflation), a 25% discount might actually be less generous than indexation – meaning investors would be worse off than under the old pre-1999 rules!

And essentially, those investors could end up paying tax on inflation.

So let’s sum it all up.

The tool being considered (reducing the 50% CGT discount to 25%) is likely not one of the top 3 or 4 tools you’d use if you wanted to address housing affordability.

And the tool being considered likely will have little impact (and probably no material impact at all) on housing affordability.

And the tool being considered may, depending on the interplay of inflation and price growth, actually end up being worse than simply indexing the cost base in the first place.

(By the way: there are some who just want to pay less tax, who’ll complain about investment moving offshore, or people not investing at all, or something else. I’ll call poppycock. In some edge cases, that might be true. It’s not even close to being impactful, overall, either on investments being made or tax being collected, in my view. They’re talking their own book, which they’re entitled to do, but they should at least just be honest about it. There are solid policy reasons to revert the 50% discount back to indexation.)

It’s tempting to think CGT is at the heart of worsening affordability: the change in treatment did roughly coincide with house price increases. And that’s why some have latched onto it. But similar increases happened right around the world at a similar time, as you’ll see from the chart below. Correlation, as the boffins would tell us, is not causation.

Source: ChatGPT-created chart using the BIS “Selected residential property prices” dataset

Our policy ambition is so low, these days, that most people will read what I’ve written and think ‘well, something is better than nothing, right?’.

And I’d be tempted to agree, except that like all other ‘housing affordability’ measures, the greatest impact is the perception that something is being done, meaning we stop trying to actually address the issue using more effective tools (and the token ‘help’ often makes things worse).

Some arguing for this change are driven by ideology. Some are against it for the same reason. Others are genuinely trying to help.

I’d suggest they’re unfortunately looking in the wrong direction, and whether or not CGT is changed, the situation will probably keep getting worse unless and until our policymakers start with evidence and work from there.

Fool on!

The post The wrong way to fix housing affordability appeared first on The Motley Fool Australia.

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Motley Fool contributor Scott Phillips has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.