Australian Taxation and Asset Prices

Does Australia have a housing bubble? I reckon yes. But that’s beside the point of this here post. I’ve seen many articles pointing out that tax incentives are making asset prices rise more than they otherwise would. What they fail to point out is that the taxation-induced effects on prices on the way down are more severe than they are on the way up.

Australia has a 50% capital gains tax discount, meaning that only half of any profit made from capital gains is taxed. Australia also allows any negative gearing to reduce your taxable income. When asset prices are rising, this means investors can gear themselves up, reduce their income tax bill every year and pocket any eventual capital gains with a 50% discount on the taxes they pay.

Lucky investor you might say. But Australia’s tax arrangements turbo charge both the rise and fall of asset prices due to higher investment demand than there otherwise would be because of the tax incentives. As soon as asset prices fall, the tax advantages evaporate and losses remain losses. So while Australia’s taxation system is excellent for investors when asset prices are on the way up, it’s disastrous when prices are on the way down. And worse than that, the effect of the 50% tax discount on capital gains is significantly more powerful on any falls in asset prices than they are on any rises.

If only considering the tax treatment of negative gearing, the taxation-induced incentive to sell would be just as strong as the taxation-induced incentive to buy. But Australia’s capital gains tax discount perversely boosts the incentive to sell when asset prices go off the boil. This is because the 50% tax discount on capital gains only applies when asset prices rise. There is no 50% boost on tax offsets from capital losses when asset prices fall. The 50% tax discount applies asymmetrically, meaning that there are only benefits when asset prices rise. Because there are benefits only when prices rise, the effect of Australia’s taxation system on sell offs is stronger when prices fall.

Of course, the capital gains tax discount and deductible negative gearing do artificially boost asset prices — but that was a once-off when the changes were first introduced, bringing more investors into the picture. That one-off taxation-induced boost in asset prices will remain for as long as the tax incentives remain, and so will the turbo-charging of rises and falls in asset prices around the one-off boost.

I have no crystal ball on property prices. Maybe they will never fall — that’s not beyond the realms of theoretical possibility. But what is certain is that should property start falling in price, that fall will be steeper than it otherwise would be because of Australia’s taxation system.