Tax on 'unearned gains' is the missing piece of the affordable housing puzzle

With housing prices still consistently in the news, could the ideas of 19th-century philosopher John Stuart Mill help improve affordability?

In 2015, some landowners near the proposed Northern Beaches hospital in Sydney were offered more than twice the area’s normal market value for their properties. They stood to make large windfall profits from zoning changes and infrastructure upgrades associated with the A$1 billion-plus public investment in the hospital.

While many may say “good luck to them”, Mill – a champion of individual freedom – may well have questioned those windfall profits by asking:

Who is entitled to the increase in land value created by planning approvals, new infrastructure, population growth or the general development of town and cities?

For Mill, the answer would have been that the increase, which he called the “unearned increment”, rightly belongs to the community rather than the individual landowner. Until well into the 20th century, many political leaders, including Winston Churchill, agreed with Mill.

What’s this got to do with housing affordability?

The main reason Australians invest in property is the expectation of future (after-tax) capital gains (that is, unearned increments) rather than rental income. Consequently, they are willing to pay more than the price that reflects rental income.

The current taxation system, while imposing some tax on capital gains, encourages this strategy, mainly through negative gearing and a discount on capital gains tax. The federal government’s 2014 Financial System Inquiry concluded:

The tax treatment of investor housing, in particular, tends to encourage leveraged and speculative investment in housing.

Could recouping more of Mill’s unearned increments through a higher capital gains tax on investor housing help make housing more affordable?

The Henry tax review accepted that a tax on land value would reduce the price buyers were willing to pay. The same principle would apply to a tax on capital gains from land, which could be seen as a type of deferred land value tax. The Reserve Bank of New Zealand also expects that increasing taxes on capital gains from property would reduce pressure on housing prices.

How to recoup more of the ‘unearned increment’

A federal capital gains tax (CGT) was introduced in Australia in 1985, with capital gains added to other income. Since 1999, capital gains may qualify for a 50% discount for taxation purposes.

Capital gains are taxed at the individual’s tax rate, providing an incentive to time the sale of the asset or use other means to minimise the impact of the CGT.

Therefore, to be more effective in reducing land prices, CGT on property would need to be reformed so it applies at a flat rate (without deductions) rather than being part of general income. Notably, this reformed CGT would capture some of the land value increases resulting from planning approvals.

The flat tax rate could be progressively increased from a lower rate during an adjustment period. Each step in the transition could be evaluated for its effect on prices.

Because Mill’s unearned increments relate to land only, the property CGT would be levied on the increase in the unimproved value of the land (indexed for inflation). That is, it would exclude the value of improvements. The principal residence would continue to be excluded, and tax would be payable only when the property was sold.

Capital gains tax or land value tax?

The Henry review and other commentators agree that a land value tax would reduce property prices. This tax would necessarily include all landowners.

In comparison, the proposed CGT reform would also be likely to reduce land prices, but would, in practice, affect investors only. Relocating homeowners would not be affected as the lower prices would be on both sides of the buying-selling equation.

In summary:

• Housing not only provides shelter but is also a form of investment.

• Favouring investment over shelter – as current tax policies do – tends to raise property prices and to crowd out some of those wanting to own their own home and so have a better chance of putting down roots in their selected local community.

• Making housing more affordable, such as by more effective taxing of capital gains, would promote a more “cohesive and just society”, as a 2008 Senate inquiry into housing affordability found.

• Most investors are motivated by expectations of future after-tax capital gains and so moderating those expectations by raising the tax on capital gains from land is likely to reduce the price investors would be prepared to pay.

• A period of transition would be needed to allow property investors to adjust to the new arrangements.

As Mill observed, these capital gains are created by others – governments, immigrants and other private investors – so there is an ethical basis for effectively taxing these “unearned” gains.