Why the proposed changes may create the opposite outcome to what policymakers intend

Ahead of tonight’s federal budget, a series of leaks have emerged around potential changes to negative gearing and capital gains tax. At this stage, none of the proposals are confirmed. But the broad direction appears relatively clear.

The government appears to be considering two major changes:

• restricting negative gearing on established properties while retaining it for new builds
• and replacing the current 50% capital gains tax discount with an inflation-indexed cost base

The intention behind these policies is straightforward. The government is attempting to redirect investor demand away from existing housing and toward new construction in order to stimulate additional housing supply. On the surface, that sounds logical.

The problem is that the policy is attempting to use a demand-side incentive to solve what is fundamentally a supply-side problem. That distinction matters enormously.

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How the current system works

Under the current tax system, investors can negatively gear both new and established properties. This means losses associated with holding the asset can be offset against taxable income. At the same time, investors who hold a property for more than 12 months receive a 50% discount on any capital gain when the property is eventually sold.

The leaked proposals appear to change both sides of this equation.

Negative gearing may become restricted to new builds only, while the current CGT discount may be replaced with an inflation-indexed cost base. In simple terms, instead of automatically discounting 50% of the gain, the original purchase price would increase over time in line with inflation before the taxable gain is calculated.

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The government’s logic

The logic behind restricting negative gearing is relatively simple. If investors can only access tax benefits by purchasing new property, then investor demand should shift toward new developments. That should increase presales, improve developer feasibility and ultimately increase housing supply. That’s the theory.

Like so many theories that sound smart on the surface, this one doesn’t survive contact with real world mechanics.

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Why the policy likely fails

Construction costs exploded after COVID. In many markets, the cost of delivering new housing has increased by 40–50% over the last few years. That creates a major disconnect between the actual cost of producing new housing and the comparable sales evidence banks use for valuations.

This is where the system begins to break down.

When an investor purchases an off-the-plan or newly constructed property, the bank still values that property against comparable sales in the surrounding area. The problem is that many of those comparable properties were built several years ago under a much lower construction cost base. As a result, the valuation often comes in below the contract price.

This creates a financing gap.

The investor cannot borrow enough money to settle the purchase. That means developers struggle to secure sufficient presales. Without presales, projects fail feasibility requirements and are mothballed.

Which means the additional supply never gets built.

This is the key issue many policymakers continue to underestimate. Redirecting demand toward new housing does not automatically create new supply if the projects themselves remain economically unviable.

The policy changes demand allocation but it doesn’t solve the core issue of feasibility.

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The likely unintended consequence

At the same time, restricting negative gearing on established property changes the economics of supplying rental stock in inner and middle-ring suburbs. If investors no longer receive tax advantages for purchasing these dwellings, fewer investors buy there over time.

That means the growth rate of rental supply in established suburbs gradually slows. But demand to live in those locations doesn’t disappear. People still want access to these suburbs because that is where much of the existing infrastructure, employment access, schools and lifestyle amenity already exists.

This becomes more obvious when viewed through the lens of immigration.

Australia’s population growth is now heavily driven by migration, and around 75% of new migrants initially enter the tenant pool rather than purchasing property. They are primarily arriving for employment opportunities, which means rental demand naturally concentrates around employment hubs rather than greenfield outer growth corridors.

That creates a structural mismatch inside the policy itself.

The government is attempting to redirect investor demand toward new developments, but much of the underlying rental demand continues concentrating in suburbs closer to jobs, transport infrastructure and existing lifestyle amenity.

If investor participation declines in those locations while tenant demand continues rising, the most likely adjustment mechanism becomes materially higher rents. But the key point is that markets being markets will likely continue repricing rents until investor returns in established areas eventually compensate for the loss of the tax advantages themselves.

In other words, the system will attempt to find a new equilibrium point.

That equilibrium may involve materially higher rents in these suburbs because those locations still generally offer the strongest access to employment, infrastructure, schools and lifestyle amenity.

Tax treatment doesn’t change where people want to live. Ironically, a policy partly designed around improving affordability can end up intensifying rental pressure in many established areas.

There is already a historical precedent for this dynamic.

During the temporary abolition of negative gearing between 1985 and 1987, several markets experienced significant rental pressure as investor participation declined.

Specifically rents for a three-bedroom house in Sydney increased by 43%. Similarly in Perth rents increased by 33% over two years.  

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The capital gains tax changes are more nuanced than they first appear

The proposed capital gains tax changes are also more complicated than most headlines suggest. Under the current system, investors who hold a property for more than 12 months receive a 50% discount on their capital gain when the asset is sold.

The leaked proposal appears to replace this with an inflation-indexed cost base.

In simple terms, instead of automatically discounting half the capital gain, the original purchase price would increase over time in line with inflation before the taxable gain is calculated. The effect of this system depends heavily on the relationship between inflation and capital growth.

If inflation averages around 3% and property prices compound at roughly 6% annually, the indexed system produces outcomes that are relatively similar to the current 50% discounting regime. In some scenarios, the taxable gain can actually be slightly lower.

The dynamic changes once capital growth materially exceeds inflation over long periods.

At higher growth rates, the inflation adjustment fails to keep pace with the compounding growth of the asset, which means taxable gains begin rising much faster than under the current system.

This changes investor incentives in subtle but important ways.

High-growth assets become increasingly less tax efficient the longer they are held. That potentially encourages either shorter holding periods for high-growth assets or alternatively, investors simply never sell and continue compounding inside the asset.

However, none of these changes affect long-term property demand.

They primarily alter holding behaviour, transaction timing and the composition of investor demand rather than the fundamental drivers of housing prices themselves.

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What changes and what doesn’t

If we move to the outer bounds of the model, these policies probably do not change aggregate housing demand.

Australia still has strong population growth, constrained housing supply, rising construction costs and a structural shortage of dwellings.

None of those forces are directly altered by these tax changes. What the policy would change however, is the composition of demand.

Investor demand likely shifts toward outer-ring growth corridors and medium-to-high density projects where tax incentives remain available. Established suburbs become increasingly owner-occupier dominated. The long-term growth trajectory of housing is therefore unlikely to change dramatically because the underlying drivers remain intact.

But the path the market takes may change significantly.

Transaction volumes may decline. Rental pressure in inner and middle-ring suburbs may intensify. New developments may continue struggling with feasibility despite increased investor demand.

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The bigger picture

At this stage, the proposals are still speculation and the details matter enormously, particularly around grandfathering provisions and implementation timing. But the broader mechanics are becoming clearer.

The government is attempting to use a demand-side incentive in order to generate a supply-side response. The problem is that the actual constraint inside the system is not investor demand. It is project feasibility.

And unless that constraint changes, there is a meaningful risk that the policy produces market distortions without materially solving the underlying housing shortage.

As always, the important thing is to focus less on the headlines and more on the mechanics underneath them.