The Australian government has “an appetite to be bold and ambitious” in its economic reform agenda. And tax reform is on the menu at its much-publicised reform roundtable, to be held next week.

Here, we serve some food for thought – the taxation of owner-occupied housing. This may seem distasteful, but there are some strong arguments for doing so.

Tax breaks for owner-occupied housing are very large

The size of tax concessions for owner-occupied housing is similar to that of superannuation, and much larger than for investment property. Treasury estimates it forgoes more than A$50 billion per year by exempting owner-occupied housing from capital gains tax (CGT).

There is also no tax on the rental value of owner-occupied housing, although we did tax such “imputed rental income” (what a homeowner would pay in rent) briefly between 1915 and 1923.

Owner-occupied housing exacerbates inequality

Australia prides itself on being a fair society. In reality, we are near the middle among developed countries on standard measures of income inequality. But such statistics ignore the income that owner-occupiers derive from their homes.

In a new paper, we see what happens to income inequality if owner-occupied housing income is included. This non-cash housing income refers to the imputed rent and unrealised capital gains on the property.

When these are included in the income measure, inequality is higher, and it increases more strongly over time. The effect is large enough to shift Australia’s inequality from 16th to tenth highest amongst OECD countries (though we haven’t conducted the same exercise for other countries).

Unsurprisingly, outright home owners are much better off than renters when income from the home is counted. They have an average income 86% higher than the average income of renters – compared with 34% higher if housing income is ignored, as it usually is.

Australia’s progressive tax system is largely a mirage

Income taxes reduce inequality because the tax rate is higher for people with higher incomes. That is what is meant by a “progressive” tax system.

Our paper finds that this changes greatly when income from owner-occupied housing is included. The income tax system reduces inequality by a lot less (about 40.5% less) if we include such housing income. Because this income is tax-free, the average tax rate for the rich is much lower than it seems. So the tax system is less progressive than it appears to be.

The same is true for government pensions and benefits. They also reduce inequality, since they are targeted to people with limited means.

But housing wealth is excluded from the pension assets test, so pensions are not as as targeted as they appear to be. Repeating the exercise above, we find the effect of pensions and benefits on inequality is 18.9% smaller when housing income is included.

Overall, the combined impact of income taxes and pensions/benefits on inequality is 26.7% lower when we include income from the family home.

Favourable tax treatment is built into house prices

These tax concessions may also increase house prices and encourage inefficient allocation of resources. Income from investing in owner-occupied housing is tax-free, while all other investments attract tax. So Australians plough their money into their home instead of other, more economically productive, investments. These funds could instead be invested into private firms (directly or through the stock market), stimulating entrepreneurial activity and lifting productivity, wages and profits.

While stamp duty is typically payable on home purchases, the value of the income tax exemption is much larger. That lifts demand for housing, and hence housing prices. We know of no recent studies that have estimated the size of this effect, but it is likely to be large and therefore make the move into home ownership more difficult.

The absence of recent studies may be because taxing owner-occupied housing is not seen as a politically viable option. Much more attention has been placed on the much smaller tax concessions for investment property income.