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Vital signs: why now is the right time to clamp down on negative gearing

When I wrote a report for the McKell Institute about negative gearing, Switching Gears, in 2015, Australia had a housing affordability crisis and negative gearing was costing the budget $4 billion per year.

Three years on, Australia still has a housing affordability crisis, and negative gearing is costing the budget $5.5 billion per year.

Back then, more than half of the money lent for housing (an unprecedented 55%) went to investors rather than people buying homes to live in. Only one in seven loans went to first home borrowers, down from one in five a few years earlier. Since then, the Australian Prudential Regulation Authority has leaned on the banks to wind back investment loans (they are down to a still-high 42%), and loans to first home buyers are back up to nearer one in five. It’s not yet clear how the changes will stick.

But negative gearing is still costing the budget billions, and its worst effects are being contained only by threatening the banks and by the (possibly temporary) easing in house prices.

How to clamp down

My report put forward five different options, ranging from doing nothing to abolishing negative gearing forthwith.

My preferred option (scenario 4) would have outlawed negative gearing except for 'grandfathered' existing negatively-geared properties, and for newly-constructed dwellings. Even where outlawed, people could continue to claim investment losses against investment income, just not against their salary. The exemption for newly-constructed dwellings would boost construction jobs and housing supply, helping affordability and economic growth.

It would also deliver a boost to the budget bottom line of more than $30 billion over 10 years, and assist financial stability by cutting the proportion of the housing market from the hands of footloose investors.

Labor adopted a version of it in 2016. At that time, even the then Treasurer Scott Morrision wanted to target “excesses”.

More than 120,000 people have three or more leveraged investment properties. Staggeringly, more than 20,000 have six or more. The Reserve Bank of Australia thinks it puts the financial system at risk, noting that “investors with multiple properties have likely contributed to higher risk”.

The Treasury found the sort of changes Labor and I were proposing would have only a “relatively modest” effect on home prices, instead of the “sledgehammer” alleged by Morrison and the then Prime Minister, Malcolm Turnbull.

What is negative gearing?

Negative gearing property involves two steps.

First, you invest in a property and get less income from it in rent than the cost of the investment (such as the interest on the loan and the cost of maintaining the property).

Second, you use that loss on the property to offset your income from unrelated streams such as wages or salary, thereby cutting your tax bill.

It’s this second part that is peculiar, and where Australia is out of step with most countries, including the United States, Canada and the UK. Other countries will allow you to use investment losses to offset investment profits, but not to offset income from wages and salaries. The tax deductions impose a big hit on the Federal Budget. The Treasury says that more than half of that $5.5 billion impact goes to families in the top 20% of the income distribution.

It hurts intending owner occupiers

Here’s how it locks genuine (residential) buyers out of the market. An investor who fronts up at a typical Saturday auction faces the prospect of the federal government paying roughly half his or her interest bill, given the top marginal tax rate and medicare levy. An owner occupier, in contrast, gets no help. Even if they have the same deposit saved and earn the same income as the investor, they can afford to borrow much less. Perhaps just half as much.

Owner occupiers get outbid. Sometimes, they end up renting from negatively gearing investors who elbowed residential buyers such as themselves out of the way.

Crimping it would level the playing field

My McKell plan levels the playing field right away. The day after the policy is enacted, owner occupiers and investors have the same firepower at auctions. Existing investors – those who already have negatively geared properties – would be able to keep those tax breaks until their loans were paid off. It would mean a smooth transition away from negative gearing, rather than an abrupt change. It would also respect the investment choices that had been made in good faith under existing policy settings.

It’s hard to find a credible economist – or even a non-credible one – who doesn’t think that negative gearing should be reformed. There has been a consistent call for reforms from leading voices like Saul Eslake and Chris Richardson. Even the then-sensible Malcolm Turnbull said in 2005 that Australia’s rules on negative gearing were “very generous” compared to those of other countries. He said it was a form of tax avoidance. Quite so.

Of course, with another federal election coming up, Treasurer Josh Frydenberg has run the same predictable scare campaign about Labor’s negative-gearing policy as last time. This time he says:

“Labor’s policy will make sure people who own their home will see the value of their home be less and fall, and if they rent their home, their rent will go up.”

His claim is dubious at best. House prices have fallen 12% in Darwin in the past year, but risen 19% in Hobart, none of it due to negative gearing. Because negative gearing would still be available for new construction under Labor’s plan (and mine), it would add to the supply of new homes and push down rents. Also, as existing renters who want to purchase find they are able to, they will move from being renters to owners, cutting the demand for places to rent and also putting downward pressure on rents.

Now is the time

Negative gearing is a costly and peculiar provision of the Australian tax code, and one that creates both intergenerational inequality and financial instability. It was long overdue for reform in 2015, and the case has strengthened since. The best time to crimp it is when the heat has already been taken out of housing prices and relatively few investors are rushing in anyway.

Opponents of reform need to explain why they would want to continue to spend $5.5 billion per year encouraging yet another wave of negatively-geared property speculation which would lock still more young people out of the dream when the market picks up.The Conversation

The Conversation

 

Richard Holden is a Professor of Economics and PLuS Alliance Fellow at the UNSW Business School, an alliance partner of Cuffelinks. This article is republished from The Conversation under a Creative Commons license. 

10 Comments

Brendan O’Brien

March 28, 2019

A couple of points I’d like to add. In the USA you can actually deduct the interest cost of your home mortgage from your salary, but all home owners are subject to land tax. Be careful of comparisons which do not explore the totality of tax systems. I also support Alexander’s argument that if you make exceptions to accepted principles in our tax system (ie tax based on aggregate income and expenses, as businesses do) then you disadvantage salary earners. Additionally, where would a ban on negative gearing leave geared sharemarket investors? Wait for a rise in interest rates and this problem will sort out those pushy investors at auctions, they will become the ones getting rid of their investment properties at a net loss.

Alexander Stitt

March 26, 2019

Thanks Richard for the article. Succinctly hits all the key points.

I was particularly interested in the statistics (which I did not know before) that 120k people have 3 or more leveraged investment properties and 20k have 6 or more. I can't find any reason why there should be income distributive tax breaks to holders of that many properties. A classic unlevel investment playing field.

For myself, since I've owned my own home, I've not gone near property investment because all the analysis I've ever seen says a balanced portfolio should not have much more than 15% property - and that's analysis encompassing both risk/volatility and return.

One thing that always bamboozled / amused me about negative gearing was that many investors did not seem to understand that it meant they were losing money. Sure they got some tax break support, but the fundamental driver seemed to be the hope / aspiration that capital gains, at whatever discount they got, would be greater than the losses. Sometimes that happened. Sometimes it did not. And almost always, investors managed to convince themselves the returns on their properties were more than they really were by downplaying the losses and the running costs, and only looking at the headlines - bought at X, sold at X-plus.

So thanks again.

A quick rejoinder to "Stefy"'s comments above ... if you're right, then surely this is the perfect! time to make such a change because the momentary impact is zero, but the policy setting impact for the future could be enormous.

harry

March 25, 2019

Why do you believe that wage incomes should be inferior to investment incomes? Do large investors really need another advantage over smaller ones?

If the Liberals had introduced this change people would have quite rightly pointed out that it was advantaging the rich, why when Labor does it is it OK?

Steve Martin

March 24, 2019

“Negative gearing is a costly and peculiar provision of the Australian tax code, and one that creates both intergenerational inequality and financial instability. “

This seems to be the nub of Professor Holden’s argument, and with respect, I disagree. Negative gearing does not sit as a peculiar provision within the tax legislation. While the tax legislation is complex, it is premised on some simple principles, from which exceptions and exemptions create complexity. Basically, a resident Australian is assessed on his or her worldwide income and is allowed deductions for revenue expenses incurred in deriving that income. Being assessed on rental income and deducting from that income, interest incurred in deriving those rents is as basic as it gets to an application of the general deduction provision s. 8-1 of the ITAA 1997, and does not derive from a ‘peculiar provision’.

The removal of negative gearing will require peculiar provisions. They in turn will be likely to have their own interpretative problems and create complexity.

So, before embarking on that path, we should be careful to ensure we have the right culprit that is stopping young people from getting their first home. Or, perhaps the real problem is a political ideology that people should not be allowed to get rich using tax laws to their advantage. To be generous and assuming it is not the politics of envy but the obstacles faced by first home buyers, we need to consider whether the taxation consequences of particular types of incomes or deductions such as negatively geared rental properties, have such extraordinary social or economic impacts that they require intervention in basic tax principles. When we do so, we need to ensure that the social or economic outcomes we desire can be achieved by legislation and will result in legislation that imposes taxes in a way that is neutral, equitable and simple (the yardstick upon which all tax laws should be judged).

Within the tax law considerations as well as outside of them there is the butterfly effect.

While I am in no qualified position to argue with a Professor of Economics, I find his arguments unpersuasive. I see little in his article that discusses how removal of negative gearing deductions might result in a reduction in supply of rental properties, and how that might have the consequence of raising rents on lower supply inhibiting a first home buyer’s capacity to save for a deposit. His article does not deal with the extraordinarily long period of low interest rates which have increased demand for income producing (and other) debt. Perhaps rather than the tax legislation over the last decade, it has been quantitative easing that has been the real villain? The tightening of credit rules has certainly had the effect of reducing borrowing for rental properties over the last year or so. Perhaps it was the availability of credit that was the villain rather than the tax legislation? I see nothing in his article that discusses how there has been a sufficient supply of rental properties over the past decade so that rental yields in the major cities have remained low better enabling first home buyers to better save for a deposit. His article makes comments about property investors elbowing out first home buyers at auction, but I see nothing in his article that discusses how supply tends to rise to meet demand in an economy. Given adequacy of supply, if you miss one you get the next one. Now, after a period of under supply in Sydney in Melbourne we appear to be going into a period of over supply. Or how the construction boom is in part a response to demand from investors.

The article deals with the increased risks faced by the financial system with increased investor borrowing. Much can be said about risks in the economy from increased debt, but surely the most direct remedy for this lies in prudential lending standards, not in changing the tax laws. The recent restrictions in the provision of credit has slowed borrowing significantly and arguably these changes ought to have been instituted earlier.

Part of his thesis is that there is an unfair playing field when a property investor is able to bid for a property against a first home buyer when they have the advantage that half of the interest cost being met by tax. So, how will the proposal structurally change that? Even if all investors who would otherwise negatively gear leave the market, home buyers will still face positively geared property investors.

Should all parts of the economy be tampered with to make sure that business cannot compete on a level playing field with private individuals at an auction of say seafood, or cars?

While I do not dispute that the taxation legislation has had a part to play, it is not the entire problem and indeed just looking at the tax law, it may not be the principles of tax law that are the problem at all.

Looking at the issue from all sides is important. Someone should advance the case that negative gearing is a good thing and allowing the basic principles of tax to apply is also a good thing. Governments need to put aside irrational ideologies. An issue not often considered with negative gearing deductions and franking credit legislation is the strain and stress placed in the investor who is engaging in risk for a living. In terms of political propaganda, there is certainly the impression that property investors are fat cats living large on the back of the worker and monstering young home buyers at auction.

The fact is that negative gearing is premised on someone actually losing money in the hope of securing their future.

There is genuine risk in borrowing for an investment. There would be many investors who bought at the top of the property market who would be sweating at night now as property prices continue to fall.

A person who borrows to invest in a property has mentally engaged in opportunity cost. They choose to have less money week by week to have for living expenses, travel or drive better cars. They prefer to have minimal cash available now in the hope that their investment will one day be paid off and will help secure their future. They provide the social benefit of providing a property for rent in a society where not everyone can afford to buy a home. Rental supply is a good thing for society. If there is too much supply, rental yields fall and investors look elsewhere for an investment.

Personally, I prefer that there be simple and consistent tax rules that apply fairly to everyone. Our tax system should generally encourage and support those who engage in personal risk to increase wealth as this also benefits the economy. Excessive financial risk should be managed with regulations and borrowing standards. I also believe we should have more faith that the laws of supply and demand will prevail, as is happening in the property market now.

Gerard Dutton

April 06, 2019

Thanks Steve Martin for your thoughtful and sensible counter arguments. I agree with your points. I wish it were understood that most investors are not fat cats, but every day working people who are trying to secure a passive income in retirement. Negative gearing is only a temporary aid, as property typically becomes positively geared as its value increases and debt is paid off over time. Property investors are not villains, just people who can manage their cashflow and capture surplus income wisely. Why should they be demonised because they were willing to take a risk for their future financial security?

Kevin

March 22, 2019

The problem I have with negative gearing is the hysteria it seems to cause.

I used it in the 1980 s and early 90 s.I always wanted to be positively geared as quickly as possible.I still sometimes wonder how I managed to survive those 18 or 19% interest rates.

Paying tax on a higher income is far better than paying less tax on a smaller income

Has anybody ever done a study on how much the government save because they helped me to get started all those years ago.

The tax I pay on my income now,in retirement I pay more tax than I did when working.

There is also the 36K in pension that the govt does not have to pay me.

Instead of looking short term saying it costs the govt X or Y in the short term,how much does it save them in the long term?

Dudley

March 21, 2019

The blue whale in the paddling pool, rarely mentioned, is interest rates.

High interest rates compound savings and decrease prices favouring prospective owner buyers - increasing the likelihood of purchasing without debt.

Paul Edwards

March 21, 2019

We would not need negative gearing nor care if it was removed including existing arrangements if the marginal tax rates on individuals income were set at sensible levels.
I am not an economist but I guess a level playing field in the first instance may lead to fairer outcomes to those aspiring to own their own home.
If a cashflow neutral result can be achieved for existing investors by lowering the marginal rates and denying negative gearing . Then we have nirvana lower home prices and greater affordability.

David Wilson

March 21, 2019

Thank you Richard for this excellent article (and thank you Cuffelinks for publishing it). It is refreshing to read a fact based and unemotional assessment of the rationale and impact of winding back negative gearing tax breaks.

As a parent with two sons who hope some day to own their own home I very pleased, to say the least, in the prospect of the playing field being levelled between investors and prospective home owners via Labor's proposal. Frankly, property 'investors' have had just about every tailwind imaginable over the past 30 years and your chart illustrates the degree to which they have piled in (often at the expense of first homebuyers), thereby pushing up house price to unsustainable levels.

Here's to a resounding Labor win at the upcoming Federal election!

stefy

March 21, 2019

"It would also deliver a boost to the budget bottom line of more than $30 billion over 10 years"
This is the usual incredibly optimistic estimate.

Existing investment properties are grandfathered - no money in that.
New housing is excepted - no money in that.
That leaves new investment in existing stock for rental purposes. But investors, including the Chinese, have fled the residential housing market in droves in the last two years - not much money in that.


 

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