Why negative gearing has failed

Tuesday 22 Mar 2011

MacroBusiness

A key reason why I started writing was because the quality of commentary and debate around housing and other important issues had deteriorated so badly that the media had become little more than a mouthpiece for vested interests. Lazy journalists were writing puff piece after puff piece parroting the latest press release or one-eyed piece of research from real estate spruikers, banks and other so-called ‘experts’.

My main goal was to add a contrarian perspective on housing-related issues in order to restore some balance to debates about housing and, in doing so, exert pressure on the media to lift their editorial standards and the government to implement evidence-based policies aimed at achieving affordable housing and financial stability.

A key focus has been negative gearing. Long-time readers will know that I have been lobbying to restrict negative gearing on the grounds that it is inequitable and inefficient, it erodes housing affordability and it does not improve the availability or affordability of rental accommodation. Readers can find my analysis on the impacts of negative gearing here and here.

As a quick primer, negative gearing is a form of leveraged investment in which an investor borrows money to buy an asset, but the income generated by that asset does not cover the interest on the loan. A negative gearing strategy can only make a profit if the asset rises in value (capital gains) by enough to cover the shortfall between the income and interest that the investor suffers.

Under Australia’s taxation system, negative gearing rules allow investors in both property and shares to write-off the cost of borrowing used to acquire an asset as well as other holding costs against all income, not just the income generated by the asset. At the same time, following changes to capital gains tax in 1999, capital gains earned on assets held for more than 12 months are taxed at half the rate of other income.

According to the Reserve Bank of Australia, "the taxation treatment [of residential investment property] in Australia is more favourable to investors than is the case in other countries". In Australia, there are no restrictions on the ability of taxpayers to negatively gear investment properties. That is, there are no limitations on the income of the taxpayer, on the size of losses, or the period over which losses can be deducted. By contrast, in the United States and Canada, there are limitations placed on negative gearing, whereas it is not permitted at all in the United Kingdom.

In July 1985, as part of a broader tax reform package, former Treasurer Paul Keating 'quarantined’ losses from negative gearing by stopping them from being deducted against other income. However, after intense lobbying by the property industry, which claimed that the changes to negative gearing had caused investment in rental accommodation to dry up and rents to rise, Treasurer Keating restored the old rules in September 1987, thereby once again permitting the deduction of interest and other rental property costs from other income sources.

One of the property industry's most ridiculous claims is that negative gearing stimulates housing supply. The below charts confirm that investors are overwhelmingly choosing to invest in existing dwellings and, therefore, that they are not adding to rental availability or affordability.

First, consider the percentage of investor mortgages going to existing dwellings versus new construction.

As you can see, the share of investment in new construction has fallen for the past 25 years, from around 60 per cent in the mid-1980s to 6 per cent currently. So despite the favourable tax treatment provided to property investors in Australia, for every 17 investment homes purchased in December 2010, only one was a new dwelling that actually added to housing supply and rental availability.

Second, as shown below, investor loans for new construction have remained relatively flat for the past 25 years whereas loans for second-hand properties surged from around 2000 onwards, coincident with the reduction in capital gains tax.

As a comparison, the ratio of investor lending for existing dwellings to new dwellings was around 2:3 in 1985; 7:1 in 2000; and is now 16:1.

The key point to take away is that negative gearing has not improved the availability of rental accommodation. Why? Because investors that buy existing homes do not increase rental availability since they do not add to overall housing supply and merely turn homes for sale into homes to let. They also do not address the shortage of rental accommodation, because the reduction in the supply of homes for sale throws potential owner-occupants onto the rental market.

These views were recently echoed by Fairfax's Michael McNamara in an analysis that, in my opinion, pushes all the right buttons. Importantly, he refutes a key industry claim that rents would rise dramatically in the absence of negative gearing.

McNamara refers to a study of mine from June 2010. In it I showed the below chart (updated) illustrating real (inflation-adjusted) rents for the Australian mainland capital cities. The first vertical dotted black line shows the beginning of the ‘ban’ on negative gearing (July 1985), whereas the second vertical dotted black line shows its reintroduction in September 1987.

Now if it is true that the abolition of negative gearing by the Hawke/Keating government in July 1985 caused investment in rental accommodation to dry up and rents to rise, you would expect rents to rise significantly in each capital city, since negative gearing affects all rental markets equally.

But this is clearly not the case. Rather, between July 1985 and September 1987, rents rose in both Sydney and Perth, were flat in Melbourne and Adelaide, and fell in Brisbane. Based on this analysis, the claim that negative gearing reduces rents is false.

The study is also backed up by research by Saul Eslake, then chief economist at ANZ Bank. Using Real Estate Institute data (as opposed to my ABS data), Eslake also found that rents went up in Sydney and Perth but that there was no discernible increase in the other state capitals.

Based on the above evidence, there is clearly little merit in Australia's tax concessions for property investment. Negative gearing and the CGT concession do not provided any incentive to invest in new housing because they are available for both existing homes as well as new ones. And since these concessions do not increase housing supply, they also do not put downward pressure on rents.

Rather, the increase of investment in existing dwellings has merely significantly added to housing demand, reduced housing affordability, and displaced potential owner-occupiers, forcing them onto the rental market. While the cost to the taxpayer is immense, the costs to younger Australians, in particular, from reduced housing affordability and increased debt levels is even greater.

The situation that has arisen in Australia, where a substantial part of the population never own their own home or have to go deep into debt to achieve home ownership, makes a complete mockery of claims about 'rising living standards' and Australia having a 'strong economy'. Successive governments have allowed an appalling situation to develop in Australian society, and new approaches are desperately needed.

- Unconventional Economist