Turning a negative into a positive

Negative gearing in real estate investment costs Australia (PDF 80KB) $1.4 billion in lost federal tax revenue each year and is a known cause of higher house prices. Proponents of negative gearing argue that these costs are worthwhile incurring for the benefits it brings. The Real Estate Institute (REIA), for example, argues that negative gearing:

• provides rental property for tenants;
• benefits the socio-economic development of the nation; and
• promotes self-funded retirement.

With housing affordability now down to at least a 22-year low it may be time to examine whether we need negative gearing in its current form to retain its benefits.

Arguments in favour of negative gearing based on supposed benefits to renters must face a particularly high burden of proof. To help those renting it is more logical and effective to direct subsidies directly to them rather than indirectly through their landlords and a theoretical trickle-down effect.

Further, there are direct disadvantages to renters by providing negative gearing to property investors. In particular, negative gearing reduces the chance of renters ever escaping renting to become homeowners through making housing less affordable. This decrease in affordability happens in at least two ways.

The negative gearing tax subsidy creates greater investor activity in the housing market which means increased competition for housing and higher prices. But it also encourages property investors to bid well beyond what the rental yield on a property would suggest was a reasonable price to pay as the government will split their losses on their overpayment from their personal tax bill. The property investor then gets exposure to a potential capital gain (taxed at a lower rate since 1999) subsidised by the taxpayer.

The theory of the proponents is that the property investor is providing rental stock for renters in the market. However, only about 10 per cent of investment housing finance goes towards new construction (PDF 779KB). The rest goes to purchase already existing properties, some previously used for rental and some owner occupied.

There has been about 1.8 times the money spent on construction of owner-occupied dwellings as on construction of investment properties over the last 10 years, yet despite this, the proportion of households that are renting off a private landlord has increased since 1994 from 18 per cent to 21 per cent. This indicates that there is a lot of conversion of owner-occupied housing into rental housing going on.

Consider an example of a deceased estate up for auction with two bidders. One bidder is a young person looking to buy their first home and the other is a property investor. If the first home buyer wins the auction, the dwelling will stay as part of the owner-occupied stock. If the investor wins then the dwelling will move from owner-occupied to rental stock, the first home buyer would then have to rent this home, or another like it and Australia would have moved one home further away from being a nation of owner occupiers.

The young person does get the first home buyers grant but as a Monash paper in the Journal of Australian Taxation found “negative gearing offers substantial tax advantages to wealthy property investors and … the first home buyers’ grant/benefits are no match for it”. Meanwhile, the property investor gets a major helping hand from the government to outbid the first home buyer and decrease the number of owner-occupied houses.

If this seems backwards, maybe it is. In the US, for example, the major tax assistance goes the other way. The US tax break to personal income from mortgage interest payments is given to owner occupiers and not to purchases of properties bought for rental. This has the effect of significantly assisting each person to own their own home but not homes bought to rent out. In terms of equity, this would seem more logical and desirable, the government helps you buy yourself a home, but not to become a property tycoon and own homes in place of those living in them.

There are times when property investment does provide rental housing and not at the expense of owner-occupied housing, such as when an off-the-plan unit is bought for rental. It may be that this transaction does deserve preferential tax treatment, but at present all property investment can be negatively geared, whether it has built a new dwelling for rental or just denied a first home buyer a chance to own a home.

In terms of the socio-economic development of the nation, negative gearing is, in its current form, a force for unaffordable housing through the pressure it puts on house prices. It is also pushing Australia away from being a land of homeowners and towards being a nation of landlords and tenants. So it is hard to see how any argument that negative gearing is good for the nation’s socio-economic development is tenable.

The argument from its promotion of self-funded retirement definitely has initial appeal. Australia has an aging population that will be an increasing burden on young people through the tax system. Getting those approaching retirement to save and invest as much as possible is, in general, a good way to reduce this burden.

However, negatively geared housing investments are explicitly speculative, mostly economically unproductive, and are aimed at reducing income tax contributions. Any reduction in pension payments as a result of tax avoided is a net no gain at all from a taxpayer perspective.

Further, the speculative gain that negative gearing bets on and encourages is a reduction in housing affordability. Gains in retirement wealth by individuals made from reductions in housing affordability may make them less reliant on pension payments. But what the younger generation saves on taxes for pensions it will pay for in bigger mortgages. Rather than the widely spread tax burden of pensions the load becomes more concentrated on first home buyers.

The concentration of ownership and exposure that negative gearing encourages has two further disadvantages. In a rising market the capital gains are concentrated in the hands of the federally-subsidised, multiple-property-owning few, an inequitable result for any tax break.

While in a falling market the concentration of losses on fewer people increases the chances of bankruptcies due to leveraged losses. This effect combines with the higher mortgages forced on new home buyers by higher house prices to increase tail risk for the economy in the event of a downturn or interest rate spike.

If interest rates returned even briefly to the levels seen in the late 1980’s the economy would not stand a chance with the gearing currently in place on property.

The Reserve Bank suggested to the Productivity Commission Report on First Home Ownership that “the most sensible area to look for moderation of demand [in housing] is among investors” in particular the curtailing of negative gearing and property depreciation allowances. Unfortunately, the Productivity Commission’s final report was a dithering lost opportunity.

The consequence of which is that we have now had five years of unaffordable housing in Australia and the Federal Government is yet to act. A refinement of negative gearing might be a good place to start. If some are truly concerned about benefits of negative gearing in the creation of rental supply housing then perhaps we should look to target negative gearing to cases where it does add to the rental housing stock without cost to owner-occupied housing.

To achieve this we could limit negative gearing to new properties where the building increases the number of dwellings on a block and limit it to a period of five to ten years after construction. Negative gearing would then channel money into productive economic activity.