Housing, Henry and the new class divide

The Federal Government has revealed its first response to the reforms proposed by the Henry Tax Review, and elements of the next Federal Budget will bring those responses into effect. One recommendation which inevitably raised its head was the tax treatment of housing, especially negative gearing. Any changes to negative gearing have been ruled out for the time being, but for how long, and is another “reform” going to raise its head in time?

The continued escalation of housing prices in Australia, despite the handbrake of a Global Financial Crisis, has had plenty of people worried – from the Reserve Bank Governor to market observers. The choking of new, low cost housing supply via planning instruments that restrict the ready supply of land is now widely acknowledged as part of the cause. Close behind this are the recent and exorbitant up front levies applied to new housing supply by State and Local Governments, and the labyrinthine regulatory complexity of planning processes in this country.

According to some recent studies, it can now take close to a decade to bring a new house to the market if starting with raw, undeveloped land. Little wonder the National Housing Supply Council has confirmed the lamentable state of new housing supply. The standard joke is that we now release more inquiries than we do land, and create more reports than houses. This shortage, in the face of demand, is fuelling further price growth to price ratios well beyond the capacity to pay of young families trying to enter the market.

As affordability has dried up for young families, market activity has been kept alive largely by the investor, employing the favourable tax treatment of negative gearing which offsets investment losses against other income sources. Investors are knowingly buying housing which is incapable of covering its debt and holding costs, banking on the presumed certainty of asset price growth to compensate for their after tax losses.

These investors aren’t all rich either. ATO analysis reveals there are plenty of people on average incomes only, who are making use of negative gearing on investments. But what they lack in income they may not lack in leverageable assets. Baby boomer and early Gen X households who bought their home when house prices were still only around four times average incomes (as recently as the late 1990s) now find themselves sitting on significant equity balances in their own home, due mainly to general asset price growth experienced since the restrictions on new land supply, levies and regulatory complexity took permanent hold. And each of them would find themselves being advised by accountants, “investment consultants” or real estate agents to leverage that equity to buy a second house. Or a third, or fourth.

A new class divide?

This has created a generational divide in Australia: a new class structure not based on birth right but property right. The class of people who own or are paying off their home are now privileged. Rising real estate prices are welcomed as they increase equity in their own home and any investment homes they own, which in turn can be leveraged again to acquire more loss-making investment property.

The underprivileged are those families that struggle to enter the market. Rents have risen, eroding their capacity to save. Deposit gaps have widened. Bank lending requirements have tightened. Wages have remained relatively flat. Yet prices continue to rise, now to more than 8 times average incomes and making housing in many parts of Australia among the most expensive in the world. This is a generation of Australians needlessly locked out of entering the housing market by mistaken planning and regulatory policies of a decade ago, which many still struggle to acknowledge are wrong for this country and for these times. At the same time, the preceding generations are the new landlord class, with rising wealth and fat inheritances. (A recent Bankwest report noted that up to $400 billion in property inheritances would be passed on in the next 15 years. You can read it here).

What happens next?

There are market boosters blindly predicting that prices can continue to escalate beyond their relationship to people’s capacity to pay, and others predicting a “bubble” will burst with spectacular consequences (one such forecaster is currently walking to Mt Kosciosko). In the midst of all this was the Henry Review and the government’s initial response.

Changes to limit negative gearing, although suggested by Henry, were ruled out by the government. Even Henry’s recommendations in this area came with a rider – that changes before supply side problems had been addressed could be counter productive.

In reality, both Henry and Treasurer Wayne Swan are in a bind. The last time negative gearing was tampered with (in the Hawke-Keating era) there was an exodus of investors from the market. Just like then, if that happened now, there would be few buyers left active in the market and probably more sellers than buyers. Prices could fall, and could fall quickly, exposing many unsuspecting members of the new landed class to negative equity positions and no way to exit them. That in turn could have profound ramifications for the economy overall, at precisely the time where our recovery is so delicately balanced that even minor shockwaves from Greece or Icelandic volcanoes are enough to unsettle markets.