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.

Restrictions on negative gearing could also pressure more landlords to raise rents to the point that assets were covering their own costs, rather than relying on offset tax breaks to cover losses. Higher rents in this market would be about as welcome as a fart in a spacesuit to families or low income workers already struggling with their existing level of rents.

Henry went further in terms of addressing the issues of housing affordability, housing supply, infrastructure levies, aspects of property taxation generally (namely land tax versus stamp duty, where he leant to the former) and intergovernmental issues, but in the main, these were left in a too hard basket (also known as suggesting they be referred to COAG). Solving the inevitable political squabbles than infect inter-jurisdictional relationships is for the realm of futurists, not economists.

The extent of recommendations proposed by Henry, compared to the relatively minor number of actions likely to be taken by the government, suggest that there is a great deal more to come, probably after the election. A “second wave” of reform perhaps?

A wild card?

So negative gearing escaped unscathed for the time being, if only to preserve the delicate state of the economy at present. Despite its faults, it has at least brought billions of dollars of private capital into the rental housing market, without which, a great deal more Australians could be reliant on government welfare.

But is there another wild card in the pack? Henry touched on it in recommendation number 25: “While no recommendation is made on the possible introduction of a tax on bequests, the government should promote further study and community discussion of the options.”

Death duties were abolished in Australia back in 1979 but it could still be an elephant in the room. As our population ages and increasingly carries with it into the ageing process a larger and larger property portfolio, there is an inevitable time when even the new landed gentry must leave behind this mortal coil and shuffle off. They can’t take their investment property with them, but they can will it to their descendents.

Go back to that Bankwest report, which said: "One in 10 homes owned by households will potentially be given away by 2025, which represents an unprecedented baton change in intergeneration wealth, the likes of which we have never seen before." The national value of that baton change is $400 billion. (That’s billion with a ‘b’ not million with an ‘m’).

The Federal Treasurer could perhaps find some aspects of this $400 billion worth of intergenerational asset movement interesting, as Treasurers do. Remember the saying: “never stand between a Treasurer and a bucket of money” (just ask the mining lobby).

It’s not likely to feature on any election agenda but the words “promote further study and community discussion of the options” might suggest the issue could reappear. The saving grace may be the political reality of just what deep emotions such a discussion might stir. In Sir Humphrey’s words:

"It is axiomatic in government that hornets' nests should be left unstirred, cans of worms should remain unopened, and cats should be left firmly in bags and not set among the pigeons. Ministers should also leave boats unrocked, nettles ungrasped, refrain from taking bulls by the horns, and resolutely turn their backs to the music."

In the case of Henry and the government, so far so good. Music, what music?

Let’s hope an inheritance tax on real estate isn’t on the cards. But if it’s to be avoided, something needs to be done to bring balance back into our housing markets, and the answer there lies not with Ken Henry or Wayne Swan but with planning ministers and land use policy makers in state and local governments.