Removing negative gearing would have little effect on rents

Property investors believe that the criticisms I made of negative gearing in a recent article on Property Observer were unfounded. Indeed, the mainstream perspective, put by Melanie Stott in a Property Observer blog, is firmly wedded to the idea that negative gearing is a sound element of the Australian tax system and should thus remain in place. Government, financiers, property industry lobbyists and investors overwhelmingly support negative gearing, but there are good reasons to think otherwise.

Some of the best work on negative gearing and associated policies is by University of Sydney economist Judith Yates (Peter Abelson and Nigel Stapledon also deserve attention). In 2009, Yates wrote a report for the Brotherhood of St Laurence, published by the Australian Housing and Urban Research Institute (AHURI), called Tax expenditures and housing.

This report provides an overview of the many tax expenditures relating to residential property in Australia. These tax expenditures "arise when departures from the generally accepted or benchmark tax structure produces a favourable tax treatment of particular types of activities or taxpayers". Examples abound; the immense tax code provides many exemptions, concessions, deductions, preferential rates, allowances, rebates, offsets, credits, and deferrals.

Negative gearing allows an investor to deduct net losses from rental property against their income tax liability at their marginal tax rate even though the loss was generated separately to those income streams. Accordingly, negative gearing arises as one such defect in the tax structure. Yates recommends quarantining any losses made to the activity that produced the loss, that is, disallowing negative gearing. Economists Saul Eslake and Leith van Onselen have likewise criticised negative gearing as an unjustified subsidy. The Henry Review recommended that 40% of net rental income remained untaxed, making negative gearing less attractive.

Yates shows that the relatively wealthy tend to benefit more from negative gearing than those within the lowest or middle income quintiles. The reason is obvious: they own proportionately more investment properties, generate bigger net losses and have higher marginal tax rates, thus allowing for larger deductions via negative gearing. Interestingly, 76% of all investment properties were owned by those earning $80,000 or less in 2009-10, with the majority owning only one property. The tax benefits that accrue to this cohort of middle class property investors are proportionately smaller, though this had not prevented those less wealthy from benefiting from a tax structure that is designed to advantage the rich.

While property investors benefit from negative gearing and the capital gains tax discount, owner-occupiers by far and away are the largest beneficiaries of the current tax system. In 2005-06, $53.2 billion in tax expenditures were extended to the residential property market: owner-occupiers ($45 billion), investors ($5.4 billion) and renters ($2.8 billion). Most property investors are also owner-occupiers, benefiting from the bias towards the latter. It is unsurprising that renters receive the least assistance.

Even though negative gearing is an unjustified tax expenditure and should be removed, this concern should be considered separately from another – whether negative gearing functions as intended. The theoretical arguments are tenuous at best, with empirical evidence lacking outright. Some 92% of property investment purchases are from the existing stock of dwellings, resulting in simply shuffling owner-occupiers and tenants around without expanding the rental stock. This misdirection peaked at 96% in 2010.

Theoretically, negative gearing makes property investment more attractive than it otherwise should be, increasing demand relative to supply and therefore leading to higher prices. The financial benefits of negative gearing are capitalized into housing prices, as has occurred with the first-home owners' grant/boost. It is doubtful that negative gearing reduces costs to investors, and hence can not be passed down to tenants (as if landlords would want to do so).

Housing prices have recently experienced the largest run-up in history: 130% between 1996 and 2010, adjusted for inflation and quality. Higher prices require larger savings deposits and/or mortgages, leading to increased net losses. During this period, capital values of properties have often escalated by $50,000 to $100,000 annually, dwarfing any increased net income loss that would have occurred if negative gearing provisions had not been made available. Accordingly, it is doubtful that property investors would abandon the market en masse if negative gearing were quarantined or removed altogether.

As housing prices have boomed, so have mortgages, leading to increased current net income losses. If this does not scare away investors during a boom, there is no reason to believe that a further net income loss from removing negative gearing would result in investors exiting the market en masse. If investors did decide to do this, it would not necessarily result in an adverse outcome. Housing prices would fall, enabling many on the sidelines who currently rent to purchase, reducing pressure on the rental market, and mitigating rental price pressure.

Given the theoretical difficulties in establishing that negative gearing functions as claimed, it is none too surprising that empirical evidence is also lacking. The best retort that the housing lobby has fabricated is that rents surged when negative gearing was quarantined during 1985-87. The evidence shows that real rents increased in only Sydney and Perth, while remaining stagnant or falling in all the other capital cities. The reintroduction of negative gearing did not lead to a discernable decrease in rents either.

Rents have surged since 2006 across Australia, though no evidence is provided to show that rents would've been even higher if negative gearing provisions had not been made available. It is important to note that when comparing historical prices, inflation should be taken into account. Adjusting prices for inflation allows for a proper apple to apple comparison rather than an apple to orange comparison that occurs when dealing with nominal prices only.

Further, it is unclear why the government should promote investment into the residential property market. Although assertions can be bandied around that benefits outweigh costs, two hurdles should be met: that intervention is necessary and that the proposed intervention is the most efficient and effective relative to alternatives. Given that surging rents in recent years have caused increasing financial stress among many renters, policymakers may believe that intervention is necessary as a social and economic objective to assist those in need. It is farfetched, however, to assume negative gearing is the best policy available, especially with the obvious alternatives of the National Rental Affordability Scheme (NRAS) and the Commonwealth Rent Assistance (CRA) program.

Much of what is written by supporters of negative gearing is in terms of assisting renters for the social good rather than admitting that it is simply an unjustified handout to property speculators. Anyone who understands the basic principles of the marketplace sees that investment is made solely for the investors' self-interest in profiteering. This, of course, does not prevent investors from trumpeting the wonder and selflessness of their actions, whether they believe it or not (witness Goldman Sachs CEO Lloyd Blankfein claiming to carry out god's work). The conservative individualism and self-interest that guides participants in the marketplace are strangely absent when negative gearing is discussed.

Given that private investment is done solely on the basis of profit, a curious contradiction arises: if eliminating negative gearing did cause rents to rise, as is commonly claimed, investors would certainly not oppose this outcome. This contradiction can be explained by realising that the housing lobby and investors recognise (never publicly) that negative gearing has little, if any, effect upon market rents. Removal of it would simply hurt their bottom line, but not that of renters. If rents did rise, the well-targeted CRA can be easily boosted to compensate accordingly.

Those who do support negative gearing, unsurprisingly, have conflicts of interest. It would help the case for negative gearing if arguments were made by those who could legitimately claim to be objective, that is, not have a stake in the policy they support. Whether it be the housing lobby or so-called "mum and dad" investors, it is difficult to accept that conflicted individuals and organizations can legitimately claim they know what is best for others when their self-interest dictates their public stance (imagine tobacco executives claiming to know what is in the best interests of public health). It is difficult to find an objective and conflict-free commentator willing to consider the necessary theoretical and empirical evidence to show that negative gearing is an efficient and effective policy.