Why we should topple the sacred cow of negative gearing

The great Australian dream is also a drain on the public purse.

ANZ Australia chief executive Phil Chronican appears to have taken surprising aim at one of Australia’s touchiest political issues: negative gearing.

“Governments might want to look at whether the current extent of negative-gearing tax breaks are fostering an unhealthy focus on housing as an investment vehicle, thereby compounding affordability issues,” Chronican reportedly told a business lunch in Sydney.

This is effectively what economists have been arguing for years.

Negative gearing has become a favoured strategy by a large and growing percentage of property investors and is viewed by many, including political parties, as something of a sacred cow.

To the extent that it encourages investment in newly constructed dwellings there are flow-on benefits to other parts of the economy.

However as we’ll explain a bit later, the flow-on effect is minimal as those using this strategy typically invest in established dwellings.

Significantly, evidence indicates that negative gearing has a social cost to society by reducing general tax revenue.

Negative gearing explained

First though, it’s worth a quick primer - just what is negative gearing?

A negatively geared asset provides an investor with an operating loss that may be used to reduce taxable income, most commonly used for shares and property.

The operating loss typically arises due to the use of leverage. Since residential property is viewed as “good security” by lenders the amount of leverage employed to acquire this asset class tends to be larger than for shares or other assets.

Hence, residential investment property is centre stage as a negative gearing strategy.

The theory goes that while an investor effectively receives a government subsidy, by paying less tax, there exists the social issue of compensation to society to justify this subsidy.

The direct beneficiaries of negative gearing are those who use gearing to invest in residential property. In return the rental market is supplied with housing at competitive rents.

But in the absence of negative gearing would these investors continue to supply rental accommodation? In addition, are prices pushed higher through investor demand?

A brief history in time

In July 1985 the Hawke-Keating labour government restricted negative gearing on new investment activity.

Expenses could only be offset against income (rent) from the investment but losses could not be offset against income and capital gains derived from other sources.

Losses were quarantined and could only be carried forward to offset against future income and capital gains from the investment.

Following this announcement, investors became less active, the supply of rental accommodation contracted significantly leading to a sharp rise in rents.

Rent rises were much greater in cities, such as Sydney, where vacancy rates were very low; suggesting that factors other than negative gearing restrictions played a role.

Later in the same year capital gains tax was introduced, which may have had a compounding effect on investors’ behaviour.

Two years later in September 1987, the government removed the restriction on negative gearing and allowed losses to be offset against income derived from other sources (such as salary and other forms of investment income).

This action was credited with easing conditions in the rental market.

There is however a view that the market would have recovered in the longer term once the changed rules had been properly understood by investors and factored in to their investment plans.

Investment incentives

The ability to consolidate income from all sources does encourage the use of negative gearing and provides an incentive for investors to engage in loss making investments at the expense of the general taxpayer.

The fairness of the taxation system is an important factor in the efficient allocation of resources within the economy.

A taxation system that favours investment property owners leads to a distortion in the employment of financial capital leading to excessive investment in property.

Investments are made to achieve the investment goals of creating future wealth and to achieve a return commensurate with the risk being undertaken.

In a market economy capital is directed towards those investments that will generate the best return allowing for the investor’s risk preferences.

This would suggest that if negative gearing into property produced better returns than investing in assets of comparable risk, more and more people would be attracted to this strategy.

The negatively geared property investor takes on a loss making investment, albeit with the help of the taxpayers’ subsidy, in the expectation that an acceptable return will eventually be achieved.

This can only occur if the market price of the property increases sufficiently over time to produce such a return. It is a risk and it may or may not be achieved.

Plenty of evidence exists to support the view that property prices in the major capital cities double approximately every ten years. Consider an investment in a relatively low risk government or corporate bond paying 6.5% per annum.

It will take approximately 11 years for this investment to double in value assuming all interest is compounded and earnings are taxed at the end.

The CGT (capital gains tax) discount of 50% applies at the end. The average property investment is far more risky but at face value does not perform much different.

What can make the difference is leverage and attractive tax concessions.

The tax system helps to mitigate losses while enhancing returns for property investors.

The favourable tax treatment of negatively geared property encourages investment in this asset at the expense of other assets that do not receive such favourable tax treatment.

Tax rates and negative gearing

Changes to marginal tax rates (MTRs) over time have reduced the amount of the subsidy available. (See Table below.)

Source: John Flaherty.

Marginal rates have declined and tax brackets have changed. In 2006 the top rate was applied to income above $70,000 whereas today the top rate cuts in for incomes of $180,000 and above.

The subsidy to the average negatively geared investor has been reduced substantially.

The strategy of negative gearing is more attractive to investors on the highest MTRs. All investor still have to fund the remaining loss from after tax funds.

A small proportion of investors may use negative gearing simply as a tax minimisation strategy without understanding investment fundamentals.

Income from non-negatively geared sources, such as wages and salary and interest earning term deposits or fixed interest securities, is effectively taxed at more punitive rates by comparison.

All other forms of investment that are funded to some degree by debt, receive more favourable tax treatment. Negative gearing is an effective wealth creation strategy with the added benefit of increasing the supply of rental accommodation.

This incentive-based system also leads to speculative behaviour by investors, many of whom are encouraged by those who promote schemes based on this strategy.

Australia is one of the few countries that allow income from all sources to be consolidated before determining assessable income.

Canada and New Zealand have similar systems. In the United States losses are quarantined to the investment and must be carried forward as a deduction against future investment income and/or capital gains.

The introduction of the CGT discount of 50% by the Howard government in 1999 provided a strong incentive to shift income from the present to the future and thereby encourage negative gearing as an investment strategy.

Data compiled by the ATO indicate that the number of property investors has increased by more than 30% since the CGT discount was introduced.

Taxable income of property investors over this period has moved from being positive to losses of $6.5 billion.

The loss is primarily attributed to debt servicing. The tax system supports and actively encourages the use of negative gearing; it is a natural response by the market.

If negative gearing is abolished this will reduce the incentive for investors to excessively gear their investments and ease the pressure on prices. A reduction in prices will improve affordability which will increase first home ownership.

The rental market will experience a reduction in supply, fewer investors, and a reduction in demand as former renters become owner occupiers. The overall effect on the rental market will depend on the magnitude of the shifts but it is unlikely to lead to excessive rent rises.

Obstacles to change and future direction

Sacred cows like negative gearing should be more critically evaluated so as to better understand their benefits to society.

The impact of the restrictions placed on negative gearing during the mid-eighties should be more carefully examined to determine what factors caused rents to rise and why the impact was uneven across the various capital cities.

Why is Australia one of the few countries in the world that retains this distortion in its tax system?

The issue of home ownership is a major concern for most Australians who are encouraged to view home ownership as something of a right.

Any hint of an interest rate rise or upward movement in property prices raises concerns about affordability with such information being widely disseminated by the popular press. The major political parties have taken this message to heart and have introduced various schemes to assist new home owners.

The Rudd Government introduced the National Rental Affordability Scheme in 2008 with the intention of providing more affordable housing.

The phased removal of negative gearing would allow the market to respond in an orderly manner and allow participants (governments, renters and investors) to adjust over a reasonable time period.

An incremental approach will minimise adverse effects and provide a better understanding of the impact on rents and dwelling prices.

The consequent increase in tax revenue could perhaps be employed to extend proven schemes to assist with the provision of more affordable housing.