Tuesday, September 28, 2010

Negative Gearing Exposed

Australia’s housing bubble has been caused, to a large extent, by investors piling into housing on the back of overly generous tax concessions.

Given the interplay between investment housing and rental availability and affordability, I thought a detailed examination was warranted of the merits of investment property tax concessions, most notably negative gearing.

While it is clearly the case that Australia’s taxation system has artificially increased the demand for housing, thereby putting upward pressure on house prices, the proponents of these tax concessions contend that any tightening of existing tax rules would significantly reduce housing supply and increase rental costs. To quote the Minister for Housing (Unaffordability), Tanya Plibersek, on this matter:

“…any change in negative gearing would be a disaster for rental availability in this country….If we changed negative gearing we would see disastrous effects for renters in Australia.”

So is the Minister correct? Would changes to negative gearing reduce rental supply and affordability? Does negative gearing and its partner in crime, the 1999 halving of the capital gains tax (CGT) rate, increase the housing stock and reduce rents? Does society benefit from these tax concessions, despite their significant cost to Government revenue and their artificial stimulus to house prices?

Before we examine some of these issues, let’s first review some history.

A quick primer:

Negative gearing is a form of leveraged investment in which an investor borrows money to buy an asset, but the income generated by that asset does not cover the interest on the loan. A negative gearing strategy can only make a profit if the asset rises in value (capital gains) by enough to cover the shortfall between the income and interest that the investor suffers.

Under Australia’s taxation system, negative gearing rules allow investors in both property and shares to write-off the cost of borrowing used to acquire an asset as well as other holding costs against all income, not just the income generated by the asset. At the same time, following changes to CGT in 1999, capital gains earned on assets held for more than 12 months are taxed at half the rate of other income.

According to the Reserve Bank of Australia"the taxation treatment [of residential investment property] in Australia is more favourable to investors than is the case in other countries". In Australia, there are no restrictions on the ability of taxpayers to negatively gear investment properties. That is, there are no limitations on the income of the taxpayer, on the size of losses, or the period over which losses can be deducted. By contrast, in the United States and Canada, there are limitations placed on negative gearing, whereas it is not permitted at all in the United Kingdom.

In July 1985, as part of a broader tax reform package, former Treasurer Paul Keating 'quarantined’ losses from negative gearing by stopping them from being deducted against other income. However, after intense lobbying  by the property industry, which claimed that the changes to negative gearing had caused investment in rental accommodation to dry up and rents to rise, Treasurer Keating restored the old rules in September 1987, thereby once again permitting the deduction of interest and other rental property costs from other income sources.

A costly policy reversal:

The reintroduction of negative gearing in 1987, in concert with the halving of the CGT rate in 1999, led to a surge in property investment in Australia. As shown in Chart 1, the number of property investors rose by 35% between 1999/00 and 2007/08, from 1.28 million to 1.73 million.

Of greater concern to taxpayers, total net rental income from investment properties has decreased from +$219m in 1999/00 to -$8,628m in 2007/08 (Chart 2). Further, the proportion of property investors declaring losses increased from 54% in 1999/00 to 69% in 2007/08. Assuming that the average marginal tax rate of property investors is 30%, negative gearing cost the Government around $2.6 billion in foregone tax revenue in 2007/08, meaning that average Australians are massively subsidising property investors.

The impact of the increase in property investment on Australia's house prices can be seen in Chart 3. Despite flat rental growth, house prices surged from 2000 as investors piled into investment property on the back of the new tax rules that enabled them to partly socialise income losses from holding investment properties (via negatively gearing), whilst privatising more of the gains achieved through capital appreciation (via the CGT concession).

This increase in property investment in Australia was also assisted by a significant increase in credit provision to property investors. From the mid-1990s, investors were permitted to purchase an investment property via accessing equity in their own home, without having to contribute any cash up front. Lending criteria on investment loans were also relaxed and became much the same as loans to owner occupiers, as did the interest rate charged. Lenders also began competing aggressively for investment loans and offered products specifically designed to attract investors, such as the split-purpose and interest only loan.

By contrast, prior to the mid-1990s, investors typically had considerable difficulty obtaining finance for an investment property, often having to rely on both their own savings and funding from non-bank sources. Investors were also typically charged a significantly higher interest rate than for owner occupiers.

This increase in credit provision for property investment is evident in Chart 4, which shows borrowings for investment properties growing at a faster rate (17% per year) than borrowings for owner occupied properties (12% per year). Accordingly, the share of investment loans has grown from around 14% in 1990 to around 30% currently.

According to the RBA, the terms at which investors can access finance in Australia are also more generous than in comparable countries. Typically, interest rates are higher for investors than for owner occupiers in these countries, and stricter lending criteria applies. Not surprisingly then, the share of investor mortgages in comparable countries is in the single digits, compared to the 30% share in Australia.

Impact on the rental market:

So having established that tax-fuelled property investment has been a key contributor to Australia's inflated house prices and costs the Government (taxpayer) billions of dollars in foregone tax revenue, the question remains as to whether these tax concessions increase the availability of rental properties and reduces rental costs?

To answer this question, let's first examine the claim by the property industry that the 'abolition' of negative gearing by the Hawke/Keating Government in July 1985 caused investment in rental accommodation to dry up and rents to rise. Chart 6 uses Australian Bureau of Statistics (ABS) data to plot real (inflation-adjusted) rents for the Australian mainland capital cities. The first vertical dotted black line shows the beginning of the ban on negative gearing (July 1985), whereas the second vertical dotted black line shows its re-introduction in September 1987.

According to the ABS data, following negative gearing's abolition, rents rose in both Sydney and Perth, were flat in Melbourne and Adelaide, and fell in Brisbane. But if it was true that the abolition of negative gearing caused rents to rise, shouldn't rents have risen Australia-wide since negative gearing affects all rental markets? Clearly, based on this evidence, the properties industry's claim about the impact of negative gearing on rents are false.

My conclusion is supported by Saul Eslake, former Chief Economist at the ANZ, using different rental data. According to Mr Eslake:  "It's true, according to Real Estate Institute data, that rents went up in Sydney and Perth. But the same data doesn't show any discernable increase in the other State capitals. I would say that, if negative gearing had been responsible for a surge in rents, then you should have observed it everywhere, not just two capitals."

So having debunked the link between negative gearing and rental costs, what about the claim that negative gearing increases the supply and availability of rental accommodation? If this claim was correct, we would expect to see a high proportion of investor borrowings being channelled into new housing construction. Investors who buy existing homes do not increase rental availability since they do not add to overall housing supply and merely turn homes for sale into homes to let. They also do not address the shortage of rental accommodation, because the reduction in the supply of homes for sale throws potential owner-occupants onto the rental market.

In order to examine the effect of property investment on the rental market, Chart 6 uses RBA data to plot the percentage of investor mortgages going to existing dwellings versus new construction.

As you can see, the share of investment in new construction has fallen for the past 25 years, from around 60% in the mid-1980s to around 5% currently. So despite the favourable tax treatment provided to property investors in Australia, for every 20 investment homes purchased in 2010, only one is a new dwelling that has actually added to housing supply and rental availability.

The data on new home construction by investors is even more damning. As shown in Chart 7, there was a surge in investor loans for second-hand properties from around 2000 onwards, coincident with the reduction in CGT. By contrast, loans for new construction have remained relatively flat for the past 25 years. As a comparison, the ratio of investor lending for existing dwellings to new dwellings was around 2:3 in 1985; 7:1 in 2000; and 15:1 in 2010.

A failed policy:

Based on the above evidence, there is clearly little merit in Australia's tax concessions for property investment. Negative gearing and the CGT concession do not provided any incentive to invest in new housing because they are available for both existing homes as well as new ones. And since these concessions do not increase housing supply, they also do not put downward pressure on rents.

Rather, the increase of investment in existing dwellings has merely significantly added to housing demand, reduced housing affordability, and displaced potential owner-occupiers, forcing them onto the rental market. While the cost to the taxpayer is immense, the costs to younger Australians, in particular, from reduced housing affordability and increased debt levels is even greater.

The situation that has arisen in Australia, where a substantial part of the population never own their own home or have to go deep into debt to achieve home ownership, makes a complete mockery of claims about 'rising living standards' and Australia having a 'strong economy'. Successive governments have allowed an appalling situation to develop in Australian society, and new approaches are desperately needed.

A better approach:

Australia's current system of negative gearing is a key factor behind the housing affordability problem in Australia. It has encouraged a flood of investors into the established housing market, it has not contributed to housing supply or rental availability or affordability, and it costs the Government billions of dollars of foregone tax revenue each year. Housing affordability will never be properly addressed in Australia until significant changes are made to negative gearing.  

Negative gearing's cost to the Government and impact on house prices would be greatly reduced if, from a certain date in the future, it was retained on newly constructed dwellings but abolished where an investor purchases an existing ('second hand') dwelling. In this way, pre-existing investment property owners would not be disadvantaged and, over time, tax deductible interest would begin to fulfil its economic purpose of encouraging real investment - the production of new housing supply - as new investors enter the housing market. Such an approach, once understood, would likely be supported by the home building and property development industry because it promotes higher building levels. Further, the increased housing supply would be likely to increase the availability of rental properties and lower rents. Of course, those groups with a direct interest in long-term house price appreciation would strongly object to such an approach including, perhaps, many current Australian home owners who (wrongly) perceive that their wealth is increased when their home value rises.

Tax purists might also disagree with such a change to negative gearing on the basis that it is wrong to discriminate among financial assets. My response is that housing is an entirely different type of asset from other financial assets, like shares. Firstly, housing is a social asset and shelter is a basic human need. Second, those buying other financial assets are bidding against other investors that can also access interest deductibility. However, with housing, the main other bidders are owner-occupiers that do not have access to this advantage (interest deductibility). So we are not comparing 'apples with apples' with regards to housing versus other financial assets.

Change ain't easy:

Of course, discussions about changing negative gearing are for now academic, since the Rudd Government recently announced, in response to the Henry Tax Review, that it would never change Australia's negative gearing or CGT rules.

While it won't admit it publicly, the Government is concerned that changes to tax concessions could lead to a stampede from property by investors and cause a bursting of Australia's housing bubble. Finance Minister, Lindsay Tanner, said as much in a recent interview on Lateline:

" The key reason why governments of both persuasions have not interfered with negative gearing is of course that that any dramatic change in the overall investment framework could lead to a stampede of people out of property, which could lead therefore to dramatic drops in prices which of course you’re seeing in other economies around the world and you see the economic devastation that flows from that."

So, despite the Government and many mainstream economists arguing that Australia's high house prices have been caused by a 'lack of supply' (housing shortages), the truth is that prices have risen largely because of speculation from housing investors combined with easy credit from Australia's lenders. And no government wants to spoil the party or have the bubble burst on their watch, despite pretending to be concerned about housing affordability.

Instead, I am left wishing that I could buy a time machine, travel back in time, and reverse those two fateful policy blunders - the reintroduction of negative gearing in 1987 and the CGT reduction in 1999. Then, maybe, Australia's house prices would still be affordable, households would be less indebted, and a large chunk of the population currently stuck in rental accommodation would be home owners instead. If only...

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