By Caelan Rafferty
Is there potential for tearing down a brick and mortar component of the Australian housing market with the recently proposed changes to negative gearing? Historically, the abolition of negative gearing during the Hawke-Keating Labour years in 1985 was viewed to have been disastrous. It resulted in decreased construction of residential homes, impacting supply, a discouragement of investment and alleged higher rental charges. The legislated abolition was subsequently overturned two years later. However, it is important to note that the prior legislative changes occurred amid high interest rates and a share market boom which could have potentially influenced the above changes, more so than any taxation change.
Nevertheless, fast-forward thirty years, negative gearing has again become the topical election issue on the political landscape. Now would be the ideal time for me to pick my favourite political party and to talk about all the great qualities of my parties proposed changes whilst bashing the other parties to oblivion. Yet I feel irrespective of the politics, there is merit in discussing the sometimes dry, yet undeniably important economics of the existing arrangements.
Negative gearing occurs where an asset is purchased using borrowed funds, whereby the income generated off the asset is insufficient in covering all the costs involved in maintaining the asset; reflecting a net loss position. While negative gearing is accepted around the world, the Australian taxation system is unique in its treatment of the mechanism. It is unique in that we can then deduct the net losses of negatively geared assets against other types of income with no recognized cap on the deductions, unlike many other systems, such as the United Kingdom. The existing negative gearing arrangements are then also aided by the Capital Gains Tax (CGT) discount which includes a 50% deduction off capital gains realized after the sale of an asset.
Combined, these two factors are advantageous to the investor. Over the course of a financial year, the property will be geared to make net losses which can subsequently be deducted off of taxable income that would otherwise be charged at the full marginal rate of your tax bracket. Meanwhile, the property is typically increasing in value over the course of the investment and once sold, the capital gains are only taxed at half your marginal rate. Consequently, over the long-term, the investor is making a net-profit instead of a net-loss as a result of capital gains.
Economically, negative gearing has staggering implications for the housing market and the wider economy. In the housing market, the negative gearing arrangements add fuel to housing price booms as the current tax arrangements promote speculative spending on housing to punt on further price increases. It also results in an investment skew towards properties likely to yield higher capital gains which are typically located in inner-city suburbs, creating a supply shortage. This investment system also results in crowding out institutions focused on rental returns to a myriad of small investors chasing capital gains, creating less stable tenancies.
These dynamics are readily observable in the current Sydney housing crisis where prices skyrocketed as housing availability diminished quite significantly. The situation places incredible pressure on both low to middle income earners and new home buyers attempting to enter the market. It is now unclear whether the bubble still exists or has burst but it is nonetheless an example of the effects negative gearing can have on the housing market.
In the wider economy, inflating asset prices during asset price booms may result in the Reserve Bank of Australia raising interest rates to combat any further price increases and to curb further investment borrowing. Furthermore, the current negative gearing setup leads to leveraged and speculative borrowing contributing to climbing household debt levels. This can leave Australia vulnerable to adverse external shocks, increasing the potential for systemic collapse of the financial system and the economy.
The current system also results in the failure of the invisible hand principle; when something is too expensive, people stop buying. With government incentives to buy, such as the National Rental Affordability Scheme, the prices of the assets are ignored and consumers continue purchasing. Thus, while negative gearing may be advantageous to investors, it does present significant economic dilemmas.
What’s the next step? I say leave it to government! However, for those who want a less cop-out answer, some argue that an attempt should be made to reduce the tax bias towards capital gains, an analysis of which can be found in the Henry Report. Others argue that restrictions should be implemented for deduction claims for investment expenses. Others still maintain that the current system is not broken and requires no changes at all. Yet regardless of who’s right and wrong, as this brick and mortar component of the Australian housing market continues to be shrouded by political mist, I feel the brick and mortar will not crumble, rather it will just be made differently in the future.