A first step on negative gearing, but not much more

Both major parties are examining changes to negative gearing. Ben Spies-Butcher argues the two proposals for reform point to just how deeply flawed negative gearing is, and why neither change goes far enough.

Recent announcements by both major parties suggest the long-held bipartisan consensus over negative gearing is finally breaking. While we can expect anguished cries from the property industry, the two proposals for reform point to just how deeply flawed negative gearing is, and why neither change goes far enough.

The proposals point to two deep contradictions at the heart of negative gearing: it is designed to deal with housing affordability (that is, demand for housing is higher than supply) by increasing demand; and it is a policy to encourage savings, that simultaneously encourages debt, and rewards those who already save far more than those who find it difficult to save.

First, though, it’s useful to clarify what negative gearing is. It’s a tax rule that allows investors (not only property investors, but mainly property investors) who run their investment at a loss to claim that loss against their other income.

Why would a rental property run at a loss? Usually because the investor borrows most of the purchase price, and interest repayments on the loan (mortgage) are higher than the income (rent).

In most other countries this would mean the investor did not have to pay tax on the rent they received. But it would not allow them to reduce the tax they pay on their other (usually wage and salary) income. Australia is an exception.

So negative gearing encourages people to invest in property, and it particularly encourages them to invest by borrowing most of the price of the house. It might already be obvious why this is a very odd kind of housing and investment policy, seemingly designed to encourage people to over-extend and expose themselves to big risks if property prices were to fall.

A false fix for affordability

However, the property industry has long argued that negative gearing helps housing affordability, particularly for renters, by expanding the supply of rental housing. Yet, as opposition treasury spokesman Chris Bowen has recently argued, 93% of negatively geared properties were existing stock – the new owners simply bought them off someone else.

Labor’s policy is to restrict negative gearing to new properties. And given the current policy setting, that is likely to have a positive impact.

But think for a moment about the logic of “increasing supply”. Negative gearing is not a subsidy for builders, it’s a subsidy for buyers. That’s right. The problem is one of too many buyers willing to pay high prices, and negative gearing is designed to create more buyers willing to pay more.

Of course, Labor’s policy will restrict the increased demand to new housing stock. But it highlights a deeper problem in the housing market.

Private developers increase supply only if it is profitable, which is usually when prices are rising. If supply were increased without increasing demand (for example, by direct government investment) that would likely contain rising prices. Doing so through the market, however, simply recreates the existing problem.

And what about rental prices?

Critics would argue I am focusing only on housing prices, not rents. Negative gearing is designed to lower rents by allowing investors to rent at a loss. The problem here is that renting at a loss is still a loss unless something else is going on. That something else is capital gains.

Negative gearing only makes sense as an investment strategy because investors make their real money by buying low and selling high. So it works only if house prices are increasing. To the extent it contains rents it only does so “relatively”: rents rise less rapidly than house prices, but both go up because of the scale of new demand.

In some market segments (especially the bottom end) new supply can make things worse. Indeed, “new supply” often increases rents because it demolishes older, cheaper housing to make newer, fancier and more expensive housing. On this score, the best part of Labor’s announcement is the reduction in the tax concession for capital gains.

Negative gearing’s other claimed benefit is that it encourages people to save. In practice, this “saving” is coupled with large new debts.

This is a serious economic problem because it means tens of thousands of Australian households have been encouraged to take on debt that they might not be able to sustain if house prices fall. And that means governments are forced to keep house prices high to avoid serious economic consequences – as the Rudd government did by increasing first home buyer grants during the GFC.

Second, negative gearing is a tax deduction. That means the higher your marginal tax rate, the more you get. Someone on $200,000 will receive about half their loss back. Someone on $30,000 will only get about a fifth.

So the rewards for saving are much greater for high-income earners (who already save a lot) than for low-income earners (who struggle to save).

This helps explain how two apparently contradictory claims are both true. Most negatively geared investors are mums and dads; nurses and police officers. Yet most of the gains from negative gearing go to the very top of the income distribution.

This is because most of the gains go to a small subset of investors with lots of properties and on very high incomes. The “mums and dads” get a relative pittance.

Much more needs to be done

The government seems to know it can raise significant revenue and target only a small group of investors. It can leave the mums and dads alone and still correct most of the inequality and expense by putting a cap on how much any one investor can claim. How far it actually goes remains to be seen.

So both proposals do good things. But once you understand the problems they are meant to resolve, you realise it is almost impossible to make negative gearing “good policy”.

Neither plan “fixes” the problem. They are mitigation at best.

Maybe we can see them both as first steps. After all, with so many investors so heavily indebted, any policy that pulled the rug out all at once has serious economic risks.

We can only hope these policies are the first instalment. Governments serious