Tuesday, March 25, 2008

Tuesday Column: Lets incentivate Australians... to lose money

It is true that Australia is just about the only country country in the world whose name rhymes with 'failure', but I mean, really!

As business people, Canberra residents make good public servants.

The latest tax figures show that around 31,000 of us are in the business of being landlords.

Taken together, we are not only not making money, we are losing a fortune.

ACT landlords lost $144 million from the business of renting during 2005-06, a performance all the more staggering when you bear in mind that six years earlier we only lost $38 million.

We appear not to be learning from our mistakes.

Perhaps you think this is an unfair way to describe the perfectly respectable, and ever more popular practice of negative gearing.

But it is the way the Tax Act sees it - as a way of making money gone wrong. Those of us who actually made money by renting out our properties will be taxed on those earnings. There aren’t many of us...

In only two of the ACT’s 25 postcodes do the landlords make money in net terms.

The rest of us who (accidentally or even deliberately) lose money renting out houses will be taken pity on.

Because we have unfortunately stuffed up and are earning negative income from rent, the rest of our income will be reduced for tax purposes, so that we are no longer as badly off.

Looking through the tax figures just released it is hard not to get the feeling that a provision originally introduced to cover an unusual and unfortunate circumstance has become mainstream.

This needn’t be a problem if it is providing the sort of incentive we want. But as a general rule an incentive that encourages someone to lose money is a bad idea.

And don’t doubt that money will be lost. When, as is likely, real estate prices turn down and there are no capital gains to be made to compensate, a good many of those 31,000 Canberra landlords are going to find their finances looking sick.

Nationwide more than one million Australians are now losing money as landlords – an extraordinary figure given the size of Australia’s population.

All up they are losing $8.7 billion.

It didn’t used to be like that.

Back in 1999 before a little-publicised but highly important change to the tax law there were only 650,000 landlords and they weren’t losing anything like as much.

In the midst of all the publicity about the impending Goods and Services Tax, the Treasurer Peter Costello more quietly commissioned another tax review. When it reported its guesses about who would win and who would lose as a result of the change it recommended were never made public - in contrast to guesses about the effect of the GST that were everywhere.

Actually its recommendation was more of less forced on it. Peter Costello gave the Ralph review of business taxation one very specific non-business term of reference.

He asked it to examine the scope for “capping the rate of tax applying to capital gains for individuals at 30 per cent.”

In fact the committee went further and recommended that only half of each capital gain be taxed - effectively cutting the rate of tax on the sale of houses and units and the like to 24 per cent.

Labor had no apparent problem with the idea, just as it doesn’t seem to now. The briefing papers it prepared for last year’s housing summit were actually rather funny. They listed a whole suite of reasons for declining housing affordability - including rising interest rates, slow land releases and the cost of building - but nowhere mentioned tax.

But Mark Latham, in 1999 a backbencher in self-imposed exile, saw things clearly and made some pretty accurate forecasts.

He told parliament that the cut in the rate of capital gains tax was “the thing that tax avoiders want. They want incentives to move out of trading income into trading assets. They want the opportunity for property and asset speculation in the Sydney land market rather than a taxation system which promotes value-adding in the information technology sector.”

The Macquarie Bank’s Rory Robertson also saw what was about to happen early.

He bought a rental property himself and then advised clients in a note that “since September 1999 it is almost as though the Australian tax system has been screaming at taxpayers to gear up to earn increased capital gains rather than to work harder to earn increased wages or salaries.”

Why bother earning money by producing something when you could borrow to the hilt to buy a rental property, make sure that your repayments exceeded your income from rent, cut the tax you paid on your other income along the way, and then sell the property for a very-lightly-taxed capital gain?

It’s a rort crying out for reform.

At various times the Productivity Commission, the Reserve Bank and Access Economics have said so.

And its getting worse. Throughout 2005-06 an extra 49,200 Australians got into negative gearing; 1,200 of them in Canberra.

The Reserve Bank has described the surge as “unprecedented, both in terms of previous experience in Australia and experience overseas”.

And don’t accept uncritically the argument that it has kept rents low. While negative gearing has encouraged individual landlords to charge rents low enough to lose money, its surge in popularity has also ramped up the price of rental and other properties as more and would be loss-making landlords tried to climb on board.

As well, any rents that it might hold back are likely to be those at the upper and middle sections of the market. Negatively gearing landlords want good properties, and tenants they believe will look after them. They are not in the business of providing low-income accommodation.

I am expecting the Rudd Labor government to move against negative gearing, despite its apparent timidity.

Rudd, Swan and the rest of the senior ministry are very serious about making sure Australia uses its scarce resources productivity. And there’s little productive about losing money.

A start would be to push the rates of tax on capital gains back up to the standard marginal rates. If at the same time the rate of company tax was cut, perhaps to as low as 20 per cent, money might start to flow instead to where it where it could actually make money.

11 comments:

Peter said...

Peter,

There are three points that most debates about this seem to miss.

1. Building depreciation

This seldom comes up in these debates but is another benefit that property investors get if their property is built after 1987. Depreciation on the building is calculated at a rate of 2.5% for 40 years, and there's provision to claim for smaller items as well.

Like other tax breaks this makes the property closer to break-even up to a point - if you buy several then you run out of tax deductions unless your job income is very high!

Depreciation also skews investor buying decisions to favour new properties (refer next point), though when the higher than established price is factored in the benefits may be illusionry.

If you wanted to make your tax refund figures look bigger, add depreciation!*

2. Supply

When vacancy is low, buyers pay near the marginal costs of new homes.

If land costs $100k and the house $150k to build, then this effectively sets a $250k floor on existing house prices.

Yet in parts of Melbourne, Adelaide and Hobart you can still buy established 30 yo detached 3br houses for under $200k on sizable blocks. They're in stigmatised suburbs, so anything better will be dearer, with people paying dearly for location.

I wonder if supply costs puts a floor on prices at the bottom end. Something like better public transport and encouraging more closely spaced centres (although in Canberra some local centres are struggling) might have some effect if it makes outer transport starved areas handier.

And maybe to encourage investors to build houses (rather than buying secondhand ones that don't alter supply) maybe depreciation could be accelerated.

But rapid depreciation might encourage shoddy building and the concept of 'depreciation' is hardly 'green'!

Also note that tracts of new houses are more likely to be on poorly serviced estates than existing homes so the amenity for tenants may be less.

3. The types of properties investors buy

With governments moving out of directly providing rental housing, it's actually investors who have taken up the slack, assisted by various subsidies.

Yes some investors buy new high-rise apartments (which add to supply, but it's not necessarily the ideal property for 'ordinary people').

Hence a lot of investors do actually buy $200k established houses. You can tell since the owner occupier proportion is lower than more middle ranking suburbs. And typically rents are less dispersed than property prices, so the yield are higher with cheaper properties, this assisting their serviceability.

As an example, gross yields of 6.5% are still possible by well-bought homes in the cheapest suburbs. This is still lower than no-risk term deposits but is a big improvement on the apallingly low 3-4% yields in 'good' suburbs in Sydney and Melbourne.

A core issue is the type of properties being built and how they're likely to match demand. My view is that medium density 1970s-style 2br villa-type units and small blocks of units (such as surround many local shopping centres in Canberra) are preferred over townhouses or high-rise units whose cost might be similar to a free-standing house.

Though such places were ugly, they fill a need in the 2000s and it should be possible to encourage such development vis a vis high-rises.

(*) Would also be interested on your thoughts about depreciation as a tax claimable. Not just housing but plant and equipment as well. Why do we tax labour (payroll tax) but give hand-outs in the form of depreciation (which discourage efficiency and frugality)? Maybe a topic for a future post?

Anonymous said...

There are some instances where negative gearing is beneficial - for example people who have bought a place and decide to rent out a part of the property. The proportional negative gearing aspect can make this attractive and thus increase the housing supply (though admittedly this is probably only a smallish number). Flat property prices only make this more attractive within the context of such a low capital gains tax rate.

swio said...

"I am expecting the Rudd Labor government to move against negative gearing, despite its apparent timidity."

Can you elaborate on that a little bit? I mean do you expect them to do this solely because its such an obviously good policy? Or have you seen something(s) which suggest policy in moving in this direction or perhaps even heard something on the grapevine?

I only ask because from a political point of view I think it would be a crazy thing to do. The benefits would take years to turn up, and would go hand in hand with a poor capital gains on housing which would not be very palatable to investors or existing homeowners and the real estate lobby would go absolutely nuts. I think it would be great to cut back on negative gearing but unless I'm missing something I have to say that, politicaly, its surely a non-starter?

Odddmonster said...

Following on from the speculation that Labor will change the application of negative gearing, how will the Liberals respond to such a change.

If they cannot see that this mechanism is one part that is failing our economy, then I don't see much of a future for those enormous economic credentials they had hanging around before the election.

Peter said...

LETTERS TO EDITOR March 27, 2008

Tax on housing

Economists like Peter Martin (''Rort ramps up rental costs'', March 25, p13) have traditionally criticised the absence of capital gains tax on principaldwellings and the availability of negative gearing concessions on rental properties on the grounds that such generous taxation arrangements have the effect of attracting too great a share of scarce investment into housing in Australia, at the expense of nationally more productive investments elsewherein the economy.

But if too much money has been attracted into housing in these ways for many years, surely that excessive investment has built more houses than would otherwise be the case.Surely rents are now lower and there are more homes available than there would have been in the absence of the tax-induced excessive investment.Imagine where home prices and rents might be if that investment had not taken place.
Economists can't have it both ways.

Jim Taylor, Kaleen

Letters said...

LETTERS TO EDITOR, April 7, 2008

Stuck in perverse gear

CATHERINE CARTER of the Property Council argues we should keep negative gearing for housing investors, because it is necessary as a subsidy to keep investors providing housing at rents which are uneconomic (''Investors geared for housing demand'', March 30, p45).However, this is ironic because negative gearing (the ability to tax deduct interest costs against other income, if renting provides a net loss) is the main financial reason for investors being able to outbid would-be owner-occupiers, and drive up house prices, as happened in the 2000-03 housing price boom, when prices roughly doubled due to a flood of housing investment finance.

It is these high house prices that make renting uneconomic.

Thus negative gearing is held out as the answer to a problem which it largely created, and we are caught in a vicious circle.Rents are only low in relation to current high house values; they are not low in relation to people's incomes. Negative gearing has not provided low rents.

Furthermore, high house prices undermine supply of new housing,because high prices limit effective demand, and negative gearing for investors in housing is always there to make sure that house prices won't gradually fall to ease this situation.

Most negative gearing-driven investment is in established housing,not new housing, so its main effect is to maintain high prices, not add to supply.

Countries comparable to Australiado not have negative gearing for housing investment as under the Australian tax system.At some point we have to break the vicious circle, perhaps by amending negative gearing so it can be part of the solution, not a big part of the problem.

Paul Pollard, O'Connor

letters said...

LETTERS TO EDITOR, April 7, 2008




GEARED FOR INVESTMENT

Paul Pollard (Letters, April 6, p20) may not remember what happened in 1985 when Bob Hawke and Paul Keating did away with negative gearing. Rental prices soared and rental accommodationall but dried up. In 1987 Labor brought back negative gearing.Negative gearing does not produce low rents, nor is it intended to. But it is an incentive to invest, for example, in rental accommodation.

Emmanuel, Kaleen

Letters said...

LETTERS TO EDITOR, April 9, 2008

Negative gearing

Sal Emmanuel says (Letters, April 7) that rents soared following the 1985 (partial) removal of negative gearing for housing investors.

However, this seems to be a myth.The Real Estate Institute of Australia,in its 2003 submission to the Productivity Commission inquiry into first-home ownership, attacked the removal but, significantly, made no claim about soaring rents, and neither should they, because rental yield figures for that period for all of Australia don't back this up.Further, Bernie Fraser, head of Treasury throughout the entire period of removal and reinstatement, has also dismissed this as a myth.

Paul Pollard, O'Connor

Anonymous said...

NEGATIVE GEARING – Incompetence or Conspiracy

A short description of Negative Gearing and the rort it is that was written by Dr Putland

http://www.prosper.org.au/2007/11/01/negative-gearing-incompetence-or-conspiracy/

A rental property is said to be negatively geared if the owner’s expenses (including mortgage interest and maintenance) exceed the rental income, so that the property makes an annual loss. If the tax system allows negative gearing deductibility, that loss can be deducted from other income for tax purposes. Abolition of this deductibility, loosely known as “abolition of negative gearing”, would make the owner’s expenses deductible against the rent alone — not against other income.

SPIN: Negative gearing deductibility helps renters and first home buyers by encouraging property investors to “supply accommodation”; the larger the supply, the lower the rents and prices.

FACT: The only investors who actually add to the supply of accommodation are those who build new accommodation. Therefore, if negative gearing deductibility were really intended to maximize the supply of accommodation, it would be allowed only for new construction — not for future purchases of established properties. But in fact the negative gearing rules fail to distinguish between new and established properties, giving no incentive to build rather than buy. So the supply of accommodation is lower than it could be, and rents and prices are consequently higher than they could be. That’s good for current owners of rental properties, but bad for renters and first home buyers.

VERDICT: Negative gearing deductibility could help renters and first home buyers if it were done properly. But it isn’t. It’s done so that established property investors get a tax break at the expense of other taxpayers plus higher rents and prices at the expense of renters and first home buyers.

PM said...

Thanks.

Anonymous said...

Hi, you may find this video amusing:

http://www.abc.net.au/tv/gruentransfer/gallery.htm?cfid=8630

Or a cartoon (same joke but just an image - other one is funnier)

http://i144.photobucket.com/albums/r165/hiredgoonadl/loan_application.jpg

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