Written Off: Negative Gearing

Philip Soos

This presentation will cover the following:

What is negative gearing? How does it work? Trends in the property market The faults of negative gearing How much does it cost? Are there alternatives? Recommendations Conclusion

Overview

A tax artefact, allowing deduction of net loss against income

NG is technically a “tax expenditure”

Arises from a departure in the generally-accepted tax structure, providing favourable tax treatment to a party

E.g., tax exemptions, concessions, deductions, preferential rates, allowances, rebates, offsets, credits, deferrals

Hence, a government-legislated privilege

What is NG?

An investor makes a net loss arising from an investment

Investor deducts the net loss against other sources of income, usually their personal income tax liability

The net loss is deducted at the investor’s marginal tax rate (MTR)

Investment can be in real estate, shares or general business

How does NG work?

John buys a property worth $500,000, financed with $100,000 in savings and the rest ($400,000) with a mortgage Interest rate is 8%, so repayments are $32,000/y Rent of $25,000 from tenants $4,000 in general property costs (repairs, property manager fees, etc.) John’s wage is $90,000, with a MTR of 37%

Net loss: $25,000 - $4,000 - $32,000 = -$11,000

John can deduct $11,000 x 37% = $4,070 from tax liability Instead makes loss of $11,000 - $4,070 = $6,930

A Simple Example

Two reasons for property investment: speculation and rent Former is in the market for capital gains Latter is in the market for eventual positive cash-flow gains

Conditions: Investor must be able to finance current income losses Can cope with sharp upward interest rate increases Capital/rental price appreciation must rise faster than inflation,

otherwise no capital gain or delays positive cash flow Must have sufficient earnings from other sources to make use of NG

Viability of NG

Housing Price IndexAustralian Real Median Capital City Housing Price Index 1880-2011, 1880=100

Source: Stapledon 1880-2006, 2007-2011 author’s estimate

The Rise of NG

Source: ATO

Escalating Losses

Source: ATO

Distribution of NG By Tax Bracket

Source: ATO, 2009-10

Two reasons for property investment: speculation and rent Former is in the market for capital gains Latter is in the market for eventual positive cash-flow gains

Conditions: Investor must be able to finance current income losses Can cope with sharp upward interest rate increases Capital/rental price appreciation must rise faster than inflation,

otherwise no capital gain or delays positive cash flow Must have sufficient earnings from other sources to makes use of NG

Is NG Justified?

Deductibility and tax minimization

Increasing the supply of rental properties

Quarantining during the 1980s

The cost of NG

Major Problems with NG

Investors can deduct the costs incurred in making an income; labour can’t;

Investors typically have higher MTRs than labour (greater deductions);

Deduct net losses against personal tax liability (NG);

Can carry forward losses;

And can lower their effective MTRs to a lower bracket.

Deductibility and tax minimization

Wealthy individuals benefit as top 1% of taxpayers receive (Ken Henry review statistics): 5% of wages and salaries 4% of net rent 9% gross interest 36% dividend income 39% net capital gain 22% business income 23% net partnership and trust income 29% capital income

Deductibility and tax minimization

Top 5% of households by net worth own (Household, Income and Labour Dynamics in Australia (HILDA) Survey): 24% of all net property 24% of super 43% of equity investments 70% of net businesses 27% of bank deposits 16% of vehicles 47% of cash investments, trust funds, life insurance and collectables

Deductibility and tax minimization

Deductibility and tax minimization

Source: Tax Review

Pays to speculate rather than work, as Alan Kohler put it:

Five years ago Treasurer Peter Costello told Australians: “Work for a living and we’ll tax you at close to 50 cents in the dollar; speculate and we'll only take 25 cents. Not only that but, as a special deal - while stocks last – we’ll pay half your speculating costs.”

Current tax law benefits investors over labour; broadly, the rich over everyone else.

Let alone what economist Fred Harrison has shown about the rich paying no taxes at all due to the uplift in land values of their property portfolios which is influenced by taxation…

Deductibility and tax minimization

The major justification for NG

Allegedly provides incentive to investors to increase the supply of rental properties, allegedly lowering rents

Some evidence to support this, but must be viewed in the context of the largest land bubble in Australian history

Strong capital appreciation is partly caused by investors piling into the market, leading to more investment

Increasing the Supply of Rentals

Increasing the Supply of Rentals

Source: Stapledon, author’s estimates

But…

Zero empirical evidence produced by supporters, only theoretical argument at best

92% of investment loans used to purchase pre-existing, not newly constructed, dwellings

Largest land bust in history will reverse the number of NGs

The evidence we have does not support NG’s argument

Increasing the Supply of Rentals

Increasing the Supply of Rentals

Source: RBA

Increasing the Supply of Rentals

Source: RBA

Favourite scare story of the housing lobby, still used today

When the Hawke/Keating government quarantined NG, it supposedly caused a rental crisis

Evidence clearly shows the opposite

Confounding factors: interest rate rise, introduction of CGT, big stock market bubble

Quarantining NG in the 1980s

Quarantining NG in the 1980s

Capital City % Change Increase?

Sydney 6.2% Yes

Melbourne 1.1% Yes

Brisbane -7.6% No

Adelaide -2.0% No

Perth 10.7% Yes

Hobart -1.5% No

Darwin -8.1% No

Canberra 0.7% Yes

Australia 2.7% Yes

Source: ABS

The Cost of NG

Source: ATO, author’s estimates

1: At a minimum, reform NG, at best, get rid of it

2: Increase CRA expenditures, currently $3.1 billion

3: Review tax law to allow labour to deduct the cost incurred in earning an income from wages/salaries

4: Solve the NG debate entirely by getting rid of income tax!

Recommendations

NG is an artefact of a perverse tax system that encourages speculation and punishes productive work

Part of a subsidy/tax expenditure package to inflate prices

Works great during the boom phase of a land market bubble

Has prompted many speculators to enter the market but will lose out when bust occurs (no capital and no rental gains)

Appalling policy to subsidize speculators in the name of the poor: protecting lords in the name of serfs

Conclusion

Questions?