Sloan’s negative gearing defence sours

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By Leith van Onselen

After her dreadful defence of negative gearing in July (thoroughly debunked here), The Australian’s Judith Sloan has returned with another abusive post aimed squarely at us “lefty” doomsayers that dare question the merits of Australia’s famed tax expenditures on investment property.

Sloan’s article is chock full of straw man arguments, misrepresentation and insults in lieu of reason. Let’s take a look at her latest installment:

Without the faintest clue of the rationale or application of the relevant tax rules, these advocates for “social justice” will still quote the billions of dollars of budget savings that could be made if only negative gearing were abolished, or at least trimmed back.

The trouble with their analysis is that it is almost always based on falsehoods and misunderstandings…

The term negative gearing is typically used in this context as shorthand for the tax deductibility of borrowing and other costs associated with investment on existing residential real estate.

In fact, this provision of the Income Tax Assessment Act is completely generic and has existed for many years. It simply enshrines the sensible principle that the costs of making an investment to generate an income should be tax deductible for the party making the investment…

In fact, the Productivity Commission thoroughly examined the taxation of investment housing some years ago in its inquiry into housing affordability. Since negative gearing has long been a feature of the tax arrangements, it found negative gearing per se did not explain the recent movements in property prices.

Actually, what the Productivity Commission found was the following (my emphasis):

Other aspects of the personal taxation regime — including negative gearing rules, ‘capital works’ deductions for buildings, the 1999 change to capital gains tax for assets held by individuals, and high marginal income tax rates — have combined to magnify the attractiveness of investing in residential property during the recent upswing in house prices, thereby adding to price pressures.

… aspects of those provisions, particularly the CGT arrangements, appear to have ‘pro-cyclical’ effects that potentially distort investment flows whether into housing or other asset classes. Attempting to address these impacts for housing alone would be hazardous. Indeed, ostensibly ‘quick fixes’ suggested by many participants — such as limiting negative gearing or removing the CGT discount for housing — could detract from rather than promote more efficient investment. Hence, the Commission considers that a broader examination is needed…

The Australian Government should, as soon as practicable, establish a review of those aspects of the personal income tax regime that may have recently contributed to excessive investment in rental housing.

Doesn’t quite match with Sloan’s claims about negative gearing does it? No, instead of finding that “negative gearing per se did not explain the recent movements in property prices”, the Productivity Commission found that it, along with its partner in crime – the 1999 halving of the rate of capital gains taxes – has added to price pressures, and recommended a thorough broad-based review that encompasses all aspects, not just housing.

And yet, this is exactly what most opponents of negative gearing are seeking: the quarantining of negative gearing losses – so that interest and other costs related to an asset can only be offset against the same asset’s income. It is also what happened when the Hawke Government temporarily ‘abolished’ negative gearing between 1985 and 1987. Such tax treatment is standard practice across most developed nations, which do not allow costs related to an investment to be deducted against non-related income (e.g. wages and salary). Australia and New Zealand are outliers in this regard.

Back to Sloan.

The more fundamental point about negative gearing, and one that lazy commentators never seem to consider, is that the flip side of the transaction is the flow of income to the lender, which is taxed. To disallow the cost of borrowing by investors would amount to double taxation and would discourage investment. If the restriction were to apply only to residential housing, the likely impact would be simply to shift investors to other tax-preferred options. The net impact on government revenue is uncertain.

The argument that “the flip side of the transaction is the flow of income to the lender, which is taxed” and to “disallow the cost of borrowing by investors would amount to double taxation” is preposterous.

Using this logic, the private health insurance rebate is not really a cost to the Budget, since it is income in the hands of health funds that in turn pay tax to the government. Using the same logic, childcare should be made tax deductible, since childcare centres would earn higher profits, part of which would also be remitted back to the government via company tax (not to mention the extra income taxes paid by childcare workers). To do otherwise would amount to double-taxation, according to Sloan’s twisted logic.

On this point, Sloan also fails to acknowledge that the extra house price inflation caused by negative gearing also means home buyers have to take-out bigger loans and pay more loan interest which, while beneficial to the banks, limits their expenditure elsewhere in the economy, in turn crimping the profits (and tax paid) by other sectors.

The second part of her argument, the claim that if the “restriction were to apply only to residential housing, the likely impact would be simply to shift investors to other tax-preferred options” is another classic straw man argument. Most opponents argue that negative gearing should be quarantined for all assets/investments, not just housing, as was the case when the Hawke Government temporarily ‘abolished’ negative gearing between 1985 and 1987.

Back to Sloan:

If a decision were made to restrict the taxation benefits of negative gearing of housing investment, there is the issue of how the transition would be managed. Were the change to be grandfathered for existing investors, for instance, arguably the costs of the change would be unfairly borne.

But even this method of change would not eliminate significant disruption to the residential real estate market because new investors would be discouraged from purchasing properties. In all likelihood, rents would rise, at least in the short term. Existing capital values would fall and the growth of capital gains would be impeded, affecting the future flow of capital gains tax revenue.

The so-called ‘problems’ outlined by Sloan aren’t really problems at all. Simply change the rules from a pre-determined future date (e.g. 1 July 2015), grandfather the rules for existing investors, and move on.

The second paragraph claiming that ‘abolishing’ negative gearing would cause “significant disruption” to the residential real estate market is not backed-up by evidence. When the Hawke Government temporarily quarantined negative gearing between 1985 and 1987, such that an asset’s losses could only be claimed against the same asset’s income (rather than unrelated wage and salary income), there was no material impact on rents (see red line in next chart).

ScreenHunter_3938 Sep. 01 08.14

And why would there be? The overwhelming majority of property investors – over 90% – invest in existing dwellings rather than new construction (see next chart), which means that they are merely turning homes for sale into homes for let, and turning would-be owner-occupiers into renters.

ScreenHunter_3940 Sep. 01 08.24

As for Sloan’s other concern that ‘abolishing’ negative gearing would lead to lower home values. So what? Australia’s housing is amongst the most expensive in the world and some price reduction would do wonders for affordability, inter-generational equity, not to mention more efficient resource allocation as less capital is pumped into a largely non-productive asset.

Sure, there would be some short-term hit to capital gains tax, but this would be offset by less money being lost to negative gearing deductions. The blow could also be lessened if real capital gains were taxed at the same rate as income, as was the case pre-1999.

Indeed, the Grattan Institute has modeled that quarantining negative gearing would save the Budget some $2 billion per year once reductions in capital gains taxes are taken into account – definitely worth pursuing in light of the added affordability and equity benefits.

Back to Sloan:

No doubt the stream of utterly predictable and ill-formed commentary about negative gearing will continue. But here’s the thing: interest payments are, and should be, a deductible expense for any income-producing asset.

To fiddle with this principle in respect of one asset — housing — would be to create a significant disturbance in the real estate market.

Sure, interest payments are, and should be, a deductible expense for any income-producing asset, but they should not be claimed against non-related wage and salary income. The overwhelming majority of developed countries do not allow such treatment, and Australia and New Zealand are outliers in this respect.

The only ill-informed commentary in this debate is from Ms Sloan.

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