Negative Gearing Revisited

My cousin, Peter van Onselen, writes for the Australian. In my opinion, he is one of the more insightful and balanced commentators on their roster (of course I am biased). Today he published an article explaining the political sensitivities and difficulties of reforming Australia’s housing policy, in particular our overly generous taxation concessions (such as negative gearing) as well as freeing-up the supply-side of the housing market in order to speed-up land release.

Whilst I agree with the crux of the article, I strongly disagree with the following part:

…Or what if the government moved to restrict the number of investment properties people could negative gear their incomes against? That might be a way to take some of the upward pressure on prices out of the equation, but it would leave existing investors upset, and there is an argument that it could constrict what is already a tight rental market.

Fewer people investing in property means fewer rental properties available. When supply is already a problem, people in lower socio-economic circumstances don’t need that. [my emphasis]

Negative gearing is an issue dear to this blogger’s heart. In fact, my June article, Negative Gearing Exposed, is possibly my best piece of work and has also been my most popular article to date. Hell, it’s even been cited in Wikipedia!

Given the “negative gearing assists the rental market” claim seems to be getting air-play once more, it’s time for a refresher on why negative gearing is a costly policy mistake that does little to improve the availability or affordability of rental accommodation.

 
One expensive policy:

Negative Gearing Exposed provides the background and history of negative gearing in Australia. In a nutshell, negative gearing was abolished by the Hawke/Keating Government in July 1985 as part of a broader tax reform package. But after intense lobbying by the property industry, which claimed that the changes to negative gearing had caused investment in rental accommodation to dry up and rents to rise, Treasurer Keating restored the old rules in September 1987, thereby once again permitting the deduction of interest and other rental property costs from other income sources.

The reintroduction of negative gearing in 1987, in concert with the halving of the Capital Gains Tax (CGT) rate in 1999, led to a surge of property investment in Australia. The below three charts come from Morgan Stanley. The first chart shows the number of taxpayers claiming rental income to the Australian Taxation Office (ATO) skyrocketed from 608,000 taxpayers in 1988/89 to 1,765,000 taxpayers in 2007/08 – 13% of the total.

  

With house prices booming and rents remaining flat, the proportion of taxpayers where rental income does not cover costs increased from around 50% in 1993/94 to 70% in 2007/08:

And the cost to the Australian taxpayer is immense, with the aggregate level of net rental losses ballooning from +$219m in 1999/00 to -$8,600m, meaning that average Australians are massively subsidising property investors:

This increase in property investment in Australia was also assisted by a significant increase in credit provision to property investors. From the mid-1990s, investors were permitted to purchase an investment property via accessing equity in their own home, without having to contribute any cash up front. Lending criteria on investment loans were also relaxed and became much the same as loans to owner occupiers, as did the interest rate charged. Lenders also began competing aggressively for investment loans and offered products specifically designed to attract investors, such as the split-purpose and interest only loan.

This increase in credit provision for property investment is evidenced by borrowings for investment properties growing at a faster rate (17% per year) than borrowings for owner occupied properties (12% per year) since 1990. Accordingly, investment loans share of total housing lending has grown from around 14% in 1990 to around 30% currently (see RBA Statistical Table D2 for data).

Impact on rental market:

Despite the massive surge of property investors and the huge subsidies provided by Australian taxpayers, negative gearing has done little to:

  1. increase the availability of rental accommodation; or
  2. reduce its cost.
On the first point, the below chart plots the percentage of investor mortgages going to existing dwellings versus new construction.
As you can see, the share of investment in new construction has fallen for the past 25 years, from around 60% in the mid-1980s to around 7% currently. So despite the favourable tax treatment provided to property investors in Australia, for every 14 investment homes purchased in September 2010, only one was a new dwelling that actually added to housing supply and rental availability.

The data on new home construction by investors is even more damning. As shown below, there was a surge in investor loans for second-hand properties from around 2000 onwards, coincident with the reduction in CGT. By contrast, loans for new construction have remained relatively flat for the past 25 years. As a comparison, the ratio of investor lending for existing dwellings to new dwellings was around 2:3 in 1985; 7:1 in 2000; and 13:1 currently.

 

 
 
 
 
 
 
 
 
 
 
 
 

The key point to take away is that negative gearing has not improved the availability of rental accommodation. Why? Because investors that buy existing homes do not increase rental availability since they do not add to overall housing supply and merely turn homes for sale into homes to let. They also do not address the shortage of rental accommodation, because the reduction in the supply of homes for sale throws potential owner-occupants onto the rental market.

On the second point – the impact on rents – consider the below chart showing real (inflation-adjusted) rents for the Australian mainland capital cities. The first vertical dotted black line shows the beginning of the ban on negative gearing (July 1985), whereas the second vertical dotted black line shows its reintroduction in September 1987.

 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

Now if it is true that the abolition of negative gearing by the Hawke/Keating Government in July 1985 caused investment in rental accommodation to dry up and rents to rise, you would expect rents to have risen significantly in each capital city, since negative gearing affects all rental markets equally.
But this is clearly not the case. Rather, between July 1985 and September 1987, rents rose in both Sydney and Perth, were flat in Melbourne and Adelaide, and fell in Brisbane. Based on this analysis, the claim that negative gearing reduces rents is false.

My conclusion is supported by Saul Eslake, former Chief Economist at the ANZ, using different rental data. According to Mr Eslake:

It’s true, according to Real Estate Institute data, that rents went up in Sydney and Perth. But the same data doesn’t show any discernable increase in the other State capitals. I would say that, if negative gearing had been responsible for a surge in rents, then you should have observed it everywhere, not just two capitals.

Based on the above evidence, there is clearly little merit in Australia’s tax concessions for property investment. Negative gearing and the CGT concession do not provided any incentive to invest in new housing because they are available for both existing homes as well as new ones. And since these concessions do not increase housing supply, they also do not put downward pressure on rents.

Rather, the increase of investment in existing dwellings has merely added to housing demand, reduced housing affordability, and displaced potential owner-occupiers, forcing them onto the rental market. While the cost to taxpayers is immense, the costs to younger Australians, in particular, from reduced housing affordability and increased debt levels is even greater.

I only wish our mainstream commentators would acknowledge these facts instead of perpetuating the myth that negative gearing is good for the rental market. Nothing could be further from the truth.

Cheers Leith

Readers seeking a more detailed examination of negative gearing are advised to read Negative Gearing Exposed.

Unconventional Economist

Leith van Onselen is Chief Economist at the MB Fund and MB Super. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.

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Comments

  1. Leith, excellent work. Thanks for sharing your insights. The facts are there for everyone to see, yet the country is being run for the benefit of baby boomers with little regard to innocent young Australians. David Murray made mention of this in todays Financial Review.

  2. I agree, top work. Negative gearing is a dinosaur. Extinction is the only way – sick of hearing ageing boomers bemoaning the current situation – the very generation that triumphed from tax incentives, negative gearing, one family earner (happily and financially comfortably) living, free uni – you name it…never enough it seems

  3. Another great post, Leith. Cheers.

    I must admit, I hate Negative Gearing as much as you do.

    But, whilst I would love nothing more than to see the Government scrap it, I have come to realise that NG is too much of a hot potato for anyone to touch.

    Notwithstanding the billions of dollars in lost tax revenues each year (which, as your graph shows, will continue to balloon), the extent to which NG is propping up the housing market plus its popularity amongst the capital-rich Baby Boomers to whom Governments tend to pander is too great a political risk to take.

    However, in light of growing chatter about housing (un)affordability and the perception (right or wrong) that we aren't building enough houses, surely some day a leader with half a spine will push to restrict Negative Gearing to investors who build NEW stock?!

    I know, it's not an ideal solution. But at least there would finally be some incentive for the market to address the (perceived) supply issues AND it is a story that a Government might be able to sell.

    A public subsidy for a public gain…

  4. Yes very insightful analysis, but are we likely to see an Australian political party change negative gearing under any scenario other than a complete residential market and wider economy meltdown ?

    In July 2003 the newly appointed Shadow Treasurer Mark Latham misspoke on the ABC by hinting Labor would reconsider the merits of NG only to be immediately contradicted by the then Opposition leader Simon Crean.

  5. And another thing – at a certain income point those people lucky enough to be able to afford an investment property can reduce their taxable income to a point where they are eligible for improved family assistance benefits, reduced medicare levies and, when they they are running at full steam, scams such as subsidised solar electricity installation costs. Those without investment properties pay for it everywhere.

  6. PS: Excuse the rubbery hypothetical situation, but (all other things being equal) shouldn't an increase in the rate of owner-occupiers and a decrease in investors actually put downward pressure on rents anyway…?

    Say 70% of houses are owner-occupied ("OO"); 30% are owned by investors ("I"); and let's assume that the "market-neutral" rental vacancy rate is 5%. To make the numbers easier, also assume that we have a total of 200 houses and ignore any increases in population / housing stock / etc…

    By removing the NG subsidy for investors, we should see prices fall, making it easier for a few renters to become owner-occupiers.

    Say the OO/I ratio eventually shifts from 70/30 to 80/20… We've got 20 more houses owned by their occupiers; 20 fewer renters; and 20 fewer houses owned by investors… What happens to the rental vacancy rate?

    At 5% of 60 (ie. 30% of the 200 houses) investor-owned properties, we had 3 rentals vacant.

    But if the pool of rental stock falls to 40 (ie. 60 less 20), those 3 empty rentals represent a vacancy rate of 7.5%.

    I understand that would be short-term factors at play and that these assumptions are very rough, but am I on the right track here?

  7. You really nail the point here and, unlike the US, there is actually a small two year window to see what would actually happen if you scrap this cherished piece of middle class entitlement.

    But, I agree with Sam…it will be very hard to get voters/homeowners to even think of scrapping it given the much wider gap between funding costs and rental income over just the last few years.

  8. You are a smart guy Leith.
    We certainly do need to free-up the supply side of housing as well as fix those pesky tax and credit factors.

  9. Leith van Onselen

    All. Thanks for your comments. I agree that we are unlikely to see any changes to negative gearing until after the market has crashed, many people have been burned, and a postmortem is conducted.

    Sam. I will think about your hypothetical and get back to you.

    Claw. I agree that the supply-side needs fixing too. I'm currently undertaking some analysis and will write about this issue again soon. Texas is my favourite case study. By having flexible planning rules and controls on speculation and finance, they have managed to achieve the holy grail: affordable housing, a strong economy and high living standards. If only Australia would learn from them. I'm not holding my breath though.

  10. Hi Leith,

    I think you are on the wrong track here, NG is not the main driver. Please bear with me.

    Rental property investment dried up when Keating quarantined rental losses, I was there. Vacancy rates in Sydney's east plummeted to near 1%, (2% is about market neutral). It was ill-timed, following just after introduction of the Capital Gains Tax and financial de-regulation. When it was subsequently lifted the rush to re-invest added fuel to the fire of lending standards going out the window (with new rules and entrants to Australian lending),prices shot to the moon (I bought for $400k on Oct 30, 1987). The response to the stock-market crash that started that day (urgent liquidity injection) was the final straw…within twelve months I had an offer of $1.2m after cosmetic renovation.

    This led to 20%+ interest rates to rein in the madness and the "recession we had to have"…btw, going into it Keating said on ABC radio there would not be a recession. Who knew? They lie. Price drops of 30-40% were common. After the over-leveraged were sold up supply dried up and sales volume plummeted.

    Lending standards tightened massively in the early 90s, for a while banks would not rollover loans and would not lend on property except to transfer their own risk to stronger customers who they repeatedly blew-up. Westpac nearly failed. Even now they will cave in when threatened with exposure of what they did then.

    In the aftermath securitised lending took off (We'll Save Ya!) and the seeds of the next boom were sown. Interest rates dropped rapidly but then surged again in 1994 as prices started to take off, that spooked many buyers. Sydney gained the Olympics. This dominated investor sentiment, as it was common knowledge that a recession automatically followed an Olympics for the host. Interest rates and lending standards slowly dropped. Still, price rises were happening but not accurately recorded by ABS, (happy to substantiate). Late in the decade (90s) the SMH ran with the common assessment "if this is a recovery why isn't my house worth more"…Howard panicked and halved Capital Gains Tax.

    Lo and behold, after the Olympics there was not a recession. As this became apparent, and interest rates were low and competition amongst bank and non-bank lenders was fierce (ie, lending standards dropped), prices took off with pent up demand…15%-20% rises per year for 3 years. MacFarlane jawboned prices down effectively and became world famous for doing so….they remained fairly constant (in real terms) until taking off again in 2009 with a resumption in agressive lending.

    In all this I believe two things rank higher as price drivers: bank lending standards, then the halving of the CGT. The 100% CGT rate only lasted 14 years.

    I think negative gearing is a social compromise, it subsidises rents. Naturally, such investment is biased towards potential capital gains and that explains why there is an overwhelming investment in existing dwellings. Being built earlier, they have the best locations.

    I think people who see the tax deductions as lost revenue have not considered that high-earners would make other arrangements to minimise tax if NG were not available…and rents would increase.

    If you want lower prices focus on the CGT, this would also dampen the enthusiasm for speculation, and leave the rental market to relatively conservative long term investors happy with a 4-5% return. It would also leave the social compromise in place, not a bad thing.

  11. In response to Sam Birmingham's hypothetical:

    I think the distinction between "investors" and "renters" is a red herring. The question is, is the house going to be occupied or not?

    If you have some investors selling up their rented investment properties to owner occupiers (who were previously renters) all that happens is that housing ownership is more evenly distributed (fewer people owning multiple houses) and the same number of houses are still occupied. The corollary is that you have the same number of vacant houses.

    If the number of rental properties decreases (through transfer to owner occupiers) then the *percentage* of vacant houses increases, although the *number* of vacant houses remains constant. The thing that you are taking the number of vacant houses as a percentage of is a bit artificial – total rental housing stock that is rented or available to be rented. Much rental housing does not get "turned over" in any given year and is thus invisible to many of the statistical measures – it will probably only show up if it is managed by a real estate agent.

    Commenting further on the vacancy question, I suspect there is a lot of housing owned by "investors" which is not occupied or even made available for rental as the owners are counting on capital gains, and couldn't be bothered renting it out for a little extra $ and a lot of extra bother, particularly if the house is of poor quality. So I think the true vacancy rate is far higher than what the real estate agents like to claim, since they don't see the private rental market or the many empty dwellings that never get placed on their books.

    I'm looking for a new place to rent (current flat is a bit expensive) and I'm wondering whether there might be a two speed rental market. North Carlton is full of "for lease" boards and the online ads are asking $210 plus per week per room in rental, yet a look online on Gumtree reveals many rooms going for far less.

    What is going on here? Could it be that the "investors" who own these places with "for lease" boards are so close to the line that they need all the $ they can get, and are chasing short term gain at the expense of long term tenancies? And are the real estate agents happy to oblige by providing more services (advertising etc) for extra income, knowing that the number of rental households is largely fixed in the short term?

    Personally, I'm beginning to think that professionally advertised rental properties should be steered well clear of, since the $ to pay for the advertising has to come from somewhere, and while some will come from the landlord I think some will also have to come from the tenant.

    Any ideas, anyone?

  12. Hi Leith – excellent article.

    I can understand your reasoning as to why NG and CGT relief have failed to do much about addressing the rental situation, but it doesn't explain the disastrous fall in the % of investment loans going in to new construction. Your chart shows it falling from 60%+ in the 80's to under 10% now. Why is this? What am I missing?

  13. Wonderful article.

    I have one question which has always bothered me on this topic: why don't more new houses get built? With the relatively low interest rates and high house prices, it would seem profitable for home builders to build and sell as much as they could. Why is the investment mostly in second-hand dwellings?

    Thanks.

  14. To The Weatherman and Anonymous Dec4th 1:32am:

    because existing suburbs, and thus existing houses, are safer bets for capital gain – they are more likely to have better established infrastructure, lower transport times, public cachet, proximity to cultural/recreational sites and less variability in demographics and price.

  15. To Luke:

    If that's true, it would support the claim that there really is a housing shorting because there is not enough land in the existing suburbs which "are more likely to have better established infrastructure, lower transport times, public cachet, proximity to cultural/recreational sites".

    I generally believe the bubble view is the right one, but there is an important disconnect here which I haven't seen either camp (the bubble or anit-bubble people) address.

    If it really is a bubble and people are buying houses willy-nilly, then why isn't there more investment in new construction? If people just really want housing in the suburbs and they pay a lot to get that, I don't know if it's really a bubble or if it really is land scarcity as the real estate lobby claims.

  16. Anonymous, don't confuse holding and speculation for land scarcity. There is the same amount of land at all times, what changes is the availability of the land.

    The issue is that property investors, by owning more than a PPOR, remove a property from the homeowners market. In a free market this would not be a issue as the costs of owning that property would soon outstrip the income derived and keep the accumulation of investment properties in check. Property investment would be no more attractive than financial forms of "low" risk, low return investment.

    However, NG has both enabled the purchase costs to far outstrip rental income, and facilitated the growth of property investors to over 1 million taxpayers. This has resulted in less properties being available for purchase, whilst also driving prices higher than the 'real' house price.

    To answer your question, IMHO there isn't more investment in new construction firstly because most property investors are not sophisticated investors. They are not interested in assessing the long term growth profiles of outer lying areas, anticipating future infrastructure developments and of course, dealing with building times, costs and overheads. Why wait ~6 months when you can buy established and have a tenant within 1 month?

    Secondly, people don't want to pay a lot to live in the suburbs, they just (think) they have to in order to get onto the property ladder. Nationwide NG results in distortion of prices in all areas. What has been happening is that every time FHB find it difficult to enter the market due to the real constraints of real income, the government and banking industry fill the gap with either lower loan requirements, grants and subsidies or direct programs. However eventually the market will become unsustainable on its own as all they are doing is sacrificing further and further future real demand for current stability.

    Lastly, the margins can be much lower on cheaper, outer lying blocks. Since capital gain is the only goal of NG investments, what would be preferable? 5% capital gain on a $400k suburb block or $800k inner city block?