Saul-ute to a real economist

Saul Eslake is on fire. Earlier this month, Mr Eslake wrote a wonderful article in Fairfax lambasting the first home owners’ grant and other demand-side measures employed in vain by Australia’s governments to make homes more affordable:

Governments have thus been providing cash handouts to first-time home buyers for almost half a century. Yet, strikingly, the home ownership rate has never been higher than the 72 per cent recorded at the time of the 1961 census, three years before the first of these schemes began. At every census since then, it has fluctuated between a low of 68 per cent (in 1976) and 72 per cent (in 1971). At the past two censuses (in 2001 and 2006), it stood at 70 per cent.

Indeed, the apparent stability of the overall home ownership rate conceals a substantial decline in home ownership rates among every age group below 50…

And it’s pretty obvious why. Cash grants and other forms of help to first-time home buyers have served simply to exacerbate the imbalance between the underlying demand for housing and the supply of it…

Cash handouts for first home buyers have simply added to upward pressure on housing prices, enriching vendors (and making those who already have housing feel richer) while doing precisely nothing to help young people into home ownership…

Policies which have, in effect, added only to the demand for housing (or, more strictly, increased the amount which people can afford to pay for housing), have conspicuously failed.

Why, then, have governments persisted with policies that have so miserably failed to meet their ostensible goals? The answer is, surely, that since about 70 per cent of Australians live in homes that they (or members of their immediate family) already own, policies that make them feel richer are much more popular than policies that might allow the small minority of Australians who don’t own their own home, but would like to, to join them.

If governments really wanted to do something about housing affordability, they would abolish cash grants to first home buyers, and ”quarantine” tax deductions for interest paid by landlords to the value of the rent received in any given financial year (with any excess carried forward against the capital gains tax liability when the property is sold); and use the resulting savings to help local governments to reduce upfront charges imposed on developers, and in various other ways increase the supply of low-cost housing.

Today, Mr Eslake followed up with another brilliant article in Fairfax attacking Australia’s dysfunctional tax system for the way in which it encourages borrowing and speculating, and penalises working and saving. Mr Eslake’s comments on negative gearing are particularly insightful:

The Australian income tax system provides substantial incentives for people to borrow money to acquire property, shares or other assets with a value they expect will appreciate over time. Unlike most other countries, it has always been possible in Australia to deduct any excess of interest payments on loans taken out to fund an investment over the income produced by that investment to reduce the tax payable on wage or salary income.

Since the Howard government’s decision in 1999 to tax capital gains at half the rate applicable to the same amount of wage and salary income, a decision that was supported by the then opposition, ”negative gearing” has become a means not only of deferring tax, but also permanently reducing it.

In 1998-99, when capital gains were last taxed at the same rate as other types of income (less an allowance for inflation), Australia had 1.3 million tax-paying landlords who in total made a taxable profit of almost $700 million. By 2007-08, the latest year for which statistics are available, the number of tax-paying landlords had risen to 1.7 million, but they collectively lost more than $8.6 billion, largely because the amount they paid out in interest rose more than fourfold (from about $5 billion to more than $20 billion over this period), while the amount they collected in rent ”only” slightly more than doubled (from $11 billion to $24 billion), as did other (non-interest) expenses.

If all the 1.2 million landlords who reported net losses in 2007-08 were in the 38 per cent income tax bracket, their ability to offset those losses against their other taxable income would have cost more than $4.8 billion in revenue forgone; if (say) a fifth of them had been in the top tax bracket, then the cost to revenue would have been more than $5 billion.

This is a pretty big subsidy from people who are working and saving to people who are borrowing and speculating (since those landlords who are making ”running losses” on their property investments expect to more than make up those losses through capital gains when they eventually sell them).

And it’s hard to think of any worthwhile public policy purpose that is served by this subsidy. It does nothing to increase the supply of housing, since the vast majority of landlords buy established properties. Precisely for that reason, it contributes to upward pressure on the prices of established dwellings, thereby diminishing housing affordability for would-be home buyers.

It’s also hard to reconcile this subsidy with the government’s stated aim of increasing participation in the workforce, especially when abolishing it could help pay for reducing some of the high effective marginal tax rates faced by those contemplating moving from taxpayer-funded benefits into paid employment.

The revenue forgone through negative gearing could alternatively be used to build nearly 20,000 new ”affordable” homes each year, making substantial inroads into the massive shortage of affordable housing.

Supporters of negative gearing argue that its abolition would lead to a ”landlords’ strike”, driving up rents and exacerbating the shortage of affordable rental housing. They point to ”what happened” when the Hawke government abolished negative gearing (only for property investment) in 1986, claiming that it led to a surge in rents, which prompted the reintroduction of negative gearing in 1988.

This assertion has attained the status of an urban myth, but it isn’t true. Rents (as measured in the consumer price index) did rise rapidly (at double-digit annual rates) in Sydney and Perth, but that was because in those two cities, rental vacancy rates were unusually low before negative gearing was abolished. In other state capitals (where vacancy rates were higher), growth in rentals was either unchanged or, in Melbourne, actually slowed.

Suppose, however, that a large number of landlords were to respond to the abolition of ”negative gearing” by selling their properties. That would push down the prices of investment properties, making them more affordable to would-be home buyers, thereby reducing the demand for rental properties in almost exactly the same proportion as the reduction in their supply.

And that, of course, is the reason why negative gearing will forever remain untouched – because the negative reaction and loss of votes from people who would experience declines in the value of their properties would outweigh the positive reaction from people who would benefit from lower property prices and would change their votes accordingly.

It’s something to remember next time you hear a politician saying he or she is committed to improving housing affordability, or increasing participation in the workforce, or both.

Over many years, Mr Eslake has shown great consistency in advocating to abolish wasteful policies like negative gearing and cash grants to home buyers, in exchange for reforms that lower tax rates across the board and remove disincentives to work (e.g. high effective marginal tax rates).

Taking such a principled stand must not always have been easy. After all, Mr Eslake’s employer for 14 years – ANZ bank –  stood to lose directly from any moves by government that restricted negative gearing and/or reduced the first home owners’ grant. Yet despite these potential conflicts, Mr Eslake possessed the fortitude and character necessary to lobby publicly for more equitable and efficient policies.

I, for one, want to thank Mr Eslake for continuing to fight the good fight.

Cheers Leith

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Unconventional Economist
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  1. Leith,

    Eslake has been indpendent but since he moved to the Grattan Institute it has flourished. At ANZ his critique was muted and more inline with bank economists on housing and affordability. It demonstrates the necessity of indenpendence to verifity any analysis – certainly from the banking sector.

    • I completely agree. The other point to mention is that the governments have a vested interest in keeping property prices high, given it is the basis from which various rates, taxes and stamp duties are derived.

  2. I think he has become much more honest on these issues since leaving ANZ – for obvious reasons.

    The last two para’s are depressing but I do not think they are correct. Sacred cows can always be got at, eventually.

    I think key is to convert the compelling logic, and the anger, around this issue into some sort of political movement. The failure of negative gearing to devliver housing supply, and the rent-seeking behaviour it encourages, provide plenty of political cover to attack it if done correctly.

    Blogging is the start.

  3. What was Saul Eslake saying about this subject 5 years ago? Nothing.

    It is easy to be a hero and go against established government policy when you are near retirement and have the financial industry equivalent of tenure.

    • Yohan, you are both unfair and inaccurate. I have been a critic of giving cash to first home buyers since 1980; and a critic of ‘negative gearing’ since at least the mid-1990s. I was often critical of negative gearing whilst employed by ANZ, as various reporters who quoted my views on the subject could readily attest. Other readers might also recall how, as Treasurer, Peter Costello rang up then ANZ CEO John McFarlane and threatened to take (in McFarlane’s words) “regulatory actions that ANZ wouldn’t like” if I repeated (fairly mild) criticisms that I had made about some of the Howard Government’s accounting practices.

      So, Yohan, by all means say I am wrong if you think I am; but don’t call me gutless.

      Can I also add that, at 53, I am nowhere near retirement (even if my rapidly greying hair gives me that impression). I have two young children; I can’t afford to retire.

      • I’m with Mr Eslake here Yohan. Google negative gearing and “Saul Eslake” and you will find many newspaper articles where Mr Eslake speaks out against this and other inequitable and inefficient policies. Also check out his articles in Online Opinion.

        It was these articles that got me thinking about the whole negative gearing issue and led to me then speaking out against it.

  4. Seems the main stream media are publishing more information regarding the bubble, but I will be very surprised if this does much.
    Unfortunately Australians will not stop buying property, I fear this country is full of greater fools that have never heard of the concept of ROI or net rental returns. So the party will stop when the banks stop lending, like the US. 
    It would be good to make changes to negative gearing but landlords are big losers but so too are the banks, and I feel this is a very politically charged issue. Who wants to bail out a bank? A perfect (bubble) storm? 
    Upon reflection I am starting to think that high prices are here to stay in Australia. To ask for reform that is contrary with tax laws, the four pillars, landlord voter wishes and current building regulations, certainly is a Goliath fight.
    So we might need to come to the realization that the worst case scenario (house prices continue to increase with wages growth), may be plausible over the medium to long term assuming everything remains equal.
    Key triggers for a bubble burst will be interest rate rises or banks have less availability to cheap debt…….. but don’t count on it, as the govt has all sorts of ways to distort markets. This might be around for a while…..

    • I would love to hear Mr Eslake’s views on the sustainability or otherwise of the Chinese fixed asset investment boom.

  5. Only two things can end the madness: 1. political action based on a morally just cause (rather than the sum total of self interests) or 2. An economic shock so large no government can stop it.

  6. The residential property market is already unravelling and is going to continue to IMO. Abolishing negative-gearing (NG) and/or capital gains tax (CGT) just isn’t necessary. That would only give a huge scapegoat to the speculators, bankers/lenders and government who have propped up this enormous bubble.

    Neither NG, not CGT are the culprits in this boom. They were merely catalysts. If we want to fix things, let’s work out what the root cause is. In my unschooled opinion the root cause is more likely the lending practises of the bank. Going further back, it’s the monetary system. Perhaps there’s a way to go further back – such as our social organisation that has led to our current monetary system.

    CGT should be 0%. Presuming the legitimacy of income tax, NG seems above board. Why wouldn’t you be able to offset income in some areas with losses in others? I think some details of deprecation on new dwellings fittings etc seems ridiculous. i.e. claiming a depreciation loss when your asset is increasing in value (during the boom).

    How would it be fair now, to change the goal-posts change the CGT just as many baby-boomers are about to sell their property portfolios and retire?

    People will probably shun debt after this thing goes big-stage. However, I think it would be a good idea reducing the term of loans from 25-30 years to whatever can be paid back in 6 years.

    • You forgot the third cause of the bubble, unresponsive housing supply. Housing bubbles need two things to inflate, weak lending standards and unresponsive supply giving the impression of a shortage and endless capital gains.

      I agree with you, changing the rules now would just create a massive scapegoat for vested interests making it even harder to get through the much needed reforms in the future.

      The 6 year time frame is excessive. A home of $140,000 (roughly twice median income) would cost about $2200 a month to pay off. Go up to 3x income at it’s over $3.5k a month. It would definetly lower home prices though.

      Simply requiring no less than a 20% deposit and limiting negative gearing to newly built properties only, would have the desired effect in my opinion. People have trouble saving, that’s why they borrow and people who can save for a home will be much more likely to be able to pay it off.

  7. I emailed the SMH article to a colleague at work yesterday who’s a believer in NG and up to his eyeballs in debt with 5 (possibly 6) properties.
    Any discussion turns into a mind numbing head bash against the wall.
    I couldn’t resist posting his response here showing the attitude of at least one….

    “I think Saul should be objective and explain why the government encourages people to borrow money and invest as landlords, if he did that, then his story would change.

    Secondly, once I have built up enough equity and spare cash flow then I will myself develop my properties and add to the amount of available housing,
    which is different to what Saul says I will do – May be he knows me better!

    I think if we sat around and waited for everybody to save up enough money to buy their own home, then the pace of development and provision of housing
    would occur at a much slower rate, some people just don’t want to take risk, however progress must occur to maintain living standards.

    On the matter of the taxation subsidy via negative gearing, the key word to understand is “Negative” which means the equity I have invested is not earning an
    income as the cash out flows exceed the cash inflows, so the economy is using my equity to provide housing until rents grow enough to become positively geared
    which takes 7 to 10 years to occur.

    Of the 1.7million landlords out there at the moment, most will have started out as negative geared investors and have the view of holding for the long term, they need to
    do this to get the gain in capital growth and rents to justify the investment of equity.

    The other thing to remember is that Australia has one of the highest levels of population home ownership in the world even though we have 1.7million greedy tax avoiding
    landlords that invest their equity for no return for a 7 to 10 year period.

    May be there is more to this negative gearing strategy and capital allocation process than Saul has explained.”

    • Are there any jobs going at your place of work, @mrobbo? Based on that chap’s response, it sounds like you share an office with a modern day Gandhi!

      In case I never have the pleasure of meeting him, please pass on my sincerest thanks for the sacrifices that he and his fellow 1.7 million landlords are making for the benefit of the rest of us simple folk.

      I can’t imagine going 7 to 10 years without a return on my equity… I guess that makes me selfish.

  8. Changes could be phased in over 10 years.

    The re-adjustment period, then the expectation that it would be revoked, (and post 87 crash liquidity) drove 100% price fluctuations over 1984-1988 in parts of Sydney.

    As well as capital gains treatment (Commonwealth) there is Land Tax (State) to be considered…presently NSW is killing the golden goose by stealth. The UCV (tax valuations) have risen tremendously and are now a real factor…2% a year for dedicated landlords.

    To encourage new construction (and maintain rental subsidies) Depreciation is an often over-looked but important factor…it drives some new construction. Then there are all the other programmes and subsidies (Commonwealth and State) not to mention the different state and council planning and compliance requirements, local community’s complicated.

    As Australia “is the most urbanised country on earth” (true?) how about some new major cities…start over.

    One flaw in SE’s suggestion that the estimated cost to revenue/taxpayer subsidy of $5bln (or whatever amount) would be available for other purposes is that this activity is tax-driven, per his own figures, and by changing the tax treatment you then change the tax-driven activity…that money is then largely gone.

    • “As Australia “is the most urbanised country on earth” (true?) how about some new major cities…start over.”

      Well that means picking a small city, and the options are industry driven such as Port Hedland and Mt Isa, which are not really desirable locations outside of mining and you risk them becoming ghost cities, ala Detroit, in the demise of its industry, or location driven with access to potential large scale sources of water harvesting such as Coffs harbour.

      The Bogan Boomers who have moved there for a sea change are the biggest NUMBY’s inthe country, and will require too much politcal effort considering the boomers sense of entitlement.

      “and by changing the tax treatment you then change the tax-driven activity”

      No, you change the activity capital seeks. Capital will always seek a destination, and whereever it goes, government can tax that. The distress here is the social impacts, not economic, that housing affordibility incurs.

      To be honest, I am not deterred if there is a complete and utter collapse of the Australian economy. I’m still young enough to feel if we all go to zero, I can then work up from there. Under the current system, it is not working for me at all.

  9. I keep my eye on a subset of the Sydney market, Lower North shore, 3 bed houses, town-houses, etc (where I was considering to buy), and e-mail vendors to get guide prices. In the last couple of weeks, I have been subsequently emailed back with price reductions (of about 10%) on the original quote for 3 properties. In addition I have received a number of vendor keen to sell type mails. I’ve been to 3 auctions, one with no registered bidders, and 2 passed in at vendors bid, with no one bidding. So for me house prices are definitely coming down.

    The question I have is will negative gearing exacerbate a housing market crash? In a rising market, people pile in receiving low rent knowing that capital returns are good. But in a falling market surely the opposite occurs, and people will try and get out, as rental returns are not worth keeping a property for? If rental returns are good, surely this cushions the blow of a falling market.

  10. I would like to ask Saul to elaborate his position on the apparent housing shortage. From a quick browse online it is easy to see why Leith has a great deal of respect for Saul’s opinions – there are few other economists I have seen speak so much sense.

    But there is still a couple of key issues relating to housing supply and price on which I strongly disagree with both Leith and Saul.

    More specifically I disagree that a shortage exists or is looming – particularly because any analysis of population and number of dwellings usually overlooks changes in the composition of housing.

    For example, the size of existing homes change over time with renovations and extensions. It has been widely acknowledged that many home owners have chosen to renovate instead of relocate in their search for more spacious accommodation. It is easy enough to imagine a street of heritage homes, for example, being renovated and extended to allow a large increase in the population of the street. No new homes, plenty of new people, and no housing shortage

    Another example. The parents of a family whose adult children have moved out with friends or partners might find that the upkeep of a large house conflicts with their ‘grey nomad’ retirement plans. They can sell their 5-bedroom house and move into a new 2-bedroom unit, pocketing the price difference for their retirement.

    In this scenario the construction of a 2-bedroom apartment resulted in a 5-bedroom home being available to meet the housing needs of population growth

    More explanation of this point here

    The second point on which we disagree is the price and quantity impacts of the usual recommendations to increase supply. For example, the two ideas below are from one of Saul’s presentations on housing

    “1. Seek to lower ‘up-front’ charges on developers – for example by removing caps on local government rates (in NSW) or allowing localgovernments more latitude in borrowing for infrastructure provision

    2. More flexible zoning and planning schemes and regulations – will require a considerable amount of communication with local residents and (possibly) afair amount of ‘political will’”

    But surely any changes to zoning and reductions in up-front infrastructure charges are simply a gift to the land owner and provide no incentive for them to develop housing. In fact I argue that the rate of housing development is limited by the rate of sales and has nothing to do with the price at all.

    Also I argue that there is a huge risk when changing zoning that landholders will game the system – preferring to hold the land and take the capital gain from increased zoning, rather than cut and run and sell to a developer or even develop the land themselves.
    More on that here –

    To summarise, I would argue that strict planning rules do not have a significant price impact but have huge social benefits (ask the locals). Indeed I don’t know of anywhere where I would say planning rules are restrictive. Here is a sample of the land supply –

    Springfield, to the west of Brisbane is only 13% developed. It has an area of 2,860Ha, and a target population of 86,000 people, with house and land packages available now. Coomera, north of the Gold Coast, has been rezoned for a new satellite city, and has very good highway access to both Brisbane and the Coast. Land is zoned for housing for an estimated 60,000 people. Sippy Downs, west of the Sunshine Coast has a new plan promoting development around the University of the Sunshine Coast. North Lakes has 5700 blocks for sale, not to mention infill projects such as Portside in Hamilton, and the ongoing transformation of Teneriffe, South Bank, and South Brisbane into dense residential areas.

    Also, I would argue that a housing shortage cannot be estimated by any analysis of population and dwelling number without critical consideration of the change in the size of dwellings and household composition. The only indicator of a shortage are rents which are relatively steady.

    • Again Cam, we’ll have to agree to disagree. When 450 square metre blocks of land are selling on our cities’ fringes for $200k plus, then it is clear that land supply is an issue. And restrictive urban planning policies are the culprit.

      Why is it that places with market-based land-use policies (e.g. Texas and Georgia) never suffered from the same land price afflictions as markets with Australian-style planning/zoning regulations (e.g. California, Nevada, Arizona, Florida, Ireland, Spain, the UK, etc)?

      When studying housing affordability, you cannot only look at the demand side. The supply-side is just as important.

    • Hi Cam
      Good to see you posting. I’m new to this blog (which led me to your blog) and I must admit, although I’ve only read a few of your blog-articles, I do tend to agree with your views on things. That’s not to say I disagree with other views expressed here, rather I think some of your comments tend to reflect what is actually happening “on site” rather than in theory (if that makes any sense).
      Hope you keep contributing. And I hope UC keeps up his excellent work – I’m really enjoying this blog-site and very glad I stumbled across it.

    • “It is easy enough to imagine a street of heritage homes, for example, being renovated and extended to allow a large increase in the population of the street. No new homes, plenty of new people, and no housing shortage”

      Wonderful sophistry there Cameron. The problem is that rich old couples like to have the whole house to themselves. Unless we all live like desperate share-house Uni students then I cannot see your plan working.
      Perhaps you just need to accept that a growing population requires more housing and less low yield farmland. Sad but true.

      • Travel 25kms north and west of Melbourne and you’ll see that it’s full of baron paddocks unsuitable for farming but ideal for housing. Yet, for some reason, the government has ruled much of this land off limits to development. Crazy stuff.

      • And when does the “more housing” and “less farmland” end?

        When theres no farmland and just millions of acres of McMansions on 400sqm blocks?

        Whats required is a freeing up of zoning, so we can build six storey high apartment blocks with retail stores on the ground floor, anywhere within a city.

        Demolish the older, less environmentally efficient homes and up the density. Inner city people practically live on top of one another anyway with the new homes being constructed only 2-3 meters from each other…

        Leave the farmland as is – even if our population stabilises (which I think it will because of economic reasons, not political) we need as much fertile land as possible.

      • I don’t know where you live DavidV, but in Brisbane this is all the rage. Old houses on stumps are raised and built in downstairs. Sometimes connected, and sometimes with a self-contained apartment.

        For example, the last street I lived on had 17 houses. It now has 18 houses (one block subdivided) but probably has double the population due to this type of renovation and extension, old couples leaving, large families moving in, and some also separately renting their downstairs apartment.

        This happens – I don’t know the exact extent, but is rarely considered.

        Of course a growing population needs more housing, but I am trying to point out the fallacy of counting people and home numbers “without critical consideration of the change in the size of dwellings and household composition.”

        Further, these underlying numbers have no direct impact on prices – it is actual supply (homes on market) and actual demand (buyers with the cash and desire to buy those homes) that determine prices.

  11. Seeing you’re reading this Saul; (and the original publisher of your article is not enabling comments)… let me say thanks.

    Thanks for putting the problem with negative gearing so succinctly… ergo: “it discourages working and saving.”

    Thanks for similarly describing why the problem won’t be solved by politicians.

    Your words point out how desperately the whole system of taxation requires a complete overhaul… and how hopelessly conflicted the political system has become in serving the interests of ALL its constituents.

    I’m finding it harder and harder to distinguish ‘Government from corporate’. They both constantly play to people’s greed. The play seems to work time and time again. How could they not become cynical?

    It’s no wonder community is losing out to an “every man for himself” culture; where (perhaps, ironically) individuals are becoming increasingly marginalised and isolated.

  12. The other advantage of not having negative gearing and/or a first home buyer schemes with lower overall taxation rates is the taxation system would be simpler and less costlier to administer.

    • Imagine if it was just 20% for individuals, 20% for small business, 30% for big business and 15% GST.

      No handouts, not tax offsets, no fringe benefits, no negative gearing, no levies, no loopholes.

  13. And my hopes were so high, when in this mornings Government news, in Wellington…. “Productivity Commission,
    – Terms of Reference: New Zealand Productivity Commission Inquiry into Housing Affordability….”…. Thanks a lot, Saul 🙂

  14. Pardon my ignorance, but I am wondering if there are other avenues beside government for tax policy review and changed, ie. High Court? Anyone?

    And it would be nice to be able to view contents of politicians property portfolios as well..

  15. Thank you Saul. I enjoyed your article.

    Now for a future piece can you destroy the notion of owing MULTIPLE properties.

    The comments in relation to the buyers strike really outed the greed factor among property bulls with the clear intention to add to their portfolio coming through loud and clear.

    But why do we allow multiple property holdings if the shortage/affordability situation is in “crisis”?

    Would not the responsibly policy response be to re-allocate housing stock to those who need it through policies that progressively tax multiple holdings?

    Of course there is also the issue of being overly exposed to one kind of asset class.

    If there is any hope of decrying the failures of negative gearing and the tax system then it is to appeal to the most highly regarded of all Aussie values – The Fair Go.

    Regards, HousingTroll