Busting negative gearing’s myths


Please find below another interesting article from Philip Soos debunking some of the common misconceptions around negative gearing of Ausralian property. Philip is a Masters research student at the School of Humanities and Social Sciences, Deakin University.

In Australia, few housing market policies are more contentious than negative gearing (NG). At the forefront of defending NG is the influential housing lobby, representing a multitude of vested interests, always alert to any threat that could potentially diminish its economic and political power. Despite the lack of evidence to support NG, it remains in place via a number of well-entrenched myths the housing lobby has manufactured. To this end, counter-arguments to these myths are presented in the analysis below.

Myth #1: Quarantining of NG during the 1980s caused a surge in rents.


The favourite scare story fabricated by the housing lobby is when the Hawke/Keating government quarantined NG during 1985-87, it caused rental prices to surge, quickly leading to its reinstatement. Fortunately, not only did the evidence contradict this urban myth, it showed NG can be safely quarantined, if not abolished. The federal government realized by 1985, negatively-geared property was becoming a favoured tax shelter in Australia, costing approximately $175 million in that year.

The government decided to quarantine NG by prohibiting any excess of expenses and interest repayments over rental income to be deducted against other assessable forms of taxable income, but only on properties purchased after 17th July 1985. Any losses made could be offset against positive returns from other rental properties purchased after this date. This form of quarantine was fairly permissive, for the government could have prohibited any loss arising from an investment property from being deducted against any type of income tax liability.

Out of Australia’s eight capital cities, real (inflation-adjusted) rents increased strongly in only two, Sydney (6.2%) and Perth (10.7%), while rents in both Canberra (0.7%) and Melbourne (1.1%) edged up above the rate of inflation during this period. Rents decreased in four capital cities, with Brisbane (-7.6%) and Darwin (-8.1%) falling substantially while Adelaide (-2.0%) and Hobart (-1.5%) posted smaller reductions.

Overall, rents across Australia increased by 2.7 per cent. If the removal of NG did cause rents to rise, it would be expected to adversely affect all capital cities, not just two. This is a critical point, and evidence of a drastic and universal surge in rents is absent. Moreover, it is likely the steep increases in Sydney and Perth rents would be independent of the quarantining given the lag in the market adjusting to the change. These two cities already had very low vacancy rates when the quarantining was implemented.


Other factors may have had greater impact on the housing market during the period of quarantine. The cash rate in July 1985 rose from 15.48 per cent to a peak of 19.39 per cent in December 1985, a relative increase of 25 per cent, before falling to 12.43 per cent in July 1987. The rapid increase in the interest rate in the latter half of 1985 appears to have curtailed investment into the residential rental market, as the value of new investment commitments fell from $193 million in July 1985 to $130 million in December 1985.

In September 1985, the capital gains tax system was implemented by the Hawke/Keating government, though it was only applicable to assets purchased on or after the date of implementation. Also, a stock market boom was then underway, with shares a more attractive investment opportunity than residential property. To date, no analysis has been provided by the housing lobby to disentangle confounding factors to prove the quarantining of NG was the primary or sole cause of the rather small national increase in rents.

Another episode from this era also tests whether rents surged in response to the quarantining of NG. For a brief period in 1983, the Victorian Deputy Commissioner of Taxation prohibited the deduction of interest costs over rental incomes. Any losses could not be carried forward to be offset again future gains. This was a more restrictive quarantining of NG than had occurred in 1985-87. As the other state Deputy Commissioners did not take this stance, eventually the Federal Commissioner of Taxation ordered the Victorian Deputy Commissioner to revoke the quarantine in the same year.


The reason for this policy shift is because this specific quarantine was not lawful and instead was based upon the Deputy Commissioner’s relative interpretation of the law. Over the four quarters of 1983, Melbourne rents increased by 0.95 per cent in real terms, essentially noise and certainly not a surge. It is easy to understand why the housing lobby never mentions this more restrictive period of quarantine, since no market-shaking increase in rents occurred.

Myth #2: NG results in an increase in the rental stock and lowers rents.

The housing lobby’s primary justification for NG is it provides an incentive for investors to buy rental properties, presumably lowering rental prices according to the traditional supply and demand model. Despite the imagery of a policy that simultaneously benefits investors and tenants, this argument in favour of NG is flawed. NG will only increase the supply of rental properties relative to the total residential dwelling stock if investors, spurred into entering the market via this incentive, purchase newly-constructed dwellings that are additions to the current stock, not from the existing stock. If the latter occurs, it is simply a substitution of renters for owner-occupiers, with the implication that the previous displaced owner-occupiers will purchase elsewhere.

In 1985, the proportion of the value of investment loans used to finance the purchase of existing properties reached a low of 32 per cent, as opposed to 68 per cent for newly-constructed dwellings, which, on the surface, would appear to partially validate NG. Two years later in 1987, the ratios inverted. The proportion of loans used to purchase existing dwellings quickly increased during 1990-1992, and has slowly increased over the last two decades to peak at a staggering 96 per cent in 2010 before falling slightly to 92 per cent in 2012.


In the long-term, it makes little sense for the supply of rental properties to increase compared to the total residential stock unless there is a profound upward swing in housing prices, with investors spurred into the market on expectations of making a substantial profit through realising capital gains upon sale. Even if there is no expectation of selling, the increase in equity can be borrowed against to finance other investment opportunities and consumption. If enough investors believe that housing prices will rise in the future, they will flood into the market, causing prices to rise, essentially creating a self-fulfilling prophesy, otherwise known as a positive feedback loop.

Alternatively, if housing prices are stagnant or falling over the long term, then there is no incentive for speculative investors to remain in the market, thus exiting en masse and refusing to return until they are sure that prices will fall no further. NG thus risks amplifying housing cycles on the up and down. Further, it is difficult to disentangle the causes of investment that may be prompted by NG with other housing policies, for, instance, the 50 per cent discount on capital gains tax for properties held for a year or more.

Another fault in the housing lobby’s line of reasoning has to do with the continued implementation of NG. If this policy enticed more investors into the rental market thereby lowering rents, then NG could be wound down and eventually removed. The strange leap in logic is, as NG has been in operation for a very long time, it has held back a substantial surge in rents over the same period. Clearly, its implementation over the long-term is contradictory. One cannot maintain the pretence that rents are ready to blow out at any moment, thus utilising NG to relieve it, because if this pressure has existed for such a long time, then NG is the wrong policy to implement due to its demonstrable ineffectiveness.


Additionally, if the premise that NG lowers rents is accepted, then it is a poorly-targeted policy. Wealthy tenants who do not require assistance, for instance, high-income professionals and millionaires, also benefit as well as those who do need it.

Myth #3: Removing NG would cause rents to surge.

Another favoured scare tactic of the housing lobby is to claim quarantining, or worse yet, eliminating NG, would cause a drastic surge in rental prices. Yes this argument too carries a contradiction. Why would investors oppose significant rent rises? The alleged spontaneous increase would compensate for the loss of NG in part, in whole or perhaps even more.

Yet another contradiction emerges if the claims of the housing lobby are taken at face value. Positively-geared investors not enjoying the benefits of NG should be strongly advocating the removal of NG on the grounds it suppresses their rental incomes and its removal would therefore have the opposite effect. Perhaps negatively-geared investors are more numerous in relative and absolute terms, and are thus more politically and economically powerful.


While this might hold true for 2009-10 (the last year ATO data on investors are available) when 63 per cent or 1.1 million out of 1.7 million investors were negatively-geared, it becomes more difficult to believe for 1993-94 (the earliest year for detailed ATO data) when 51 per cent or half a million investors were negatively-geared. Positively-geared investors would have approximately half the power, so investor-led calls for ending NG should’ve been stronger back then. Clearly, these calls have not been forthcoming.

This contradiction is simply explained as the housing lobby and investors recognize, but never publicly acknowledge: NG has little, if any, effect upon market rents. Removal of it would hurt the bottom line of negatively-geared investors but not tenants. If rents did rise due to rental stock shortages, those on the margin would share house, return to parents or move away. Few recognise just how elastic the residential rental market is.

The well-targeted Commonwealth Rent Assistance scheme (CRA) can easily be boosted to compensate accordingly. Thankfully, the CRA is one policy investors and the housing lobby don’t oppose on the grounds that, as a demand-side measure, it places upward pressure upon rents. Increases in the CRA would have the effect of pulling tenants out of housing stress faster than the associated rise in rents.


Probably the strangest contradiction of all is when the housing lobby defends NG, it is done so in terms of helping tenants. Investors enter into the rental market for one obvious reason: to profit from rents and capital gains. Yet NG is defended on the grounds it assists tenants who would struggle if NG were not available (this is despite the overwhelming evidence that NG doesn’t lower rents).

It is blatant hypocrisy to hear profit-motivated landlords and the housing lobby transform themselves into raving socialists whose only concern is the welfare of their poor tenants. Conservative economists, for instance, Milton Friedman, have argued the only social responsibility that investors have is to increase profit. Supplying rental properties should be the limit of landlords’ concerns about tenants’ welfare, but strangely, their impersonal market-oriented arguments abruptly change when talk of quarantining or removing NG occurs.

In fact, if landlords were truly concerned about the welfare of their tenants, they would attend to repairs and maintenance in a timely manner. Evidence indicates the primary problem faced by property managers of private rentals today is not rent arrears but ensuring that landlords undertake maintenance and repairs. The advent of rental databases has made it easier to filter out candidates with a troublesome history, so the issue of rent arrears has almost disappeared compared to the time before databases became widespread.


Myth #4: Removing NG would cause investors to flee the rental market.

This interesting myth follows on from the previous one. If NG were eliminated, thereby causing rents to surge, why would investors exit the market? The argument by the housing lobby would have the opposite cause to the one claimed. Rising rents and the possibility of growing capital values provide a market signal for investors to enter the market rather than to leave.

Another point that is never clarified is how many landlords would, against their self-interest, exit the market. As of 2009-10, there are 1.7 million residential investors, owning approximately two million properties. As noted, 63 per cent of landlords are negatively-geared, meaning an estimated 1.26 million loss-making properties. Those who spread this scare story never attempt to specify how many landlords would pack up and leave if NG were to be removed. The exit of only a few would have a limited effect upon the rental market. But this is not what the housing lobby is suggesting. Rather, a mass exodus is implied. Absurdly, we are supposed to believe hundreds of thousands of landlords will sell immediately if NG is removed.

It doesn’t take a genius to figure out this many new sellers on the market would collapse housing prices. In fact, the supply surge would swamp demand. As economist Saul Eslake pointed out years ago, if landlords do exit the market and housing prices fall, this is not necessarily a bad outcome for tenants. Housing prices would fall, enabling many currently obliged to rent to purchase, reducing pressure on the rental market and hence rents.


Housing prices have recently experienced the largest boom in recorded history, escalating by 122% between 1996 and 2010, adjusted for both inflation and quality. During this period, capital values have often increased by $50,000 to $100,000 annually, a substantial windfall of unearned wealth (outside of improvements) for both owner-occupiers and investors. Even if NG were to be quarantined or removed, no sane landlord would exit the market during a housing boom just because they are receiving slightly less benefit than before.

Mortgages are larger than ever, leading to increased current net income losses stemming from greater interest repayments. If this does not deter fresh investment during a boom, there is no reason to believe that a further net income loss from removing NG would result in investors exiting the market en masse. As with the First Home Owners Grant (FHOG) and related boosts, it can be argued the benefit of NG is capitalized into higher property values, raising housing prices. Negatively-geared landlords thus suffer a double hit in the form of higher debt repayments and supposedly lower rental incomes. It is not clear if the benefit of NG outweigh these two factors.

Myth #5: NG is not an unjustified subsidy.


The housing lobby likes to claim NG is not a subsidy provided by the government to landlords, rather, it is simply the way the tax system has always functioned. Technically, NG is a tax expenditure, which arise when departures from the generally accepted or benchmark tax structure produces a favourable tax treatment to particular activities or taxpayers.

Australia’s tattered tax code abounds with many exemptions, concessions, deductions, preferential rates, allowances, rebates, offsets, credits, and deferrals. By allowing landlords to deduct expenses that exceed gross rental income against the tax liability on other income streams at their marginal tax rate, NG becomes just another defect in the tax structure.

An ever popular argument in favour of NG is it has always existed, somehow cloaking NG in legitimacy, as if the past is the universal measure of what is appropriate today. Even though NG provisions apply to other investments (shares and businesses), this does not make its application to real estate any more legitimate. Interestingly, the tax code provides property with the most generous deductions relating to NG, with shares and businesses less so.

Myth #6: NG is a costly housing-related policy.


Although there is some debate about NG as an unjustified subsidy to speculators (some landlords are in the market for a long-term rental play rather than hoping for capital gains), it is merely a small fish in a large pond as there are much greater defects in the tax code concerning property. In 2009-10, NG cost taxpayers $2.9 billion, comprising a tiny proportion of the economic defects in the housing market.

The biggest fish is the privatization of economic rents from land, in the order of hundreds of billions of dollars a year. At a distant second is the exemption from capital gains tax on owner-occupied property and the 50 per cent discount on investment properties, yielding tens of billions of dollars to owners annually. Economist Judith Yates’ 2009 report on the numerous tax expenditures relating to housing provides an in-depth analysis of the structural defects in the tax code regarding real estate.

To ensure NG functions as the housing lobby claims it does, at a minimum it should be quarantined to the purchase of newly-commissioned properties to ensure it expands the stock of rentals. Better yet, it should be eliminated altogether to ensure financial stability.

About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.