We should blame Howard for the bubble

By Leith van Onselen

Fairfax’s Peter Martin has done a good job today describing how the Howard Government’s short-sighted decision to halve the rate of capital gains tax (CGT) in 1999 ignited the investor orgy that is now helping to price young Australians out of home ownership:

Tax is an awfully big part of it. When the Howard government halved the headline rate of capital gains tax at the end of the 1990s the price of a typical house jumped from two to three times household disposable income to four times disposable income. At no other time in Australian history have prices jumped so far so quickly. Negative gearing (making losses on rent to offset against other income in order to enjoy a barely-taxed capital gain) became mainstream.

“It is a truism that if an investor is buying a property, an owner-occupier is not,” the head of the Bank’s financial stability department Lucci Ellis told the parliament’s home ownership inquiry in July. “To the extent that person is not then buying their own home, they are therefore creating a market for rental and making it attractive to purchase investor properties.”

Investors like to believe that they are creating new properties, adding to supply and driving down prices. But few of them are. Before the explosion in negative gearing, one in every six new investors built a home. It’s now one in 16.

Martin does also highlight other factors contributing to the price escalation, such as: 1) low nominal interest rates and low inflation, which has made it easier to get into the market, but much harder to actually pay-off one’s home; 2) the fact that owner-occupied housing is largely tax free; and 3) rising incomes, which has increased the amount that can be spent on housing after meeting other basic needs.

Nevertheless, on the 50% CGT discount, Martin makes a very good case.

Shortly after CGT was halved, loans to investors surged, growing almost exponentially over the following four years (see next chart).

ScreenHunter_9829 Oct. 20 09.35

As pointed out by Martin, this growth was driven by a massive increase in the number of negatively geared investors, whose numbers have roughly doubled since 1999 at the same time as the number of positively geared investors has remained roughly stable (see next chart).

ScreenHunter_7697 Jun. 10 08.20

Indeed, the slashing of CGT made negative gearing a much more effective tax shelter – for reasons explained in the Hawke Government’s 1987 Cabinet Submission to re-instate negative gearing (viewable via searching here):

The negative gearing measure was introduced [in 1985] to partially close-off a generally recognised tax shelter, a rationale which remains broadly valid…

The three basic features of a typical tax shelter are the absence of a full nominal capital gains tax, the deductibility of full nominal interest expenses, and the mis-match in the timing of the deductions and the recognition of taxable income (for example, because capital tax is payable on a realisations rather than accrual basis).

Rental property investment clearly exhibits each of these features, as do some other activities, and so effectively obtains tax benefits under the current tax system.

It is also a key reason why the value of rental losses exploded after the CGT discount’s introduction (see below charts).

ScreenHunter_7700 Jun. 10 08.38 ScreenHunter_7701 Jun. 10 08.38

It’s fair to say that John Howard shares much of the blame for Australia’s housing bubble.

It was the Howard Government’s halving of CGT that first put a rocket under negatively geared investment which continues to plague the housing market today, to the detriment of first home buyers. It was also his government that allowed self-managed superannuation funds to leverage into property, ramped-up immigration, and implemented a raft of first home buyer subsidies.

Of course there are other important contributing factors, including financial deregulation (reduced bank capital requirements), falling nominal interest rates, foreign investors, and the states’ increasingly restrictive land-use policies. But it was the Howard Government that first kicked this bubble off.

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Unconventional Economist

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