Wednesday, March 23, 2016

Rights and Wrongs of Labor's Negative Gearing Policy

Last year I wrote a post on negative gearing (The Politics of Negative Gearing), finishing on this note:
"Despite housing affordability being a hot topic at the last federal election, neither of the major parties had any policy specifically directed at tackling it. Though quarantining negative gearing to new builds or removing it completely would only be one part of a solution to tackle the problem, Abbott has made it quite clear that he's not interested in a sensible debate on the matter. Last month Labor released a discussion paper aimed at informing Labor’s Housing Affordability Strategy (to be taken to the next election). I'd expect that with the right mix of policies directed to tackling housing affordability and the right attitude, Labor might just have an edge that could help them secure a win at the next federal election."
Recently Labor released their policy on negative gearing (along with reducing the capital gains tax discount) and it has been making plenty of headlines since.

For a long time negative gearing has been considered a sacred cow, but it was obvious with housing affordability concerns growing that something would need to change and we are nearing a point where even the 'untouchables' of our tax system may end up being manhandled (if not as a result of this election, then perhaps the next). Sentiment and polls have moved in Labor's favour following their policy announcement, but not yet decisively enough to win them an election.

Sadly some of those who have been campaigning for changes to negative gearing for as long as I have are blinded by the shiny coating of Labor's policy and are not interested in looking under the bonnet at the details.

The subject of negative gearing brings out a very black and white argument from most. Both those for and against negative gearing changes seem content spreading any research they can to support their particular side, without any consideration to the accuracy. For example the Liberal Party was quick to highlight the details from a BIS Shrapnel report and connect them to Labor's policy even though the details modeled were not all the same as Labor's policy. Similarly those in support of Labor's policy have suggested independent modeling from Ben Phillips is a 'slam dunk' in support of that policy despite the fact that it doesn't account for behaviour changes, doesn't consider the accounting impacts (such as carrying forward losses) and doesn't differentiate between the types of income investors negatively gear against (i.e. wage vs investment, so at face value it doesn't appear to model Labor's policy either).

I have tried to take a more objective approach even though I am in favour of changes to negative gearing in order to reduce investor demand in the housing market. We do need to take care when changing the rules which govern our $6 trillion housing market. Negative gearing should only be removed or changed with an objective in mind and it should only be changed if we are confident the legislative changes will achieve that objective. With that basis I present what I consider to be the rights and wrongs of Labor's negative gearing policy (because it's far from perfect).

Firstly, what Labor got right...

Making the first move

Changes to negative gearing are something that have been raised regularly in political discourse, but not to the point where a major political party was ready to take a policy to an election (in recent history). Labor released a discussion paper on housing affordability in early 2015 and now have a policy to change negative gearing (and capital gains tax) to improve the same. Whether you agree or disagree with the policy (or parts of it), there is no question that it is a brave move and Labor deserves applause for taking the issue seriously and being the first to bring forward firm policy for consideration.

Tackling housing affordability

Some may be surprised that I support changes to negative gearing, which essentially results in higher taxes for investors (at least in the short term). I come from a position that government controls essentially all levers affecting the housing market (see Who's to Blame for Australia's Expensive Property?), if that degree of control over the market is to continue (and I would be all for a change to that), then government needs to take responsibility for the outcomes of their policy, such as the reduction in housing affordability and home ownership rates (source).

Click Chart to Enlarge
Abolishing (or changes to) negative gearing isn't a one policy fix to housing affordability, but it will reduce investor demand by removing an incentive and reduce the level of debt they can carry/prices they are prepared to pay.

Click Chart to Enlarge
Secondly, what Labor got right/wrong depending on how you view it...

/ Grandfathering existing investors who are negatively geared

As Jordan Eliseo pointed out in a recent post, grandfathering existing investors is unfair: hardly seems fair to say to 1.3 million Australians that they can keep a tax lurk that will be closed forever more to the remaining 20 million plus Australians, the great majority of whom are nowhere near as well off financially as a large portion of those who will get to keep the sweetheart deal in perpetuity.

If it is bad policy it should be junked outright.
It could also pull forward demand as is highlighted by Eliseo, if the policy is introduced at a future date investors may rush out to buy before the cutoff.

However not grandfathering investors is also unfair to those who've made significant decisions based on the current taxation settings.

Also, it's likely a policy change wouldn't get wide enough support without the grandfathering of existing investors.

/ Allowing negative gearing for new builds

There are well-intentioned reasons for allowing negative gearing (against salary/wages) to continue for new construction. It has the potential to encourage investors to provide and drive new supply. That means jobs and a boost to economic growth.

The downside to encouraging more new residential construction is that many say we already have an oversupply, particularly in the apartment market. Such a policy could broaden the oversupply to other types of housing and/or increase the oversupply of apartments, which I expect would lead to a collapse in prices. An oversupply of property has been one characteristic of other global housing bubbles which have collapsed.

Lastly (but not least), what Labor got wrong...

It will help to repair the budget

Labor's policy document states that:
Two specific tax deductions – negative gearing and capital gains subsidies – are both significant calls on the budget and are growing at a rapid rate.
However, negative gearing shouldn't be seen as a budget boon for reasons I have highlighted in the past:
The reality is that an end to negative gearing for property wouldn't be a huge budgetary boon (as these commentators have suggested). Most advocating for it's removal suggest a 'grandfathered' approach, which means properties already owned by investors aren't affected (until the asset is sold). Even when investors make a purchase (following negative gearing's removal), any losses which would have previously been deducted in the same financial year against other income could be carried forward to claim against future income or profit from the same asset class (property). While it might delay when deductions are made (and some investors may not make a future profit in property meaning it never is), improving the government budget in the short term, it's long term impact would be negligible.
Furthermore, it's likely that over time investors would adjust their expectations and reasons for investing in property. Currently a large number of investors buy for the tax advantages that negative gearing (and other tax breaks) offers. 
It's removal would result in a lower number of investors prepared to speculatively purchase at higher prices knowing that (as it stands now) low yields (& resulting losses) are partially offset by a tax deduction against other income at the end of the financial year (or as they go for those investors using an Income Tax Withholding Variation). Over time this would likely result in a normalisation of rent to price ratios so that fewer investment property purchases would be loss making from the outset.
Other than the carried forward losses and behaviour changes, we also have to consider that Labor's policy doesn't necessarily stop an investor from negatively gearing an established property if they have other income (that doesn't fall under salary / wages) against which they can claim their property related losses (covered in more detail below).

Only stops losses claimed against salary/wages 

Some have tried to claim that negative gearing (as it relates to property) is only those net losses which are claimed against salary / wages, but that is not the case. The ATO makes it quite clear:
A rental property is negatively geared if it is purchased with the assistance of borrowed funds and the net rental income, after deducting other expenses, is less than the interest on the borrowings.

The overall taxation result of a negatively geared property is that a net rental loss arises. In this case, you may be able to claim a deduction for the full amount of rental expenses against your rental and other income (such as salary, wages or business income) when you complete your tax return for the relevant income year. Where the other income is not sufficient to absorb the loss it is carried forward to the next tax year.
Labor's definition and policy appears to only affect those offsetting losses against salary / wage income:
The investor can deduct any losses associated with the investment from their salary and wage income.
This will mean that taxpayers will continue to be able to deduct net rental losses against their wage income, providing the losses come from newly constructed housing.
This suggests investors will be able to continue buying established homes and negatively gearing those losses against income other than wages. Granted salary and wages are the largest income item, but there is plenty of other income that property losses could be offset against. Look at this table from the ATO (showing 2013-2014), rental losses are minuscule compared to the other income they could be offset against:

Click Table to Enlarge
Based on the information we have available I am not convinced we can conclude (with certainty) that negative gearing of established houses will reduce with Labor's policy.

It could increase rents in desirable (established) suburbs

Some have made the point that negative gearing won't increase rents because even if the pool of rental housing reduces due to fewer investors (in the established market), these houses have to be sold to someone, i.e. one less investor is one new home owner. They also highlight that increased investor participation in new builds will expand the rental supply.

I agree with those comments and would think it unlikely rents in aggregate increase as a result of Labor's policy, however... while median rents may see downward pressure or a lack of growth, the ability for investors to negatively gear new properties could create a distortion where most of that downward pressure on rents is in the outer suburbs (where the number of rental properties will increase), while inner/sought after suburbs with mostly established housing stock see rents rise as natural attrition of existing established investors reduces the pool of available rental properties. Yes that means an increase in owner occupiers in those suburbs, but those who can’t afford to buy in those suburbs may be left to pay higher rents or be forced to move to less desirable suburbs.


As you can see, while well intentioned Labor's policy is far from ideal, in fact we can't even be sure it will achieve what it sets out to. Sadly many of those who want negative gearing to go are defending Labor's policy without giving it the careful consideration it needs. Here's hoping that changes as we near the election or if Labor does get into office, then I hope they review their policy and make the changes required to meet an objective of improved housing affordability and a higher home ownership rate.


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