My wife, being South African, finds a number of things about Australian culture strange. Friends turning up at your house and eating your food whenever they feel like it, for example. Or special security guards in pubs making sure you don’t drink too much. In South Africa, she says, that is the point of going to the pub.
But the strangest thing about Australia is its obsession with tax losses. Perhaps biased by my father being one of the first locals she met in this country, she finds it odd that he has spent his whole life running a farm at a loss just to avoid the tax man. We are not alone – the Germans love a good tax dodge too – but, to her, it is unbelievable that someone is prepared to spend more than $1 million on a house just so they can “negative gear” it. In South Africa, you buy houses where the rent is more than the interest payments. Again, she says, that is the point of an investment – it generates you income.
It’s not quite that simple. Historically, negative gearing has been a very effective strategy. Interest rates included an inflation component that was deductible upfront and taxable as discounted capital gains well into the future.
When inflation was 5%, say, you could buy a house on a 5% rental yield, fund it with debt that costs 8% and expect to do very well. You run at an annual income loss of 3% initially, but the value of the house is growing at something like 7% per annum, 2% real plus the 5% inflation. That 7% growth more than offsets the 3% losses, and you don’t pay tax on it until you sell the property.
Negative gearing is a strategy that works best in a high inflation world.
So why is it still so popular when inflation is just 1-2% per annum and at risk of going lower? Well, I’m going to have to side with the wife on this one. It’s popular because people love a tax deduction, but it no longer makes economic sense. I know, I know, you are going to tell me property prices are going to keep going up forever and you don’t need to worry about yield.
But that is speculation. From a pure economic standpoint, paying 4.5% interest on a property that yields less than 2% doesn’t make any sense in a low- or no- inflation environment (or, shudder, a deflationary environment). Negative gearing is no longer a strategy. It’s an obsession. My guess is people will get sick of it without the government changing a thing.
15 thoughts on “There’s no Need for Government, Negative Gearing Will Fix Itself”
Negative gearing is a catalyst; CGT discount is the problem. “Investors” effectively defer and shift the taxing of gains from revenue account to capital account, and at their marginal rate in whatever year that particular gain is realised. CGT discount, available to individuals at 50% on property, has made residential property far more tantalising than share investments due to the ability to borrow large sums (even positively geared) at competitive rates. Negative gearing inflates these outcomes.
As to its desirability going forward, it is troubling that a lot of Australians mindlessly consider that “tax deductible” means 100% refundable without regard to their tax effected return of interest payments. This alone will hold back plummeting sale prices as some investors don’t comprehend opportunity cost and will hold on to what “ought to be” a big capital gain when, and only when, it is sold.
G Bradford, LLM (Tax)
Greg I agree that negative gearing is a catalyst; it defers taxation from current income to a future possible capital gain that has a discount rate of taxation, but so does any share capital gain.
The trouble with shares for many investors is that they are harder to borrow against – higher interest rate and lesser leverage allowed.
If the government does away with the CGT discount then they would introduce indexation which still has a ‘discounting’ effect.
People are following established practices that have worked well over the last 50 years but I agree that it does look over-done.
Theoretically I would agree, but it is not as if a low inflation environment is a recent development. Feel free to check me, but we havn’t had anything north of 5% since the very early 2000’s (aside from a brief peak in ’09).
The reason why Australians love it so much is that it’s one of the few ways that they can leverage up their small amount of equity, and use other people’s money to invest. Yes there are the tax breaks and we do love that, but the consistent capital gains in property mean for many it’s a simple, understandable way to invest (Check out the ASX’s latest asset class performance report – where residential property outperformed equities over 20 years).
Many Australians are scared off by the sharemarket whereas property is physical/tangible, and you don’t need much knowledge, experience or skill to buy property. Many of us do it buying our own home – so how hard can it be to buy an investment property right?
Property investors also don’t have to do much maintenance if they don’t want to and can even leave that to someone else – so dare I say it’s almost a ‘lazy’ way of investing.
I think we’ve also become accustomed to hearing those stories about the friend of a friend who sold their house for multiples of what they bought it for – but very few understand the ‘hidden costs’ along the way, and the real after-tax return.
As such, I don’t think we’ll see it lose its appeal. The only thing that might kill that would be a full blown property crash – and I can’t see that happening (it might slow down and fall, but not crash).
Personally I think negative gearing distorts the property market, and capital gains should be limited to being offset against capital losses, and taxed at marginal tax rates.
I agree Mike, that is the way the average ‘punter’ thinks. Add to that the reality that property provides the solid basis to get a loan and as DeSoto, in his book on the mystery of wealth growth in the west, shows that property and property laws provide the catalyst. Property provides the ‘invisible’ way to increase wealth. I think most people pick this up intuitively and negative gearing provides a good catalyst for a lot of ‘wage earners’ to do that.
I think the tax saving is the incentive that needs to be factored in, not just the difference between capital growth and interest cost
My belief is that the only way that Australia’s politicians could possibly end negative gearing without upending the entire economy would be if the economics of negative gearing caused it to die a natural death as described in this blogpost.
Australia is structurally wedded to negative gearing, and if there is one thing that politicians (and most people) don’t understand, it is the tendency of systems to react badly to structural shifts.
Any dinner-table economist can rightly say that socialism is a stupid system that doesn’t work in practice or that gun control reduces violent crime. These points may be truisms when considered from the perspective of a tabula rasa, but when such ‘obviously true facts’ are imposed on a structurally opposite pre-existing system the results are often disastrous.
The end of Soviet socialism is a good example. Under communism, the USSR was the world’s second largest economy, and its citizens were undoubtedly better off than they were through whole of the 1990s, and in most of the former USSR, the median citizen is still not too much better off today (25 years on) than back then.
Similarly, the post apartheid introduction of gun control to South Africa has been an utter disaster simply because in a society that was already saturated with guns, introducing gun laws simply created a situation where the majority of people who kept their firearms were the law breakers. Violent crime went through the roof, and now the RSA is one of the world’s most violent places.
Negative gearing may or may not be a good idea in theory, but in practice, forcibly getting rid of it would certainly dislocate almost every aspect of the Australian financial landscape.
Even letting it die a natural death is going to cause some serious problems: one that I see is that in a low to negative inflation environment deleveraging is incentivised, which reduces the money supply, which reduces inflation further, which further incentivises more deleveraging etc, resulting in a self perpetuating cycle.
If and when property prices decline so that people are suddenly facing real losses, I just hope that there isn’t a bail out. I remember the cries for compensation when UK investors who had invested in Icelandic banks had suddenly had their savings wiped out. They blamed the government for not preventing it.
As Buffett once said, what the wise do in the beginning, fools do in the end…
Right now, property prices are reflecting lower interest rates, but they are not yet reflecting the lower inflation & growth rates which are likely to come along as part of the bargain. The latter quite likely means low or even negative rental growth (and income growth) in coming years. You can’t have your cake and eat it too.
It is possible to rationalise lower cap rates by saying interest rates – domestic and global – may have structurally fallen. However, that requires a concurrent acknowledgement that future returns will be much lower, whereas the rapid capital appreciation we have seen in recent years as cap rates have fallen has created exactly the opposite expectation amongst most property market participants. And therein lies the bubble’s key fallacy.
The other issue is that inflation has historically helped ease the debt servicing burden of households who have signed up for larger mortgages than they can sustainably afford. If your mortgage payment is 50% of take home pay in year one of a mortgage, for instance, but your salary is rising 10-15% because inflation is 5%+, that 50% servicing burden comes down pretty quickly (assuming interest rates don’t rise further) – e.g. to roughly a third of income within 3-4yrs. No such luck in a low inflation/deflationary environment. Today’s aggressive borrowers could be unwittingly locking themselves in to 20-30yrs of mortgage slavery.
The negatively geared losses are going to start to feel very burdensome for a lot of people when property price merely stop appreciating, a partial tax subsidy notwithstanding. How long are the punters going to put up with huge mortgage bills, broken toilets, replacing tenants, etc, without any gains in equity to show for it? Retail investors are not renowned for their patience in the face of adversity, and at some point at least some are likely to start throwing in the towel – perhaps after 2-3yrs of unrewarded effort. At that point a long and cold winter is likely in store for Ausy property values.
The delightful challenge of course is that there is no telling how long it will be before we reach that point. Cap rates got as low as 1% in Ireland in 2007, and the RBA is still yet to hit 0%. Further AUD depreciation will also likely provide some cushion. It’s hard to imagine this not ending badly though.
Trouble is inflation is not running at 1-2% in the market you are talking about…… http://www.rba.gov.au/publications/bulletin/2015/sep/pdf/bu-0915-3.pdf. The RBA states for the last 30 years its closer to 7%, and over the last decade (to 2015 around 5%.) With the leverage inherent in property of 5 or 10 to one that’s a pretty healthy growth rate on your equity, with a tax break on top of it.
No doubt. I think Steve’s retort would be that this cannot go on forever – housing has become a larger and larger slice of the economic pie over the last 30 years, but it cannot become bigger than the pie itself. House price growth at multiples of the inflation rate or economic growth rate is a historic anomaly, it cannot continue to do that over the very long term (decades and decades more). Although far from a sure bet, the inflation rate is likely to provide a better guess of future house price growth than recent historical data.
People keep raising the CGT discount as a problem. In its current form, it is! It encourages
short-term gain seeking, whereas the policy it replaced compensated investors for the inflation effects of long term investment.
At that time, capital gains were adjusted for inflation based on the CPI, but no other discount applied. Thus if one bought and then quickly sold at a profit (say after 366 days) only a very small taxable discount applied. If on the other hand one purchased, held for a number of years, and then sold at a profit, the CGT applicable was adjusted to take account of inflation over the investment period.
I say, bring back the CPI-adjusted method, give investors a fair deal, and make speculators pay their fair share (of tax)!!
What will cause the end to the property ponzi scheme is anybody’s guess. I believe the catalyst will come from overseas and likely Japan. Japan is literally going bankrupt and have no choice but continue QE. However, this time Japan will instigate the mother of all devaluations of the yen with China and Europe forced to follow. In this situation we will see deflation which will be inescapable even in Australia. Property prices will have no other way to go than down. The reason being that banks will no longer lend and because prices are falling there is no reason to buy. And so we will trapped in the game of ever falling prices.
One of the main incentives for negative gearing is our high marginal tax rates at relatively low levels of income. Until the income tax regimen is reformed , we won’t get any significant impetus to stop negative gearing – unless of course, widespread capital losses on real estate start to accrue. Similarly for multinational profit shifting – the elephant in the room here is of course is internationally uncompetitive tax rates, as it is with income tax. When are we going to realise we aren’t an economic island, needing to compete globally and start to reform our tax system to resemble something akin to an internationally competitive one?
Spot on Jenny.
My family have just started a business in Canada with one of the primary drivers being their low company tax rate (15%). We are just small fry so I imagine anyone with significant business investments or capital will be thinking along similar lines. As you say, we need to compete globally, and that includes on taxation which really for any business is mainly seen as an expense (as well as being part of being a good citizen etc – but in reality that is overplayed a bit too much I reckon).
But the politicians are not listening I’m afraid.
Too busy spending ‘other peoples money’ without recognising how it is generated. Margaret Thatcher has some great quotes on how this worked – a rare bird (with no pun intended) in the political spectrum these days.
Assuming you are an Australian resident, how does it advantage you to set up your business in Canada? Whether the company tax rate is 15% or 30%, it will be credited to your personal income tax liability, and you’ll have to pay personal income tax at your marginal rate on the dividends.