Monday, March 7, 2016

A comment on negative gearing in the Australian property market

This blog only infrequently wades into Australian politics - but the negative gearing debate has large economic and financial market implications. Moreover I am going to express an opinion moderately contrary to my self interest. Financially I would love the Labor Party policy to abolish negative gearing to be implemented (I am short Australian banks). But intellectually I think the Labor Party is mostly talking nonsense.

Background for non-Australians

In Australia you can deduct losses that you might make in renting a house against your ordinary (wages) income. This includes interest losses.

This is widely thought of as a tax incentive or even a tax rort. The aggregate amount of losses taken against tax is about 1% of GDP which is - to be blunt - a very large number. Negative gearing is widespread and part of our culture.

Moreover it is widely considered to be beneficial to have tax losses. I have had taxi drivers patiently explain that it is better not to pay principal on loans to buy investment properties (ie buy-to-let properties) because you want to keep the tax deductions as large as possible.

The Labor Party has promised to "abolish negative gearing". This has been a policy agenda for fringe groups (notably affordable housing activists) for some time.

Is negative gearing even a tax concession?

I sometimes express my view that negative gearing is not a tax concession and I am howled down by the consensus in this country. [This is despite doing an honours thesis on tax policy and working for five years in the Tax Policy Division of the Australian Treasury.]

But lets lay out the argument.

Imagine I have two business enterprises. One works well and the other one fails.

One makes $120. The other loses $100. My net gain is $20. If the tax rate is 30% I will pay $6 tax on on the net gain.

Now suppose that I can't deduct the losses against the profits. Then my loss will cost me $100. But my gain will be taxed at 30% and I will gain only $84 after tax. I will be $16 out of pocket.

If you do not allow losses to be taken against profits then you introduce an incentive against risk taking. Quarantining losses is expensive from a tax-policy perspective. Taken to its limit quarantining is a tax policy against innovation. [The benchmark for the taxation system is one that does not discriminate in taxation by how you make your income. Its a benchmark which implies tax policy should not in the benchmark case "pick winners".]

There is a case for quarantining losses - and it is done all over the place in tax policy - but almost everywhere the case for quarantining is anti-avoidance.  The most famous example is that offshore losses tend to be quarantined against offshore income. The reasons are (a) the offshore losses are hard to audit and (b) the offshore income that it is quarantined against might not have hit the domestic tax base anyway.

Risks from not quarantining

If you do not quarantine losses you can wind up with completely anomalous situations. For example Australian once had a 150 percent R&D tax concession. If something were certified as R&D all inputs to the process were entitled to a 150 percent tax deduction. Then some enterprising minerals processing company did some tweaking of their processing technology. It was legitimate R&D whilst they were measuring the efficiency of their processes. All inputs to that process (ie the minerals they bought) were deductible at 150%. The output only taxable at 100 percent.

They bought say $10 million of minerals, processed them and sold $11 million worth of metals. But they got a net tax deduction of $4 million even though the activity was profitable and the real amount spent on R&D (ie the amount spent tweaking equipment) was tiny.

Done on this scale the concession could - and did - produce tax losses for the mining company in the hundreds of millions of dollars. There was almost no limit to how large the tax losses could be.

If these losses were not quarantined somehow they could erode the entire corporate tax base.

But the issue here was a "clever avoidance scheme", not that quarantining is of a benefit in itself.

And if you take the typical negative gearing case in Australia (a doctor or middle-income professional) buys a property and makes a real loss it is pretty hard to see how this is a "clever avoidance scheme". Its just a loss.

And real losses are normally deductible.

Countries that ban negative gearing

It is commonly asserted that other countries do not allow negative gearing - and that is true. In some countries capital income is always and everywhere quarantined from wages income. (Scandinavia is a key example where taxes on wages can be much higher than taxes on capital and quarantining is enforced against all businesses not just property investment.)

It seems the Australian Treasury agrees with my view that negative gearing is not a tax concession

The Australian Treasury (for foreigners the main economic policy advice department of the Australian Government) publishes a "Tax Expenditure Statement" which estimates how much various tax concessions cost on the basis that money spent via a tax expenditure is economically similar to money a government might spend directly if it taxed the income and then gave it back through grants or similar.

The tax expenditure statement gives a list of major tax concessions and lists two big housing related expenditures. First the imputed rent that you might receive owing your own house is not taxed even though it might conceptually be thought of as part of your income. Second the capital gains you might make selling your primary residence is not taxed (though it would be taxed if it were an investment property).

They do not list negative gearing as a tax expenditure. The list of big tax expenditures can be found on page 8 of the Tax Expenditure Statement.

But everyone thinks that negative gearing is a concession

Its pretty clear the view that negative gearing is not a tax concession is a minority view in Australia (though it is a view held fairly widely by senior tax people I have known and seems to be held by the Commonwealth Treasury).

The general consensus that negative gearing is a tax concession and that the smart money should and do take advantage of it.

And you find negative gearing all over the income spectrum including some high income earners (but very few mega-high income earners).

I find negative gearing intellectually amusing. It is not a tax concession but after much marketing by the Property Council, various spruikers and the otherwise ill informed negative gearing has been in part responsible for pushing house prices in Australia to ridiculous levels.

People will not only make investments when you give them a real tax concession - they will do so when they think they are getting a concession even if they are not. [We have likewise observed that it is easier to defraud people if they think they are getting a tax concession - witness forestry schemes in Australia.]

Implementing the Labor Party no-negative-gearing pledge

The Labor Party is careful not to ban negative gearing for existing property investments. If they did there would be squeals about retrospectivity. Also there would be dumping of property on the market by people who were no longer entitled to their tax concessions.

But they do plan to ban negative gearing prospectively. So I will throw up a simple example that shows the implementation difficulties.

Imagine a house that is positively geared. Rent is $800 a week and all outgoings are $700 a week.

But the tenant trashes it. (This happens, not often but it happens.) There is $10,000 worth of maintenance.

The landlord is out-of-pocket. Even after than $5000 net rent they collect in the year they are out of pocket.

Does the Labour Party have an argument for quarantining that loss that is not an argument for quarantining all business income against wages income? If so I have not heard it.


PS. I am not averse generally to the Scandinavian idea of income quarantining. However in that case all income from capital is separate for tax purposes from income from wages. I have not heard a good case for selective quarantining that is not an anti-avoidance case.


CrocodileChuck said...

Meanwhile, back in the jungle:

Tim Lamb said...

Thanks John. This is good. I think the other point is for most properties negative gearing is tax-deferral only i.e. if you assume inflation eventually will take the rentals past the costs. Where they don't (say if you bought in a mining town and the property halved on value) and then you sell, your bigger loss is the CGT (capital gains tax loss) will be quarantined (only used against other capital gains). Secondly, given where rates are now, abolishing it will not have much revenue benefit, as most properties are positively geared (as recent time passed depreciation falls away sharply and rents rise and interest rates fall). Abolishing it will have an effect on supply, which is the ultimate determinant of affordability. Lastly, only PAYG taxpayers will be affected (as someone with a successful business can simply distribute to the loss making property entity). All this hoo ha will not change much in terms of revenue.

Peter said...

I don't this is why people have an issue with negative gearing, even though your comments are spot on the mark.

I think most people don't believe buy to let should be considered a business venture at all and be entitled to interest cost deduction because (btw I'm not saying I agree):

a) It doesn't provide anything productive to the economy; and most importantly
b) It's not a business venture because many perceive THERE IS NO RISK. This makes negative gearing haters get so annoyed because so many have made money from it, and what makes negative gearing supporters think it's a tax concession.

Any rational person knows there is risk. But most people in Australia haven't experienced a sustained downturn in housing prices, therefore if it has a minimal perceived chance of happening and negative gearing is a tax concession. It is NOT a concession if you think prices can go both ways, but it is if you believe that the government is giving you a freebie to get on a trend that only goes one-way...up.

James Peterson said...


The current policy discussion is terrible because it has been mixed with politics.

Yet it cannot be ignored that deducting short term losses at twice the tax rate as the related earnings is a tax concession. The rort is not negative gearing, but the combination with the CGT discount.

The Henry Report screamed this from the roof tops (negative tax rates over the life of highly geared property investments). People's behaviour didn't change until the CGT discount was reintroduced. The problem is with the CGT discount.

Would love to read your thoughts on changing CGT discount (rather than being able to claim deductions, which is fundamental to our income tax).



Lionel said...

Owning real estate as a business is the question. Neg hearing for real operating business sure, but for owning property. As in UK, massive missallocation of capital in low productivity investment.

Dan Davies said...

Although "as in the UK" is an interesting comparison to make, since the UK has a very similar rental market and house price problem to Australia, despite having basically no negative gearing at all.

(I don't think the UK authorities have ever given any justification at all for successively and selectively tightening the quarantine of rental profit and loss, other than that they wanted the tax and it seemed quite inelastic. They've basically used it as a way to monetise the British middle class's distrust of all other forms of saving)

Anonymous said...

In the example the person takes a $5000 loss and thinks twice about speculating in housing on such slim margin, allowing such tenants to stay in the future, and might now purchase insurance or retain some earnings as a buffer for such eventualities.

There is no problem here.

Anonymous said...

The issue is that the level of mortgage debt/gdp is highest in Australia, hence hedge fund interest in shorting banks. Professor Steve Keen has produced much research to show that property price rises track credit growth closely and he maintains that it is a causal relationship (I know he hasn't been so good at predicting when the debt bubble will burst!!). Given that my concern is for my 20-something daughter trying to get a foothold in the property market without becoming a mortgage slave for life, it would be good if property investment in the residential sector became a yield play and not continue to be a spec frenzy. Can we have policy for this?

Anonymous said...


You may want to change " can deduct losses that you might make in renting a house..." to say "...losses you might make in owning and renting out an investment property ...", otherwise that sentence could be read to mean that people can deduct their personal rent.


Anonymous said...

I would love for a hedge fund manager to buy say 50 properties in Sydney (and this would cost at least $50m given the prices in Sydney) then list it on the Aussie Stock Exchange. It would then be priced against other property trusts like offices, shopping centres, or warehouses and from that point of view, there is no doubt that it is overvalued. If the stock could then be shorted then would this then become a new proxy for property prices?

Would really really like someone to give this a go...

GrueBleen said...

"...negative gearing has been in part responsible for pushing house prices in Australia to ridiculous levels."

You said it John, and I, amongst many, many others, completely agree with you. Would you now care to explain why the tax concession that isn't a tax concession should be set up so that the young are being almost totally priced out of the "own and occupy" market ? Is this the Australia we all want to live in ?

And also:
"But they [the Labor Party] do plan to ban negative gearing prospectively."

Shouldn't you explain, maybe just for any foreigners reading, that the Labor Party actually intend to end ("ban" ?) negative gearing only for existing properties, but retain it unaltered for new builds. On the basis that this just might increase the total stock of houses while hopefully decreasing the price of existing houses so as to let the young back into the market.


dan said...

john, re how does labor deal with positively geared properties that might become negatively geared in future - i would suggest they just set a date, and anything bought before that date is eligible for negative gearing concessions (if negatively geared), anything bought after that date is not. seems simple to me?

i think the counter of your point about the general public *perceiving* negative gearing is a concession when it really isn't is that if this perceived concession is removed they will perceive they have lost a concession and this may trigger (irrational) market activity to the detriment of future demand and/or values.

i am keen to hear your detailed thoughts on this issue - the stuff in the AFR and 60mins is just a tease.

Anonymous said...

Your reasonaing would have been far more cogent without the analogy of two businesses. Its simply not a relevant comparison, as has been pointed out. Property is not a business, end of analysis. "If you do not allow losses to be taken against profits then you introduce an incentive against risk taking" - this is precisely the relevant point. You do not want such an incentive for real estate. End of reasoning, exactly why negative gearing is a stupid idea. Its a name game, call it what you like, a tax allowance, a concession against an alternatively taxable gain, a non concession that results in paying less tax than you may otherwise pay, whats the point of labelling it? It makes no policy sense whatsoever.

3d1k said...

Labor will grandfather existing negative gearing on established residential property for ten years; post July 1 2017 negative gearing will not be applicable to established residential properties, rather restricted to new builds.

Indeed, Labor's policy perpetuates the negative gearing tradition so beloved by Australian property investors - restricted to new builds.

Much argument surrounds the question whether or not excising the established residential market from NG investors will tip a bubbly property market into decline - 93% of property investment is established residential and 2 of every 3 investor mortgages are interest only.

A real and present danger.

Anonymous said...

John, a few points/questions:

What AT thinks is irrelevant, as it's a political decision, not factual.

NG could be ok, if you can deduce ANY costs (yes, I mean any. For me to be able to do my job, I need food, I need housing, to function reasonably mentally I need my loving family etc..) from your income.

If you say that mortgage interest is deductible, but (say) paying for upskilling course/etc. isn't, then there's clearly a tax incentive to do something but not something else. Whether you call it tax concession technically doesn't matter - from practical perspective you have different treatment of costs and incomes. Either you quarantine, or you don't.

In your example, yes, landlord is out of pocket now. But surely, he has carried tax loss that he can offset against income from the property going forwards? If that's the case, well, what's the problem?

If it's not the case, and loss cannot be offset, that means your business risks increased - but it doesn't matter whether the reason for your asset underperforming is that a tenant trashed the house, or that you can rent it only for 600 when your costs are 700. Ultimately, you'd need to adjust the rent for the risk. Right now, there's little (apparent) incentive to adjust the rent for the risk, because if you expect that the main income will be from the leveraged value of your house, you may as well keep it unrented and avoid the hassle, while deducting the interest from your main income.

Or you can establish an LTD, and have the tax loss carry-over, problem solved.

Rick Steele said...

Oh John how silly of you. EVERYONE knows that property prices ALWAYS go UP, therefore any losses you make on your interest payments and other expenses against your rent will be made up with the capital gain you make on the property. The ability to match these losses against other income, including your salary, is just cream on the cake. Hmm, I wonder what might happen if interest rates rose faster than rent (and thus increased losses) and property values FELL? Unthinkable of course, right?

Anonymous said...

If you want to combine income from wages and income from capital, you should also include the profit you make when you sell the property with your wages for that year.

Otherwise, if the profit from capital is compartmentalized from wages then so should the cost of holding that capital position.

Anonymous said...

Here's one inconsistency in the negative gearing argument I have never understood: If I start a real business - the type of risk taking activity that this country needs - and my company loses $100k in its first year of operation, then I cannot offset this loss against my wage income.

If I buy a property and lose $100k in the first year following the purchase, then I can offset this loss against my wage income.


Mars said...

Hello John,

I don't think there is a problem with negative gearing per se. Deducting legitimate business expenses (including interest expense) from business income is valid. Also, not discriminating against income from various sources is valid.

Whereas this is permitted for property investments - even a single investment - this isn't permitted for people who run small businesses in addition to their normal jobs. These losses are quarantined till certain thresholds are met.

Such deductions for low volume transactions, irrespective of the capital at risk isn't permitted for investments in the stock market. These people are classified as Share Investors and get the 50% capital gains discount for long term holdings. When they use their quarantined losses sometime in the future to reduce their long term capital gains, they are only allowed to use half those losses if they utilize the 50% discount.

If one has high enough number of transactions in the stock market, they can get classified as a share trader. In this case, they will be able to claim their share trading losses immediately - subject to thresholds applicable to those earning a wage _and_ running a small business - but they are not allowed to get the long term capital gains discount.

So, here's my point -

By being able to deduct current losses - including from depreciation that reduces the cost base - at the marginal tax rate; and by being taxed on the capital gains at the long term discount capital gains tax rate, the declared loss to reduce tax is at least twice as much as the declared gains that are taxed when the property is sold.

This is how it becomes a tax concession. Property investors get to have their cake and eat it too.


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