The Positives of Negative Gearing

The Morrison government is in a world of pain and, with Malcolm Turnbull exercising his malevolence behind the scenes, things are apt to get worse — unless, of course, the Coalition can craft policies that will take the fight to Labor, rather than  complacently acquiescing to the foe’s agenda.  My purpose here is to demonstrate just one example in which the government can turn what appears at a glance to be a Shorten vote-winner into a negative.

To be frank, in view of recent developments including the punishment being inflicted on Jim Molan and Craig Kelly for the crime of holding traditional Liberal views, I no longer much care about a party that knows not its own mind, let alone that of the electorate. But old habits die hard and I have always hated to see specious and facile claims go unchallenged. The issue of negative gearing is my case in point.

Compared to the devastation Labor will inflict on our economy at large – particularly in the sectors exposed to crippling and quixotic warmist initiatives – the issue of negative gearing is probably not a first-order concern. Nonetheless, it does merit some attention. While Labor presents negative gearing as part of its ‘politics of envy’ strategy, the government is failing to counter that narrative by not fully explaining how negative gearing works and the benefits flowing from it. Let me try to redress that failure.

The very term ‘negative gearing’ suggests some dodgy mechanism to evade paying tax and Shorten & Co play subtly on this theme.  But the first point to make is that genuine investors of any kind do not set out to make a loss; they want a return on their investment.  The second point to make is that investment in property is designed to accumulate personal wealth, which the party of Menzies has always held to be a good thing. The third point is that all wealth, other than the inherited sort, is built on borrowing.

Rental properties are investments like shares, bonds or avocado farms. Rental-property receipts are treated like any other income (eg share dividends) and are taxable. By virtue of negative gearing, they are treated the same as the latter: profits are taxable and losses tax deductible. If legitimate investments why should that not be the case?  Why would economists, even Keynesian ones, cheer measures designed to reduce the value of an asset, which is what Labor’s policy would do.

The fundamental questions concern whether residential housing is a legitimate investment, or is there some higher social need that should see it removed from the strictures of the free market?

Two propositions are most often advanced for removing negative gearing. First, it is often stated that it allows rapacious investors to snap up housing to the detriment of first-home buyers, well-heeled investors being in a position to outbid the would-be owner occupier; therefore negative gearing needs to be curtailed or eliminated in order to satisfy the national aspiration to own one’s home. At what price point does negative gearing switch from being a good thing to an evil that must be curtailed by legislated fiat?

But do property investors really drive up the price of residential housing?  This meme is being driven by the fact that housing prices in Sydney and Melbourne have sky-rocketed in recent years.  But if property investment were to blame, why wouldn’t we see the same phenomenon in every other capital city?  The table below is from Domain’s June 2018 report, and median incomes according to Melbourne University’s HILDA report for 2018 (Hobart was not included in this report and Canberra and Darwin were joined):

We are told that approximately 7% of Australians ‘negatively gear’.  Assuming that these investors are spread uniformly across the country, what the table above tells me is that, essentially, prices are high in Sydney and Melbourne because that’s where the bulk of people want to live and supply has not kept up with demand.  Cynics might add that prices are high in Canberra because it is full of overpaid bureaucrats.

The second anti-negative gearing proposition, according to Comrade Shorten, is the way in which it allows fat cats to rip off the taxpayer. If you look at Labor’s policy, presented under the headline “Positive plan to help housing affordability”, the emphasis is on increasing revenue by the removal of tax concessions which, in true Wayne Swan mode, are called ‘tax subsidies’. Here’s a sample:

Tax subsidies are skewed to high income earners. Australians benefits from the Commonwealth through either the payments or the tax system.  The OECD and the Henry Tax Review has recognised that payments are highly targeted in Australia, and overwhelmingly support low income Australians.  However tax subsidies are highly inequitable, with the vast majority of benefit to high income earners.

For negative gearing, the top 20% of income earners receiving around half of the negative gearing benefits, according to NATSEM.  The top 10% capture more benefit that the bottom 60%.

In February, then-treasurer Scott Morrison told the National Press Club:

“Two-thirds of those who use negative gearing have a taxable income of $80,000 or less. Seventy per cent own just one property, and 70 per cent have a net rental loss of less than $10,000”.

To me, the central message is that negative gearing is a tool not only available to those of relatively modest means — teachers, policemen, nurses and the like —  it is, in fact, being used by them.  In other words, negative gearing is not the exclusive preserve of the rich, contrary to Labor’s claims.

Here’s how the ABC’s Fact Check Unit responded.

Mr Morrison’s claim is selective. 

Australian Tax Office data shows that one in 10 Australians who files a tax return is negatively geared in terms of rental property.  Data provided by Mr Morrison’s office, based on Treasury calculations, showed 67 per cent of the people who use negative gearing have taxable incomes of $80,000 or less.   This was backed up by Fact Check’s analysis of ATO statistics.

So Mr Morrison’s claim is correct. But the ABC being what it is, there is also this qualification:

However, as 82 per cent of all taxpayers have taxable incomes below $80,000, it is not surprising that most of the negative gearers fall into this category. 

If you believe Labor’s hype, it is surprising.

As this category represents only 67 per cent of negative gearers, it is clear that these taxpayers use negative gearing proportionately less than taxpayers with higher income. 

Since people with incomes below $80,000 include many whose incomes are so low they pay no net tax and therefore would not have the wherewithal to invest in property, it is not surprising that proportionally more of higher income earners use negative gearing.

Put another way, only 8 per cent of people with taxable incomes less than $80,000 use negative gearing, compared with more than double that proportion among people with taxable incomes above $80,000. 

Fact Check used Professor Miranda Stewart of the Tax and Transfer Policy Institute of the ANU to help discredit Morrison.  Here is a gem from her:

Professor Stewart told Fact Check that average male full time earnings were about $82,000. “I don’t think average full time male earnings is modest,” she said. “By definition it’s average and much higher than many workers get.” 

She says that median income of about $52,000 is a more meaningful basis to assess the fairness of negative gearing.  Fair enough.  The Fact Check report then goes on to say that only 40% of negative gearers are in the $52,000-or-below cohort. Only 40%?  That seems a pretty respectable figure to me.

Finally:

Fact Check’s analysis showed that 70 per cent of negative gearers had rental losses of $10,000 or less.

The low rental losses claimed by the majority of negative gearers show that most are not gaining a significant benefit from negative gearing. 

That’s also what Morrison claimed and hardly supports the idea that rich investors are ripping off the taxpayer.  And, by the way, that last statement holds true only if the primary purpose of negative gearing is tax avoidance or tax minimisation.

Let’s have a look at a couple of negative gearing case studies. Let’s say I’m earning $80,000 and I pay a top marginal rate of 32.5c in the dollar.  So before any deductions, I pay $17,547 income tax. (For the purposes of this example, I’ll ignore all other deductions.) Let’s further say that I manage to save $300,000 and use that for a deposit on a rental property worth $800,000.  I need to borrow $500,000 and secure an interest-only loan over 30 years at 6%. (In reality, I wouldn’t maintain an interest-only loan over such a long period but would pay down principal wherever and whenever I was able.)

Let’s say I get $600 per week rent, $31,200 pa. I am paying $30,000 p.a. interest on my loan.  That is tax deductible. I pay annual property rates of $2,000 and insurance of $1,000, plus I engage a managing agent who charges, say, 10% or $3,120.

My outgoings are $36,120.  So I’ve made a loss of $4,920.  My taxable income is now $75,080 and tax payable is $15,948.  So I’ve “ripped off” the government to the tune of a measly $1,599 – considerably less, I would guess, than the average low-income worker draws in various benefits and subsidies.  And keep in mind that in order to achieve this tax saving of $1,599, I’ve had to fork out $4,920 in interest payments.  That’s come out of my take home pay.  Day to day I’m living on less than I otherwise would have — $126 per fortnight less to be exact.

So getting back to those ‘negative gearers’ with losses of $10,000, in my case I would need two investment properties leveraged  as above and my out-of-pocket expense would be $6,642 and the loss to taxpayers would be only $3,200.  Not $10,000 as some might infer from Morrison’s statement.

But what about those high-income earners?  Just how rapacious is the ‘speculator’ class? Fortuitously, a perfect example presented itself a year or so ago in the person of one David Feeney, one of Labor’s own stalwarts and the then-member for the Melbourne seat of Batman who failed to declare on the Register of Pecuniary Interests a rental property worth a reputed $2.3 million in the trendy Melbourne suburb of Northcote. Feeney told us the property was rented at $700 per week and that it was negatively geared.  As an aside, an annual return of $36,400 on capital of $2.3 million does not strike me as a particularly savvy or fruitful investment. Thank goodness Feeney never got his hands any of the financial levers available to government.

I don’t know exactly how much Feeney pocketed as an Opposition frontbencher but, for the purposes of this exercise and ease of calculation, let’s use $200,000 (MP base salary is $193,000).  That puts Feeney in the top tax bracket.  On $200,000 he would pay $63,547 p.a. income tax. Let’s further assume he borrowed $1 million on the property.  His annual interest bill, again based on interest at 6%, would be $60,000.

Let’s again assume rates and insurance at $3,000 p.a. and agents fees of $3,640, giving total annual expenses of $66,640. Feeney’s annual loss would be $30,240, leaving him a taxable income of $169,760.  On this he would pay $50,758, saving himself $12,742 p.a. and leaving him $17,498 out of pocket.

Let’s now imagine Feeney were a more canny investor than he appeared to be and outbid me for the same notional $800,000 property that I mentioned earlier, and that he also borrowed the same amount ($500,000). His annual loss, not surprisingly, would be the same: $4,920, reducing his taxable income to $195,180.  He would now pay tax of $61,634, a saving of only $1,866, and be $3,054 out of pocket.  A result virtually indistinguishable from mine.

In pushing its anti-negative gearing line, Labor often cites a hypothetical high income earner with ten negatively geared properties.  There may be a such investors, but you can bet they won’t have 10 properties all as highly leveraged as in my examples.  But, even if they do, the tax advantage they receive will be neither here nor there in the grand scheme of things vis a vis total government debt.

And keep in mind that these figures are based on interest-only loans.  In reality, the serious property investor will also pay down principal while seeing his rental income increase over time, thus reducing the annual loss.  In other words, in the examples quoted above the tax savings at the start of the loan are as big as they get.  As principal gets paid down the losses decline.

In case you haven’t already got it, my point is that serious property investors, if they are honest, are not doing it to minimize tax.  They are doing it to accumulate wealth.  I’m willing to bet that property investment, kick-started by negative gearing, has been hugely more successful than superannuation at keeping people off the age pension.

Right now the Age Pension costs us about $50 billion per year. Universal  superannuation was supposed to help rein in this figure, which it has signally failed to do.  If anything we should be encouraging more people to invest in property. And, of course, superannuation contributions also attract ‘tax subsidies’. The reasons why wealthier taxpayers ‘benefit’ more from negative gearing than middle or working class families are because they have more disposable income and they pay higher rates of tax. But the fact that they do proportionately better is hardly a good reason to deny the less well off the same opportunity. This is nothing more than the politics of envy on steroids.

But what about Labor’s policy?  They claim it will ‘make housing more affordable’.  They have produced modelling to prove it. The government has cited modelling that proves it will decimate the real estate market.  By now, we all know that there is wishful thinking, damned wishful thinking … and modelling. When it comes to duelling models, the one that underpins the slickest snake oil will prevail in the public mind. It is hard to see how restricting negative gearing to new properties will give first home owners a better shot at their dream. Won’t investors also target these properties?  Labor’s policy is incoherent, except when viewed as a thinly disguised tax grab.

So what can the Liberals do?  Well, for a start they could respond to Labor’s policy by packaging up a new policy of their own, promoting the concept of property investment (with negative gearing as one incentive) as a mechanism for long-term financial independence. They could encourage first home buyers to take advantage of the scheme by, for example (and this is just a thought bubble), restricting the sale of Defence Housing properties to first home buyers. DHA properties are a very good investment with guaranteed income. They could subsidize such sales by picking up the tab for stamp duty.  They could negotiate agreements with state governments to extend the first home buyers grant to such sales.

They could also tighten up the regime by banning interest-only loans and ensure that the ATO cracks down on infractions where, for example, properties are let at well below market rates or left untenanted for long periods. I doubt much of this goes on but it’s good window dressing to counter the inevitable Labor counter attack. Government might also (another thought bubble) entirely waive capital gains tax on properties (it is now 50% on those held more than a year) sold after owners reach retirement age, cutting down on speculation.

And, perhaps most potently, they could shout from the rooftops that even economists openly sympathetic to Labor are now saying the planned assault on negative gearing is a lunacy in light of the downturn in Melbourne and Sydney property prices. Here, for example, is Michael Pascoe writing in the left-wing, union-funded New Daily:

The current correction in Sydney and Melbourne housing markets is unlikely to be over. Investor interest has already been curtailed by regulator-enforced credit tightening and many investors having the brains to realise the party is over for the time being.

Those two factors have reduced the need for restricting negative gearing…

Sadly, riven as it is by factional discord and harbouring political malignancies who really belong in some other party, the Liberals have only a half measure of the wits needed to mount a persuasive and coherent counterattack. If Labor gets in, as seems likely, and sticks to its class-war policies, brace yourself. It won’t be pretty.