In defence of negative gearing

Ross Gittins is excellent, as usual, in his latest piece on the housing bubble. He points out that most unit investors have put their own homes up as collateral and stand to lose them if prices decline sharply (say by 40 per cent). But I have a quibble about his conclusion, saying that, if this happens

the Howard Government’s reputation as incomparable economic managers might be looking pretty tarnished.

If so, it would have only itself to blame. Why? Because it left open the negative-gearing loophole on which this whole rocky edifice has been built. And then it compounded its failure by halving the tax on capital gains. I call that asking for a property boom.

As Gittins explains, negative gearing involves taking tax-deductible losses on rental property in the hope of getting a capital gain taxed at half the normal rate.

The fundamental problem here is not the tax deductibility of losses but the concessional treatment of capital gains. In principle, at least, losses should be tax deductible. The practical problems are those of bogus losses and avoidance/evasion of tax on the associated income. But where possible, it is better to tackle these problems directly than to make particular categories of loss nondeductible.

The government certainly deserves blame for the decision, taken at the height of the dotcom mania, to halve the rate of capital gains tax. But Labor must share the blame for going along with this. As I wrote at the beginning of 2000.

Unfortunately, the Labor Party has decided that it can win the next election on the basis of the government’s difficulties with the GST, while proposing little more than cosmetic changes if elected.

Whether this is a viable political strategy is not for me to say. But it has already had disastrous effects on tax policy. In order to clear the way for a opportunistic campaign on the GST issue, Labor aided and abetted the government in destroying one of the Hawke-Keating government’s most important reforms, the taxation of capital gains on the same basis as other incomes.

The implementation problems associated with the GST will pale into insignificance compared to those that will arise from this cynical deal. The tax avoidance industry and the courts will be kept busy for years dealing with attempts to convert taxable income into capital gains. Moreover, the policy will favour heavily leveraged speculative investments at the expense of real investments generating taxable income. The danger of a speculative bubble, leading to an asset price boom and slump, will be enhanced. …. (emphasis added)

(The mysterious, and not entirely accurate, term ‘negative gearing’ can be parsed as follows. ‘Gearing’ refers to the ratio of debt to equity, which is approximately proportional to the ratio of interest payments to net returns. If interest payments exceed gross returns, net returns become negative, and the ratio becomes meaningless).

I’ve appended a bit more of the article below for anyone interested

even if it worked as intended, the New Business Tax system would be grossly inequitable, and an important step in the division of Australia into two classes, the winners and the losers from the New Economy. More than 70 per cent of the benefits from this policy change will go to the top 15 per cent of income-earners. Labor has decided to back the winners and hope that the losers can fooled by cheap shots at a tax that Labor secretly supports and will in any case never remove.

According to press reports, the only member of the Labor Caucus to oppose this sordid deal was Mark Latham. His dissent, even though confined to the party room, was seen as further evidence that he is not ministerial material. Leading members of the ‘Socialist Left’ faction joined the Sydney-based right-wing machine in pointing out the economic and political advantages of subsidising upwardly mobile property-owners and share speculators. The strategy of another GST election was supported by all.

The GST has been correctly described as a fourth-order issue, not worth an election campaign. Australia has already had two elections fought on the issue of the GST. We do not need a third.

8 thoughts on “In defence of negative gearing

  1. John

    It looks like a lot of fools will soon be parted from their money, which will be tough for them.

    I am sure you are right that the concessional capital gains treatment has been a contributing factor in all of this, but let’s face it, as a nation, we are obsessed with making money from property, and it probably would have happened anyway, in a slightly diliuted form, at the old capital gains tax rate. My guess is that low interest rates have been driving these investments at least as much as the prospect of low capital gains tax.

    The irony is that those investors who sell at a capital loss will now only be able to claim half the deduction that could have before (assuming they have other capital gains to offset the loss against.) So the hit to the government’s tax revenue will only be half as bad.

    One more thing: why aren’t you blaming the banks for encouraging people to borrow to buy these properties? I don’t see any great difference between this and the foreign currency loans you were blogging about a short time ago.

  2. I think Gittins has the allocation of blame about right in the piece I linked (banks bad, but speculators deserve all they get). The foreign currency case was worse because
    (1) The risks were less obvious
    (2) The loans were pushed on people who came in wanting to borrow money, not just advertised to people looking for a speculative investment

  3. John,
    I beg to differ concerning capital gains tax.

    1) firstly it was not cut by half. Previously only REAL gains were taxed and it was taken over a five year period. Now it is taxed on NOMINAL gains with no five year grace. Thus for quite a lot of people capital gains tax has increased.

    2) The Submission by the ASX convincingly showed that a lower tax rate on CGT has a very postive eefect on the economy. I was initially sceptical of this claim but it proved to be true when I examined the claims. I am happy to be proved wrong if someone else can refute the claim.

  4. Homer

    your first point directly and obviously contradicts your second point.

    On your first point, the CGT rate fell from 48% to 24% so with inflation at 2% you’d have to hold an investment for over 10 years to be worse off under the new CGT rules. This would apply to very few people. So it’s unlikely your first point is valid.

    But if your first point turns out to be right, then on your second argument , the new CGT rules are bad for the economy, which is the opposite of what you are trying to say.

    Not that anyone should believe the self-serving pap put forward by the ASX in the first place.

  5. I’m not clear on why exactly Gittins’ analysis applies only or mostly to flats. Obviously the supply of flats is more responsive than that of houses, which means that their value is less likely to approach infinity over time. But presumably people who buy flats at least vaguely understand this and moderate their borrowing accordingly. Meanwhile, those who buy houses borrow more and endure bigger losses in the expectation of greater capital gains. Aren’t both types of investors equally reckless? Doesn’t the market equate the marginal recklessness of a dollar of speculation across domicile categories, or is that too neoclassical?

  6. Dave,
    You missed the five year averaging which my accounting mates tell me was very useful for reducing the tax bill. you will have noted in the ‘Ralph’ Report that it was revenue neutral.

  7. Homer

    No doubt there are now all sorts of ways of reducing your tax bill. So what’s with your statement

    “Thus for quite a lot of people capital gains tax has increased.”

    Which people would they be? Those who can’t afford to hire accountants to advise them on the averaging provisions?

    I’ve looked through my collection of Ralph magazines and found no reference to capital gains tax revenue. So I don’t know which Ralph you’re talking about.

    But if it’s all revenue neutral, how is it so good for the economy? And please, don’t tell me it’s all about how at these lower rates, everyone is incentivised to invest more. I believe the father of the current US President termed that type of thinking, “voodoo economics”, circa 1980.

  8. Ralph magazine? what is that?

    Dave I used hyperbole and was careless. I should have said little difference on average.

    I used to share your attitude towards lower capital gains taxes but the weight of evidence forced me to change my mind. Indeed lower capital gains taxes are a much better bet than lowering income taxes for an economy. It is quite remarkable the effect it has on small business.

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