Negative gearing: busting myths and analyzing Australia’s economic situation

There is a lot of false information on economic matters available, and it appears that this is the case when you mix property and taxes.

One example of this is negative gearing.

Australia is a one-off?

Contrary to the common belief that Australia stands alone in allowing negative gearing deductions, numerous other countries share comparable systems. Germany, Japan, Canada, and Norway, for instance, have structures akin to Australia’s, permitting the offsetting of rental losses against total income tax and the carry-forward of unused losses to mitigate future tax obligations.

Beyond these, several other nations, such as France, the United States, Ireland, and Finland, operate systems slightly less generous. In these countries, rental losses can generally be applied to offset future rental income but not other forms of income, like wages.

Additionally, Spain and Sweden, while disallowing negative gearing, incorporate provisions for rental expenses to contribute to an overall reduction in tax liability. Thus, the misconception that Australia is unique in this aspect is dispelled by the presence of similar practices in various international tax systems.

Negative gearing 101

“Gearing” an asset, such as a rental property, involves borrowing for its acquisition. An asset is considered “negatively” geared if it incurs a financial loss. In the context of a rental property, negative gearing occurs when the rent charged falls short of covering the landlord’s expenses, encompassing interest payments on the loan, as well as additional costs like repairs, land taxes, and rates.

When the topic of negative gearing arises at social gatherings, particularly around the barbecue, it often revolves around the ability to offset such losses against another income source, commonly wages. Consequently, negatively geared investments hold greater appeal for individuals with higher wages and correspondingly elevated marginal tax rates.

Presently, the Australian tax system imposes no constraints on taxpayers’ ability to negatively gear investment properties. There are no limitations on the taxpayer’s income, the magnitude of losses, or the timeframe for deducting losses. While negative gearing is commonly associated with the housing market, its application extends to various asset types.

However, the current landscape is under scrutiny, with the Greens contemplating restricting negative gearing to new builds. Unsurprisingly, this has sparked a flurry of discussions, accompanied by a substantial amount of misinformation.

Before delving into the historical context of when negative gearing was last halted, between 1985 and 1987, let’s first examine the current situation.

Current state of play

According to the Federal Treasury’s 2023–24 annual overview of tax expenditures, which is a fascinating read! A remarkable increase from the $17.1 billion recorded in 2020–21 was the $27.1 billion in deductions that investors claimed for “maintaining and financing property interests.”

Unfortunately, the Treasury failed to reveal the precise amount of exemptions for the most recent fiscal year that were attributable to rental losses—a practice popularly referred to as negative gearing. But in 2021, 1.1 million investors reported losses of $7.8 billion, which resulted in a $2.7 billion tax benefit.

According to an analysis of the 2020–21 data, those earning more than the median income benefited from the tax decrease associated with rents in 80% of cases, with the top 10% of earners receiving 37% of the benefits. According to projections, negative gearing may wind up costing about $100 billion in the following ten years.

One in nine taxpayers in Australia currently participate in negative gearing, with almost a million people doing so. Any modifications made in this area will undoubtedly cause the public to become quite concerned.

It is important to remember that an estimated 400,000 additional people—nearly the population of two Canberras—might have had the chance to purchase their own homes if negative gearing hadn’t been reinstated in the middle of 1987.

There has been much discussion on the possibility of doing away with negative gearing, and opinions on the possible outcomes have been divided.

What happened between 1985-1987?

Below are eight charts that outline what happened between 1985 and 1987 when negative gearing was previously paused in Australia.

Chart 1 shows that the vacancy rate across Australia actually rose.

The fluctuations in rental vacancy rates during this period were not consistent nationwide. Notably, they experienced declines in Brisbane, Perth, and Sydney, while witnessing an increase in Adelaide and Canberra (refer to charts 2 and 3 for a detailed breakdown). However, when considering the national average, the rental vacancy rate displayed a noteworthy ascent, surging by 2% from 2.2% in mid-1985 to 4.4% in mid-1987.

Chart 4 tells me that, despite a rising vacancy rate, annual rental growth was elevated between 1985 and 1987.

Traditionally, rental growth tends to decelerate when vacancy rates increase, and conversely, it accelerates during periods of declining vacancy rates, as evident in the correlation presented in charts 1 and 4.

During that era, a commonly held assertion attributed the surge in rents to a confluence of factors, notably the slowdown in dwelling starts, as illustrated in chart 5, juxtaposed against the backdrop of escalating annual population growth.

See chart 6.

Nevertheless, in mid-1985, there existed an annual demand for approximately 100,000 new dwellings, and by mid-1987, this requirement escalated to 115,000, marking a 15% increase. Despite a notable 25% decrease in new housing starts, an excess of new housing stock persisted, as illustrated by the annotated figures in chart 5.

The primary culprit behind this phenomenon, however, was the upward trajectory of interest rates, as depicted in chart 7.

The official cash rate witnessed a notable climb, ascending from 11.75% in mid-1985 to 13.2% within a span of two years. Between 1985 and 1987, there was a brief surge in the cash rate, reaching an astonishing 19.4% for a short duration.

This escalation in interest rates significantly curtailed purchasing activity, resulting in a decline in housing starts and an upswing in rental costs, as investors sought to offset the heightened borrowing expenses. Drawing from personal experience, mortgage rates during this era were exceptionally steep, exemplified by our inaugural home loan carrying a staggering 17.5% annual interest rate. Developers, too, grappled with financial burdens, facing interest rates exceeding 20% per annum.

Despite the elimination of negative gearing, coupled with soaring interest rates and an oversupply of new properties, Australia’s housing market demonstrated resilience. Between 1985 and 1987, while the growth rate may not have mirrored the long-term average precisely, it remained in close proximity to it.

Chart 8 illustrates the remarkable resilience of Australia’s house values, experiencing only brief periods of negative growth, occurring just six times since 1981.

Looking forward

Within the housing industry, divergent opinions abound, with one faction anticipating a decline in property values, a surge in investor sell-offs, a further drop in vacancy rates, accelerated rent increases, and a significant plummet in building starts. It’s a cascade of speculations and predictions.

Conversely, another school of thought holds the belief that any potential impact will be relatively mild. Count me among those in the latter camp.

Why this perspective?

Primarily because much of the discourse surrounding the removal of negative gearing in the past was, frankly, baseless. The subsequent reinstatement of negative gearing appeared to be driven more by political considerations than sound economic or policy rationale.

I am inclined to believe that history often tends to echo itself, and understanding the contextual factors at play in previous scenarios lends credence to a more measured outlook.

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Negative gearing: busting myths and analyzing Australia’s economic situation

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