Reply to Henry Ergas on negative gearing

Nothing to do with raising or minimizing taxes, says Gavin R. Putland.

Until a few weeks ago, the defenders of negative gearing (NG) preferred not to mention the possibility of limiting it to new homes, lest they give the idea any free publicity. Then, on 22 April — six days after the PM ruled out any changes to NG — shadow treasurer Chris Bowen pointedly left open the possibility of limiting NG to new homes for future investors while grandfathering existing arrangements. Although grandfathering was the only NG-related policy to which Bowen actually committed his party, commentators quickly noted that the policy of limiting NG to new homes for future investors would be consistent with his stated aims. Since then, the Establishment's response to that policy has shifted from silence to frontal attack.

So today [4 May 2015] we have Henry Ergas in the Australian claiming that any modification to NG is a coward's route to raising tax on the middle class.

As any changes to NG will be limited to future investors, Ergas is accusing the reformers of wanting to increase taxes on a group of taxpayers that does not yet exist. Presumably what he really means is that this group, when it eventually comes into existence, will pay more tax than it would have paid under the old rules. But will it? If NG is limited to new homes for future investors, those future investors who are positively geared will be unaffected by the change, while those who are negatively geared will be more likely to choose new homes in order to escape the change. The only people who pay more tax than under the old rules will be future investors who choose to defy the new incentives by negatively gearing established homes. Their choice: their responsibility!

Ergas asks:

[I]f you are going to prevent interest expense from being fully deductible against property investors' taxable income,… why not limit investors' ability to deduct maintenance costs as well? …

And if the interest deduction is “unfair”,… why would the maintenance deduction be any fairer…?

[I]f double taxation of maintenance is unacceptable, why would it be acceptable for interest payments…?

Well, for one thing, there is a public interest in keeping the existing housing stock in habitable condition, but no public interest in helping would-be landlords to outborrow and hence outbid would-be owner-occupants who are competing for the same existing stock. In answer to the first question, Ergas writes:

True, rental homes need to be maintained; but it is every bit as true that they need to be financed.

But if a home already exists, it has already been financed at least once! If it is to be financed again, why should it be financed for the benefit of an investor instead of an owner-occupant?

Attempting to deny that investors have a tax advantage, Ergas writes:

[I]t should be obvious that owner-occupied housing enjoys any number of tax advantages that rental housing does not, including the complete exemption from tax of imputed rent (that is, the rent an owner would pay for using the dwelling) and of capital gains. And owner-occupied houses are also fully exempted from the means tests for the age pension and for aged care benefits.

Careful, Henry! If owner-occupants are getting a favour by not being assessed on imputed rents, although they also can't claim deductions for interest or maintenance, then investors are getting a favour by not being assessed on their unrealized capital gains while they do claim deductions for interest and maintenance. Ergas doesn't mention the crucial fact that owner-occupants can't claim deductions for interest and therefore can't exploit negative gearing, even if their outgoings exceed their imputed rent. And the exemption of owner-occupied homes from future capital-gains tax and means tests, unlike NG for investment homes, does not help first-time buyers to win the bidding war for entry to the market.

Having apparently given up on the old furphy that Keating's quarantining of negative gearing caused a blowout in rents (actually rents rose faster before and after the quarantining period than during it), Ergas looks across the Pacific for another anecdote:

The US experience is telling: the 1986 tax reform, which imposed “quarantining” provisions that limit the scope to offset losses from real estate investment against other personal income, helped decimate investment in smaller rental properties, leaving a gap ever-growing public subsidies have been unable to close.

Did those quarantining provisions make an exception for new homes, Henry? If not, that story is inapplicable to the present proposal. (And the story about Keating's quarantining, if it were true, would be inapplicable for the same reason.)

Defending current arrangements, Ergas notes that

…while prices for capital city houses have doubled since 2000, rents have risen only marginally more rapidly than median household incomes.

If workers on minimum wages are to be able to afford housing without pricing themselves out of jobs, the upward trend in rents will need to be slower than that of median household incomes. If that is to happen, tax concessions for housing will need to do something about supply — e.g. by requiring investors to build or buy new homes in order to qualify for NG.

But this is clearly the policy that Ergas has in his sights:

[E]ven the options that have been mooted as intermediate solutions are more likely to compound the difficulties than to solve them.

The proposal to limit negative gearing to new homes is a case in point. Given the restrictions on land availability, its immediate effect would be to raise the price of new, compared to existing, rental properties…

Note the implicit admission that NG drives up prices! But if prices of new homes are not driven up by NG, they will be driven up by big developers withholding land from sale until the market is ready to pay whatever ransom they demand. If limiting NG to new homes drives up prices of new house-land packages, it will enable builders to pay more for developed lots and thereby induce developers to sell their stock earlier. Meanwhile, the diversion of investors' demand from established homes will make established homes more affordable for owner-occupants, while the increase in the overall supply of housing will make rents more affordable. But, of course, improved affordability is precisely what the defenders of the status quo are afraid of.

There's another way to induce developers to sell, namely to slap a whopping great holding tax on vacant land. But I'm pretty sure Ergas wouldn't approve of that, regardless of how much payroll tax and stamp duty were cut at the same time.

On limiting negative gearing to new homes, Ergas continues:

…over time, however, it would accelerate, possibly materially, the rate at which existing properties were scrapped so as to make room for new, tax-advantaged, dwellings.

That is easily prevented or neutralized by requiring new negatively-geared dwellings to be additional dwellings, over and above those that merely replace old ones. But if, like Ergas, you don't want to require negative gearers to build new homes, neither will you want to require them to build more homes than they demolish.

In short, just as the proposal to limit NG to new homes (for future investors) has nothing to do with raising taxes and everything to do with improving housing affordability, so the opposition to this proposal has nothing to do with minimizing taxes, and everything to do with maximizing prices and rents of established properties for the benefit of incumbent owners.

[First posted at Catallaxy Files, 4 May 2015. Also see the comments on Judith Sloan's “More drivel on negative gearing”.]