Why abolishing negative gearing makes complete sense
As housing prices plummet in capital cities across Australia, with clearance rates in Melbourne and Sydney slumping to about 50% and prices dropping by 2% in the March quarter, one of Australia’s wealthiest property developers launched a bizarre defence of the negative gearing, the regime that operates to help maintain artificially high property prices.
Eddie Kutner, a former accountant and one of the founders and chairman of Melbourne-based apartment developer Central Equity, wrote an impassioned defence of negative gearing in The Age last week. Central Equity is one of Melbourne’s largest developers, with the Financial Review reporting that it allegedly generated a $59 million profit last year, after being privatised by Kutner and co-founders Dennis Wilson and John Bourke in 2006 for $67.5 million.
“Negative gearing” allows investors to use losses from property investments to reduce their overall taxable income. This effectively encourages property buyers to use debt and “bid up” the price of investment property in the hope of a subsequent capital gain. When utilising negative gearing, an investor will take out a substantial loan over a property, such that rental income is less than interest payments and other costs. The strategy is especially effective when the investor is paying the top marginal tax rate of 46%.
Eventually, when the property is finally sold, the investors will hope to make a “capital gain”. Courtesy of various poorly constructed government policy, capital gains are taxed at half the rate of income derived from labour.
Kutner made several claims in defence of negative gearing which appear somewhat illogical.
Kutner initially claimed that “for a short period, from 1986-88, treasurer Paul Keating abolished negative gearing for property investment, but quickly reinstated it when the disastrous impact of this policy on the housing market became obvious”.
This claim is mystifying given the temporary abolition of negative gearing by Keating was not a disaster at all — rather, as former ANZ chief economist Saul Eslake noted, “rents … actually only rose rapidly (at double-digit rates) in Sydney and Perth. And that was because rental vacancy rates were unusually low (in Sydney’s case, barely above 1%) before negative gearing was abolished. In other state capitals (where vacancy rates were higher), growth in rentals was either unchanged or, in Melbourne, actually slowed.”
Kutner then claimed that negative gearing must be a good idea because politicians like it, stating that “surely if negative gearing didn’t have a positive influence on supply (given that it involves a loss of tax revenue), it would be scrapped immediately”. Kutner appears to be confusing sound economic policy with populist vote seeking. Further, other countries don’t appear to share Kutner’s positive views on negative gearing, with the practice not permitted in most countries, including the US and Britain.
But Kutner’s arguments became even more baffling, with the multimillionaire developer claiming that “simply put, were it not for negative gearing, many investors could not afford and would not invest in property. Developments would not have the finance to proceed”.
Of course, the opposite is true.
Negative gearing encourages investors to pay far more for property than its “intrinsic value” (which is determined by the cash profits of an asset over its life, not merely what someone else is willing to pay). This is because the tax benefits of negative gearing compel investors to borrow excessively to purchase a property, so much so, that the yields on residential property are as low as 2% and most investors make a loss on their property investments.
Removing negative gearing would mean investors are not incentivised to borrow such large amounts and instead, investors would limit how much they pay for a property to ensure that they receive a reasonable risk-adjusted yield. This would make property far more affordable — the exact opposite to what Kutner claimed.
Kutner than noted that “if negative gearing were abolished not only would housing supply decrease and prices increase, but the rental market would be decimated. Sometimes 20 or more prospective tenants vie for one property. The rental market needs more properties, not fewer”. As Eslake noted, when negative gearing was removed in the 1980s, rental prices remained steady or actually fell in the majority of Australian cities. Housing supply itself wouldn’t necessarily decrease — however, the profits of builders such as Kutner’s Central Equity would fall and home prices would become far more affordable.
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