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The Australian Financial Review (aka the AFR) raised the negative gearing issue on 24 February 2014, when they published an opinion piece by Bob Officer titled, “Removing negative gearing would be a mistake”, link here. Bob Officer is professor emeritus, University of Melbourne. According to his CV, he finished in the top 5% of his MBA class at the University of Chicago and he also holds a PHD from the same university.

For clarity, let’s go through his opinion piece by randomly selecting those paragraphs where he is trying to make a point.

“It is sometimes asserted that negative gearing does nothing to increase the supply of housing because most investment property is for established dwellings. What causes negative gearing to suspend the laws of supply and demand? To the extent that negative gearing increases the demand by investors for housing, causing house prices to rise, resources will be attracted into housing, thus increasing the supply of housing.”

Let’s add some factual information to the above paragraph.

Why would people be asserting that negative gearing does nothing to increase the supply of housing?

RBA website > Statistics > D6 gives us the amount of money lent by all lenders for investment loans and owner occupier loans on residential property.

In December 2013, residential property investors borrowed $10.02 billion to purchase existing houses and $0.74 billion to construct new houses.

That’s only 6.9% of investor lending going to increasing the supply of housing and 93% buying existing dwellings.

What about residential property owners?

Are they better than investors at increasing the supply of housing?

In December 2013 owner occupiers borrowed $10.1 billion to buy existing houses and borrowed $1.62 billion to build new houses.

Therefore, owner occupiers are spending 13.82% of their new mortgages on building new houses whereas investors are only spending 6.9% of their new mortgage debt on building new houses.

We can now well and truly bury the idea that investors are doing us any favors on the housing supply front.

“In the context of property, negative gearing is when a property owner and investor borrows such that the interest cost offsets (or more than offsets) the income (rent) from the property so that there is no income tax liability. Effectively this converts the return from the property from rent-plus-capital-gain to all capital gain. Moreover, capital gains are typically taxed at a lower rate than rental income.”

The above is a sugar coated way of saying that investors are using negative gearing to buy “investments” that are not making profit from cash flow right now and that they have to wait for someone else to come along and bid up the price of houses so they can make a capital gain some time in the future.

This is ponzi scheme reasoning.

Our tax system encourages investors to buy investments that LOSE MONEY, because they can claim the LOSS against their wage in an unrelated job.

The only way these investors can make a profit is if someone comes along, borrows even more money and uses that money to bid up the price of our homes so the earlier investors can make a capital gain.

That’s pyramid scheme economics.

“What is the social cost associated with home ownership or investment in housing? As a generality there is none. In fact, one could argue for a social benefit in that providing housing encourages better citizenship and social cohesion.”

I believe the above is a slippery use of language.

Home ownership encourages better citizenship and social cohesion.

I am not aware of any significant social costs associated with home ownership.

Residential property investment has a social cost that is inversely proportional to the benefits of home ownership, because it directly takes away the possibility of home ownership from working class Australians.

“All asset classes, again as a generality, can be negatively geared; there is no good reason to single out housing for special treatment, and to do so will result in a mis-allocation of resources.”

Negative gearing for residential property is encouraging a mis-allocation of resources.

Should we be encouraging everyone on a wage with money to invest to put that money into a physical asset that produces nothing via negative gearing?

How does that support our economy?

If investors stopped buying our houses at auctions each weekend what would happen?

Home owners would be the winning bidders. Renters would move out of their rentals and into their new homes.

If investors stopped buying our houses on the weekend, they would have to start looking for investments to invest in that are actually cash flow positive, LIKE A REAL BUSINESS THAT PRODUCES SOMETHING.

Imagine if investors actually had to put their money into a productive asset that produced something real in the economy, like a new bakery or a mobile dog-wash van.

Negative gearing for residential property should be singled out immediately because it prevents potential home owners from buying a home each weekend at property auctions across Australia and encourages Australians to buy loss making investments (would you give your teenage children $100 and encourage them to buy shares in a company that is losing money every month in the hope that the company becomes profitable some time in the future?).

“Removal of negative gearing effectively double-taxes debt capital since the interest is taxed in both the hands of the borrower and the lender. In a similar vein, we have been there with a classical tax system that double-taxes dividends, but fortunately Australia has removed that flawed system. The Campbell Committee (1981) recommended an integrated tax system, the ideal system for company taxation. The introduction in 1987 of a full imputation tax goes close to the ideal where company profits are only taxed in the hands of the owners and not taxed twice at both the company and owner levels. To remove negative gearing on property that would result in a double tax on interest on debt is going backwards. “

I fail to see the connection between company dividends being taxed twice and interest being taxed twice.

Let’s say a bank lends you $730,000 at 5% per annum so you can buy an investment property and the bank is sourcing that $730,000 at 3% (or creating the money themselves). The bank is therefore making 2% gross profit on the interest component of your repayments which it will then pay tax on after costs are taken out.

You use that $730k to buy a three bedroom house in Burwood, Vic and rent it out at $410 per week (current house price and rental data here).

Your mortgage is roughly $4,268 per month and your rental income is roughly $1,777 per month.

Ignoring essential costs, you’re losing at least $2,491 per month, or $575 per week.

So why did you buy this investment property?

It’s losing money hand over fist, so the only logical reason you may have bought it is that you expect someone else to come along, borrow even more money than you did and bid up the price of surrounding houses in your suburb.

You’re not paying tax on the interest on your loan, because you’re making a loss that you’re claiming as a deduction against your wage in a completely unrelated field of work.

So what is this double taxation on interest Bob Officer is referring to?

Image above by Alex.