Is it Negative Gearing or Monetised Housing?
For many years, Australia has had an on-again, off-again debate about negative gearing. It’s now on again. There are two reasons why some policymakers, as far as I can tell, want to remove negative gearing: (1) to collect additional tax revenue to spend on other government programs; and/or (2) to reduce the price of houses. I’m not sure that there is a straight line to be drawn between the removal of negative gearing and the achievement of either objective, especially the second one. The reason is simple. Of all the forces involved in pushing house prices higher, negative gearing is relatively weak compared with the interplay between inflation, asset prices, and wealth protection.
A primary reason why house prices are so high is that houses have become “monetised” assets. That is, about 25 years ago, people began to use them as a store of value, not just as a place to live in. Though everyone may call these “investment properties”, most are really “store-of-value properties”.
People see the need to do this because inflation in Australia has averaged more than 4% p.a. for more than fifty years. Housing is the real asset that people know and think they understand. So, they direct their wealth into it if they can. House price growth has, on average, outpaced inflation, protecting wealth (purchasing power) and adding a little bit besides.
The stock market has performed much better than housing (11% p.a. since 2004 vs 5.4% p.a.), but it is more volatile, and people feel less comfortable owning stocks as a store of value. They also feel more comfortable with housing than with gold, silver, or more recently, something like Bitcoin. That could change. If it does, the edge would come off the housing market as people embrace what they think is a better store of value.
When the Reserve bank began targeting inflation in the 1990s, an old idea that resurfaced at that time, the game changed. The RBA’s goal is to run inflation at between 2% and 3%. They’ll think well of themselves if they achieve it. And that’s inflation measured by the CPI. There are some who argue that the official CPI inflation rate understates the cost of living by a factor of at least three or four. If the RBA achieves its goal at the mid-point, 2.5% p.a., that alone will reduce the purchasing power of a $1 today to just 36 cents over 40 years. If an $800,000 house keeps pace with 2.5% p.a. inflation, then that house will be priced at more than $2 million, even if no other factors are at play (e.g., supply and demand, credit growth, migration etc.).
How can you protect yourself? People instinctually know they need to shift dollars into something real. What’s the best idea they have? Houses. If governments and central banks behave like they have since the 1990s and especially since 2008, it’s obvious what house prices will do. They’ll keep going up unless people find some other way to protect their wealth or something comes along that upends the whole game, like an economic crisis or a major geopolitical event.
The expected growth in house prices (and expected decline in the value of the dollar) is a much greater force than negative gearing. People will try to protect their wealth and purchasing power by doing what they know best. While negative gearing is feasible because the game is the way it is, it not the whole game. It is an appendage to the game. It “works” when house prices rise. However, the negative gearing concept is not pulling itself up by its own bootstraps.
There are almost 11 million dwellings in Australia. According to the Australian Financial Review (June 8, 2021), 2.2 million Australians own a rental property. Of these, 1.3 million are negatively geared either by circumstance or design. The others are positively geared (i.e., their rental income exceeds their expenses). Of the 1.3 million people who negatively gear, 77% negatively gear one home/dwelling. That’s about 1 million dwellings or around 9% of the total housing stock. If negative gearing were the driving force of house price growth, we would expect the percentage of negatively geared properties to be much higher by now because it would be upon new entrants to the game that existing players would be reliant.
It is possible that many new entrants could be substituted for far fewer high stakes players. According to the AFR (June 8, 2021), 2% of the 1.3 million negatively geared investors own four properties and 1% own more upwards of 6. If we allow 1% of negatively geared investors, which is about 13,000 people, to own 6 properties each, that’s about 78,000 dwellings. Each year, 5% of all houses or between 500,000 to 600,000 dwellings change hands. While it seems unfair that a small group of people could own many houses, it seems unlikely that this is sufficient to move house prices higher in general.
We should ask how some people been able to accumulate multiple investment properties in the first place. The answer is simple: they held at least one house or some other tangible assets when the inflation game started and/or managed to get in at some point before it became increasingly harder to do so. They likely had wealth or income they needed to protect and saw the writing on the wall. Culturally, Australians favour buying houses, so none of this is a surprise. The game was still open, just, until about 2010, but the entrance got narrower as money poured in due to low interest rates/easy credit and huge increases in the money supply after 2008 and especially during 2020-2021.
It is also worth noting the size of the Australian property market relative to the size of the negative gearing tax deductions. The total value of Australian housing stock is about $10,000,000,000,000 ($10 trillion). Total negative gearing deductions are estimated somewhere around $3 billion to $10 billion per year. The biggest forward estimate I have seen is about $12 billion. If the total value of the housing stock increases by 2% p.a., that’s a $200 billion p.a. increase. The gains are more than proportional to the incentive. Let’s look a little more closely at this.
When the income from your property (or other asset) is less than the expenses incurred, you can deduct the loss against other income. That’s the essence of negative gearing. If you earned $25,000 in rent but incurred $35,000 in expenses, you can deduct the $10,000 against other income. If you earned $100,000 in your day job, then the deduction reduces your taxable income to $90,000, saving about $3,000 in taxes. A better way to put it is that it reduces your loss on your investment property from $10,000 to $7,000.
But remember, if house prices keep pace with inflation, then at the midpoint of the RBA’s range, 2.5% p.a., a $600,000 house will be worth $615,000 after one year. If inflation continues to run at its long-term average of closer to 4% (leaving aside the debate about whether this figure understates the matter) then the $600,000 house is worth $624,000 after one year. Even if the loss on income vs expenses is $10,000 instead of $7,000, provided the property owner can absorb it, the property owner is still ahead. People will try to play the game if they can.
The obvious expense that property investors incur is interest, but this is usually only about half the story (or less). The other half (or more) is other types of expenses, including repairs, maintenance, and renovations/improvements that might be deducted at some percentage per year over time. It would be worth figuring out how removing or changing negative gearing would affect the flow-on business generated by rental property owners for builders, electricians, plumbers, etc.
Using housing as a store of value is the action that people have taken to protect themselves from perennial inflation. You can’t help anyone with policy changes if you don’t understand how inflation works. The price of real assets, not just houses, will continue to increase if inflation persists, even at the central bank’s preferred 2-3% p.a. Unless something dramatic happens.
Politically, removing negative gearing would be tumultuous enough for politicians. It is unlikely that they would attempt anything more than that. Central banking philosophy doesn’t appear likely to change anytime soon. Alternatives to inflation targeting are out of favour. In fact, even after the rapid increase in interest rates, the RBA has only made moderate progress in soaking up the extra money printed during the pandemic.
The RBA’s balance sheet on Christmas Day 2019 was about $175 billion. By the end of 2021, it was over $630 billion. This is predominantly government debt taken onto its balance sheet, purchased with newly printed money. By early 2022, the balance sheet was over $640 billion. While the interest rate increases of 2022-2023 attracted all the attention, the RBA’s progress towards unwinding its balance sheet has been slow. By selling the government securities it holds, it would withdraw money from the economic system. But it’s doing so at a very slow pace, partly because many of the bonds it holds are worth less than what the RBA paid (when interest rates go up, bond prices go down). In early 2024, the RBA’s balance sheet was still sitting at $533 billion.
Possibly the most orderly way out of this situation will be experienced if excess money/credit can be soaked up by productivity or offset by other policy changes (e.g., regulation, energy policy etc.). There is a less pleasant pathway out of an inflationary boom in asset prices: a crisis. A crisis disintegrates, almost overnight, all the extra money that has flowed into the system and all the misallocated capital. But at the cost of great turmoil.
Discussion Question
What do you think? Will removing negative gearing make any difference to the trajectory of house prices in Australia? Will housing always be the “store of value” investment or are there alternatives that could “demonetise” housing? Will nothing short of a crisis put an end to the status quo?