Michael Keating. The Outlook for Housing and Labor’s Tax Proposals

Mar 21, 2016

Since the collapse of the mining boom, housing investment has been an important driver of the Australian economic performance. Furthermore, notwithstanding the rapid growth in superannuation balances, housing still accounts for over half of the wealth of Australian households.

In these circumstances it is important to have an accurate appreciation of the likely outlook for housing, and what difference – if any – would result from Labor’s tax proposals to substantially reduce the scope for negative gearing for housing and to increase the taxation of capital gains. So far, the only modelling has been by the consultancy firm, BIS Shrapnel, and as has been widely observed, this modelling has been a source of confusion and propaganda, and certainly not of enlightenment.

Some facts about Australian housing

In Australia housing is a major source of capital gains, and very much a preferred vehicle for investment. Indeed, in the last 35 years since 1980, Australian house prices have risen faster than in any other developed country. Although prior to the Global Financial Crisis, there were a few other countries that experienced faster rises in their house prices, house prices in those countries have since fallen, and now over the whole 35-year period, Australia has experienced the fastest rate of price increase. Furthermore, the data for the last few years indicate that Australia’s relatively fast rate of increase in housing prices is continuing.

On the other hand, and despite a strong preference for home ownership, housing appears to be less affordable for the typical Australian household than in other countries. For example, Australian house prices now represent a 43 per cent higher share of households’ incomes than the past 35-year average, and this currently high level of unaffordability is higher than in other countries (See Table 1). Equally house prices relative to rents are presently 63 per cent higher than their long run average (Table 1). This effectively means that the rental return on investment in rental housing is currently very poor – a gross return of only about 3 per cent in nominal terms, from which expenses such as maintenance rates, etc. have to be deducted. So unless there is a strong possibility of further price rises and consequent capital appreciation, rental housing is not a good investment. Again in this respect Australia is an outlier compared to other comparable countries.

Indeed, some years ago the IMF and the OECD reached the conclusion that the Australian housing market was over-priced, and they both sounded warnings about the risks this over-inflation might pose for the stability of the Australian financial system. The Reserve Bank, however, has traditionally been somewhat more sanguine – and has largely been proved right, at least so far. The RBA points to supply constraints regarding available land, both for urban renewal, and for further urban expansion, and how this shortage of supply of dwellings has up-held the market. In addition, Australian housing debt is only 28 per cent of housing assets, and so even a major fall in house prices would not of itself affect the security of the loan materially. Nevertheless, the RBA has on occasions in the past expressed concern about the extent to which the investment incentives created by negative gearing have contributed to the possible over-valuation of housing prices.

Table 1

Measures of Housing Affordability

Average Annual Nominal House Price Growth % Average Annual Real House Price Growth % House Prices relative to average income (long-term aver. = 100) House Prices relative to rents (long-term average = 100)
Australia 7.43 3.11 142.8 163.1
Britain 7.07 3.41 126.9 146.2
Germany 1.75 -0.36 89.8 91.1
Japan 0.50 -0.42 69.6 73.4
Spain 7.08 2.16 104.7 111.7
United States 3.91 0.72 91.9 107.7

Source: Economist global house prices. Data from Q1 1980 to Q1 2015.

The Impact of Labor’s Proposed Tax Changes

At present capital gains are taxed after they are realised with the amount of that gain subject to taxation being discounted by 50 per cent. There is general agreement that only real gains should be taxed and that any increase in the asset value due to inflation should not be subject to taxation. Administratively this is most simply achieved by the application of this 50 per cent discount. However, experience suggests that this discount rate is excessive, and the Henry Report into Australia’s Future Tax System favoured a lower discount rate of 40 per cent. By comparison Labor is proposing a discount rate of only 25 per cent, which looks a bit low relative to the recent record of inflation.

Labor’s proposed changes to negative gearing would remove negative gearing for all non-business related investments except for newly constructed dwellings. This removal of negative gearing would also only affect new investments, with the tax arrangements for existing investments being “grandfathered”.

Together the proposed changes in the taxation of capital gains and negative gearing arrangements would reduce the incentive to invest, but this reduction will apply to all investments, and not just to housing investment. Thus it is unlikely that these proposed tax changes would lead to much if any switch between investments, except for newly constructed dwellings. Because under Labor’s proposals it would still be possible to negatively gear investments in new dwellings, there is likely to be a switch by investors and an increase in investment in new housing. This new housing could be in the inner city through urban renewal or in new outer suburbs as the footprints of our cities continue to expand.

The return on housing investment would fall under Labor’s proposals, consequently it is likely that the value of existing houses would fall or rents would rise, or some combination of both would occur in order to restore the yield on housing investment to a required rate of return. In a tight rental market, it is more likely that rents would rise, and that there would be only a modest fall in housing prices.

As has been widely recognised, many of the claims about the negative impact of Labor’s tax changes on the economy and especially on the building industry have been greatly exaggerated. As other commentators have pointed out, the claim by BIS Shrapnel that tax changes that are estimated to raise only another $2 billion a year initially will shrink the economy by as much as $19 billion a year, should have been immediately dismissed as ridiculous and not taken seriously by anyone – let alone our Treasurer.

Instead the reality is that, as generally agreed, the housing industry is the principal industry that would be affected, and it is quite likely that these changes would actually increase the amount of investment in new housing. First, as already noted investors are likely to shift to new housing, and in addition, new housing is likely to become more affordable for first home buyers due to the likely price drop affecting all houses. In short, it is reasonable to think that these tax changes proposed by Labor, could actually lead to an increase in housing investment, and this might be sufficient to offset any reduction in investment more generally in other assets. After all, when the Hawke-Keating Government first introduced the capital gains tax thirty years ago there was no discernible impact on total investment.

In sum, there is a reasonable probability that Labor’s proposed tax changes, affecting negative gearing and a reduced discount for capital gains, would have no significant impact on the aggregate level of economic output. These changes would, however, make a useful contribution to restoring the Budget to balance, and especially over time as the impact of the changes in negative gearing bite more strongly.

Michael Keating AC was formerly Secretary of the Department of Finance and Secretary, Department of Prime Minister and Cabinet.

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