Ultimately, the prime minister has not been capable of providing the economic leadership our nation needs… We need a different style of leadership. We need a style of leadership that… respects the people’s intelligence, that explains these complex issues and then sets out a course of action that we believe we should take… We need to respect the intelligence of the Australian people. We need to restore traditional cabinet government [and] put an end to policy on the run and captain’s calls.
– Malcolm Turnbull, launching his leadership challenge, 14 September 2015.
The last fortnight has been a bitter one for many Australians who wanted to see Malcolm Turnbull succeed as prime minister. His first weeks in power felt like a liberation: not only from the strident Abbott era, but also from the failed Labor governments before it. At last, the most intelligent, far-sighted man in parliament had become the nation’s leader. It seemed natural, it seemed right. We wanted it to work.
And for four months or so, it did. Turnbull engaged us in the adult conversation he had promised; he respected our intelligence. He embarked on a bold course of tax reform, leaving everything on the table, and highlighting its importance for our future growth. Few decisions were made, but they were mostly sensible ones. It seemed that due process and cabinet decision-making were back as the framework of government. The polls showed Australians were happy with their leader.
Then the tax reform debate started going off the rails – and the economic horizon grew cloudier. Those two developments arrived together, and it is important to grasp the link between them. Tax reform was always going to be hard, but it becomes a lot harder if the economy is heading into trouble. That might have played a part in Turnbull’s decision to put off big tax reforms.
The economic news in 2016 has been more bad than good. The main threat to Australia’s economy lies outside these shores: it’s the price, as yet unknown, that China will be forced to pay for its long binge of reckless lending for unviable investments. At home, too, the signs aren’t good; Wednesday’s first peek at next week’s national accounts shows construction activity falling by the equivalent of almost 0.5 per cent of GDP in the December quarter. Mining investment is still shrinking faster than residential and other building investment is growing to replace it.
Also on Wednesday, the Australian Financial Review published a disturbing article by Anne Hyland in which analysts John Hempton and Jonathan Tepper used anecdotal and statistical evidence to argue that extraordinarily lax credit standards were behind the boom in which banks and others last year lent out $391 billion – that’s almost a quarter of the annual output of the Australian economy – to people buying houses and apartments.
Banks, we were told, rarely checked with employers whether borrowers really received the wage they claimed. More than 40 per cent of their lending last year was in interest-only mortgages, which make sense only if house prices rise faster than the costs of the loan.
The Fin drew a long bow in likening it to the lack of credit standards in the US housing market that led to the global financial crisis, as depicted in the film The Big Short. But an ominous drumbeat ran through the piece, warning of the potential for disaster ahead. The banks and the authorities were quick to dispute the findings, but there’s no disputing the fact that the median Sydney property price has soared by 60 per cent in four years. Fears of a sharp corrective slump might also have influenced Turnbull’s sudden change of policy and persona on tax.
There are certainly risks. Remember that in the past twenty years, the median house price in capital cities has quadrupled – or, if you’re in Melbourne, quintupled – yet median household disposable incomes have risen at only half that rate. The gap has been filled by massive increases in debt. Total household debt now tallies at 185 per cent of household disposable income, twice the ratio of twenty years ago. Debt due to rental housing investments is now 40 per cent of household income, up from 6 per cent in 1995. It’s not another subprime crisis, but that huge debt burden makes the economy slower, less agile, and more at risk of capsizing.
Whatever happens next, we, and the world, need to rethink the role that debt and the finance sector now play in economic development. Are we right to allow firms to write off their interest bills against tax? Or is this an incentive to overgearing at the risk of economic stability? Debt can be useful. It can also be dangerous.
The tax debate was already going badly for Turnbull. Labor, having been locked out of the reform process, was scoring points in its scare campaign against a higher GST, and government MPs were becoming nervous. Why do we have to risk my seat, they asked, to raise money for state governments that don’t even have the guts to campaign with us? Why does it have to be the GST? Why do it now?
So Turnbull backed off – so suddenly that for a few days he and treasurer Scott Morrison were sending out conflicting signals. It didn’t look pretty, and raised doubts about whether the cabinet process under Turnbull really has replaced the captain’s call. Soon, the higher GST Morrison had been trying to sell was swept off the table, at the same time that Labor, which we had scourged for its lack of courage, decided to put negative gearing on the table.
Since the PM and others appear confused about exactly what Labor is proposing, let’s spell it out. From 1 July 2017 (the start of the 2017–18 financial year), landlords who claim to be losing money on their financial investments – whether in rental housing or other areas – would be able to offset those losses for tax purposes only against other investment income. They would no longer be able to deduct them from their wage or salary income.
There are, however, three caveats. The new policy would apply only to properties purchased from that date; in other words, the existing tax breaks would remain for existing rental properties. Landlords who invest their money in building new housing would still be able to deduct rental losses against income from other sources. And others would be allowed to carry their losses forward to claim against capital gains tax when the property is eventually sold.
At the same time, the tax discount applied to income from capital gains would be reduced from 50 per cent to 25 per cent. (Or, to put it another way, you would have to pay tax on 75 per cent of your capital gain, rather than 50 per cent as now.) Again, the new rule would apply only to new investments from 1 July 2017; the current rules would remain for all investments before that date.
In the circles of non-partisan tax economists, the Labor policy has won widespread applause; the only criticisms have come from industry lobbies and predictable Liberal partisans. Leading economists such as Chris Richardson, Saul Eslake and John Daley have endorsed the policy as one that, in Richardson’s words, “has the potential to help provide better outcomes for all Australians.”
As someone who has been writing on tax reform for a long time myself, I see it as a bold policy, but with sensible safeguards to meet the obvious objections. My one criticism is that it should also incorporate the measure the Turnbull government is reportedly planning, which puts an annual cap on the value of tax breaks from existing rental investments.
Why do this? First, because the negative gearing tax break alone is now so widespread that it costs revenue – that is, other taxpayers – between $3 billion and $6 billion a year, depending on the level of interest rates. In effect, other taxpayers are subsidising the beneficiaries in their aspiration to become landlords.
Second, unless rental investment is used to supply new housing – which only 7 per cent is – rental housing can expand only by shrinking owner-occupied housing. Lower- and middle-income people who want to buy their own home are outbid at the auctions, and forced to remain renters. Sydney housing economist Judith Yates told the recent House of Representatives inquiry into home ownership, under Liberal MP John Alexander, that since 1981 – which was roughly when negative gearing started to spread as a tax avoidance strategy – home ownership rates among households headed by people aged twenty-five to thirty-four have fallen from 61 per cent to 47 per cent. Among those aged thirty-five to forty-four, they have plunged from 75 to 64 per cent, and among those aged forty-five to fifty-four, from 79 to 73 per cent. This is a cost of the tax break that’s always ignored by its supporters.
Labor’s move opened up various options for Turnbull. First, and most obviously, it gave him the option of taking over Labor’s policy himself, at no political cost; as the superior debater, he could quickly establish his ownership of it, yet he would be protected from political harm because Labor could not back away from its own policy. That option is gone now.
A second option is still open to him: as an alternative, adopt the Henry tax review’s proposal for a flat 40 per cent discount to apply to net income from all savings-related investments: bank interest, rental housing, capital gains (and losses), and share trading. This would cover a wider range of investments but in a less dramatic manner, and would create a level playing field across the very uneven tax laws now applying. In particular, it would remove the tax system’s discrimination against bank deposits, and hence make them a more attractive savings option – with gains to the wider economy.
Instead, Turnbull somehow decided to discard his better self and try to morph into Tony Abbott. He is making heavy weather of it; he is much better being true to himself. If you admired the real Malcolm, his recent performances in parliament and press conferences have been embarrassing to watch, a pastiche of outright lies, made-up statistics and ridiculous statements.
One example: “They want the price of homes to go down – that is their objective! And if they win the election, they will succeed in smashing home values… Vote Labor, and be poorer! Every single home owner in every single electorate represented in this House will be poorer if the Labor Party is elected to government.”
Well, when Sydney prices have shot up 60 per cent in four years, it’s very likely that they will fall some time soon, whoever is in government. They often do; the Bureau of Statistics tells us that in the past twelve years they’ve had three sustained falls, of up to 10 per cent. Sydney prices in fact have fallen for five of the past twelve years. That’s often the pattern of Australian property prices: dramatic surges followed by flat periods or prices drifting gradually up or down until a new surge hits.
Another example, a blatant fib from question time on Wednesday: “They [Labor] are proposing to remove from the market for established dwellings one-third of demand. All investors would be gone.” The PM is well aware that Labor is not proposing to ban people from owning rental investments. There will always be rental property investors, and they will do what investors did before negative gearing became fashionable: they will borrow prudently, charge the rents the market will bear, and make a profit. Even now, a third of Australian rental investors do precisely that. Rental investments provide them with an income, not a tax loss. That’s the way it’s meant to work.
Buried under Turnbull’s bluster is a serious issue: what will happen to a housing market in which prices have peaked, and the incentive for rental investment is sharply reduced? That could be very interesting indeed.
First, if Labor wins the election and can get its policy through the Senate, we’d expect to see some shift of new rental investment from established housing to new housing. That’s what Labor wants to have happen, and so long as the shift goes to filling real gaps in the market rather than building substandard apartment blocks where there’s already a glut of them, that would be a good thing. The consensus is that we need more housing, except in and around Melbourne’s CBD, and more housing choices. This policy would help in that direction.
But what would happen to the established housing market? The reduced incentive for investors would shift the balance between supply and demand. Depending on the circumstances, this would reduce either the price of houses or the growth in their price.
We can’t be sure which, but given the size of the recent price surges in Sydney and Melbourne – 61 per cent in Sydney, 30 per cent in Melbourne – falls are likely in those two cities. In regional Australia and the other capitals, where price rises since 2011–12 range from 9 per cent in Hobart to 17 per cent in Brisbane and Perth, it’s less clear.
Second, the demand vacuum created by investors moving out of the established home market would quickly be filled by would-be owner-occupiers. Rapid price rises are already telling us there is no shortage of demand. But the aspiring owner-occupiers would not be able to pay the same prices as the investors, so that too makes it more likely that prices would fall, although it is impossible to say how much.
Third, what is the likelihood of existing investors deciding that the game is up, and making a stampede for the exit gates? That would be the most disruptive outcome for the economy, although very good for those who have been forced to rent because they can’t afford to buy. Labor’s policy does try to guard against this by grandfathering existing investors from both rule changes, but it is certainly true that future house prices will be lower under its policy than they would be if the tax breaks remain.
No doubt some existing investors, particularly those with interest-only loans, would decide that speculation on future housing prices has become a risky game, and might sell out and switch to alternative investments. No doubt many others will remain in housing because they don’t see a disaster looming and/or because housing is a traditional favourite of investors seeking a safe choice they understand. Again, it’s impossible to guess from here what the balance between these two groups will be.
Finally, some confused souls have told us that if some housing investors leave the market, rents will rise. It’s a common misconception, but no, they won’t. If there are fewer housing investors, then it is axiomatic that there must be more owner-occupiers – someone has to own the joint. If there are more owner-occupiers, then there are fewer renters. The balance between supply and demand determines the price, and that will remain unchanged – except that by stimulating an increased supply of housing, Labor’s tax changes would tend to reduce rents.
Labor’s proposed policy reform is the most important that has come out of this tax debate. It would redirect some investment towards creating new assets instead of simply changing the ownership and bidding up the price of existing assets. It would make housing more affordable, for aspiring owner-occupiers and (at the margin) renters. It would save the budget (and other taxpayers) many, many billions of dollars over time.
It would also make the tax system fairer, by closing off a loophole that delivers the biggest benefits to high-income earners who need no help. And it would make the housing market fairer by gradually removing a subsidy to investors that is not available to those who want to own their own home.
The risk is that it could exacerbate a slide in housing prices that already looks likely, and in an economy that could be in fragile shape. Who knows? Economist and former Reserve Bank board member Warwick McKibbin summed the choice up well: ‘‘The question is, do you want to avoid the problem now, or do you want to wait until the thing just bursts?’’
Act now, and you make it less likely that our housing market will suffer a US-style meltdown in the future. Malcolm Turnbull should find a way to get on board, and not cheapen himself by trying to run a low-quality scare campaign. •