Is GDP doomed to low growth?

GDP failed to rebound after the 2008 Financial Crisis, sinking into a period of stubborn low growth. Economic commentators have advanced many explanations for the causes, while the consensus seems to be that this is the new normal, with the global economy destined to decades of poor growth.

Real GDP Growth

This is a classic case of recency bias. Where observers attach the most value to recent observations and assume that the current state of affairs will continue for the foreseeable future. The inverse of the Dow 100,000 projections during the Dotcom bubble.

Real GDP for Q1 2018 recorded 2.9% growth over the last 4 quarters. Not exactly shooting the lights out, but is the recent up-trend likely to continue?

Real GDP Growth and estimate based on Private Sector Employment and Average Weekly Hours Worked

Neils Jensen from Absolute Return Partners does a good job of summarizing the arguments for low growth in his latest newsletter:

The bear story

Putting my (very) long-term bearishness on fossil fuels aside for a moment, there is also a bear story with the potential to unfold in the short to medium-term, but that bear story is a very different one. It is a story about GDP growth likely to suffer as a consequence of the oil industry’s insatiable appetite for working capital, which is presumably a function of the low hanging fruit having been picked already.

In the US today, the oil industry ties up 31 times more capital per barrel of oil produced than it did in 1980, when we came out of the second oil crisis. ….Such a hefty capital requirement is a significant tax on economic growth. Think of it the following way. Capital is a major driver of productivity growth, which again is a key driver of economic growth. Capital tied up by the oil industry cannot be used to enhance productivity elsewhere, i.e. overall productivity growth suffers as more and more capital is ‘confiscated’ by the oil industry.

I am tempted to remind you (yet again!) of one of the most important equations in the world of economics:

∆GDP = ∆Workforce + ∆Productivity

We already know that the workforce will decline in many countries in the years to come; hence productivity growth is the only solution to a world drowning in debt, if that debt is to be serviced. Why? Because we need economic growth to be able to service all that debt.

Now, if productivity growth is going to suffer for years to come, all this fancy new stuff that we all count on to save our bacon (advanced robotics, artificial intelligence, etc.) may never be fully taken advantage of, because the money needed to make it happen won’t be there. It is not a given but certainly a risk that shouldn’t be ignored.

….For that reason, we need to retire fossil fuels as quickly as possible. Ageing of society (older workers are less productive than their younger peers) and a global economy drowning in debt (servicing all that debt is immensely expensive, leaving less capital for productivity enhancing purposes) are widely perceived to be the two most important reasons why productivity growth is so pedestrian at present.

I am not about to tell you that those two reasons are not important. They certainly are. However, the adverse impact the oil industry is having on overall productivity should not be underestimated.

I tend to take a simpler view, where I equate changes in GDP to changes in hours worked and in capital investment:

∆GDP = ∆Workforce + ∆Capital

Workers work harder if they are motivated or if there is a more efficient organizational structure, but these are a secondary influence on productivity when compared to capital investment.

The chart below compares net capital formation by the corporate sector (over GDP) to real GDP growth. It is evident that GDP growth rises and falls in line with net capital formation (or investment as it is loosely termed) by corporations.

Net Capital Formation by the corporate sector/GDP compared to Real GDP Growth

A quick primer (with help from Wikipedia):

  • Capital Formation measures net additions to the capital stock of a country.
  • Capital refers to physical (or tangible) assets and includes plant and equipment, computer software, inventories and real estate. Any non-financial asset used in the production of goods or services.
  • Capital does not include financial assets such as bonds and stocks.
  • Net Capital Formation makes allowance for depreciation of the existing capital stock due to wear and tear, obsolescence, etc.

Net Capital Formation peaked at around 5.0% from the mid-1960s to the mid-1980s, made a brief recovery to 4.0% during the Dotcom bubble and has since struggled to make the bar at 3.0%. Rather like me doing chin-ups.

Net Capital Formation Declining in the Corporate Sector

There are a number of factors contributing to this.

Intangible Assets

Capital formation only measures tangible assets. The last two decades have seen a massive surge in investment in intangible assets. Look no further than the big five on the Nasdaq:

Stock Symbol Price ($) Book Value ($) Times Book Value
Amazon AMZN 1582.26 64.85 24.40
Microsoft MSFT 95.00 10.32 9.21
Facebook FB 173.86 26.83 6.48
Apple AAPL 169.10 27.60 6.12
Alphabet GOOGL 1040.75 235.46 4.42

Currency Manipulation

Capital formation first fell off the cliff in the 1980s. This coincides with the growth of currency manipulation by Japan, purchasing excessive US foreign reserves to suppress the Yen and establish a trade advantage over US manufacturers. China joined the party in the late 1990s, exceeding Japan’s current account surplus by 2006. Currency suppression creates another incentive for corporations to offshore or outsource manufacturing to Asia.

China & Japan Current Account Surpluses

Tax on Offshore Profits

Many large corporations took advantage of low tax rates in offshore havens such as Ireland, avoiding US taxes while the funds were held offshore. This created an incentive for large corporations to invest retained earnings offshore rather than in the USA.

The net effect has been that retained earnings are invested elsewhere, while new capital formation in the USA is almost entirely funded by debt.

Net Capital Formation by the corporate sector/GDP compared to Corporate Debt Growth/GDP

Donald Trump’s tax deal will make a dent in this but will not undo past damage. The horse has already bolted.

Offshore Manufacturing

Apart from tax incentives, lower labor costs (enhanced by currency manipulation) led large corporations to set up or outsource manufacturing to Asia and other developing countries. In effect, offshoring capital formation and — more importantly — GDP growth to foreign destinations.

Offshoring Jobs

Along with manufacturing plants, blue-collar jobs also moved offshore. While this may improve the company bottom-line for a few years, the long-term, macro effects are devastating.

Think of it this way. If you build a manufacturing plant offshore rather than in the USA you may save millions of dollars a year in labor costs. Great for the bottom line and executive bonuses. But one man’s wage is another man/woman’s income (when he/she spends it). So, from a macro perspective, the US loses GDP equal to the entire factory wages bill plus the wage component of any input costs. A far larger figure than the company’s savings. As more companies offshore jobs, sales growth in the USA is affected. In the end this is likely to more than offset the savings that justified the offshore move in the first place.

Stock Buybacks

Stock buybacks accelerate EPS (earnings per share) growth and are great for boosting stock prices and executive bonuses. But they create the illusion of growth while GDP stands still. There is no new capital formation.

Can GDP Growth Recover?

Yes. Restore capital formation and GDP growth will recover.

How to do this:

Trump has already made an important move, revising tax laws to encourage corporations to repatriate offshore funds.

But more needs to be done to create a level playing field.

Stop currency manipulation and theft of technology by developing countries, especially China. Trump has also signaled his intention to tackle this thorny issue.

Repatriating offshore manufacturing and jobs is a much more difficult task. You can’t just pack a factory in a box and ship it home. There is also the matter of lost skills in the local workforce. But manufacturing jobs are being lost globally at an alarming rate to new technology. In the long-term, offshore manufacturing plants will be made obsolete and replaced by new automated, high-tech manufacturing facilities. Incentives need to be created to encourage new capital formation, especially high-tech manufacturing, at home.

Stock buybacks, I suspect, will always be around. But remove the incentive to boost stock prices by targeting the structure of executive bonuses. It would be difficult to isolate benefits from stock buybacks and tax them directly. But removing tax on dividends — in my opinion far simpler and more effective than the dividend imputation system in Australia — would remove the incentive for stock buybacks and make it difficult for management to justify this action to investors.

We already seem to be moving in the right direction. The last two points are relatively easy when compared to the first two. If Donald Trump manages to pull them (the first two) off, he will already move sharply upward in my estimation.

Judge a tree by the fruit it bears.

~ Matthew 7:15–20

Consider Republicans’ tax plan | Ross Garnaut

From Patrick Hatch:

“Our existing tax base for the corporate income tax is in deep trouble,” Professor Garnaut told the Melbourne Economic Forum on Tuesday. “It’s subject to egregious avoidance or evasions, with two of the main instruments of avoidance being arbitrary use of interest on debt to reduce taxable income and, more importantly, arbitrary use of payment for import of services as deductions.

“You have a lot of what must be fundamentally some of the most profitable enterprises in Australia paying no corporate income tax.

“Google and Microsoft and Uber, they manage to generate very large sales in Australia … but somehow make no profit from it because of payment for intellectual property, payments for services.”

Cutting rates while broadening the base is a step in the right direction. But the broader base has to offset the rate cut, so that tax revenues are not depleted.

One of the oldest tricks in the tax avoidance industry is to set up a structure where A receives a deduction for an expense while the receiving party (B) is either tax exempt or is resident in a tax haven, and does not pay tax on the income. The effect is to substantially reduce tax payable by A.

Disallowing all deductions would unfairly penalize legitimate transactions. A simpler method would be to require A to collect a withholding tax on the payment to B (or B provides a tax file number showing that the income will be taxed in Australia) else the deduction by A will be disallowed.

Source: Consider Republicans’ tax plan, says economist Ross Garnaut

Priming the Pump

US stocks are buoyant on hopes that a Donald Trump presidency will benefit business, with major indexes flagging a bull market. But promises come first, the costs come later. While I support a broad infrastructure program and the creation of a level playing field in global markets, the actual execution of these ideas is critical and should not be allowed to be hijacked by the establishment for their own ends.

Erection of trade barriers is a useful negotiating position but is unlikely to be achieved without enormous damage to the global economy. As long as your trading partners think you are crazy enough to do it, they may be more amenable to establishing fair ground rules for international trade. If they don’t believe the threat, they will be happy to continue on their present path. So Trump walks a fine line between reassuring his allies and the domestic market, while keeping others guessing about his intentions.

Before we get carried away with hopes and expectations, however, we need to evaluate the current state of the economy in order to assess the current potential for growth.

The Cons

Let’s start with the negatives.

Construction spending is slow, at about three-quarters of pre-GFC (and sub-prime) levels. It will take more than an infrastructure program to restore this (though it is a step in the right direction). What is needed is higher growth expectations for the economy.

Construction Spending to GDP

Industrial production is close to its pre-GFC peak but has been declining since 2014.

Industrial Production Index

Job growth is slowing. Decline below 1.0 percent would be cause for concern.

Employment Growth

Rail and freight activity also reflects a slow-down since 2015.

Rail & Freight Index

The Philadelphia Fed’s broad-based Leading Index has also softened since 2014. Decline below 1.0 percent would be cause for concern.

Leading Index

One of my favorite indicators, this graph compares profit margins (per unit of gross value added) to employee costs. There is a clear cycle: employee costs (per unit) fall after a recession while profits rise. As the economy recovers and approaches full capacity, employee costs start to rise and profits fall — which leads to the next recession. At present we can clearly see employee costs are rising and profit margins are falling.

Profits and Employee Costs per unit of Value Added

It will be difficult for corporations to continue to grow earnings in this environment. Business investment is falling.

Gross Private Nonresidential Fixed Investment

Plowing money into stock buybacks rather than into new investment may shore up corporate performance for a while but hurts construction and industrial production. Turning this around is a major challenge facing the new administration.

The Pros

Retail sales are rising as increased employee compensation costs lift consumer confidence. Solid November sales with strong Black Friday numbers would help lift confidence even further.

Retail Sales

Light vehicle sales are also recovering, a key indicator of consumers’ long-term outlook.

Light Vehicle Sales

Rising sales and infrastructure investment are only part of the solution. What Donald Trump needs to do is prime the pump: introduce a fairer tax system, minimize red tape and reduce political interference in the economy, while enforcing strong regulation of the financial sector. Not an easy task, but achieving these goals would help restore business confidence, revive investment, and set the economy on a sound growth path.

In the short run, the market is a voting machine
but in the long run it is a weighing machine.

~ Benjamin Graham: Security Analysis (1934)

Big government doesn’t kill growth???

I take issue with this article published in Macrobusiness:

Sorry Coalition, “big Government” doesn’t kill growth

By Leith van Onselen

During the Federal Election campaign, Labor’s shadow treasurer, Chris Bowen, confirmed that the overall tax burden would hit 24.8% GDP by 2026-27 under Labor, up from 23.5% in 2019-20:

Mr Bowen told The Australian Financial Review that his number was lower than the 25.7 per cent of GDP that Treasurer Scott Morrison claimed Labor would deliver, but higher than the Coalition’s ceiling of 23.9 per cent.

Mr Bowen said the alternative would be spending cuts to essential services.

“Let me be clear: tax-to-GDP will be higher over the medium term under both the Coalition and Labor government. Either that, or the Coalition will continue to deliver more savage cuts to Medicare and education,” he said.

The admission was immediately seized upon by Treasurer Scott Morrison, who claimed that a higher tax burden would damage the Australian economy’s growth:

“Labor might want to think you can have a tax-to-GDP ratio approaching 26 per cent and that will have no impact on the Australian economy. They are kidding themselves…”

The Coalition’s 23.9% of GDP ceiling on tax is based on the National Commission of Audit’s recommendation that taxation revenue as a share of GDP should be capped at 24%.

The assumption that higher tax equals less economic growth is a popular one among conservatives, not just in Australia.

However, four American academics have published an important new book, entitled “How Big Should our Government Be?”, which examines in detail the vexed issue of government size and growth.

According to the Washington Post, which provides a good summary of the book, there is actually a positive correlation between the size of government and economic growth per capita:

ScreenHunter_14443 Aug. 10 08.40

Using data on 12 advanced economies from 1870, the authors of the book conclude with the following:

“In the century and a half since then, government expenditures as a share of GDP have risen sharply in these countries. Yet they didn’t experience a slowdown in their long-run economic growth rates. The fact that economic growth has been so stable over this lengthy period, despite huge increases in the size of government, suggests that government size probably has had little or no impact on growth.”

The authors also note that “A national instinct that small government is always better than large government is grounded not in facts but rather in ideology and politics,” and that the evidence “shows that more government can lead to greater security, enhanced opportunity and a fairer sharing of national wealth.”

In particularly, the authors call for more investment in infrastructure, education, as well as proper safety nets for the unemployed and those that get sick.

The Turnbull Government should take note as it considers taking an axe to Australia’s public services.

MY REBUTTAL:

Let me start by saying that I am not in favor of austerity as a response to a major economic slow-down. If anything that will exacerbate unemployment and prolong the contraction. Instead I advocate major infrastructure programs to stimulate the economy. But with two caveats: (1) investments must generate a market-related return on investment; and (2) there must be strong involvement from the private sector. Investment in assets that do not generate direct revenue leaves future taxpayers with a pile of debt and no income (or saleable assets) that can service (or repay) it. Involvement of the private sector should be structured to ensure that the benchmark of market-related returns is not superseded by projects selected to win the most votes. Also, the private sector should have skin in the game to restrict cost blowouts. They are not immune to cost blowouts but are not in the same league as big government.

I also believe that weak government will harm an economy. We need strong regulators, rule of law, police and military to ensure stability. Also spending on education and science to foster growth.

But the article by Jared Bernstein in the Washington Post typifies the kind of rubbish pedaled to voters around election time. And seems to have been swallowed hook-line-and-sinker by the author of the MB article.

Where do I start?
First, the fact that a book by four unnamed academics is cited as proof in itself should tell us how much credibility to attach to their claims.

Second, the author mentions that there is “a positive correlation between the size of government and economic growth per capita…”. A positive correlation is any correlation coefficient greater than zero. The highest correlation is a value of 1.0 which represents a perfect fit. No correlation coefficient is provided in either article and judging from the graph I would assume it is closer to zero than 1, meaning there is only a vague correlation. If you ignore the line drawn on graph, the data looks randomly scattered with no clear trend.

Also the author overlooks that he is only dealing with a sample of 12 countries, which again would give a low level of confidence in any result.

Further, in the WP article the author concedes that correlation is not equal to causation: “That positive slope in the figure on the left above could easily be a function of reverse causality: As economies grow, their citizens demand more from them.” This is omitted in the MB report.

Then the study of data for the 12 economies from 1870 up top the present is used to argue that growth in government expenditures does not hinder GDP growth. I would be surprised if the data didn’t show growth in government across all countries as it spans the era from horse-drawn carts up to the area of modern jets and space travel. From the country GP with a stethoscope to modern nuclear medicine and MRIs. From slate and chalk to super-computers and digital technology. Of course the demand for infrastructure has grown exponentially over that time. To argue otherwise would be stupid.

But that is not an argument in favor of a welfare state or increased government expenditure. In fact, most of those advances in technology were driven by private individuals and not by government.

Finally, I will use another graph from “How big should our government be,” Bakija et al in the same Washington Post article to argue the case for lean government (as opposed to small government circa 1870):

Tax Revenue as Percentage of GDP and GDP Growth

The graph shows that tax revenues as a percentage of GDP have steadily declined, since the late 1990s, for every country except France. Why has this occurred in even model welfare states like Sweden and, to a lesser extent, Canada? Simply because they reached “peak welfare” in the 1990s and realized that the only way to revive GDP growth was to reduce the role of government in the economy.

Tax Revenue as Percentage of GDP

The only one who hasn’t accepted the evidence is France. Which may well be contributing to their poor economic performance.

Michael Pettis: Brexit could speed breakup of the Euro

On secular stagnation: “I don’t see growth picking up until you either redistribute income downwards — which is politically quite difficult and slow — or developed countries which are credible borrowers engage in massive infrastructure spending — which would be a great idea but politically difficult — so I’m afraid secular stagnation is going to last several more years.”

On BREXIT: “I’m not to optimistic that the Euro will be around in 10 years…BREXIT could speed up the process if England does well.”

On future crises: “It’s always the same thing: a huge switch from New York to Washington (in American terms) where policy begins to dominate the whole process…because the solutions to the problems are political solutions, not really economic or financial solutions…”

Land tax is needed but won’t happen | Macrobusiness

Taxes

By Leith van Onselen. Reproduced with kind permission from Macrobusiness.

The Australian’s Adam Creighton has written a ripper post explaining why, in the wake of tax avoidance scandals (e.g. multinational and the Panama Papers), a broad-based land tax is needed more than ever, but will never see the light of day due to vested interests and weak politicians:

Windfall gains to private land owners stemming from developments outside their control are a far better object for taxation than income and consumption, which prop up vast avoidance industries…

Taxes on land are unique economically because they can’t be avoided and they don’t distort supply…

In fact, over time land tax (which should apply only to the unimproved part) could even ­reduce rents by encouraging development, including more apartments, on undeveloped land…

Land taxes may well be fairer, too. Just as the owners of land adjacent to new railway stations have done nothing to generate their windfall, land owners don’t lift a finger to generate increases in unimproved land values…

A comprehensive national, flat rate tax on unimproved land taxes was part of Labor’s platform from 1891 to 1905. The party should consider resurrecting this policy and using the proceeds entirely to slash personal income and/or company tax to unleash a productivity, investment and spending boom. This would help affordability; property prices would automatically fall…

A 1 per cent annual land tax without any exemptions could raise around $44bn based on the ABS’s estimates…

The economic ignorance and self-interest of land owners will, however, prevent any shift towards land tax, however beneficial it might be in the long run for almost everyone.

Vested interests would launch a hysterical defence of existing arrangements, wrongly claiming poor renters would be harmed.

Others would argue even stupid policies can’t be changed because some people have arranged their affairs around them.

Creighton has nailed it.

Land taxes are one of the most efficient sources of tax available, actually creating positive welfare gains to the domestic population of $0.10 for each dollar raised, since non-resident home owners are also taxed (see below Treasury chart).

ScreenHunter_6774 Mar. 30 10.24

Even just switching inefficient stamp duties (which cost the economy $0.70 per dollar raised) to a broad-based land tax would produce an estimated 1.5% increase in GDP, or $24 billion, without changing the amount of tax raised.

Unfortunately, while the arguments for shifting the tax base towards land taxes are impeccable, there are several key factors holding politicians back.

Consider the proposal to merely junk stamp duties in favour of a broad-based land tax levied on all land holders.

As shown by the RBA, only around 6% of the housing stock is transacted on average in a given year:

This means that in a given year, only a small minority of households pay stamp duty (albeit tens-of-thousands of dollars of dollars). And once they pay it, they automatically become a roadblock to reform (“why should I pay tax twice”, is the common retort).

While having such a small group of taxpayers supporting services for the whole community is ridiculous, rather than governments sharing the tax burden by levying each household a much smaller amount on a regular basis, it is far easier politically to tax a small group than everyone.

The other major roadblock with land taxes is that they would be levied on retirees that are asset (house) rich but cash poor. They would, therefore, squeal like stuffed pigs if they were required to pay tax.

The obvious solutions to these roadblocks are:

  1. To overcome concerns around “double taxation”, provide a credit to anyone that has purchased a home in the past 10 years, equal to the amount of stamp duty paid, and then subtract the hypothetical land tax that would have been paid since the home was purchased.
  2. Allow retirees to accumulate their land tax liability, with the bill payable upon death (via the estate) or once the house is eventually sold (whichever comes first), with interest charged on any outstandings.

However, even with such arrangements in place, politicians would still face the option of maintaining the status quo and taxing only a small number of people each year (easy) versus reforming and taxing almost everyone (hard).

Add in a fierce scare campaign from the property lobby – especially if land taxes were extended beyond just stamp duties to replace income taxes – and the likelihood of achieving meaningful reform is slim, especially with the current useless crop of politicians.

Megalogenis: Australian Panic! | MacroBusiness

From Unconventional Economist at Macrobusiness:

…..George is back, this time with The Australian Panic in a new Quarterly Essay:

The Australian Panic

In this urgent essay, George Megalogenis argues that Australia risks becoming globalisation’s next and most unnecessary victim. The next shock, whenever it comes, will find us with our economic guard down, and a political system that has shredded its authority. Megalogenis outlines the challenge for Malcolm Turnbull and his government. Our tax system is unfair and we have failed to invest in infrastructure and education. Both sides of politics are clinging defensively to an old model because it tells them a reassuring story of Australian success. But that model has been exhausted by capitalism’s extended crisis and the end of the mining boom. Trusting to the market has left us with gridlocked cities, growing inequality and a corporate sector that feels no obligation to pay tax. It is time to redraw the line between market and state.

Balancing Act is a passionate look at the politics of change and renewal, and a bold call for active government. It took World War II to provide the energy and focus for the reconstruction that laid the foundation for modern Australia. Will it take another crisis to prompt a new reconstruction?

I think George has it right this time.

Source: Megalogenis: From Australian Moment to Australian Panic! – MacroBusiness

Axe negative gearing for a healthier property market | Saul Eslake

Thanks to Ody for posting this on IC forum. I feel it is worth repeating here because of the current debate around negative gearing.

Axe negative gearing for a healthier property market
Apr 25, 2011: Saul Eslake

The property market would look a lot healthier without it, writes Saul Eslake.

For almost a quarter of a century, successive Australian governments have, with varying degrees of enthusiasm, sought to promote higher levels of participation in employment, and higher levels of personal saving.

These are both worthy objectives, ones which public policy should seek to promote. It’s therefore surprising that successive governments have not merely been content to maintain a tax system that taxes income from working and saving at higher rates than those at which it taxes income from borrowing and speculating, but have either increased the extent to which income from borrowing and speculating is treated more favourably by the tax system, or explicitly rejected sensible proposals to balance incentives between the two as Wayne Swan did in May last year when ruling out recommendations made by the Henry Review.

Under the taxation system, income from working – that is, wages and salaries – is taxed at higher marginal rates than any other kind of income: 31.5 per cent for most Australians with full-time jobs (earning between $37,000 and $80,000 a year), 38.5 per cent for those earning over $80,000 a year and 46.5 per cent for those earning over $180,000 a year.

Income from deposits in banks, building societies and credit unions is taxed at the same marginal rates.

For those contemplating entering, or re-entering, paid employment (say, after a period of caring for children or aged parents) the impact of tax on income from work can result in effective marginal tax rates of close to, or even over, 60 per cent, on what are quite modest levels of income. The Henry Review concluded that ”some people [are] likely to reduce their level of work as a result” of these very high effective marginal tax rates. This may be one reason why the workforce participation rates of women with children, and older people, are lower here than in other OECD countries.

By contrast, income from most forms of investment, other than interest-bearing deposits, is typically taxed at lower rates than similar amounts of income derived from working. Income from saving through superannuation funds, and from ”geared” investments (that is, the purchase of assets funded by borrowing) is especially lightly taxed.

The review calculated that, for a top-rate taxpayer, the real effective marginal tax rates (after taking account of inflation assumed to average 2.5 per cent per annum, and the time at which tax is payable) on income earned from superannuation savings or highly-geared property investments are actually negative, while the real effective marginal tax rate on interest income from deposits can be as high as 80 per cent.

Very few other ”advanced” economies are as generous in their tax treatment of geared investments as Australia is. In the United States, investors can only deduct interest incurred on borrowings undertaken to purchase property or shares up to the amount of income (dividends or rent) earned in any given financial year; any excess of interest expense over income (as in a ”negatively geared” investment) must be ”carried forward” as a deduction against the capital gains tax payable when the asset is eventually sold.

In Australia, by contrast, that excess can be deducted against a taxpayer’s other income (such as wages and salaries) thereby reducing the amount of tax otherwise payable on that other income.

The Howard government’s decision in 1999 to tax capital gains at half the rate applicable to wage and salary income, converted negative gearing from a vehicle allowing taxpayers to defer tax on their wage and salary income (until they sold the property or shares which they had purchased with borrowed money), into one allowing taxpayers to reduce their tax obligations (by, in effect, converting wage and salary income into capital gains taxed at half the normal rate) as well as deferring them.

As a result, ”negative gearing” has become much more widespread over the past decade, and much more costly in terms of the revenue thereby foregone. In 1998-99, when capital gains were last taxed at the same rate as other types of income (less an allowance for inflation), Australia had 1.3 million tax-paying landlords who in total made a taxable profit of almost $700 million.

By 2008-09, the latest year for which statistics are available, the number of landlords had risen to just under 1.7 million: but they collectively lost $6.5 billion, largely because the amount they paid out in interest rose almost fourfold (from just over $5 billion to almost $20 billion over this period), while the amount they collected in rent only slightly more than doubled (from $11 billion to $26 billion), as did other (non-interest) expenses. If all of the 1.1 million landlords who in total reported net losses in 2008-09 were in the 38 per cent income tax bracket, their ability to offset those losses against their other taxable income would have cost over $4.3 billion in revenue foregone; if, say, one fifth of them had been in the top tax bracket then the cost to revenue would have been over $4.6 billion.

This is a pretty large subsidy from people who are working and saving to people who are borrowing and speculating. And it’s hard to think of any worthwhile public policy purpose which is served by it. It certainly does nothing to increase the supply of housing, since the vast majority of landlords buy established properties: 92 per cent of all borrowing by residential property investors over the past decade has been for the purchase of established dwellings, as against 82 per cent of all borrowing by owner-occupiers.

For that reason, the availability of negative gearing contributes to upward pressure on the prices of established dwellings, and thus diminishes housing affordability for would-be home buyers.

Supporters of negative gearing argue that its abolition would lead to a ”landlords’ strike”, driving up rents and exacerbating the existing shortage of affordable rental housing. They point to ”what happened” when the Hawke government abolished negative gearing (only for property investment) in 1986, claiming that it led to a surge in rents, which prompted the reintroduction of negative gearing in 1988.

This assertion has attained the status of an urban myth. However it’s actually not true. If the abolition of ”negative gearing” had led to a ”landlords’ strike”, then rents should have risen everywhere (since ”negative gearing” had been available everywhere). In fact, rents (as measured in the consumer price index) 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 per cent) 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.

Notwithstanding this history, suppose that a large number of landlords were to respond to the abolition of negative gearing by selling their properties. That would push down the prices of investment properties, making them more affordable to would-be home buyers, allowing more of them to become home owners, and thereby reducing the demand for rental properties in almost exactly the same proportion as the reduction in the supply of them. It’s actually quite difficult to think of anything that would do more to improve affordability conditions for would-be home buyers than the abolition of ”negative gearing”.

There’s absolutely no evidence to support the assertion made by proponents of the continued existence of ”negative gearing” that it results in more rental housing being available than would be the case were it to be abolished (even though the Henry Review appears to have swallowed this assertion). Most other ”advanced” economies don’t have ”negative gearing”: yet most other countries have higher rental vacancy rates than Australia does.

I’m not advocating that ”negative gearing” be abolished for property investments only, as happened between 1986 and 1988. That would be unfair to property investors. Personally, I think negative gearing should be abolished for all investors, so that interest expenses would only be deductible in any given year up to the amount of investment income earned in that year, with any excess ”carried forward” against the ultimate capital gains tax liability. But I’d settle for the review’s recommendation, which was that only 40 per cent of interest (and other expenses) associated with investments be allowed as a deduction, and that capital gains (and other forms of investment income, including interest on deposits) be taxed at 60 per cent (rather than 50 per cent as at present) of the rates applicable to the same amounts of wage and salary income.

This recommendation would not amount to the abolition of ”negative gearing”; it would just make it less generous. It would be likely, as the review suggested, ”to change investor demand towards housing with higher rental yields and longer investment horizons [and] may result in a more stable housing market, as the current incentive for investors to chase large capital gains in housing would be reduced”.

Sadly, these recommendations were among the 19 that the Treasurer explicitly ruled out when releasing the review last year. That makes it hard to believe that this government (or indeed any alternative government) is serious about increasing the incentives to work and save – or at least, about doing so without risking the votes of those who borrow and speculate, in effect subsidised by those who don’t, or can’t.


Saul Eslake is a Program Director with the Grattan Institute. The views expressed here are his own.

Saul’s suggestion of carrying forward losses rather than writing them off against other income is a good one. But I would go a lot further with tax reform:

  • a 10% flat rate of tax on all income;
  • 10% corporate tax rate;
  • 10% tax rate for super funds;
  • no capital gains discount and no inflation adjustment;

While a comprehensive 10% tax on all income and capital gains would raise a substantial sum, there is bound to be a shortfall compared to the current system. My solution would be a land tax (similar to local council rates), excise taxes (alcohol, petrol and tobacco), and a flat rate of GST on all goods (including basic foods and medicine) to balance the budget.

Some would argue that this would increase the tax burden for the poorest families, but that could easily be addressed through food stamps or “rent stamps” for families on welfare. Land tax is a highly progressive (the opposite of “regressive”) tax that is closely correlated to wealth rather than income. The overall aim would be to encourage GDP growth by removing the burden of a complex income tax system with high marginal rates that serve as a disincentive to create additional income. Simplicity would improve fairness, minimize avoidance and reduce the cost of reporting and administration.

….Don’t hold your breath.