Nonsensical Gearing

Imagine an investment scheme designed to lose money; that fails if it inadvertently makes a profit. Conniving to make money out of a sure-fire flop sounds like the Broadway antics of The Producers. But no, it’s investment Australian style, thanks to negative gearing.
There is a fundamental investment contradiction in the Australian notion of negative gearing, which is that it's only feasible if the investment makes no economic sense pre-tax. It is certainly a weird way to run a portfolio. A house built on rotten stumps can be propped up for years but will eventually fall over.

To put it even more brutally, we have an artificial tax-avoidance system in place in Australia that fails if any of three things happen: your scheme inadvertently makes an investment profit; the tax rate is lowered during the lifetime of the investment; or you lose your income and thus your basic obligation to pay tax. That third scenario, being outside the tax system, puts this accounting dodge outside the scope of the average income-poor pensioner, adding further to the inexcusable inequity of its effect on different age and income cohorts in our “egalitarian” society.

That artificiality grossly distorts asset prices and also leads to inequalities in the current treatment of citizens for tax purposes. It also distorts the tax treatment of non-resident investors relative to their resident counterparts (as does our imputation system, though to a less economically damaging extent). Because negative gearing is an artificial device it won't last forever; the greater trend '” and the more economically rational one '” is to progressively lower personal as well as corporate tax rates with the passage of time (and as our foreign competitors lead the way towards leaner and less intrusive government). That trend will diminish the supposed “benefits” of publicly subsidising those who are best able to borrow.

The only justification of our negative gearing rort is political; economically it is indefensible. But politics change a lot faster than a country's economic dynamics, so the rort will eventually become too difficult to uphold.

The problems caused by this mad system of ours can already be seen in the creation of unsustainable debt-financed asset bubbles, particularly in the property-investment market. The resulting expensive misallocation of resources does four things, all of them bad:

1) It creates over-investment in residential property, which is economically sterile once constructed, and at the same time exaggerates the sector's cyclical volatility (and the local lenders' business risk);

2) Because it lowers the after-tax effective interest rate on “uneconomic” borrowings, it displaces (or “crowds out”) genuinely productive investment by making people more indifferent to real pre-tax borrowing costs '” so there's more debt at any given level of interest rates, and more economic risk;

3) It reduces the budget sector's overall tax receipts, placing upward pressure on general rates of tax throughout the economy (and/or preventing their decline to more internationally competitive and economically productive levels); and

4) It encourages a massive expansion of national indebtedness to the rest of the world through the capital account of our balance of payments, since our total domestic savings are inadequate to finance our exaggerated requirements for new tax-driven credit.

Taken in combination, these effects '” exacerbated by negative gearing '” put all of us in financial peril when global interest rates once again begin to rise. The short-term “advantages” of gearing up into speculatively priced assets, at the expense of foreign savers' capital and of our fellow citizens' tax bill, will be quickly and terminally reversed as those nasty consequences inevitably flow through.

By contrast, long-term investment in productive assets through super is not only truly tax-efficient for the individual and for society at large, but it also serves a wide range of fundamentally sound economic objectives. It directs real domestic savings into real investments, raises long-term growth without raising inflation, and lowers domestic interest rates without undermining the currency. At the same time it bolsters national self-sufficiency and allows taxes to be reduced.

* Property editor Mark Armstrong writes: Some quick calculations to compare an investment in superannuation and in shares or property using negative gearing, show that to break even with superannuation, a negatively geared investor would need borrowings equivalent to about half their principal '” gearing of about 33 percent.

So $100,000 invested in super '” with an annual return of 10 percent, taxed at 15 percent per annum over 10 years and at 15 percent on the way out '” would give an after-tax gain of $107,000 after 10 years.

The negative gearing example (property or shares) assumes an interest rate of 8 percent, capital growth rate of 6 percent and income of 3 percent (a total of 9 percent) and a tax rate of 47 percent. On these numbers, investing $100,000 and borrowing $50,000 (33 percent gearing) would produce a gain of $108,000 after 10 years, allowing for all taxes (including CGT) and holding costs.

Negative gearing’s power starts to show when you gearing level is raised. Again assuming an investment of $100,000, with borrowings of: $100,000 (50 percent gearing) gives a $155,000 gain; $150,000 (60 percent) gives a $202,797 gain; $233,000 (70 percent) gives a $278,000 gain; and $400,000 (80 percent) gives a $439,000 gain.

The question is not what is better or worse. It is clearly more effective to use gearing techniques to maximise investments. The question is the ability to fund the strategy over time and having the time to let the strategy work. The selection of the asset and the risk profile of the individual investor are also important.