From: c.oneill@trl.oz.au (Chris O'Neill)
Subject: Re: Negative Gearing
Organization: Telecom Australia Research Laboratories
Date: Thu, 19 Nov 1992 08:44:57 GMT

I have already posted two articles which cover some of the points in the
referenced article, so I will refer to them where appropriate.

In article <1992Nov19.033826.19190@cs.su.oz.au> yar@cs.su.oz.au (Ray Loyzaga)
writes:
>In article <1992Nov18.005443.8650@trl.oz.au> c.oneill@trl.oz.au (Chris
O'Neill) writes:
>>In article <BxusMp.29n@bunyip.cc.uq.oz.au> kerry@citr.uq.oz.au (Kerry
Raymond)
>>writes:
>>>>The fundamental point is that if I borrow money at say 10% real and use it
to
>>>>finance an investment returning say 6% real then I am making a real loss
>>which
>>>>has to be abosrbed by someone somewhere or other.  If the tax system makes
it
>>>>possible for an individual to profit in this situation then the tax system
is
>>>>absorbing that loss.  It means that overall, our community is incurring a
net
>>>>loss even though the individuals doing the negative gearing are making a
gain
>>>>for themselves.
>>>
>>>Negative gearing and making a gain are not possible simultaneously!
>>
>>They are!!
>
>What the guy actually meant to say was that "negative gearing"
>is a term used to describe the situation where the costs of funding
>a project outweigh the returns, 

when you don't consider capital gain (inflationary or otherwise)

>since the most popular example is
>property it means that the sum of (mortgage interest, rates, insurance,
>utilities, legal and agents fees and various other duties) is more than
>the rental income of the property. This property is said to be
>negatively geared.  A property is positively geared if the reverse is true.

Thank you for reminding us what negative gearing is.  My point was about more
than just the definition of negative gearing.

>>Negative gearing does not view the inflationary part of capital gain as
taxable
>>whereas it does view the inflationary part of interest on borrowings as tax
>>deductable.  This is how you make a gain while fobbing the loss on to the tax
>>office:
>
>Under the present capital gains tax legislation, nothing views the
>infaltionary part of the capital gain, it is the same whether the
>asset is negatively geared, positively geared or purchased outright.

That was part of my point.

>>If the real interest rate on borrowings is 10%, the rate of inflation is 8%
>>(thus the nominal interest rate is 18%), the real rate of return on the
>>investment is 6% and the tax rate is 48.5%, then the negatively gearable loss
>>is
>
>What you really mean to say is, you pay an interest rate of 18%,
>inflation is 8%, therefor the "real" interest rate is 10%. 

Thanks for the re-iteration.

>(obviously
>you did your calculations in the late 80's).

That's what we were talking about.

>>(nominal interest rate) - (rate of return on investment)
>>= 18% - 6%
>>= 12%
>>
>>This loss is fully tax deductable, so it reduces tax (on other unrelated
>>income) by
>>
>>12% x tax rate
>>= 12% x 48.5%
>>= 5.82%
>>
>>So the net loss to the owner is 12% - 5.82% = 6.18%.  However, when you add
the
>>capital gain due to inflation, 8%, (which is not taxable), the overall gain
to
>>the owner is
>>
>>8% - 6.18% = 1.82%
>>
>>QED
>>So the owner makes a gain and the tax office on behalf of the rest of the
>>Australian community makes a loss.
>
>As I said previously, 

and I said even earlier,

>the inflation portion of the capital gain
>made by the owner is not taxed whether it is negatively geared
>or not. After a while, the asset becomes more positively geared and
>the tax office starts getting money. Answer this, how much money
>would the tax office make if you didn't invest? How much would it
>make in the future?

I have made calculations of the loss the tax office makes in two other
articles.  Make sure you read at least the second one (which includes a lot of
the first one anyway).

>>>Negative gearing is where the cost of borrowing exceeds the income
>>>produced. When there is a gain (i.e. when the income exceeds the
>>>interest payments), then it is *not* negative gearing.
>>>
>>>Suppose I borrow $100K at 10% 
>>
>>I presume you mean 10% nominal.  It is not clear that you understand the
>>difference between nominal and real.  The real interest rate is:
>
>Very few people talk about real interest rates, name one bank that
>quotes "real interest rates", 

Their economists do, but not to plebeians like you.  It would be worthwhile if
more people were familiar with the concept.

>I note that the real interest rate
>was completely irrelevant to your calculations, so why did you mention it?

Well if you had been following the thread from earlier on you would have
noticed where I said:

The fundamental point is that if I borrow money at say 10% real and use it to
finance an investment returning say 6% real then I am making a real loss which
has to be abosrbed by someone somewhere or other.  If the tax system makes it
possible for an individual to profit in this situation then the tax system is
absorbing that loss.  It means that overall, our community is incurring a net
loss even though the individuals doing the negative gearing are making a gain
for themselves.

The real interest rate has fundamental importance.

>>>to obtain a return of 6%. I earn $6K income
>>>and I spend $10K in interest repayments creating a loss of $4K.
>>>This loss of $4K reduces my taxable income by $4K. Assuming I am a high
>>>income earner, then despite the reduction in taxable income by $4K, I will
>>>still be in the highest tax bracket (approx 50%) and the loss of $4K will
>>>result in a tax bill of $2K (50% of $4K) less than it would have been due
>>>to my other income.
>>>
>>>So I have spent $10K to earn me $6K income and a $2K tax saving.
>>>Net result = $2K loss to me! Where's the gain to me?
>
>Well, lets get the word "gain" out of this, it seems to be too loaded
>a term for this group and beyond the grasp of some. The effect
>of the tax deductability of genuine expenses in the pursuit of
>income (of which interest payments are one such expense) is to lower
>the cost of funds to the investor, i.e  the actual cost of making the
>investment is reduced since you are effectively paying the interest
>with pre-tax dollars, rather than with post-tax dollars.
>
>>Capital gain.  Remember, we are talking about times of high inflation (during
>>the eighties) when the inflationary part of capital gain was enough to cover
>>the negatively geared losses.  We are not talking about now when inflation is
>>very low.
>
>For a large part of the eighties, there was no capital gains tax, this
>came in in late '85. Before that there was a speculative gains tax.
>Capital gain is available no matter what the gearing is, the real
>benefit to the investor of all this is that they can basically
>use capital gains to grow someone elses money, and reduce the cost
>of using that money.

Thanks for this way of thinking about the situation.  This doesn't mean that
what I've said is wrong.

>>>I repeat my point. There is no point in borrowing unless your investment
>>>will in the long term generate more income or capital gain than the cost
>>>of borrowing.
>>
>>So you do make a profit.
>
>No, you donate it to the boy scouts, of course you make a profit.

He was referring to his statement:

>>>Negative gearing and making a gain are not possible simultaneously!

The point is that you can have negative gearing and make an overall gain
simultaneously.

>>>Let us suppose after one year of my investment returning 6%, it strikes
>>>gold and earns me 16% in the second year, i.e. $16K income less $10K
>>>interest repayments. I now have an extra $6K to add to my income and
>>>assuming the highest tax bracket, that translates to an extra tax bill
>>>of $3K.
>>>
>>>So (in Year 2) I have spent $10K in interest plus $3K in tax to earn $16K.
>>>Net result = $3K gain to me!
>>>
>>>So, is it fair? I say YES because if you look at the lifetime of the
>>>investment (2 years) you see:
>>>
>>>Interest payments = $10K + $10K = $20K
>>>Income Earned = $6K + $16K = $22K
>>>Tax Paid = -$2K + $3K = $1K
>>>
>>>So in the lifetime of the investment, there has been a profit of $2K
>>>($22K-$20K) on which total tax of $1K is payable which is correct for
>>>a taxpayer at that marginal rate.
>>
>>In your example the tax office loses $2K in one year and gains $3K in the
>>following year giving it a net gain of
>>
>>$3K - $2K - interest on $2k
>>
>>You forgot the interest on $2K term.  This doesn't matter much in your
example
>>but in a more realistic example where you don't strike gold in the second
year
>>and where it takes a lot longer for income to exceed interest, the interest
on
>>the tax office losses is much more significant.  See if you can make a
>>realistic example that includes interest on the tax office losses.
>
>Like I said, show me how much money the tax office makes in a zero
>investment climate. 

As I mentioned, I have calculated how much the tax office loses in another
article.  And contrary to your implication, it is not necessary for the tax
office to indiscriminately subsidize loss making investment for there to be any
investment.

>Or if you disallow interest payments as a deduction,

I didn't say disallow interest payments as a deduction.  I just said disallow
negative gearing against unrelated income.

>how much effect will the increased effective cost of funds have on
>investment.

It won't have any effect on productive investment.

>>>>In conclusion, there is no economic justification for negative gearing
unless
>>>>the loss making activity must exist for the profit making activity to make
>>its
>>>>profit.
>>>
>>>Absolutely!
>>>
>>>>For example, negative gearing is one example of the tax deductability of
>>costs
>>>>in a business.  A business can deduct costs such as rent in calculating its
>>>>profit because it would not earn that profit unless it used the property
that
>>>>it pays rent on.
>>>
>>>>For an opposite example, if a salary earner negatively gears a rental
>>property,
>>>>there is no justification for negatively gearing against his salary because
>>he
>>>>gets his salary regardless of whether he has the rental property or not.
>>>
>>>Why is renting out a property not the same as being a shop keeper? 
>>
>>Because there is no way that you need to rent out a property in order to earn
>>your salary.  In contrast, a shop keeper must pay his rent to have his
>>business.
>
>Maybe the guy is multi-talented and can be a property investor and a
>salary earner, or is that a crime? What you are arguing for is that
>income losses and expenses can only be claimed in the activity that generates
>it, this will also have the effect of reducing activity, as it will
>be harder to expand into other business areas because the cost of
>funds will be high during the establishment phase of the investment,
>the exact time that you need all the cash you can lay your hands on.

It will be harder to expand into unproductive business areas.

>>>Renting
>>>houses is a business! 
>>
>>but independent of earning a salary.
>
>who cares.

Yes, I know you don't care about getting my point.

>>>The shop keeper can deduct expenses like rent of the
>>>shop and interest on the loan to pay for the fit-out. The landlord can
deduct
>>>expenses like rent of the purchase price (i.e. interest repayments) in
exactly
>>>the same way. 
>>
>>Sure, but why is he entitled to deduct them against some independent source
of
>>income?
>
>Ok, would you then allow the $5k tax free threshold on each independent
>business activity? Or will you treat income in one lump sum? Doesn't
>this lead to a bit of a problem???

You'd better explain what the problem is.

>>>The rules for rental property deductions are based on the
>>>same principles as any other business. Just as many people who start a
>>>small business have to use other income or savings to tide them through
>>>the initial loss-making years, 
>>
>>These losses are part of the capital of the business.  There is no reason why
>>money used for capital formation should be taxed any differently from money
>>used for any other purpose.
>>
>But you are arguing that they should be, you are arguing that
>the costs of the capital base (interest) should not be deductable,

no, just that negative gearing of any cost against unrelated income should not
be allowed.

>whereas I would be arguing that the inflation component of earning
>interest income should be deducted from the interest to bring it
>into line with the capital gains tax rules.

Ah yes, inflation adjustment of taxation, that would also solve the problem
(seriously).  But as we know from bitter experience, there's a snowflake's
chance in hell that the government would implement inflation adjustment of
taxation.  I have tried to determine if there is another fundamental defect in
the tax system that causes the problems with negative gearing and I have found
that it is negative gearing against unrelated income.

The problem with negative gearing would not exist if inflation adjustment of
taxation occurred.  This is because the inflation adjustment would remove a lot
of the tax deductability of interest and hence make unproductive investments
unprofitable to their owners.

However since there is no hope of inflation adjustment, I have studied the
fundamental defect in negative gearing.

>>>so do people who buy investment property.
>>>Both are risking their current income or savings because they believe that
>>>in the long term, they will make a profit -- a profit that will then be
taxed.
>>
>>After the tax office has lost vast amounts in lost interest.
>They haven't lost a thing, thats the law, 

They lose, read my examples.

>they are however gouging
>the person earning a paltry few percent interest in savings accounts
>by not deducting the effets of inflation from the interest earned.
>>
>>>The salary earner's salary *is* the same regardless of whether they have
>>>a rental property but the salary earner's INCOME is not the same. We have
>>>an INCOME tax system and not a SALARY tax system. One salary earner is
>>>investing part of their salary 
>>
>>Well if I use part of my salary to buy shares, I can't claim the cost as a
tax
>>deduction.  This is an argument about the appropriate circumstances for tax
>>deductions.
>
>Of course you can, the "cost" of buying shares are agents fees, which are
>deductable.

I was referring to the cost of the shares themselves.  If an investment
requires part of your salary that is a CAPITAL injection.  Capital injections
are normally not tax deductable.

>>>into a business which produces either gains
>>>or losses and pays more or less tax accordingly.
>>
>>I know what we've got, but just because we've got something doesn't mean that
>>it's right.
>>
>>>I borrow money for investment because I believe that with that larger
>>>sum of money I can get into investments that will return enough over the
>>>long term to meet the interest payments and leave me with more than if
>>>I had relied on bank interest on my small savings. 
>>
>>I know that it may benefit you.  I just wanted to point out how it
>>disadvantages everyone else.
>
>So when are you going to start?

Please read my other articles.

>>>Provided I remain in 
>>>the same tax bracket throughout the lifetime of an investment, the tax
>>>position should remain neutral (as I illustrated with the simple example
>>>above).
>>
>>and if you ignore the lost opportunity cost that the tax office has to bear
in
>>a realistic example.
>
>Once again you fail to miss the point that encouraging investment is
>hardly a case of "opportunity cost".

The lost opportunity cost is the cost of having to wait many years to recoup
some tax from a negative gearing deduction.

>>>Negative gearing makes it possible to start-up small businesses, 
>>
>>with the tax office as a loss-making shareholder
>
>Lets call it a "subsidy".

Yes it's a subsidy of loss making enterprises.

>>>whether
>>>those businesses are shops, factories, or renting out property. It's not
>>>evil unless you believe that the only people entitled to try to do better
>>>than bank interest are the people who are already rich.
>>
>>I don't believe that it's evil to try to do better than bank interest but
that
>>doesn't mean that I think negative gearing is not evil.
>
>Funny, I think that in many circumstances, capital gains tax is evil.

perhaps because you can avoid it so often.
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