From: c.oneill@trl.oz.au (Chris O'Neill)
Subject: Re: Negative Gearing
Organization: Telecom Australia Research Laboratories
Date: Wed, 18 Nov 1992 00:54:43 GMT

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!!

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:

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

(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.

>Negative gearing is where the cost of borrowing exceeds the income
>produced. When there is a gain 

excluding any form of capital gain, inflationary or real,

>(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:

real interest rate = nominal interest rate - inflation rate (approximately)

In my example I was talking about 10% real interest rate.

>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?

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.

>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.

>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.

>>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.

>Renting
>houses is a business! 

but independent of earning a salary.

>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?

>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.

>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.

>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.

>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.

>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.

>Negative gearing makes it possible to start-up small businesses, 

with the tax office as a loss-making shareholder

>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.

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