Submission to the Productivity Commission Inquiry on First Home Ownership 3. Policy Considerations

This chapter of the submission discusses various areas that could be examined further in addressing the overall affordability of home ownership.

The focus of the chapter is the demand for housing. As noted earlier, the Bank is of the view that the increase in house prices over recent years is not primarily the result of a shortage of overall supply of new housing. The Bank, however, recognises that changes on the supply side have the potential to affect overall housing prices, particularly in the medium term, so it is appropriate for the Productivity Commission to conduct a thorough analysis of the supply side of the housing market.

In assessing alternative proposals that affect the demand side it is important to keep in mind the experience of the past decade. As argued in the previous chapter, strong increases in housing demand from the mid 1990s onwards, largely as a result of improved access to finance and demand by investors, were readily translated into higher house prices. As a result, it has become more difficult for first-home buyers to obtain the necessary funds for a deposit and other establishment costs. The increases in house prices over this period have more than offset the contribution to affordability arising from lower housing interest rates.

An important lesson from this experience is that simply adding to the capacity of the household sector to pay more for residential property does little to improve overall affordability. Indeed, by pushing up prices it can make it more difficult for those who do not already own a property to get a foothold in the market.

A number of recent proposals that seek to improve affordability by further enhancing access to finance, if implemented without other changes, would inevitably lead to a further increase in the overall demand for housing. These proposals include:

• the promotion of shared-appreciation mortgages;
• the development of parental-pledge mortgages;
• wider availability of loans with high loan-to-valuation ratios; and
• access to superannuation for the purposes of funding the purchase of a home.

The main effect of policies that add to demand would be further upward pressure on housing prices. While those households that were in a position to take early advantage of the implementation of these proposals would benefit, in the medium term, prices would be likely to rise in line with the increase in overall purchasing capacity. This suggests that if initiatives to improve the affordability of home purchase by first-time buyers are deemed necessary, and if they are to have more than a temporary effect, they need to be narrowly targeted so as to limit their effect on overall demand. Importantly, they should also be combined with other changes that reduce demand elsewhere, leaving the overall demand for housing broadly unchanged.

One narrowly targeted response worthy of further consideration is reducing the rate of stamp duty that currently applies to many first-home buyers. As discussed in the previous chapter, the general rise in house prices has meant that the burden posed by stamp duty has grown in magnitude over recent years. Alleviating this burden would reduce the ‘deposit gap’ faced by many first-home buyers, and could be expected to have only a limited effect on overall prices.

The main way in which the current mix of demand could be altered is through a reduction in demand by investors. Reduced investor demand would allow scope for increased demand from those purchasing a house for the first time, without adding to the overall pressure on demand and prices.

Addressing the issue of investor demand might also be justified on other grounds. As discussed in the previous chapters, the central role played by investors in the current housing boom is quite unusual by international standards. By adding to the speculative dynamics in the market, the activity of investors has not only pushed up house prices, but has also contributed to an increase in the overall vulnerability of the household sector to a deterioration in economic conditions. Policies that had the effect of reducing the strongly procyclical nature of investor demand could have the dual advantages of creating more room for first-home buyers and contributing to a more stable housing market.

As discussed in the previous chapter, the main factors underpinning the unusually strong investor demand in Australia are the favourable terms on which lenders are prepared to provide finance to investors, the taxation treatment of investor housing, and the active promotion being undertaken by the property investment seminar industry.

3.1 Financing

The liberal access to finance enjoyed by investors in the residential property market is a by-product of financial liberalisation and strong competition in the mortgage market. These developments, on the whole, have served the Australian community well. They have greatly increased the availability and flexibility of finance and reduced the cost of borrowing. There is no case for turning the clock back on these changes.

An important issue, nonetheless, is whether competition and unrealistic expectations by lenders have led to pricing that does not adequately cover the credit risk associated with loans to investors, particularly those that are highly leveraged and that own properties where vacancy rates are high. A related issue is whether lenders are holding sufficient capital to cover these types of loans. In this regard, the recent work by the Australian Prudential Regulation Authority (APRA) assessing the vulnerability of deposit-taking institutions to a downturn in the housing market is both timely and very welcome. While the findings were for the most part reassuring, the work did highlight deficiencies in information and risk-monitoring systems in some financial institutions. The Bank welcomes the fact that APRA will continue to monitor the situation closely and that it will follow up the results of the stress test with individual institutions.

3.2 Taxation

The taxation arrangements that apply to rental properties in Australia are the same as those that apply to other forms of investment; there are no concessions or restrictions that apply specifically to rental properties. Notwithstanding this, the taxation arrangements in Australia are more favourable to investors in residential property than are the arrangements in other countries studied in preparing this submission.

This more favourable treatment has played a role in investors being prepared to accept rental yields that are lower than those seen in other countries. While taxation arrangements are not the source of the current speculative activity in the housing market, they may affect the price dynamics once the attractiveness of investing in housing has improved for other reasons.

The Bank does not have specific recommendations for modifying the taxation treatment of residential property. It does, however, encourage the Productivity Commission and others more expert in tax matters than the Bank, to examine the current arrangements, and in particular, those areas where the treatment in Australia differs from that commonly seen overseas. The work undertaken in preparing this submission has highlighted three relevant areas that appear worthy of further examination.

• The ability of investors to negatively gear an investment property for many years.

As discussed above, an investor in Australia can under plausible assumptions claim tax losses on an investment property for many decades. In most other countries, limitations on negative gearing and higher rental yields make such an outcome unlikely.

• The benefit arising from depreciation due to differences in income and capital gains tax rates.

As noted above, depreciation reduces the current income tax liability of the investor, but increases the future capital gains tax liability. The treatment is relatively favourable to investors, given the difference in the income and capital gains tax rates.

• The general treatment of property depreciation.

The treatment of depreciation varies considerably across countries. In the United Kingdom, depreciation deductions are not permitted, and correspondingly, there is no adjustment to the cost base for purposes of calculating capital gains tax. It is less advantageous to investors than the Australian approach, particularly in terms of cash flow, as the amount of tax payable is higher during the period over which the property is held, though this is largely offset by a lower capital gains tax liability upon sale. The issue of obtaining a tax deduction for depreciation at one rate and paying capital gains tax at another rate also does not arise.

The Bank does not see a case for an outright prohibition on negative gearing for investment in residential property. The ability to offset losses from one activity against income or profits from another is part of the normal operation of the Australian tax system, and applies to a wide range of investments and business activities.

Ideally, any modifications to the current taxation system should apply, wherever practical, to all investments so as to ensure the neutrality of the taxation system across investment classes. Importantly, any evaluation of potential modifications would also need to consider the timing of their implementation and the implications for both existing and new investors, as well as on the overall operation of the rental market.

Another tax-related issue is the enforcement of existing laws. The recent announcement by the Australian Taxation Office (ATO) that it has increased its scrutiny of rental deductions is a welcome step. As part of its current compliance program the ATO has sent out around 15,000 letters explaining to taxpayers the common mistakes made in claiming rental deductions. It has also asked another 5,000 taxpayers to complete a rental expenses schedule and lodge it with this year's tax return. It is a matter of priority that these efforts continue and that the existing laws are rigorously enforced.

3.3 Property Investment Advice

As discussed in the previous chapter, much of the advice provided by the investment seminar industry falls outside the regulatory framework that applies to other types of financial advice. While ASIC and the ACCC both have consumer protection powers, the overall regulatory framework governing the provision of advice on real estate investments has not kept pace with the rapid change in the industry and the increase in the number of ordinary households with property investments. As ASIC has noted, the current regulatory regime was not designed for the purpose of regulating the provision of financial advice. In particular, while securities and other financial services advisors have significant obligations under the Corporations Law regarding disclosure and the suitability of advice, no such requirements apply in respect of real estate investment advice.

In its review of the provision of real estate advice in 1999 and 2000, ASIC recommended that where real estate agents give advice based on the investor's individual circumstances they should be subject to authorisation requirements, disclosure requirements, standards of conduct, and investor redress mechanisms that are comparable to those that are available to retail investors obtaining personal securities advice.^[28] Where the advice is more general, ASIC recommended that there should be disclosure to the effect that:

• the advice is general in nature and not based on the circumstances of the individual investor;
• intending purchasers should assess the suitability of a property in light of their own individual needs, perhaps with the help of a licensed financial advisor; and
• any conflicts of interest of the advisor (for example, a relationship with the property developer) should be made known to intending purchasers.

The recent initiative of the Commonwealth and state governments to establish a working group, including the ACCC and ASIC, to develop a common framework for regulating real estate investment advice is an important step. Hopefully, this group will be able to make concrete progress quickly.

Footnote

For further details, see Australian Securities and Investments Commission, ‘ASIC review of financial advising activities of real estate agents: February 2000’ and Australian Securities and Investments Commission, ‘Review of the financial advising activities of real estate agents: Interim report’, July 1999. [28]