Negative Gearing – Page 3 – Digital Finance Analytics (DFA) Blog

The Negative Gearing Salvos Continue

The ABC reported that “a Treasury document obtained by the ABC under Freedom of Information (FOI) shows most of the windfall from the property tax break goes to high-income earners. The modelling said more than half of the negative gearing tax benefits go to the top 20 per cent of incomes in Australia. “Negative gearing benefits high-income families,” the document said. The report stated those in the bottom 20 per cent were getting just over 5 per cent of negative gearing tax benefits”.

On the other hand, the Government has continued to argue “mum and dad” investors and Australians on average earnings are the main beneficiaries. “It does not change the fact that two thirds of Australians using negative gearing have a taxable income of less than $80,000,” Treasurer Scott Morrison said. This is of course axiomatic, but misses the point, because the whole idea of negative gearing is to offset interest costs and other losses to reduce total income, and therefore taxable income. Mr Morrison played down the heavily-redacted Treasury submission. “The numbers in the document released by Treasury are not Treasury numbers, but are a summary of a report from an ANU associate professor, Ben Phillips, that Labor uses to justify their negative gearing policy,” he said.

The previously reported RBA FOI had rebutted one of the government’s principal arguments against negative gearing namely that there would be a collapse in home prices. The Grattan Institute had argued for negative gearing reform. You can read the DFA research archive on negative gearing here.

Worth then reflecting on earlier DFA analysis which showed how complex the negative gearing questions is. We pulled data from the DFA household surveys, to examine the distribution of negative gearing. Our segmented surveys, show some of the nuances in behaviour. We start with age distribution. We find that households of all ages may use negative gearing, but more than a quarter are aged 50-59. We see the DFA household segmentation in evidence, with a number of young affluent households active aged 20-29, especially using an investment property as an alternative to buying their own place to live. We discussed this before. As we progress up the age bands, we see a strong representation by the more affluent segments, including mature stable families and exclusive professionals. In later life, wealth seniors are also active, especially in the 60-69 year bands. So negative gearing is being used by households across all age groups.

Our survey suggests that negative gearing, whilst it is spread across the income bands, is indeed concentrated among more affluent households. Four segments, exclusive professionals, mature steady state, wealthy seniors and young affluent households contain the lions share of negative geared investment property. These segments are at different life stages, have different income profiles, and different strategies. For example the young affluent are often using investment property as a potential on-ramp to later owner occupied purchase, whereas wealthy seniors are all about income, and the others more wealth creation.

This analysis shows how complex the true situation is. Prospective changes are likely to impact different segments in diverse ways and there is plenty potential for spill-over impacts and unintended consequences. But the truth is, most negative gearing resides among more affluent households. The current settings are not correct.

Might Labor’s negative-gearing policy yet save the housing market?

From The Conversation.

The Real Estate Institute of Australia (REIA) has unleashed the hounds on Labor’s proposed reforms to negative gearing. The REIA’s campaign, Negative Gearing Affects Everyone, follows the lead of the Property Council, which describes the Australian housing market as a “house of cards”, with the REIA stressing how “fragile” the Australian economy is. You might be tempted to dismiss this as propaganda from people who exaggerate for a living, but evidence is mounting of instability close to the REIA’s home: the off-the-plan apartment sector.

An array of forces are converging to give the multi-unit house of cards a shove. Over the past couple of years apartment development has boomed. The Australian Bureau of Statistics shows building approvals for new flats, units and apartments reached a huge peak last year. It has stepped down in the most recent quarter, but is still very high.

ABS, 8731.0 Building approvals, Table 6

You can see this development in the skylines of our cities, especially in Sydney, Melbourne, Brisbane and Canberra – and in the RLB Crane Index. RLB counts a total of almost 650 cranes engaged in construction in our capital cities, and says more than 80% of these are on residential projects.

RLB Crane Index, 8th Edition

This coming supply is reflected in CoreLogic’s projections for new units hitting the market. It estimates that sales for more than 92,000 new units will be settled in the next 12 months, only slightly less than last year’s total number of sales of new and established units. The year after, a further 139,000 new units sales are due to be settled, substantially more than total sales (new and established) last year.

Source: CoreLogic

Dampeners on demand

But for all this supply, it appears there may be much less demand than anticipated, particularly from the foreign investors who did so much to stoke the boom. Evidence for this includes:

Over the last six months the Chinese government has tightened controls over currency exchange by its citizens. This has restricted their capacity to buy – and repay loans to buy – property in Australia and elsewhere. This in turn has led to…

Credit restrictions by Australian banks. Last month each of the Big Four banks restricted how much they’ll lend to foreign buyers (lower loan-to-valuation ratios), with Westpac withdrawing altogether. This month, Macquarie has pulled its horns in.

The Victorian government has doubled the stamp duty payable by foreigners – it’s now 7% of the property purchase price. The NSW government is reported to be considering doing something similar; it is also introducing checks for residency and Foreign Investment Review Board approvals as a condition for conveyance of property titles, and the FIRB is now charging $5,000 for applications.

Foreign demand for new dwellings (as gauged by the NAB’s Quarterly Australian Residential Property Survey) was already down over the first quarter of the year, before the credit restrictions cut in. Now the media are reporting that Chinese demand for apartments has “fallen off dramatically”: Meriton says the number of Chinese buyers of its apartments halved in the last month.

As those cranes in the sky indicate, there’s a lot of people out there – foreign and local – who’ve paid deposits and entered into contracts to pay boom-era prices on completion of their units. When they go to the bank to borrow the balance, they may find that, between lower loan-to-valuation ratios and lower valuations, they are caught short. Some might make up the difference by selling another property, but many of those settlements projected by CoreLogic may not settle at all.

The result: deposits forfeited, unsold units dumped on the market – accelerating the bust – and possibly, at least for buyers who are actually in the jurisdiction, the threat of being sued by developers for the loss of the contracted higher price.

So what might policymakers do?

Faced with such a calamity, why won’t our politicians do something to shore up demand for all these newly constructed rental properties? Oh wait….

This is precisely what Labor’s proposed negative-gearing reform promises do, by allowing rental losses to be set against non-rental income only where the property is newly built. Under Treasurer Bowen, Australia’s dedicated army of negative gearers would be given new direction and purpose, switching from the established dwelling market into the new-built market deserted by foreign buyers. Furthermore, because no-one after the first purchaser can call a dwelling new (and hence get the same preferential treatment on their gearing), they may be inclined to hang on to their properties even as demand looks weak.

We should still expect such a reform to reduce total investor demand for housing, and hence reduce house prices overall. These are both good things. But it may also help cushion what might otherwise be a drastic and painful collapse in the new-build sector.

Both the REIA and the Coalition government talk about Australia’s “transitioning” economy. They should consider negative-gearing reform as a measure for transitioning out of our presently fragile, property-bubble-led economy.

Author: Chris Martin, Research Fellow, Housing Policy and Practice, UNSW Australia

What the Reserve Bank memo really says about negative gearing

From The Conversation.

A memo on the subject of housing taxation from the Reserve Bank of Australia (RBA) is stirring up debate on proposed changes to negative gearing and capital gains tax in the election campaign. The memo, dated December 9 2014, does counter the government’s claim that changes to negative gearing will have an adverse effect on housing prices, although this was never its intended purpose.

The memo was in response to the report from the Financial System Inquiry two weeks earlier. The inquiry noted that reducing capital gains tax concessions would “lead to a more efficient allocation of funding in the economy,” that “the tax treatment of investor housing…tends to encourage leveraged and speculative investment,” and that “housing is a potential source of systemic risk for the financial system and the economy”.

The RBA is usually reluctant to comment on areas of government policy outside its remit and hasn’t expressed any views on whether changes are needed to the long-standing tax treatment of housing investment. However, in response to a Productivity Commission inquiry 12 years ago, the RBA pointed out that:

“…taxation arrangements in Australia are more favourable to investors in residential property than are the arrangements in other countries.”

It also went on to note that a higher share of Australian taxpayers are attracted to property investment to lighten their tax burden and reducing investor demand would allow for more demand from first home buyers, without adding to the overall pressure on demand and prices. The RBA submission suggested this could also lead to a more stable housing market.

At that time, housing investors accounted for just over 45% of all lending by Australian financial institutions. In 1999 this was less than 32%, when the Howard government amended the tax treatment of capital gains in a way that made it more generous to investors (in property and other assets).

After falling back to around 36% in the aftermath of the global financial crisis, the share of property loans taken out by investors rebounded to more than 50% in the first half of 2015. The Australian Prudential Regulatory Authority (APRA) has since required banks to tighten their lending standards for property investment loans, now the share of new housing loans going to investors has fallen back to about 45%.

The key point to note here is that the changes enforced by APRA to banks’ lending criteria have also had the effect of dampening investor demand, as Labor’s current policy also intends, without any obvious adverse effects on property prices.

The government’s strict enforcement of foreign investment regulations, designed to prevent foreigners from purchasing established properties (other than in limited circumstances), and the cutting of grants to first-time buyers of established properties while boosting grants to first-time buyers of new dwellings at a state level, have both failed to dampen investor demand for property.

In other words, governments are trying with these policies to reduce demand for the purchase of established dwellings (90% of borrowing by Australian property investors is for the purchase of established dwellings) while encouraging the demand, and therefore building of, new properties. This is exactly what the Opposition’s proposed changes to negative gearing and the capital gains tax discount seek to do.

Labor is trying to make it less attractive for investors to buy an established property after 1 July 2017. As a result, the prices of established dwellings should go up at a slower rate than it would otherwise – and from the standpoint of would-be home-buyers, this is a good thing.

However, the Opposition proposes to “grandfather” existing negatively-geared investors from these changes. This means anyone who has a negatively geared property investment as of 30 June 2017 will still be able to offset the excess of their interest costs over their net rental income against their other taxable income. So there is no reason to expect that investors will seek to sell their investments en masse and that prices of existing properties will fall any more than they have done as a result of the other government measures.

And this is precisely what the memo from the RBA notes:

“only if changes were not grandfathered” would there be a risk of “large scale sale of negatively geared properties.”

The RBA note also raises the possibility that changes to negative gearing could prompt a “potential increase in rents” – a point which the Coalition has been as quick to seize upon. Presumably this concern reflects an assumption that if changes were to be made to existing negative gearing arrangements, those changes would apply to new properties as well as established ones (since the Financial System Inquiry whose recommendations prompted this staff memo didn’t make any distinction between the two).

The Opposition’s policy is to keep existing negative gearing arrangements for investors in new dwellings. There is a risk that it could end up inflating builders’ profit margins, rather than boosting the supply of new housing.

However, to the extent that it does the latter, there is less reason to expect rents to rise. This is because under the Opposition’s policy more would-be home-buyers could fulfil their aspirations. It would reduce the competition they face from investors who negatively gear and this would decrease the demand for rental housing.

The Reserve Bank hasn’t explicitly supported Labor’s negative gearing policy. But it does appear to have rebutted one of the government’s principal arguments against it.

Author: Saul Eslake, Vice-Chancellor’s Fellow, University of Tasmania

RBA FOI on Negative Gearing and Investment Properties

Under a freedom of information request, the RBA has just released some material which casts light on their perspective on investment property and negative gearing from the Financial System Inquiry.

There are a few interesting points.

Whilst tax reform is an issue for Government, the RBA has noted that concessional rates of taxation of capital gains might encourage leverage speculation, especially in combination with negative gearing provisions.
Risks have been building in investor housing (no coincidence, this is happening at a time when some other asset classes have seen modest/volatile returns).
Negative gearing and capital gains concessions could together encourage “leveraged and speculative investment in housing” – including bidding up house prices, risks to financial stability if prices were to fall, and a rise in interest only loans (which do not repay capital so do not build an equity buffer).
If changes were made to these policies, it might increase rents, and if the arrangements were not grandfathered, could lead to the large-scale sale of negatively geared properties.

Note: Labor’s proposals, of course include grandfathering.

Why it is good policy, not bad politics, to ignore bad modelling on negative gearing

From The Conversation.

Negative gearing and capital gains tax are a looming battleground in the federal election. The debate was heightened last month by the release of modelling by consultants BIS Shrapnel purporting to show that reforms would lead to rent increases of between 4% and 10%. If correct, this would scare any political party.

An article in The Australian on Tuesday revealed that the ALP had seen this modelling before it released its policy to wind back the tax breaks on negative gearing and capital gains,

The ALP should be applauded for proceeding nevertheless. The report was clearly going to be inconvenient. But it was also not worth the paper on which it was printed.

The report implied that a $2 billion increase in tax would reduce economic activity by $19 billion a year. The report’s model also suggested that every additional house or apartment would increase the size of the Australian economy by $2.6 million.

None of this is remotely plausible, and consequently, it is difficult to believe anything else that the modelling or the report has to say.

Nonetheless, this report is still being discussed a month later – so it clearly needs some more critical analysis.

Tax changes will clearly reduce the after tax benefits for property investors. The key question is whether the market responds by reducing the price of housing, or by increasing rents, or by absorbing a reduction in returns.

Most likely, the price of housing will fall somewhat, investor returns will reduce a little, and rents will barely move. This is why.

Changes to negative gearing and capital gains tax will increase taxes for investors and lower their returns. Normally this would lead to lower asset prices.

But the outlook for home-buyers is different. The benefits for a home-buyer (of living in the home) won’t change. The price of the home will be a little lower due to the changes in negative gearing and capital gains tax. Therefore the return on assets (the benefits divided by the price) will be a little higher for home-buyers.

Combining the effects of the changes for investors and home-owners leads to an average after tax return on housing that is about the same as today. There will be more home-owners and correspondingly fewer investors – but higher rates of home ownership are the political goal.

The outcome might be different if the supply of new housing dried up. If there were fewer incentives to develop new homes, then eventually rents would increase.

However, our best guess is that tax changes will have little effect on housing construction. The supply of new housing is mainly restricted by planning rules rather than a lack of returns. In any case, reforms to negative gearing are likely to reduce the price of developable land, but they won’t change the returns on development.

BIS Shrapnel assume otherwise. They believe that changes to negative gearing rules will reduce the price and therefore the profitability of property developments, but not the price of developable land. And so they assert that tax changes will lead to less residential development, and therefore higher rents in the long run. Their report assumed that the price of developable land wouldn’t change based on three claims.

First claim: if the price of developable housing land fell, sites would instead be used for commercial purposes. But as a firm that advises clients on property development, BIS Shrapnel should know that in most localities land provides a much higher return per square metre when turned into residences than when used for commercial purposes. Indeed, there are concerns that too much of the Melbourne and Sydney CBDs is being converted to residential rather than commercial uses. There isn’t much evidence of enormous pent-up demand for commercial development.

Second claim: landholders will be reluctant to sell at lower prices. This is simply wishful thinking. Prices don’t rise just because sellers would like them to do so.

Third claim: it will be more expensive to aggregate sites for development. But lower prices as a result of negative gearing reform will affect all residential properties, irrespective of whether they have already been developed, or have potential to be aggregated further.

Instead of assuming that tax changes will only affect the price of development, it is much more plausible that changes in after tax returns to investors will primarily lead to lower land prices. This won’t hurt the profitability of development, the supply of rental property will continue, and the impacts on rents will be minimal.

Even if tax changes did affect the profitability of development, it’s all small beer. Quick sanity checks (the kind of things that property developers do to ensure that their modellers don’t lose them a fortune) show that the effect of negative gearing changes on property prices will be less than 2 per cent across the Australian market.

One way to think about it is that negative gearing and capital gains tax provide investors in real estate with a tax benefit of about $3 billion a year; that annual benefit converts to an asset value of about $55 billion; and all Australian residential property is worth a little over $5 trillion. If negative gearing were abolished entirely the lost value would be $55 billion, just over 1 per cent of $5 trillion of property value.

Another way to crunch the numbers shows that negative gearing and capital gains tax changes would reduce the after tax returns on real estate investment assets by about 7 per cent. But this wouldn’t affect all housing assets – only 30 per cent are investment properties, and the rest are owner occupied. So across the market, return on assets – and therefore asset values –would fall by about 2 per cent. Or in the unlikely event that investors succeed in passing on tax costs, rents would rise by at most 2 per cent.

BIS Shrapnel presented the ALP with a claim that tax changes would increase rents by 4 to 10 per cent. But that claim was several times larger than fundamentals would suggest. It used a model that was not publicly available. It was allied with a series of manifestly ridiculous economic results. And it all rested on an unjustifiable assumption that tax changes won’t affect land prices.

The ALP was right to ignore such flawed analysis. It is a relief to discover that – sometimes – a political party’s policy cannot be bought off just by commissioning a flawed report with scary numbers.

Author: John Daley, Chief Executive Officer , Grattan Institute

Negative gearing distorting Sydney housing market: Report

From Australian Broker.

Sydney’s housing affordability crisis is being artificially exacerbated by “lunacy” tax incentives, a new report has claimed.

According to the analysis by the UNSW’s City Futures Research Centre, up to 90,000 properties are sitting empty in some of Sydney’s most sought-after suburbs as investors chase capital gains over rental returns.

The analysis’ researchers, Professor Bill Randolph and Dr Laurence Troy, said this is thanks to the “perverse outcomes” of tax incentives such as negative gearing, Fairfax has reported.

“Leaving housing empty is both profitable and subsidised by government,” Randolph and Troy told Fairfax.

“This is taxation lunacy and a national scandal.”

According to Fairfax, the 2011 census revealed that in Sydney’s “emptiest” neighbourhood of the CBD, Haymarket and The Rocks, one in seven dwellings was vacant.

Close behind were Manly-Fairlight, Potts Point-Woolloomooloo, Darlinghurst and Neutral Bay-Kirribilli, which all had vacancy levels above 13%. These neighbourhoods, together with central Sydney, account for nearly 7,200 empty homes.

The UNSW analysis of the 90,000 unoccupied dwellings across metropolitan Sydney compared the number of empty homes in a suburb against the rate of return investors made by renting out a property.

It found that properties in neighbourhoods with lower rental yields and higher expected capital gains were more likely to be unoccupied.

Gordon-Killara on the north shore had the highest share of vacant apartments, with more than one in six unoccupied on Census night, according to Fairfax. By contrast, only one in 42 dwellings (2.4%) in Green Valley-Cecil Hills, in Sydney’s west, was unoccupied.

These results suggest property investors in some of Sydney’s most desirable areas have become indifferent to whether their investment property is rented or not. Instead, investors are chasing capital gains with rental losses offset by negative gearing and capital gains concessions.

According to Troy and Randolph, this calls into question Sydney’s housing supply and affordability problem.

“If you choose to accept that there is a housing shortage in Sydney, then the sheer scale and location of these figures strongly suggest that this is an artificially produced scarcity,” they said, according to Fairfax.

Will house prices ‘collapse’ if negative gearing is changed?

From The Conversation.

There is much confusion about the effects of Labor’s tax proposals with respect to investors in rental housing. They propose to grandfather existing arrangements. But investors in the future can only negatively gear newly constructed housing, while the policy recommends the capital gains discount fall from 50% to 25%.

Claims by Prime Minister Malcolm Turnbull that house prices will collapse appear to be contradicted by his assistant treasurer Kelly O’Dwyer who claims that housing costs will soar. These puzzling assertions arise due to a failure to distinguish between the market in rental housing, where housing is leased, and the market in which investors and owner occupiers buy and sell housing. Critically these two markets are interrelated.

To see why, consider the first round effects of Labor’s proposals when we put the grandfathering arrangements to one side (for the moment). Some existing investors will sell up when leases come up for renewal. There are now more tenants seeking rental housing opportunities than there is supply to meet their demand. Rents will begin to rise.

But the houses which investors quit add to the properties available for sale; there are now more houses available for purchase than there are buyers. House prices will begin to fall.

These market signals trigger a second round of effects. Some tenants will elect to buy rather than rent. After all renting has become more expensive and home ownership has become cheaper. These second round effects help to put a floor under falls in house prices, and help cap rent rises.

By considering the inter-relationships between the two markets we can understand how the government has issued apparently contradictory statements. Rents will rise and so the housing costs of tenants will increase. But there will be falls in house prices (or more likely a slower growth in prices); while existing owners take a hit, first home buyers housing costs are lower and attainment of home ownership becomes more affordable.

The second round effects mean that impacts are likely to be muted. This is made even more likely by a grandfathering proposal that should prevent a stampede by existing investors seeking to relinquish their property investments.

A disappointing aspect of the debate so far has been its neglect of the longer term structural consequences of Labor’s suggested reforms. Our current arrangements encourage high tax bracket investors to take on debt in the “chase” for capital gains. Capital gains are leniently taxed as compared to ordinary sources of income, such as earnings and rents.

Only 50% of capital gains are added to assessable incomes. This is particularly attractive to high tax bracket investors. Moreover, they are taxed on realisation rather than as they accrue. The shrewd investor realises the gains when assessable income from other sources declines; for example, following retirement when the investor’s marginal tax rate commonly falls.

There are not enough high tax bracket investors willing and able to invest in all our private rental housing stock. They tend to cluster in those segments of the market where healthy capital growth is expected, but rental yields are lower. Low tax bracket investors tend to cluster in segments where capital growth is expected to be subdued. Typically these are areas with lower house prices. To ensure adequate returns rental yields have to be higher in these low house price segments.

We therefore get a distorted investment pattern that disadvantages the supply of affordable rental housing.

Labor’s proposals will curb these distortionary effects by reducing the capital gains discount. They will also reduce the tax incentives to leverage investments. Rising indebtedness is a threat to the resilience and stability of our housing market.

Many believe that repayment and investment risks carried by heavily indebted home buyers played a central role in precipitating the global financial crisis. Tax concessions that favour taking on debt exacerbate those risks. If Labor’s proposals succeed in attracting attention to these and other structural problems that plague Australian housing markets, they will have a much wider significance.

Author: Gavin Wood, Professor of Housing, RMIT University

Fact Check On Negative Gearing, Using DFA Data

Labor have announced proposals to change the negative gearing and capital gains tax rules relating to property investments. In an interview today on ABC Insiders, Chris Bowen, Shadow Treasurer said that negative gearing would potentially only be available on new property in 2017 , currently half of the benefit goes to top income earners, and proposes changes to CGT concessions, referring to the Murray FSI recommendations. 70% of benefit he says goes to top income earners. What “top” means was not defined.

Expect to see more tax reform shots exchanged as we progress through the year.

We decided to pull data from the DFA household surveys, to examine the distribution of negative gearing. Our segmented surveys, show some of the nuances in behaviour. We start with age distribution. We find that households of all ages may use negative gearing, but more than a quarter are aged 50-59. We see the DFA household segmentation in evidence, with a number of young affluent households active aged 20-29, especially using an investment property as an alternative to buying their own place to live. We discussed this before. As we progress up the age bands, we see a strong representation by the more affluent segments, including mature stable families and exclusive professionals. In later life, wealth seniors are also active, especially in the 60-69 year bands. So negative gearing is being used by households across all age groups.

Then we looked at distribution, by segment, across the income bands. The horizontal scale shows the upper cut-off in each band, for example, the first is up to $24,000. Wealth seniors, with lower incomes are well represented in the lower income bands, but as income rises, we see a mix of households using negative gearing. What is true, is that there is a greater proportion of households in the $100-$200k band. Above that, there is a fall in all households represented, but we see those with very large incomes still represented to some extent. Again we see our segments highlighting the strong presence of exclusive professionals and mature stable families.

If we then look specifically at borrowing households using negative gearing, as compared to all households in the segments, the picture is quite striking. In our most affluent segment – exclusive professionals, nearly half are using negative gearing for property investment. Wealth seniors and mature steady state families are also well represented. But the most striking observation is that among young affluent households more than half are geared. Other segments are less represented.

The final picture is all household, compared with those negatively geared. We see a concentration in the more affluent segments, and other segments where negative gearing hardly exists.

So, our survey suggests that negative gearing, whilst it is spread across the income bands, is indeed concentrated among more affluent households. Four segments, exclusive professionals, mature steady state, wealthy seniors and young affluent households contain the lions share of negative geared investment property. These segments are at different life stages, have different income profiles, and different strategies. For example the young affluent are often using investment property as a potential on-ramp to later owner occupied purchase, whereas wealthy seniors are all about income, and the others more wealth creation.

In the RBA’s submission to the Inquiry on Home Ownership, they argue that negative gearing for investment property should be reviewed, because it has the potential to raise risks in the market, lift prices and distort the market.

The UK has just reduced the opportunity for negative gearing, there, and the Grattan Institute also makes a strong case for change.

The tax system can play a role in Australian innovation

From The Conversation.

Australia’s quest to develop a stronger innovation ecosystem has seen a growing focus on the income tax system, and whether it should be used as a lever to help achieve this goal.

Some have argued the government should not use tax incentives to spur the shifts needed to make Australia an innovation hub. This view is based on the argument that tax incentives have never been central to the success of Silicon Valley or Israel’s innovation ecosystems. However, there has been little analysis of why this is so and no-one has stopped to ask whether this analogy is apt for Australia.

Australia is in a very different position now to where the US was from the 1970s through to 2000 when Silicon Valley went through the biggest phase in its development. One part of this difference is the level of military expenditure available for investment in technology.

In the US, between 1970 and 1992, the lowest level of military expenditure as a percentage of GDP was 4.6%. At the start of the 1970s, the level was much higher (7.8%), and that was a decrease from the level in the 1960s (in 1962 and 1968, the level was 9.0% and 9.1% respectively). Between 1992 and 2001 in the US, the level steadily fell from 4.3% down to 2.9%.

There are various reasons for the fluctuations across time, including engagement in war (the Cold War and the Vietnam War) and changes between Democratic and Republican administrations. But the broader point is that the baseline of military spending in the US at the crucial stage in the development of Silicon Valley was very high. The same is true of military spending in Israel – in 2014, military expenditure accounted for 5.2% of GDP. That is the lowest level of military expenditure there for at least 15 years.

By comparison, the level in Australia in 2014 was much lower, at 1.8% of GDP. This is nothing near the historic levels in the US or the relatively recent levels in Israel. While only a small proportion of military expenditure will be invested in new technology in any country, countries that have had high levels of military expenditure have had higher levels of investment in new technology.

Submarines alone won’t do it

Some have pointed out that, given the importance of military investment to the ecosystems in Silicon Valley and Israel, Australia’s next submarine contract is vital. However, one contract is unlikely to be enough to single handedly develop technology that can dramatically transform the existing landscape and provide a backbone for the future of innovation in Australia. (No pressure, right?) This also raises a broader question about whether it’s possible for Australia to increase its current level of military expenditure and whether that is what we want.

In addition to the disparity between military expenditure in Australia and the US, there is a huge difference in scale of GDP. In 2014, Australian GDP was approximately US$1.454 trillion and US GDP was US$17.419 trillion. The sheer scale of US GDP is significant due to the failure rate of startups. Anecdotally the failure rate for tech startups in the US is around 90%. A lot of capital is lost in the quest to find the next Facebook or Snapchat. Scale helps innovation.

Further, an important part of the success of US startups has been the scale of their domestic market. Exporting to international markets has tended to come much later (although this temporal lag was more pronounced in the 1980s than it is now).

In Australia, the relatively small size of the domestic market means Australian startups will need to export much earlier in their lifecycle. Ian Maxwell has previously suggested that a startup tech sector in Australia could be successful if startups were acquired by the corporate sector, and established corporations then went through the process of commercialising and exporting the process or technology globally. This point is worth exploring further. His broader point – that Australia is going to need to come at the problem differently to the US – is compelling given we are building from a different baseline, in different conditions and with very different parameters. We need to work with our strengths.

Given the figures above, it’s highly unlikely investment from military spending alone will be able to sustain an innovation ecosystem in Australia. Given the capital required to commercialise research and innovation and the size of our economy, we will need to be clever about how to drive capital towards such an ecosystem.

Tax concessions may not be the silver bullet. Based on past experience, e.g. with concessions for film, R&D and infrastructure bonds, any concessions would need to be tightly controlled to prevent manipulation and avoidance. However, it seems unwise to completely dismiss the tax system as playing a role in achieving the economic shift we are seeking.

One idea worth exploring further is whether it is valuable to undertake some rebalancing between the level of concessions and subsidies that are currently directed towards individuals and those directed towards business vehicles, even if this is only temporary. The rationale is that a flourishing and productive private sector may remove the need, or assume responsibility, for providing some of the benefits to individuals. The UK seems to have had some success with that strategy.

In this vein, some have recently argued that the revenue lost to negative gearing and the investment in real property that it has encouraged would be better redirected towards the startup sector.

In 2015, NATSEM estimated that Australia currently foregoes A$3.7 billion in revenue each year to negative gearing of residential property (A$7.7 bn when combined with the CGT discount) and there’s also evidence negative gearing mostly benefits higher income taxpayers.

Abolishing the Australian tax sacred cow of negative gearing would be unpopular. But it is the type of change we should be considering if we really want to direct investment towards innnovation.

Author: Alex Evans, Lecturer in Tax Law, Australian School of Business, UNSW Australia