The world according to GRP — Monday, July 16, 2007:
Howard for Nobel Prize in Economics
In Australia's long-running debate about housing affordability, the contribution by former Prime Minister John Howard to the progress of economic thought — in particular, the understanding of incentives — has been truly Nobel-worthy.
For centuries, economists have assumed that if an economic reward, such as a subsidy or tax break, is to serve as an incentive to do something, it must be contingent on actually doing it; that is, if you don't perform the desired action, you don't get the reward.
But Mr Howard has discovered a counterexample in what is commonly called "negative gearing" or, more precisely, negative gearing deductibility — that is, the full tax-deductibility of interest payments on an investment property even if the interest exceeds the rental income.
Mr Howard's reason for retaining negative gearing is that it encourages the supply of housing and thereby helps to minimize rents. As long ago as December 2003, he told ABC television that "one of the reasons why we reject a removal of negative gearing is that it would drive up rents... Poorer people rent more than own their own home, and getting rid of negative gearing would strike a blow at the most vulnerable section of the community..." His concern was not limited to complete abolition of negative gearing, because "anything that has an effect... on negative gearing will reduce the investment dollar going into rental properties and it will drive up rents and it will hurt the poor."
Mr Howard maintains that position to this day. (And so much for the oft-heard accusation that his government only stood for the big end of town.)
If Mr Howard's claim were wrong, the Labor Party would surely have pounced on it. But in fact Labor has ruled out any change to negative gearing for precisely the reason given by Mr Howard. As recently as July 6, 2007, Labor's Treasury spokesman Wayne Swan declared: "We won't be touching negative gearing and to touch negative gearing in the current environment would be detrimental to the supply of rental housing."
We must therefore take it as fact that the negative gearing deduction is an incentive to supply rental housing. But is it contingent on supplying rental housing?
The only people who actually supply housing, rental or otherwise, are those who build dwellings (or engage contractors to build them). But do you have to build a dwelling in order to claim negative gearing? No! You can simply buy an existing dwelling. If, in so doing, you take the home from another would-be investor, you merely substitute one landlord for another, with no increase in the supply of rental housing. If, on the contrary, you take it from a would-be owner-occupant, the gain for renters (one more house to rent) is a loss for first-time buyers (one house fewer to buy), with no increase in the overall supply of housing; and if just one first-time buyer responds by deciding to rent instead, the increase in the supply of rental housing is cancelled by the increase in demand, with no downward effect on rent.
In fact, to claim negative gearing you don't even have to buy a dwelling. You can buy a bare block of land, hold it while waiting for the price to go up, then sell it and claim the interest against the capital gain or other capital gains. In so doing, you have not only failed to build a dwelling, but also probably frustrated someone else's plans to build one.
Yet this is an incentive to supply housing. Mr Howard told us so, and Labor meekly agreed.
According to the aforesaid centuries-old assumption which Mr Howard has consigned to the dustbin of history, negative gearing would not be an incentive to supply housing unless it were contingent on actually building a dwelling, so that (for example) you could claim negative gearing on new homes, but not for future purchases of established homes. But Mr Howard, at the very beginning of the debate, implicitly ruled out that proposal, and the Labor Party quickly followed. (Indeed this writer, though it pains him to confess it, put that very proposal to Mark Latham on talkback radio during the 2004 election campaign. Mr Latham dismissed the idea without apology or explanation.)
So there we have it: an incentive for a desired action need not be contingent on performance of that action.
The implications for public policy are stunning. As soon as the nexus between the reward and the desired action has been breached, there seems to be no limit to the degree of separation. Any favour to anyone can be an incentive for anything. Does a major donor to your party want a tax break for no reason in particular? Does some unrelated problem cry out for a solution? Good: grant the tax break as an incentive to provide the solution!
Of course some people will say that this conclusion flies in the face of common sense. But discoveries that blow away our preconceptions are precisely the sort of thing for which Nobel prizes are given!
Mr Howard must surely be a front runner.
[Revised December 7, 2007 (post-election).]
Copyright © Gavin R. Putland except as otherwise attributed. Posted at The world according to GRP under the title Howard for Nobel Prize in Economics. You may republish this item verbatim on your website or blog provided that you include this notice (with hyperlinks).
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