Will the budget sink the property market?

Peter Boehm is one of Australia's leading property and finance commentators with over thirty years experience in the banking, finance and property sectors gained in Australia and overseas. He has a deep understanding of the residential property market, is a published author and is regularly quoted in the press on matters including home ownership, first time buyers, property investment, home loans and consumer finance.

 

The newly elected Liberal coalition government presents its first federal budget on the 13th May. And to paraphrase an old Chinese saying, it will be delivered with the Australian economy in and approaching some very interesting times.

The budget dilemma

The government has made no secret of the fact that it has inherited a budgetary position which is much worse than it had anticipated and certainly much worse than was acknowledged by its predecessor. In fact, the forward projections show significant budgetary gaps (that is, payments far exceeding receipts) over the next ten years or so and especially over the next three to four years. Demand for services such as welfare, health and education far exceeds the government’s capacity to fund which, according to its own figures, will result in gross debt exceeding 25% of GDP from around 2016 unless and until the government balances its books. Basically Australia could be faced with over a decade of budget deficits if nothing is done to remedy the situation.

Australian governments are heavily reliant on personal income tax revenue to fund their budgets. For instance, the current ratio of personal tax to company tax receipts sits at around 3 to 1. So having policies and initiatives which sustain, protect and increase this source of revenue is fundamental to the financial wellbeing of the country. However, with unemployment on the rise (forecast to be around 6.25% over the next two years) and participation rates falling and presently sitting under 65% (the participation rate is the percentage of working age people working or looking for work) not only will the level of personal tax revenue come under pressure, but demand for welfare payments is likely to rise. And this would combine to further exasperate an already problematic situation.

Sustained employment, jobs growth and job security are key indicators of a healthy residential property market (not to mention a healthy economy). They are not the only inductors but certainly important ones. But the labour market outlook is not flash at present with the level of advertising and vacancy rates dropping and some fairly major structural changes occurring.

For instance, demand for labourers, clerical and administration staff have dropped considerably over the last year or so while demand for community and personal services (e.g. aged carers), professional and manager roles are now key employment growth areas.

The dilemma the government faces is that it needs to make tough decisions now to fix an impending and longer term fiscal problem. It must balance the economic and political impact of delivering a contractionary budget (that is, one that reins in government spending) with the need to protect and grow jobs and stimulate the economy for the long term wellbeing of everyone. And this is not an easy task.

Full coverage: Federal Budget 2014-15

Budget options

Simply put the government could adopt one of three core strategies to deal with the current budget dilemma. It could cut its spending, increase its revenue or do both. Let’s take a look at some of the key drivers under each option.

Option 1: Cut spending

If the government opted to cut spending (and depending on where the cuts were directed) this would clearly have a contractionary effect on the economy and could push unemployment higher, cause employment participation rates to fall further, reduce personal tax revenue collected and place further stress on the welfare system.

Significantly, with the Cash Rate at historically low levels there is little scope for the Reserve Bank to drop interest rates to cushion the economy from a possible downtown. So there would be limited monetary policy support if major spending cuts were announced.

For these reasons it is highly unlikely the government would adopt a contractionary strategy. In addition, it has a stated objective of increased infrastructure spending. This is something I agree with as it represents the vital investment needed to support our growing population and remedy the inadequacy of things like our current roads and transport system.

As an aside, it would be beneficial if any further investments demonstrated clear and measurable social and financial benefits with a greater focus on upgrading and improving existing infrastructure – basically let’s fix what we’ve got before building new stuff.

There are some spending areas that the government may have no choice but to curtail. And chief among these is the funding of the aged pension. The issues surrounding an aging population and the affordability of maintaining the pension are well documented and pretty much accepted by the wider community. The level of foreign aid is another area the government will need to review.

While Australia has shown commitment to helping countries in need through financial and other aid assistance, it is going to be difficult for the government to stick to its agreed quantum of support (which is based on a % of GDP) given current domestic economic constraints. And finally, welfare payments and tax breaks will yet again be the focus of close scrutiny.

It would come as no surprise if the budget included announcements around things such as increasing the pensionable age and including the value of the home into pension calculations, reducing foreign aid (at least for now) and changes to tax perks like Family Tax Benefit B.

Option 2: Increase revenue

A key focus must be on increasing personal income tax revenues. If this is achieved through increasing employment and participation rates than this will be a positive development for the economy and the housing market. And the level of government spending not to mention the adequacy of its labour market and jobs growth policies will play a key role in delivering this.

The government has the option of increasing personal tax rates, especially at the top end. Whilst this is a possibility it is highly unlikely given the substantial political risk, voter backlash and negative impact such a move would have on low income earners. Instead it may be forced, at least for the foreseeable future, to fix current personal tax bands at their present level which would help raise revenue as everyone moves up into higher bands through CPI and other pay increases.

This would effectively signal the end of the ongoing cuts in personal tax we’ve come to expect and as a result we’ll be paying more tax as a proportion of our income as our pay increases. While this would not be a popular outcome, given the state of the nation’s finances, it is probably a necessary one.

In addition, the government could Increase the GST rate and/or include otherwise exempt items. On the face of it this appears a fair approach as everyone is affected equally. However it is more likely to hurt the most vulnerable in our community and would be highly unpopular with voters. I expect this option will be off the table for this budget, but will certainly be in contention for the next one.

The government could also increase tax revenues by removing the personal Capital Gains Tax concession. This of course would affect property investors and could dissuade some from entering the market. However, this would be good news for first time buyers. This option, or some form of it, is a real possibility.

The budget could also herald in an increase in the company tax rate. However this would be highly unpopular among business leaders (home and abroad) which could lead to a detrimental effect on businesses investment in Australia and a consequent negative knock-on effect on employment and economic growth. On balance, the company tax rate will probably stay where it is.

Finally, the recently announced sale of Medibank could signal a wider asset sell-down program. Setting aside the social and commercial issues, the sale proceeds could be used to fund initiatives and pay down debt, both worthwhile outcomes. Watch this space regarding other potential asset sales.

Option 3: Do both - cut spending and increase revenues

In reality this happens in pretty much every budget – there are always winners and losers. Focusing on only one side of the ledger won’t cut it as the impact will not be sufficient enough to narrow the budgetary gap in the time needed.

There are some vital areas of spending that must proceed while others will need to be cut or significantly reduced. Similarly, the government will have to look to increase tax revenues by removing certain offsets or tax breaks that are costing too much to fund and ask those who can afford it to contribute more to the public coffers.

I suspect the budget will comprise a mix of options 1 and 2 above, with priority given to those considered to have the greatest positive impact and political expediency – and not necessarily in that order.

Property market options

Looking at the property market specifically, there are a number of key initiatives the budget could address.

First among these is the removal of negative gearing on property investments. With around $13 billion wiped off personal tax collection every year due to investment property loss offsets there is a strong argument to scrap the tax break. Whilst this would be an unpopular decision and might damage house price growth in the short term, there would be some significant social and financial benefits over the long term, including more stable and sustainable house price growth and a higher proportion of first time buyers able to enter the market since they would be able to compete on more equal terms with investors.

I’m confident this is a perennial budget consideration and the time is probably nigh when negative gearing rules will change, but probably not in this budget.

Another consideration would be for the government to address supply side constraints – that is, alleviating land supply issues and removing or reducing as much red tape as possible. This would assist in opening more land for timely and cost efficient housing developments.

Whilst this is not strictly speaking a federal issue the government should set aside time and money to work more closely with its state and territory colleagues to help bridge the gap between housing supply and demand and to better co-ordinate federal and state infrastructure investments.

And finally, an interesting development over the past five years or so has been the emergence of the foreign property investor. Estimates indicate around 1 in 12 or over 8% of all investment properties are bought by overseas buyers. There is some talk of restricting or taxing these buyers. How this would operate in practice is unclear (although Residex in its article Two brave budget decisions that would benefit tomorrow’s generation raised an interesting point around increasing land tax to foreign buyers) but any reduction in overseas demand would assist domestic buyers, including first timers. However, this issue may not be high on the government’s agenda at this stage.

Outlook for the property market

A strong and growing residential property market (especially new builds) is vital to Australia’s economic and social wellbeing and way of life. The employment, investment and spending that housing generates is substantial and because of this the government must be mindful that the budget does not directly or indirectly adversely affect Australia’s property market. And on balance I do not think it will.

Sure, some tough decisions will have to be taken but I do not foresee any major policy shifts or budgetary cuts that will negatively impact owner-occupiers or investors that cannot be absorbed.

In fact, if the government is able to deliver a budget that promotes jobs and economic growth while keeping a lid on wasteful expenditure the property market should continue its trend of strong growth, especially given the robustness of the underlying demand drivers which include a growing population, sustained demand for housing, lack of supply, and the availability of relatively cheap mortgage finance.

Peter Boehm is the Consulting Finance Editor with onthehouse.com.au which offers a unique information source on virtually every property in Australia and provides data on a property’s sold and rental history as well as current property valuations. The onthehouse.com.au Investor Centre provides research on suburbs, market update reports and calculators to help investors make informed property decisions.