The OECD (Organisation for Economic Development and Cooperation) is out with its latest global outlook, warning Australia about the blindingly obvious. That is, labour costs and house prices are too high, which threatens our competitiveness on the global stage.

As reported in today's Financial Review:

'Australia's relative unit labour costs have surged 54.1 per cent since 2000.

By contrast, labour costs have fallen 14.6 per cent in Germany, 20.4 per cent in the UK, 25.9 per cent in the US and 46.2 per cent in Japan.'

The OECD also states that the huge rise in house prices presents a risk to the economy.

Is this really news to anyone with more than a passing interest in economics or finance? The two factors are clearly related...higher wages, along with low interest rates, tend to lead to higher house prices. The fact that house priceincreases have outpaced the rise in wages reflects the leverage involved in the property market (most of the purchase price is debt funded).

The commodity boom is directly responsible for the wages boom, and there's nothing wrong with labour getting a bigger slice of the pie when a country's national income rises on the back of stronger demand for its exports.

But the problem arises when a very large proportion of those wage gains goes into housing. We're not talking about housing as in a roof over one's head and security for a family...we're talking about housing as an 'investment'. (For reasons that will become apparent, it's a term we use very loosely.)

When a nation receives a large pay rise (which is what the commodity boom provided) its potential tax bill also rises. People then seek to minimise their tax.

--In Australia, what's the default tax minimisation strategy? Negative gearing on investment property! So in addition to our income gains going into basic housing needs (fair enough) Australia's tax system encouraged further investment into the housing sector.

Negative gearing is the biggest rort in the tax system. Instead of promoting housing construction and increased supply of new housing (which was what it was supposed to do) it's merely encouraged property speculation on established homes as a way to minimize personal income tax.

In case you're unfamiliar with how this drain on our society works, here's a basic run down:

You buy an 'investment' property for $500,000. The net yield (after all expenses) is 3%, or $15,000. But your interest expense on the $400,000 you borrowed is 5.5%, or $22,000.

That's a dud investment, right? You're losing $7,000 a year.

With negative gearing, you can use that loss to offset the tax you pay on other income. And because property prices always go up in Australia, the gain from your investment comes in the form of a capital gain.

In this case, let's assume prices rise by the magic 7% per year. That's an increase of $35,000, or 35% on your initial equity investment of $100,000. Who cares about income when these are the gains you can expect from property?

We were going to do an example of how things would look with a 7% price decline but there's no point; property prices always rise in Australia.

The whole point of negative gearing was to increase the supply of housing. But all we've heard over the past few years is how Australia suffers from a housing shortage.

Negative gearing clearly does not work. It disproportionately advantages the wealthy while punishing the less well off with high housing prices. It's a policy that explicitly encourages malinvestment. That is, it encourages capital to flow into an asset class where the returns on that capital are lower than its cost. Insane.

According to the latest Australian tax office figures, in 2010-11, negatively geared property investors lost $13.2 billion on their 'investment', which they would have claimed against other taxable income. For a policy that doesn't work, it sure is expensive.

The OECD report suggested the Abbot government find ways to tax real estate more efficiently, which is code for have a look at negative gearing. Unfortunately it's not likely to happen anytime soon. We don't have political leaders willing to make tough but necessary decisions.

We think it will happen though. Negative gearing costs the government billions in revenue. As our economy enters a long period of below average economic growth, the budget will remain under pressure. If we do slip into recession, the deficit will blow out significantly.

Only under this type of pressure will politicians have the gumption to look at such inefficient policies as negative gearing. If they're genuine about increasing housing supply, they will only make negative gearing available to new housing investment.
But that's just a start. Many changes have to be made to cut out the red tape of increasing land and housing supply. Contrary to what Glenn Stevens and the Reserve Bank of Australia think, rising house prices won't encourage new housing construction. It will continue to fuel speculation in the existing housing stock, as capital gains are the only bait for the negatively geared.

But genuine sustainable investment only occurs when the prospect of a decent return on capital (relative to the risk involved) looks attractive. To the rational investor, right now the prospect of sound, risk-adjusted returns on capital doesn't look good when it comes to new housing construction. Why would it, when it's competing with speculators who don't care about income returns?

That's why new housing starts have been so low for such a long time. Higher prices are an investment disincentive. For a given level of income, a higher price reduces your future return. And with the outlook for economic growth and wages growth looking tepid, incomes gains from property over the next few years will be muted at best.

So if politicians and the RBA want housing investment to take over from the fading mining boom, making changes to negative gearing will be a good start. Because that will take a lot of the heat out of the market and move prices back to a level where investment (as in construction) starts to look attractive again.

But such a move will have a big impact on the fabled 'wealth effect', which is held in high esteem by the world's central bankers.

The upshot of all this is that nothing will happen. Policy making will be reactive, not proactive. Australia's politicians will continue to ignore sound advice, cross their fingers and hope that low interest rates will make everything better.

Regards,

Greg Canavan+
for The Daily Reckoning Australia