Reserve Bank reacts to a strengthening economy

Asset Check - Daryl Dixon

The Canberra Times, 7 March 2010


As widely expected, the Reserve Bank reacted to a strengthening economy by increasing the official short term interest rate by 0.25 per cent a year to 4 per cent a year. This action will be followed by further increases during the year as the Reserve Bank pursues its dual objectives of controlling inflation and preventing an asset price bubble, particularly in residential housing. Higher interest rates keep inflation under control by strengthening the value of the Australian dollar thereby lowering the price of imports.

They also reduce consumer demand by squeezing family budgets through higher debt servicing costs. The second objective of preventing a housing price bubble will, however, be more difficult to achieve without substantial future rate increases. This is because the main driver of housing price increases in 2010 will be a return of investors to the market.

These purchasers are being encouraged by the major change in taxation incentives in the May 2009 budget. Before the change, higher income earners aged over 50 were able to gain a no risk tax saving of up to $31,500 a year by diverting $100,000 of taxable income to super. From July 1, 2009, however, this maximum tax saving fell to $15,750 for a $50,000 annual contribution.

This will fall even further from July 1, 2010 to $7878 for a maximum $25,000 annual deduction. Younger higher income earners already only have access to a maximum tax advantage of $7875 annual for diverting pre-tax income to superannuation. This compares unfavourably with the unlimited tax advantages from negatively gearing property investments. Furthermore, unlike superannuation, which requires taxpayers to save the money diverted to super, all the funds required to obtain negative gearing tax deductions can be borrowed on a tax deductible basis.

Investors can, subject to loan collateral requirements and their ability to obtain loans, gain access to whatever level of tax deduction they desire. Compared to home owners who do not receive any tax deduction for their interest costs, investors obtain a tax deduction which reduces the effective cost of their borrowings. The variable mortgage interest rate after this week's increase is now around 7 per cent a year.

This effectively costs a top rate 46.5 per cent marginal rate taxpayer 3.75 per cent a year after tax. Even for a 31.5 per cent marginal rate taxpayer the after-tax cost is only 4.8 per cent a year.


Daryl Dixon is executive chairman of Dixon Advisory and Superannuation Services.