Capital Gains Tax – Is This Needed In New Zealand?

Capital Gains Tax – Is This Needed In New Zealand?

To say that New Zealand house prices have risen spectacularly is not entirely unfair.

It’s certainly concerning the Reserve Bank which said in its latest Monetary Policy Statement this month that heightened medium term inflation pressures were underpinned by both expansionary government fiscal policy and buoyant housing and labour markets.

When it comes to housing affordability, it is sobering to reflect that the median house price was 3.75 times the average household disposable income six years ago, and is now 6.3 times that average income. With the median house price in Australia being 5.4 times the average household disposable income and only 2.7 times in the United States, it is fair to say that New Zealand housing is on the expensive side.

Affordability, however, is not the only issue. Equity withdrawal from housing has undoubtedly fuelled consumption in recent times, adding further to inflationary pressures.

So, I do not dispute there’s an issue. But I do dispute that a capital gains tax is the answer.

It’s really important we don’t have a knee-jerk reaction to this challenging issue. It’s also important we don’t start by focussing on a single possible solution – in this case a capital gains tax – rather than making sure we analyse the actual problem very carefully. To jump too quickly to possible solutions can lead to unintended consequences for both businesses and the economy at large. And, need I say it, National is more interested in reducing the tax burden on New Zealanders, not increasing it.

What’s more, a capital gains tax on housing cannot solve housing affordability and rising inflation when a major part of the problem is actually government spending. This is an aspect of inflationary pressure that the government can control, and I will return to it.

Put another way, imposing a tax that will increase government revenue in an effort to control the effects of government expenditure seems a little like chasing ones own tail and is likely to be equally fruitful.

So let’s go back to the basic problem. What’s been driving our housing boom?

Put simply, it is supply and demand. Net immigration means more housing is required.

Moreover, demand for housing has been driven by cheaper finance, and cheaper finance that’s available to more people. But the supply of housing has been slow to adjust to this increased demand.

When we look at global trends, the most important common factor driving housing demand internationally has been the wave of deregulation and product innovation taking place in the financial sectors of most countries. This has reduced interest margins on housing loans and lowered the interest rates paid by mortgage borrowers.

It has also expanded the range of mortgage providers and of mortgage products. Finance is now available to a much wider group of potential borrowers than was the case previously.

We’ve seen this in New Zealand. There are now more mortgage lenders offering a wider range of mortgage products, including 100% loans, revolving credit, interest only and fixed rate loans etc. The competition among lenders is so intense that a new form of business, the mortgage broker, has emerged.

In combination, these trends have boosted lending and stimulated the demand for housing.

It’s also fair to suggest that both the tax treatment of housing and our social attitudes towards housing as a savings vehicle have reinforced those trends.

Many experts are of the view that some features of our tax system do tend to favour housing over other forms of investment, but it’s not necessarily the absence of a full capital gains tax.

The ability to fully deduct rental income losses against other income may encourage some people to take on higher levels of debt in order to purchase investment property.

In fact, just last week an article by Westpac Bank suggested that the increase in the top personal tax rate made by Labour in 2000 has pushed house prices up by about one fifth. The tax increase made housing investment more attractive to higher income property investors.

It works like this. Most landlords make a loss on their rental properties, since rent doesn’t usually cover mortgage interest and expenses. As I’ve just mentioned, this loss can be used to reduce the landlord’s other taxable income.

The landlord receives a tax rebate on rental losses at his or her marginal tax rate. So, if that marginal tax rate increases from 33% to 39% the tax rebate available also increases. And this increased rebate will be available every year. Little wonder then, that many people are willing to invest increasing amounts on properties to secure that tax break.

It shouldn’t surprise, therefore, that recent analysis by Treasury suggests that about 19% of couples and 8% of individuals own some form of secondary residential property.

But other factors are at work as well. Let’s not forget that housing has been an effective savings vehicle for many people – in many cases it’s been their only way of saving.

It has been reported, for example, that only 5% of New Zealand pensioners are in financial hardship, compared with 20% in Britain.

A recent report on living standards by the Ministry of Social Development suggests the explanation may lie in high home ownership rates among older New Zealanders.

Home ownership is linked to good living standards for many older people here. And in saying that, I am not in any way suggesting a diversified portfolio of non-housing savings assets is not important.

So, for a range of reasons from net immigration pressures through an explosion in the diversity of borrowing arrangements, certain taxation incentives and a widespread belief that property is a reliable and secure form of investment, demand for housing has been increasing while supply has lagged.

Indeed, various legislative changes in the past 20 years such as changes to the Building Act, and increased compliance costs associated with such things as the Resource Management Act, and the OSH legislation, not to mention the Local Government Act, have slowed down and added to the costs of building in New Zealand. Even the supply of skilled builders has been a limiting factor.

This is reflected in a study for the Auckland City Council that found building a home in New Zealand’s two largest cities, Auckland and Wellington, is now 60% to 80% more expensive than constructing a similar home across the Tasman.

The report compared the cost of labour, building materials and contractors’ overheads in both countries per square metre. It showed that building costs in Auckland between July 1999 and July 2006 rose 65% for a small home and 60% for a large one.

And so, how would a new capital gains tax fit into this matrix of issues all putting pressure on house prices.

First, it must be made clear that New Zealand does have a capital gains tax on the profits from the sale of certain properties.

If a housing property is not lived in by the owner, and was acquired with the purpose or intention of resale, then any capital gain on that property is taxable under today’s law.

This so-called “intention test” is outlined in the Income Tax Act 2004.

While Section CB14 excludes residential property from the definition of income, provided the house or property was occupied mainly as a residence by the person, their family, or under certain trust arrangements, the exclusion explicitly does not apply to a person who has engaged in a regular pattern of acquiring and disposing, or erecting and disposing of dwelling houses.

The Inland Revenue Department has had a few sporadic attempts at enforcing that law.

For example, in 2004, IRD targeted property investment in Queenstown, Wanaka and some parts of Auckland. They gathered an extra $106.6 million in tax from those investigations, including $52.9 million from Auckland alone.

The Reserve Bank, IRD and Treasury all agree there continues to be widespread non-compliance with that existing law. In fact, in its March Monetary Policy Statement, the Reserve Bank went so far as to refer to a “greater emphasis on the enforcement of existing tax laws regarding capital gains made on investment properties”, and implied criticism that IRD is failing to enforce the law.

A quick glance at property sales statistics suggests these criticisms might be valid. Work by Treasury and the Reserve Bank last year showed that about 25% of residential property sales in 2005 were of properties that had been owned for less than 2 years. This was up from 10% in 2001. Such high turnover suggests a significant portion of residential property was acquired with the intention of resale.

The problem for IRD is that under existing law the buyer must have intended to buy and sell for profit when they purchased the property, for the tax rule to apply.

Perhaps it’s not surprising that in the March Monetary Policy Statement, the Reserve Bank hinted at the need for changes to the tax rules around investor housing. Under questioning at Parliament’s Finance and Expenditure Select Committee, however, the Governor stated that the bank did not have a view on a more comprehensive capital gains tax.

Last year the Reserve Bank and the Treasury looked at a range of options to cool the housing market and/or the market for residential mortgage credit – including better use of the existing capital gains rules.

First – and probably the most well known – was the mortgage interest levy. This was to be a levy imposed on all loans secured by residential property. It would be triggered whenever the housing market looked to be rising rapidly and when New Zealand interest rates were well above foreign rates.

In effect, it would do away with fixed rate mortgages. Apart from the technical difficulties involved in determining the right time to apply it, the mortgage levy also had disadvantages of impacting more heavily on first time and lower income borrowers, and on the many small businesses financed by housing loans. It was also widely seen to be the political equivalent of bird flu.

Another option considered included imposing a discretionary loan-to-value limit on lenders. Intense competition among lenders has led to banks and others offering mortgages of up to 100% of a property’s value. Similar lending practices in the UK meant that when their economy experienced a downturn, many homeowners who were unable to pay the interest had to hand over their keys to their banks.

A discretionary loan-to-value limit would set a cap on such lending. Again there were a number of technical difficulties in determining just what the limit would be and when to apply it — in fact, it seemed most likely that it would be applied late in any cycle — favouring those who “got in early” so to speak. And again it would impact more heavily on first time and lower income borrowers.

A third option was to require banks to hold more capital to cover their lending. If a bank wants to lend money then that loan has to be covered by a certain percentage of capital. The Reserve Bank could require banks to hold more capital to cover housing lending — it already has this ability. We asked Dr Bollard about this during the Finance and Expenditure Select Committee examination of the March Monetary Policy Statement.

We gained the impression that Reserve Bank officials are holding one-on-one discussions with the major banks about this right now, so the option remains live.

A fourth option was to ring-fence operating losses on residential properties. In effect, it would close off the ability to apply such losses to reduce a landlord’s taxable income. While ring-fencing of such losses is common overseas, these same countries also experience quite volatile housing cycles.

In their report, the Treasury and the Reserve Bank cautioned that ring-fencing could reduce the stock of rental property available to those on low incomes and could force rents up as landlords tried to avoid losses. In addition, the legislation to put this into effect would be complex to administer and may catch small businesses using the provisions for other legitimate purposes.

A fifth option was a more comprehensive capital gains tax on housing to overcome the problems in enforcing the existing law based on intent.

As I’ve mentioned, the Treasury and the Reserve Bank flirted with the idea of removing the current exemption for residential property altogether. In effect, anyone selling a house within, say, two years of purchasing it would see any profits or gains on that sale being counted as income — and taxed as such.

The problem, as one tax practitioner has noted, is that “it becomes easy to avoid, expensive to administer, easily exploitable, and still favours some taxpayers over others." And I’d add that countries with such taxes have still experienced housing booms.

Improving responsiveness of housing supply was the final option looked at. New Zealand is building about six new homes per 1000 people each year. This is below the rate of seven to nine needed simply to replace old homes and to respond to projected population growth. Australia builds about seven houses per 1000 people and some states in the US build 13.

The Reserve Bank and the Treasury also noted that land prices have risen twice as fast as house values, yet there was little research as to why.

One recent report, from the centre for housing research, suggested that zoning, infill/density regulation (such as plot sizes in fringe areas), infrastructure provision and planning regulation were contributing to increased prices. In my view this is fertile territory but an immediate impact is not possible and success would involve extensive work with local government.

Looking at all of these options, the main conclusion reached by the Reserve Bank and Treasury was “that there are no simple, or readily implemented, options that would provide large payoffs in the near-term. Moreover, it is important to stress that significant house price cycles have been a feature of many, perhaps most, developed market economies in the last decade or so.”

And let’s not forget a number of those developed market economies do have more comprehensive capital gains taxes than New Zealand. Yet, that has not prevented those significant house price cycles.

What’s more, we must recognise that the majority of New Zealand firms are small family businesses. Many of these are financed either directly or indirectly using housing mortgages.

A crackdown on those mortgages may, therefore, have the unintended consequence of damaging our business sector.

Having explored this wide range of issues with you today, I believe there are some simple things that the government can and should do to help take pressure off both house prices and inflation.

Improving housing supply would be a worthy long-term goal. In the short term, however, the Reserve Bank’s Monetary Policy Statement makes it very clear that government spending and the effects of certain government policies are significant contributors to current inflationary pressures.

The bank was quite blunt about this. Expansionary fiscal policy was as much, perhaps even more, to blame for increased inflation pressures the Bank was reacting to when it recently increased interest rates.

Before you dismiss this as simply what any party in opposition would say, consider this: according to The Reserve Bank , between 2005 and 2007 total core government spending increased by 17% while the economy had grown just 9% in that same period. That growth in government spending is almost twice the rate the economy is growing.

Add to that the fact that the Government’s recent Budget Policy Statement identifies an additional $7 billion of spending over the next two years, and a picture emerges of expenditure growth consistently exceeding GDP growth. And remember, next year is election year and those spending forecasts don’t even include any of the bids to try and win your votes.

I mentioned earlier that it has been estimated that housing equity withdrawal in 2006 amounted to 5.3% of disposable income for households. It’s believed much of that is going directly to fuelling the current consumer spending boom.

And so my final message is this. The Government needs to get its own house in order rather than trying to divert attention onto housing market disorder. Recent years have seen an unprecedented government spending binge that has possibly had the greatest impact of all.

The risk we face is of a rapid rather than a gradual unwinding of the current residential property situation. Other countries, such as Australia and the U.S. have seen a gradual unwinding, but they let existing mechanisms work. That’s what New Zealand should do without undermining the Reserve Bank’s official cash rate tool.

The chance of that gradual unwinding is less likely if the Labour Government continues its massive spending binge.

The longer that spending delays the correction, the greater its impact will be. That is the real issue that must be addressed.