Taxing residential properties: Is it time to pull the lever?

A recent New Zealand Herald article trumpeted the news that house prices will rise by 13 to 16% over the next few months.

Most people I have spoken to express disbelief that there is such a disconnection between these asset values, the ratio of average income to average property prices, and the comparative cost of residential property in other jurisdictions.

I believe that rapidly growing house prices are a problem for four reasons.

• It generates inequality of a relatively high level within our society. This inequality results in different opportunities for people in the circles in which they mix, the education they receive, the investment opportunities offered to them, and the experience they receive in terms of law and order and personal security.

• It creates an intergenerational unfairness. Children cannot afford deposits or borrowing without parental help, yet those same parents had little problems finding sufficient funds to purchase their properties. It also could be noted that some of these parents enjoyed free tertiary education when they were young and now a universal pension.

• Except for real estate agents and the banks, the country doesn't become a more productive or wealthy society because of these inflated prices.

• Increased indebtedness associated with such stretched pricing results in greater risk and fragility in the economy. Interest rates are at historic lows. The Government has itself borrowed and pumped money into a Covid-19-sized economic hole. An increase in interest rates will cause considerable distress in the private and public sectors, but in the private sector in particular.
 

Susan St John has rightly raised the logic of using the riskfree return method (RFRM) as a sensible alternative. The Government's Tax Working Group in 2018-19 carefully considered RFRM as an alternative to a comprehensive capital gains tax.

In the end, the majority (of eight members) thought that the best way to future-proof a tax system that was going to encounter problems with ageing demographics, reduced labour income and increasing inequality was a comprehensive capital gains tax.

The minority (three members) in essence thought the costs of a CGT outweighed the benefits. All 11 members of the tax working group agreed that residential property investment required additional taxation.

Papers prepared for the Tax Working Group discussion in October 2018 disclosed that at a risk-free return rate of 3.5%, the estimated revenue from introducing an RFRM (in addition to the existing rules such as the bright-line provisions) would be about $1 billion in year one. After 10 years, by 2031, this would increase to $2 billion a year. Some landlords would pay less tax (if they had meagre interest costs and high rental returns), but there would be extra deemed income across the sector.

Some of the objections to RFRM remain valid (such as singling out an asset class and the possibility of inadequate cash flows to fund the tax). Still, numerous attractions include comparative ease of calculation and certainty of income stream for the Government.

Consequently, the tax lever is likely to tax a currently undertaxed asset class more adequately and act as a curb to burgeoning house prices.

Westpac economist Dominic Stevens calculates that a 10% CGT would reduce house prices by nearly 11%. It is unclear what effect the RFRM would have, but it should stem the increase.

It might also be worth asking why we should offer a tax preference of zero taxation on nonowner-occupied housing. Although the bright-line and other tests apply to a residential investment property, they are easily circumvented (by holding on to the property for the five years).

Evidence suggests that tax cuts for the rich do not significantly improve the economic performance of a country. In a recent study by the London School of Economics of 18 countries (including New Zealand), tax cuts for the wealthy were found to increase their share of income and did nothing to trickle down to boost real GDP per capita or influence the unemployment rate.

In summary, the preference of non-taxation extended to nonowner-occupied residential property increases inequality and does not contribute to the economic growth of New Zealand in a meaningful way. Tax can play an essential role in reducing (or slowing) runaway house prices, encouraging more productive investment and reducing inequality.

Previous governments, in introducing a fair dividend rate on foreign investment funds, were adamant that they were taxing an imputed return, and was not so evil, shockingly reviled, and radio host criticised as capital gains tax. So perhaps even the political obstacle is illusory.