Weak Analyses Plus Political Bias: Failure Inevitable for the Tax Working Group?

The TWG has been set an impossible mission – improve the tax regime, make it more efficient and fair, but don’t recommend any changes to the tax treatment of owner occupied housing. And another – make the tax system fairer but don’t deal with the interface between tax rates and welfare (which is just negative tax after all).

Due to the contorted nature of its terms of reference, the TWG will fail; its recommendations will be so dependent on what it has been barred from considering as to render any recommendations irrelevant. But given the political nature of its pedigree it’s bound to come up with some silly recommendations nevertheless. Worse, they could even be adopted if the political landscape remains unchanged.

I won’t deal with the nonsensical requirement of excluding the labyrinth of targeted welfare benefits that make a mockery of fairness in the tax regime as that has been outlined elsewhere, but with respect to housing there are two dimensions that need to be analysed separately. Firstly, the dynamic of recent house price inflation that has at its source demand-factors that have been common in several economies around the world and we should not conflate those with the more fundamental distortion to fairness and economic efficiency. This second influence arises from the peculiar interface between the income tax regime and owner occupied property which New Zealand has almost uniquely concocted. It is this latter factor that lies at the heart of the inefficiency and unfair nature of tax, tenancy, ownership and intergenerational equity.

Don’t expect this government to address competently this fundamental issue – simply because it has ruled it out of the Tax Working Groups terms of reference.

The Housing Market Macro Dynamic

Over the last decade or so the house price to income ratio has soared but the ratio of interest costs to real disposable income hasn’t. In other words the rise in (nominal and real) house prices has been in large part driven by the fall in (nominal and real) interest rates, augmented by a global slackening of lending criteria on housing that came from financial market deregulation. New Zealand household debt rose as did our private sector foreign debt (as this is where the banks sourced their funding). In addition New Zealand’s population growth rate lifted from 1-1.5% pa to 1.5-2% pa due to higher net immigration.

The rise has been so large that the ability to accumulate the deposit on a first home has fallen – real house prices are over double what they were before the year 2000

Blaming Land Shortages – An Easy but Incorrect Conclusion from Official Advisers

“Section prices have grown more quickly than house prices over the last 20 years, indicating that

appreciating land prices have been a key driver of house price inflation in New Zealand. This suggests a shortage of residential land in places where people want to live.”  NZ Productivity Commission 2012

No it doesn’t suggest that at all. The inference made by the Productivity Commission that land shortage is contributing to house price inflation doesn’t necessarily follow at all. If the underlying drivers of the increasing price of housing are demand-based (and some of these are as the Commission outlines) then it’s inevitable that higher demand will hit the constraint of inelastic supply at some point. But that does not change the conclusion that it is demand which is the primary driver and that supply constraints only arise once demand gets to a sufficiently high level to reveal that supply inelasticity.

One of the real risks with the fallacy of the Productivity Commission’s interpretation (alleging supply is the problem), is that the Commission concludes that if we release more land that will solve the house price inflation issue. Of course it does only to the extent of offering breathing space until the inevitable rise in demand once again pushes against the (new) supply ceiling. In other words such an inference results in recommendations for policy that do not address the underlying primary driver – demand.

It behoves the Commission then to delineate the extent that it sees the primary drivers of real house price rises being demand rather than supply ones. The Commission has failed to do this and worse, it has promoted publicly that land supply is the major constraint. That analytical shortcoming has now led to Tax Working Group Secretariat advising the Tax Working Group that land supply is the primary driver of house price rises –

“..but the existence of substantial constraints on the supply of housing means that tax policy is unlikely to be the dominant driver of high house prices.” – p28 op cit

Error upon error is compounding, all because the analysts have been too cavalier in their analysis. Neither the Productivity Commission nor the TWG Secretariat have produced any evidence whatsoever that supply is the primary driver of the house price rises. Indeed the TWG Secretariat provides itself with a very weak “out clause” to excuse the shortcomings of its work –

“It is very difficult to quantify how much the tax system affects the housing market.” – p28 op cit

Unfortunately because it’s “difficult”, the Secretariat has preferred to conclude that land supply is what matters most – that is just not intellectually acceptable, and would certainly attract a “fail” in any introductory economics exam. 

An Alternative Explanation

It’s pretty simple really and has been highlighted by two previous tax working groups that were arguably more independent than the one currently sitting. Both the 2001 McLeod Enquiry and the Tax Working Group of 2010concluded that owner occupied housing confers a tax privilege. Put simply, the owner of a house receives a benefit in terms of the roof over their head each year, and that benefit is not subject to income tax. A tenant who instead owns a bank deposit or a business, pays tax on that benefit (interest or profit) and then pays for the “roof over their head” from tax paid income – which is taxable as well in the hands of the landlord.

This is a massive difference in effective rates of return from the alternative assets, and underpins a permanent and ongoing year-by-year benefit to owner occupiers of property. So long as this persists it makes sense to buy more and more valuable property because the tax wedge rises concomitantly.

And of course to the extent that we all recognise this and clamber to get into home ownership, the demand for property far exceeds any level of demand our accommodation needs alone would imply, and the supply constraints in the market will always be tested.

The primary driver of real property price rises is categorically the factors that drive demand. Supply constraints are a second order issue (including obviously any changes to the RMA).

But of course this government has instructed the Tax Working Group not to look at closing the loophole on owner occupation of property. The TWG is thus compromised from the start; it is subject to a political agenda that seeks to protect the tax privilege of property owners and by inference, discriminate against tenants – most of whom are younger generations.