Terry Baucher on how a change in tax law caused the current housing crisis

By Terry Baucher*

I am not surprised by economist Andrew Coleman’s conclusion in a recent paper that a tax change in 1989 is to blame for the current state of the housing market. It is also one of the conclusions my co-author Deborah Russell and I reach in our new book Tax and Fairness.

Coleman argues a change in the tax treatment of superannuation savings introduced a huge distortion in the tax treatment of property the ultimate result of which is the current housing crisis. 

He concludes:

“New Zealand’s tax treatment of housing is so distortionary not because of the way we tax housing but because of the differences between how we tax housing and how we tax other assets.”

Andrew Coleman has focused on the decision to change the taxation of superannuation schemes in 1989. As I noted last year one result was an immediate and permanent flow of funds away from superannuation schemes.

But there were several other tax changes during this period the effect of which was to enhance the distortionary tax treatment of property relative to other assets. 

The first was the introduction of the foreign investment fund (FIF) regime. As the authors of a 1988 consultative document on international tax reform pointed out:

"The effectiveness of the superannuation fund tax reforms depends in part on the international tax regime covering offshore vehicles which could substitute for domestic superannuation funds."

The problem was that the FIF regime initially proposed by Inland Revenue would tax investments outside New Zealand on the annual change in their market value, or the ‘comparative value’ (CV) basis. Conceptually, this was consistent with the theory of taxing the full economic return, but no such regime existed anywhere else in the world and the idea was roundly dismissed by the committee considering international tax reform:

“Given the complete novelty of the CV proposal, its lack of any international precedent, its valuation problems, its cashflow consequences and the absence of a convincing justification for it in the [consultative document], it is not surprising that the proposal found no support amongst those who made submissions.” (para 1.5.7)

The committee recommended instead that the taxation of gains, other than dividends, derived by residents from offshore investments ‘should await the introduction of a general capital gains tax’ (para 3.1.3). This advice was ignored and the FIF regime introduced. 

Despite the publication of a consultative document in December 1989 proposing a broadly based, realisation-based capital gains tax (including the sale of principal private residences), the proposal was side-lined in 1990.  It was then dropped entirely by the National government elected in October 1990. Since then, no government has tried to introduce a comprehensive capital gains tax.  Failing to follow through on this reform therefore gave investors in property a huge advantage relative to other asset classes.

Three other tax changes in the early 1990s further tilted the balance. First, the previous cap of $10,000 on offsetting rental income losses was removed in 1991.  From then on, the full amount of any residential property losses could be offset against a taxpayer’s other income for the year. By contrast, FIF losses were ‘ring-fenced’ and could only be offset against future FIF income. 

The second change was the introduction of the qualifying company regime in 1992, designed for small, closely held companies with five or fewer taxpayers. (There is a specific sub-part within the Income Tax Act for qualifying companies hence why often referred to as part of a separate regime.) QCs had greater flexibility about the tax treatment of distributions to shareholders. For example, they could distribute capital profits tax-free. Shareholders could also choose to be a loss-attributing qualifying company (LAQC), in which case profits remained taxable at the company rate of 33 per cent (30 per cent from 2008 onwards) but losses flowed through to shareholders. This ability to pass through losses became particularly useful after the Labour government raised the top rate of personal income tax to 39 per cent in 2000. 

Finally, in 1993, the depreciation rate for buildings was raised and depreciation was allowed on a wider range of chattels and assets. A cottage industry soon emerged of analysing the assets in a property and where possible separating them into different depreciable parts in order to maximise deductions. 

Although the numbers of taxpayers returning rental income rose steadily from 1991 on, the tax take did not rise as well.  Recording in 2004 that the number of individual taxpayers reporting rental income had risen by about 150% between 1991 and 2002, Inland Revenue officials noted that while net rental income had fallen between 1994 and 1999, ‘negative income’ from rental property investments had increased.

As the following graph prepared by Inland Revenue shows, ‘negative income’ from rental property more than quadrupled from just under $100 million in 1991 to $400 million in 1999. In fact, the scale of the losses was such that in both the 1999 and 2001 income years, overall net rental income was negative. In effect, the general taxpayer was subsidising loss-making landlords, some of whom were also benefiting from the payment of accommodation supplement to tenants.

Rental income 1991 to 2002 income years

Given this background it seems astonishing that the Labour Government chose to expand the ambit of the FIF regime in 2007.  (This proposal was so unpopular that of the almost 3,400 submissions made to Parliament’s Finance and Expenditure Committee only two supported it). Then opposition MP Lockwood Smith speaking against the legislation argued the expanded FIF legislation would:

“...Provide a serious disincentive to invest offshore in a diversified portfolio. This legislation will provide an even greater incentive for New Zealanders to bring back their money from overseas and invest in residential property here in New Zealand. People get the capital gains tax-free and the returns are far better, so why would they not? This is bad legislation because of all those complexities and distortions.”

Now 10 years later the current state of our housing market stands as evidence that Lockwood Smith’s prediction was right.  

Andrew Coleman’s paper concludes that the present tax treatment represents an intergenerational transfer, “making new generations collectively worse off and being particularly hard on low equity owner- occupiers”.  We also see intergenerational tensions increasing particularly given that more than 2.5 million Kiwis now have KiwiSaver accounts. 

Andrew Coleman is not hopeful about building a political solution to this problem.  However, it’s worth noting that in the past 30 years the public has accepted with little disruption the introduction of GST, two subsequent rate increases as well as electing Helen Clark’s government in 1999 with a specific promise to raise income tax. All these changes passed off smoothly, perhaps because each time there were compensatory income tax cuts and benefit adjustments.  

There is no reason why a similar approach could not be adopted to fix one of the biggest remaining inequities in our tax system.


*Terry Baucher is an Auckland-based tax specialist and head of Baucher Consulting. You can contact him here »

[Parts of this article reproduced from Tax and Fairness by Deborah Russell and Terry Baucher published by Bridget Williams Books May 2017]

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22 Comments

This will not be well received...

Everyone "knows" that the problems are solely due to National, not Labour.

I especially am amused by the finger pointing around here for Auckland. Nobody points the finger at the council or mayor of the past decade despite their very large role in creating the supply imbalance.

Yeah, nah. No one actually says that, and people are constantly commenting on the failings of the Auckland council.

up
10

The "farming debt for tax free capital gain" mindset foundations were in place when Cullen's envy tax on high earners came in. It really drove the LAQC offset bandwagon, that has continued to grow to the mess we have today. The crux is

“New Zealand’s tax treatment of housing is so distortionary not because of the way we tax housing but because of the differences between how we tax housing and how we tax other assets.”

Needs fixing or the ponzi will stagger on.

Why is everyone talking about housing (immigration) day in and day out, if it is not a crisis as per national.

Simple if their is no housing issue and national is right than vote for national OTHERWISE vote for change.

Election 4 months away.

Nice bit of electioneering but Labour didn't fix the prolem either e.g. increasing thr FIF regime in 2007.

The FIF regime stands as a monumental stuff up based on the popular socialist misconception that profit and capital gain are a bad thing. The bloody stupid socialists end up adopting a bunch of policies that favour the Australian banks above all else.

Equity capital is a precious resource and society benefits enormously if it is in the hands of those who are able to use it well. Conversely, as the socialists rightly identify, society suffers if capital ends up in the hands of those who use it poorly. The stupid socialists therefore do their best to put capital in the wrong hands, into the hands of the bureaucrats and the bankers.

Where to begin? New Zealand currently has only one major outlet for those with a spark of individual entrepreneurial spirit, namely residential housing. The others have been shut down by the bureaucrats and stupid socialists.

The housing price problem is not caused by the kiwis who own a few houses. The prices are inflated by the banks importing vast sums of overseas money and lending it to kiwis, and by the vast sums coming into the country with the excessive number of immigrants. The banks can be brought under control via a royalty on their loan book for the privilege they enjoy, and by taking away the excessive privilege they enjoy due to the tax deductibility of interest as an expense.

The FIF regime is fundamentally stupid in that it encourages stupid capital allocation decisions. If a talented individual kiwi investor can, at a particular point in time, get a better return on his savings by investing them abroad then he should not be penalised for doing so. When there are few sensible investments in NZ, due to the widespread overpricing that occurs from time to time, this is the best thing to do, both for the individual and for society.

I am sure the "stupid" socialists of Scandinavia will appreciate that term. Try not to be so abusive or you will find you will get it back

Sorry, I was trying to be provocative and provide a caricature, a sort of verbal cartoon. I realise this can be offensive and therefore counter productive, but the subject seems to stir me up and the only way I can express it seems to be rather blunt and aggressive. The alliteration seemed to work and I am making the point that some of the socialist policies have backfired badly. Stalin's term was "useful idiots", and my point is they were useful idiots for the bankers and bureaucrats. Hopefully, with practise I will get better at expressing my point of view clearly and forcefully without giving offense.

I have great respect for the civilised countries of Norway, Sweden, Denmark and Finland and I think much of our respect for the individual and for fairness comes from the historic cultural links between England and Scandinavia. Incidentally, I found the Netflix series on The Last Kingdom of Wessex was a real eye opener for me, as it deals with these very issues.

The monks of Lindisfarne had this to say:

Never before has such terror appeared in Britain as we have now suffered from a pagan race ... The heathens poured out the blood of saints around the altar, and trampled on the bodies of saints in the temple of God, like dung in the streets.

The very concept of private property comes from Danelaw, as far as I can tell. Otherwise we would have Real Estate, ie all property would belong to the King, the ideal of all statist dictators and their lick-spittle bureaucrats, whether socialists or absolute monarchists.

So do you think that taxing labour is also evil? Because people should not be penalised for earning a living off their own sweat? I mean labour is a precious resource that can do a lot of good if they are doing the right jobs
right? The government needs to raise tax some how, that in itself is not socialism, it is democracy. The FIF rules seems to be a red herring the govt can use to say the extreme house prices are not their fault. Even though they rejected a comprehensive capital gains tax which would have evened the field, or if as you say free untaxed capital is the fix to all our ails, they could have got rid of FIF. They have had the reigns a long time now. It seems the problem with free capital is it looks for the best return, not the best outcome for society. I would argue that the government is there to set the rules to dis-incentivise capital use which is bad for society as a whole. National has failed in that role, and has brought the financial system closer to a point of instability.

The point I am trying to make is that both National and Labour subscribe to a bunch of outdated ideas that have brought us to the current situation.

National are denying that immigration and tourism are excessive, or that capital can be poorly allocated, and that banking has excessive privilege.

Labour understand that capital in the wrong hands is highly destructive but don't like leaving it in the hands of those who do know how to use it well (I would argue this is the private SME sector). Labour put in place the current immigration policy.

Winston can see the problems of the immigration policy we have but his personal weaknesses sabotage him.

The Greens can see some problems but not others. Specifically they think that if they are nice to others they will be nice back.

None of them can see that New Zealands main problem is too much overseas capital flooding in and destroying our productive base.

Fair enough, I agree with your above comment. You were just coming across as a bit of an extreme right wing libertarian in earlier comments.

Yes, sorry about that. I just wanted to give a forceful delivery, not the weak and inoffensive drivel we are usually fed, a bit like this chap:
https://www.youtube.com/watch?v=h5vNbGLhZXw

While regimes such as Stalin's and the Kim dynasty of North Korea might like to be referred to as "socialist" they are/were no such thing, they are dictatorships run to keep the elite from getting themselves burned at the stake by the poor people of the nation they are terrorizing. It is a mistake to call them socialist, as they were more like end game capitalist with all the power and wealth in the hands of a few while the rest starved and died.
Norway and other Scandinavian countries better represent what socialism is and should be, even their royalty lives fairly ordinary lives and therein lies the proof.
Real, workable socialism requires co-operation and much intelligence and education, it has much to recommend it and it is where the human race will need to go in the much changed future or capitalism will end up in the exact same place as Stalin's Russia, in order to protect itself.

Ok, Ok. I was using strong language to make my point. My apologies for offending you. It is not meant personally. The problem is that if I tone down the language I weaken the message.

Taking away the tax deductability of interest as an expense might be transformative. .. in my view
Id vote for that..

It is a bit radical, but it redresses the balance between equity (savings) and banking. There is a point of view that interest is not an operating expense at all and there is no justification for treating it as such. The decision to borrow money rather than use equity is a decision made by the owners about how to raise capital. I note that in the UK they have started to disallow the deduction of interest as an expense for residential housing investment.

It is a tricky area, but fundamental to how society functions. At the moment the system seems to favour excessive borrowing and penalise the prudent saver. This feeds money to the top 0.1% of society who can borrow most and on the best terms.

Globalisation has lifted the wealth in many countries including poorer countries, it has allowed for easier trade and investment. Countries like NZ have gotten caught with their pants down. We openly pushed for trade without understanding the many effects that would come out of that push and the changes we would need to make in an open market. We failed to understand that many other people in the world thought that we were desirable. While people at home here in NZ complain about all and sundry they have know idea what it is like to live under the various regimes around the world. Right up until this day we do everything we can to make sure supply is restricted, we have a stupid mentality that we can tax ourselves out of this problem and that is the very problem that has been enforced in many of the countries others are running from to come here or Australia, Canada etc..... Every bureaucracy, every politican and every journalist fails to see what the restrictive legislation and codes does to house prices here.......It is very simple to measure the effects of bureaucratic interferference in the market, right down to the OCR which is really a tax by another name...........We need to go back to basics, remove the RMA, Building Act, LGA, Change the tax restrictive policies of the Brightline test, Remove the RBNZ ability to implement LVR's and other pipeline policy of Debt to Income Ratios. We need to accept that banks and private people are best left to their own contractural arrangements.

I would be an advocate for tax changes but only if it is a huge reduction in taxes and compliance.....that is why I would level the field completely and introduce an APT TAx........everyone, every investment is the same........all is equal regarldless of who you are or where you are.......we don't need fancy taxation systems for different groups this is nothing more than segregation by income and country which filters through to to things like housing affordability etc!! Why do the media, politicians and bureaucrats refuse to even entertain the APT tax concept???? Is it because they can only survive by ensuring people are segregated into different groups?

APT tax sounds like not a bad idea at first look. But believing that banks and other industries do not need any regulation, as they will always do the best for the country as a whole because of market forces, is stark raving lunacy in my opinion.

I don't believe a different tax system would have built houses for over 200,000 immigrants in just the last 3 years or provided the infrastructure that is needed to support this population growth.
I don't believe a different tax system would have supported this population growth.
The damage is done but we keep blaming other parties. The sooner people recognize that NZ can not support this population growth the sooner we shut the door and start trying to catch up on the deficit of infrastructure and housing. Meanwhile the immigration door is wide open and the economic and lifestyle damage is getting worse.

I have tried to save for my retirement without "investing" in property. The grossly unfair FIF tax regime has made this endeavour extremely difficult and demoralising. The FIF regime is an effective barrier to entry for low cost international index tracking funds that disadvantages small investors and protects the high fee charging NZ fund managers from international competition. The sooner this unfair tax is repealed the better.