By Andrew Coleman*
[This is Appendix 3 of a paper entitled Taxing capital income in New Zealand: an international perspective which is available here.]
This appendix considers the extent that residential property income is taxed less than other commonly held assets. It makes the comparison with income from directly held interest-earning securities such as bank accounts, and income from interest-earning and equity securities held in KiwiSaver and other retirement income accounts. These are the most commonly held classes of assets in New Zealand.
New Zealand taxes nominal interest earnings. While the effective tax rate on nominal interest earnings is the standard income tax rate, the effective tax rate on real interest earnings is much higher than the statutory rate when the inflation rate is positive because the inflation component of nominal interest rates is taxed. This raises the effective tax rate on real interest payments by an amount (1 + π) i / ( i - π) where i is the nominal interest rate and π is the inflation rate. For instance, if the nominal interest rate were 4% and the inflation rate were 1.5%, this would increase the effective tax rate by more than 60 percent. For someone facing a 33% marginal tax rate, the effective rate on real interest income in this case would be 54%.
Income earned in most KiwiSaver accounts is taxed either at a 28 percent rate or at the appropriate PIE rate, depending on the scheme. Nominal interest income and dividend income are both taxed at these rates. In general, capital gains from investments in New Zealand and Australian shares are not taxed, but the taxation of other capital gains depends on the exact structure of the fund. Thus real income from debt securities held in KiwiSaver accounts is taxed at rates higher than statutory rates, because the inflation component of income is taxed, while real income from equity securities held in KiwiSaver accounts is likely to be taxed at rates lower than statutory rates, because capital gains are not taxed.
Table A2.1 indicates the major tax advantages of owner-occupied and rental property investments relative to interest-earning securities and KiwiSaver accounts. The extent of the tax advantage varies across the twelve possible comparisons, but in all but two cases (rental property investments versus equities held in KiwiSaver accounts) property is tax advantaged. These differences are discussed in detail below.
Approximately half of all owner-occupied housing is owned debt free. The tax rate on income from debt-free owner-occupied housing is lower than the tax rates on income from either debt or on KiwiSaver assets. According to the Haig-Simon definition, the income from debt-free owner-occupied housing is the implicit rent earned from the ‘housing services’ generated by the property plus any change in the real value of the property. The change in the value of the property should include the effects of depreciation. Neither of these components are currently taxed. Moreover, real income from interest-earning accounts are over-taxed in an inflationary environment. Consequently, income from owner-occupied property is taxed substantially less than income from interest earning securities, whether these are held directly or in KiwiSaver accounts. Income from owner-occupied property is also taxed less than the income from equity securities held in KiwiSaver accounts, for while both are largely exempt from capital gains taxes, dividend income is taxed but the value of imputed rent is not.
A neutral tax regime for debt-financed owner-occupied housing is similar, except the owner of the property should be taxed on the imputed rent net of real interest payments, and the holder of the debt security should pay tax on the real interest payment. Since real interest payments are not deductible, debt-financed owners of owner-occupied property are less tax advantaged than debtfree owners of owner-occupied property. Nonetheless, real capital gains are still tax exempt, and in circumstances where capital gains are large and expected to continue, debt-financed property is still likely to be tax advantaged relative to interest-earning securities.
The tax situation for owner occupiers is complicated by local government property taxes. In 2013 local government rates totalled $4.6 billion, of which approximately 30 percent was paid by non-residential entities.42 As the value of residential property services was $29 billion, or 4.3 percent of the estimated value of property, the average rate of local property taxes was 11 percent of the value of residential property services.43 If these payments were a proxy for income tax payments, they would need to be counted when comparing the income tax paid on property income and other classes of capital income. These payments are not income taxes, however, just as tobacco taxes are not income taxes, and under the current tax regime they should not be treated as such, partly because the incidence of property taxes does not normally fall on those paying the tax.44,45 Consequently, they need not be counted when comparing taxes on different classes of capital income. Even if they were counted, income from owner-occupied property would still be taxed lower than normal rates, as the average local property tax rate is much lower than normal income tax rates.
Taxes on rental property are less than they would be under a neutral tax system for two reasons. First, real capital gains and losses are not taxed. The treatment of capital gains and losses is particularly complex, for while depreciation allowances should be incorporated into the calculation of capital gains and losses, they are not. Consequently, neither capital gains nor losses are taxed appropriately. Secondly, investors who borrow can deduct nominal interest payments rather than real interest payments from their taxable income even though the inflation component of interest payments is properly treated as a real debt repayment. This factor is sizeable: in March 2017, mortgage debt held against rental property was $67 billion.46 When the inflation rate is one percent, this means the interest deduction that is claimed by residential landlords is approximately $700 million too large, a subsidy worth over $200 million.
Investments in leased residential property are taxed lightly relative to interest-earning securities because real capital gains are not taxed, the inflation component of interest payments is deductible, and the inflation component of interest income is taxed. Investments in leased residential property are taxed lightly relative to equity investments held in KiwiSaver accounts because the inflation component of interest payments is tax deductible.
To summarise, both owner-occupied and rental property are taxed less than the two most common alternative forms of investments, interest-earning securities and KiwiSaver accounts. Debt-free owner-occupied property is particularly tax advantaged relative to interest-earning securities but is also tax advantaged relative to equity securities as imputed rent is not taxed. The tax advantage of debt-financed owner-occupied property is smaller, as mortgage payments are not deductible, but for households expecting to be debt free at some stage owner-occupied property is taxed at significantly lower rates than interest-earning securities. The tax advantages of rental property relative to interest-earning securities occur because capital gains are not taxed, and the inflation component of interest payments are incorrectly taxed. The advantage relative to equities held in KiwiSaver accounts primarily concerns the way residential landlords who borrow can deduct the inflation component of interest payments.
42. Local Government New Zealand (2015) p19.
43. The 2013 input-output tables produced by Statistics New Zealand record the value of residential property operation as $8472 million, and the value of owner-occupied housing services as $20,7175 million. The value of the housing and utility final consumption component of GDP for the year to March 2013 was $33198 (Infos series SNE036AA.) The value of residential property in March 2013 was $672 billion (Reserve Bank of New Zealand series HC22 HHAL.QC1).
44. A government could use a property tax as a proxy for an income tax if it were difficult to tax the value of imputed rent directly. To do this they would need estimate the imputed value of rent conditional on the property value and then tax this sum at the householders’ individual income tax rate.
45. Standard theory dating back to Ricardo (1817) argues that property taxes are partially capitalised into the value of the land and thus the incidence of the tax is different to an income tax. If land is supplied inelastically, the incidence of the tax falls on the owner of the property at the time the tax is introduced, although the incidence will partially fall on the contemporaneous occupants to the extent that the supply of land is elastic. See Hilber (2017) for a discussion of the conditions where a property tax will fall on the contemporaneous occupants of residential housing.
46. This is calculated as the difference between all housing loan and housing loans borrowed by residential households, calculated from the Reserve Bank of New Zealand household balance sheet HC22.
* Andrew Coleman is a senior lecturer in the economics department at the University of Otago. He's also principal advisor & economics lecturer at Treasury.