Andrew Coleman puts a spotlight on housing taxation in New Zealand, looking at problems and offering solutions

By Andrew Coleman*

Over the last five decades New Zealand has accumulated a diverse series of taxes that increase the demand for housing and artificially inflate housing prices. This is unfortunate for young people and anyone else struggling to buy a house. New Zealand is not alone in having taxes that create incentives to build bigger and bigger houses and to push up house prices. However, we have managed to specialize in it by the ways that we do or don’t tax retirement savings, interest income, capital gains, and the implicit income stemming from owner-occupied houses.

Last week I argued that some of the problems in housing markets would be solved if we changed the way retirement savings were taxed and adopted the approach followed in most OECD countries. I still believe this would be a very good idea. But it is only one of a set of reforms that is necessary to tax housing sensibly, and even then there are some alternative ways of approaching the problem. Because this is such an important issue, this article is going to take a bit of a break from retirement policy and discuss housing taxation more generally. Unfortunately, it is not possible to do this in one or two thousand words, so this article is longer than normal. Tax, whether done by accountants, lawyers or economists is complicated and the details matter. Next week I shall get back to retirement income and look at surveys detailing what New Zealanders want from their policies. Until then, let’s start at the beginning, which means starting with taxes.

Indirect effects of housing on taxation

Taxes have direct and indirect effects on house prices. For example, GST raises the price of new properties, by directly increasing the cost of building and the price paid for land. The price of second-hand houses also increases even though GST is only applied to new houses, as people bid up prices to match the price of new houses. Since housing is the biggest asset class in New Zealand, it is really important to understand both the direct and indirect ways that taxes affect housing markets.

The indirect effects of taxes on housing markets are particularly complicated because two separate sets of taxes matter, since people can buy property or rent property. About two thirds of houses are owner-occupied. For these houses, the key issue is the way owner-occupied property is taxed relative to other investments. The remaining third are owned by landlords, and in this case what really matters is the way rental property investments are taxed relative to other investments. To understand how taxes affect property markets, you need to see how the tax system encourages owner-occupiers and landlords to pay extra for a property, and then see who wins the auctions. The relative tax advantage each person gets is only one factor, because even if a potential owner-occupier has the bigger tax advantage a landlord may win the auction if they can borrow more or if they have a bigger deposit.

Owner-occupiers and tax

Tax matters for people who live in their own homes because it affects how much they are willing to pay to purchase a house. Most people treat a house as a place to live and as an investment and when taxes on housing are lower than taxes on other investments, they are happy to buy a bigger or better house rather than invest in other things. Because the supply of property in desirable locations can only be increased by a limited amount when prices increase, lower taxes on property relative to other investments generate artificially high prices.

There are two ways to tax housing at similar rates to other investments. One way, discussed last week, is to reduce the tax on other investments so that it is similar to the tax on owner-occupied housing. This is the globally preferred solution, as it tends to reduce the economic distortions arising from taxation and is politically sustainable. But we should consider the alternative way as well, which is to increase the tax on housing so it matches taxes on other investments. If taxes on the income from housing were increased, it is very likely that house prices would decline from their artificially inflated levels. This approach is not common in the rest of the world, but it should at least be considered.

To tax the income produced by a house you must first measure the income from an owner-occupied house. Since owning your own home saves paying rent, economists estimate the value of the income a person gets from their own home as the rent they would pay if they rented from someone else. This is called ‘imputed rent’. The government currently estimates the value of imputed rent and includes it in its measure of economic activity, GDP. However, imputed rent is not taxed, unlike the rent earned by the landlord. This is the main reason why investments in a person’s own home have tax advantages over other investments.

It is possible to tax imputed rent. Basically, this means home-owning households would pay an additional tax each year based on the amount of equity they have in the house. If a person owned a house worth $750,000 without a mortgage, for instance, they might have to pay tax on an extra $15,000 per year (or $300 per week), the estimated value of the imputed rent after expenses such as insurance and rates. A tax like this would raise a lot of revenue enabling other taxes to be reduced, and it would reduce property prices. People would think twice about paying a fortune to buy a really nice house if it raised how much they pay in taxes every year. (See more here and here). For young people an imputed rent tax would be a good deal, because even though they would have to pay tax on their imputed rent, they would pay less in other taxes and they would also pay less for their property when they purchased it.

Unfortunately, an imputed rent tax is not as easy as it sounds. To calculate a person’s imputed rent, a tax inspector has to come around and make a rent assessment, and this is likely to be disputed. Expenses like insurance or city property rates will have to be deducted. There will have to be an allowance for depreciation and repairs and mortgage interest payments. Basically, everyone would have to file a tax form similar to the tax forms that landlords currently file. This would make tax collection more complicated and tax accountants would have a field day. In practice, these issues are sufficiently difficult that the government would simply tax an amount based on the value of the equity that a person has in their property. For example, the government might say that the imputed rent was 2% of the equity a person had in their house, so if they had $400,000 housing equity their housing income would be calculated as $8,000 and they would have to pay income tax on this amount. This is very similar to a wealth tax, just applied to housing wealth, and with a tax rate equal to a person’s income tax rate.

In practice, a tax on imputed rent or on housing wealth may not be a workable solution to the housing problem. Many homeowners would campaign to have the tax removed (so their house prices would increase again) and many politicians would support them. Not many countries tax imputed rent because it is difficult to determine the right amount and because it is politically unsustainable. Switzerland is one of the few counterexamples – possibly because their home ownership rate is less than 40%. New Zealand considered taxing imputed rent back in 1989 but political realities meant nothing came of it.  Many people find this a bit disappointing, because taxes on owner-occupied houses have the potential to be efficient, fair, and simple. Nonetheless, at this stage an imputed rent tax or a housing wealth tax does not seem a realistic option. Most governments understand that even if they could introduce an imputed rent tax there would be enormous political pressure to abolish it in favour of some other taxes.

While most economic theory suggests that property prices would be lower if housing were taxed more like other investments, this doesn’t mean taxes on houses need to be higher. Rather, taxes could be reduced on other forms of savings and investments. As was discussed last week, one of the easiest ways to do this is to reduce the tax on retirement savings so they are taxed the way they are taxed in most overseas countries – by reverting back to an EET (Exempt-Exempt-Taxed) form of taxation rather than the TTE (Taxed, Taxed, Exempt) form adopted in 1989. This solution is not only appealing on the logical grounds that it reduces the extent that tax distorts economic activity and artificially raises house prices, but it is practical as well – it is the solution adopted by most OECD countries.

Even if it is not considered practical to raise taxes on housing income, or change the taxes on retirement savings, there are still other ways to improve the tax situation. One of the simplest ways is to reduce the extent that interest earnings are over-taxed because the tax system does not adjust interest earnings for the effects of inflation. It is widely recognized that New Zealand’s current system penalises people who save by depositing money in banks or by buying private or public interest-earning bonds. If this were corrected there would be less incentive to purchase the most expensive house that you can afford, and more incentive to save by lending money.

It should be noted that an income tax applied to housing is different to a property tax. Property taxes are paid on the value of an asset at a rate that is the same for everyone and is thus independent of the owner’s income or the equity they have in a property. These taxes have a long history and are widely considered be very efficient, particularly if they are applied to land rather than structures. In New Zealand local body taxes are generally collected at rates that are much lower than income tax rate. If they are applied by local governments they are usually politically sustainable as local governments have few other sources of revenue and most people are willing to pay taxes to have their streets maintained and cleaned and their waste water collected.

Rented housing and capital gains taxes

The retirement savings tax regime also affects landlords. Most middle- and higher- income people want to save extra for their retirement, thinking that the government pension will not be enough to support a decent lifestyle. Many investors seek out investments that are lightly taxed. Since New Zealand’s tax system does not tax all income types in the same way, some people invest in businesses for tax reasons rather than because they are the best or most profitable companies. For 30 years New Zealand investors have favoured investment property and one of the reasons is the lack of a capital gains tax.

New Zealand is quite unusual. Most countries have a capital gains tax to reduce tax distortions and to increase fairness. If a country taxes income without a capital gains tax, there are incentives to invest in some types of assets such as share investments or rental property rather than others like bank deposits. Indeed, unless there is a capital gains tax, there are incentives to make too many investments in low-yielding, long-term assets and too few investments in higher-yielding, short-term assets, since the latter are effectively taxed at higher rates than the former. (The original paper arguing this was written 60 years ago by the Nobel prize winning economist Paul Samuelson). A tax on capital gains evens up the tax treatment of different types of income and this should lead to a higher productivity, higher wage economy. This is particularly important in countries like New Zealand, which have relatively high income taxes on capital incomes, because then the tax exemptions on some classes of investment generate big incentives to invest in one type of asset rather than another.

The lack of a capital gains tax causes particularly acute problems when it comes to investments in residential property. If people think they can buy a property and make untaxed capital gains, they will be prepared to buy the property even if it only provides a low rental return, because they can be pretty sure they will be able to sell it again sometime in the distant future. Untaxed capital gains raise the demand for property as an investment asset, and this increases prices.

The second argument for a capital gains tax is fairness. Over the last two decades, most capital gains in New Zealand have been from residential property particularly if you take ordinary inflation into account. If there had been a capital gains tax, some of this income would have been taxed. Many New Zealanders think this is only fair: people should be taxed on their income, regardless of whether that income comes from working a nine-to-five job or from flipping investment properties.  This argument is not really compelling, because even if people think something is fair it does not mean it is also good tax policy. As I discussed in Article 8 on the Nordic tax system, the governments of most countries and many tax experts seem to think that it is more effective to tax labour income at higher rates than capital income if you want a high wage economy. Nonetheless, fairness is an important component of a tax system.

Is it unfair not to tax capital gains? Probably, but the arguments are often overstated. This is because it can be really difficult to determine the incidence of a tax and sometimes people who are not directly paying taxes to the government are paying them indirectly. For example, consider who pays rates to the Wellington City Council. Renters do not pay rates directly – their landlords do –  but renters often pay them indirectly, because their rent is raised to cover the rates bill that the landlord pays. It would be a brave person that claimed renters were freeloaders that didn’t pay anything towards city services. A similar issue arises with capital gains taxes – even if a person obtaining a capital gain does not pay tax on the gain directly to the government, there are good reasons to think they still might be paying indirectly. It is crucially important to calculate the incidence of taxes before making pronouncements on what is and is not fair, although this is not always done in the heat of political debates.

Capital gains taxes can be complicated to introduce, as they mean people need to record when they buy and sell assets, but we shouldn’t overstate these difficulties. After all, most countries have them. In Australia, they raise about 1% of GDP per year in tax revenue, or the equivalent to roughly $3 billion to $4 billion per year in New Zealand. This would be about 3% of all the tax revenue that is collected in New Zealand each year. This is not a huge amount, and some of this revenue is offset by a reduction in income taxes paid at a later date, but if it makes the economy fairer and more efficient, why not? Most countries tax capital gains to make sure the returns to different classes of assets are taxed as equally as possible, so that are not artificial incentives to favour one class of assets over another. If a capital gains tax had been introduced in 2000, the government would have made a lot of revenue, property prices are likely to be lower, and the economy might be more productive as some of the effort that landlords placed in finding the right property would have been redirected towards potentially more productive activities.

Capital gains taxes work best if they are applied to all capital gains but in most countries owner-occupiers are exempt. In New Zealand capital gains taxes are only likely to be applied to rental housing and shares and some businesses. This means the tax system will still have a distortion that favours owner-occupiers. A capital gains tax applied to landlords could be a good idea but it won’t fix the whole problem. To get rid of the distortions it is also necessary to change the tax system facing owner-occupiers as well as landlords. You may be tired of hearing me say this, but the common and efficient way this is done around the world is by changing the way retirement savings are taxed.

Capital gains taxes are only one of the issues facing landlords. Even though successive governments have shied away from a capital gains tax, they have been acutely aware that lots of property investors have paid rather little tax on their property returns. Rather than fix the problem at the source, over the years they have introduced a series of “fixes” which meant that by 2023 residential property investments were taxed in a manner inconsistent with the taxation of any other type of business either in New Zealand or overseas. Landlords could not claim depreciation allowances as their buildings wore out; if they had borrowed money they could not deduct the real (inflation-adjusted) cost of the interest payments they made from any rental income they earned, even though the lenders pay tax on these interest payments; and there were various ad hoc bright-line tests requiring landlords to pay taxes on capital gains if they had not owned the property for a sufficiently long time. In 2022 and 2023 it was not clear whether residential rental property was tax advantaged or tax disadvantaged relative to other investments, and it was not clear what this would do to the future availability and price of rental accommodation. In 2024 many of these rules were changed or are under review. What is clear, however, is that the taxation regime for rental property has been flawed for decades and by 2023 it no longer made any sense. Introducing a bit of logic into the system could be quite helpful.

Is change possible?

New Zealand is not the only country to adopt taxes that favour housing, although we do have a rather unusual collection of distortions.  There is a vast economics literature arguing that when housing is taxed less than other assets property prices increase and housing affordability becomes worse. (See more here, here and here). The high prices transfer resources between generations. The losers are young people. This is because land prices are bid to artificially high levels, which means current and future generations of young people have to pay more to buy or rent housing. The beneficiaries are the owners of the land when the taxes were first introduced, or their descendants if they choose to leave an inheritance. But the ripples don’t stop there. Since people end up putting more of their savings into housing, they have less to invest in other things and this can reduce the amount of business investment in the economy. As wages are lower when there is less business investment, it can end up as one large vicious circle, at least if you are young. 

There is also a significant body of New Zealand and international literature that suggests the tax system delays the time it takes young people to purchase their first house. This will become increasingly problematic if the size of the pension system increases as life expectancy increases, for then the tax distortions will get larger. Some models of this issue suggest that young people would be better off increasing the pension age as longevity increases, rather than raising taxes and keeping the pension age constant, because the interaction of the tax system and the retirement income system will further delay the time they can first move into a house. (See more on this here).

The path forward

The simplest ways to correct these problems is to (i) introduce a capital gains tax on any capital gains on rental property (and other investment assets) that exceed the inflation rate, and (ii) change the way retirement savings are taxed by adopting an EET approach. These measures should reduce house prices and improve the return to other forms of saving. This is the approach adopted in many OECD countries. (See more here and here). Even if this is not possible, changing the way that interest income is taxed by adjusting it properly for inflation before it is taxed will make an appreciable difference.

Should young people change the way their retirement savings are taxed? As you know by now, it is my view that it should be for them to decide. There are good reasons to support a change and adopt the tax system for retirement savings that is used in most other countries. Of course, young people could well decide it is too complex to make changes and that it is better to put up with a system that distorts investment patterns and generates artificially high house prices. That might be their choice. But surely the decision should rest with them, as they are the people most adversely affected by the current system, and they are the people who will have to live with any decisions that are made.

*This series and an accompanying paper are based on work I started in 2020 with Jeanne-Marie Bonnet while we were both at the University of Otago. I am very grateful for her assistance and insights. All errors remain my own.

(This article is part 10 in the series. You can find all other articles in the series to date here).

**Andrew Coleman is a visiting professor at the Asia School of Business. This article is his personal view of retirement policy in New Zealand, based on academic study.

Coleman is on extended leave from the Reserve Bank of New Zealand, while working overseas. The views expressed in this article do not represent the RBNZ and are unrelated to work conducted at the Bank, which has no responsibility for retirement policy in New Zealand.