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Keith Rankin: Home Expensive Home

The OECD report on the New Zealand economy released last Thursday suggested, among other things, that the New Zealand government should tax the imputed income on owner occupied housing. Minister of Finance, Dr Michael Cullen, promptly dismissed the idea, stating that home ownership was a special feature of New Zealand life.

On the following day, some low-income New Zealanders - a million miles away from home ownership - found themselves better off, thanks to new income- related subsidies payable to Housing New Zealand tenants.

Both tenants and home-purchasers pay much more than they should for the rooves over their heads.

The OECD suggested an important part of the solution to Dr Cullen, but he dismissed their suggestion; guilty by association with the otherwise neoliberal tone of the OECD report. (The OECD report was in fact mostly written by NZ Treasury mandarins for whom Dr Cullen is boss).

So what does it mean to tax the imputed income on owner occupied housing?

The problem arises because the rent that a homeowner does not have to pay is not intuitively regarded as income by most of us. On the other hand, to economists and statisticians, the rent that owner-occupiers pay to themselves cannot be anything other than income and therefore should always be treated for tax purposes in the same way as other income.

Ironically in the light of the Minister's comments, the consequence of not taxing imputed rentals is that residential property is overvalued, making it less accessible to New Zealand's 30-somethings, and making the market value of rental housing higher than it would otherwise be. It's a big issue that is rarely debated on account of the tacit assumption that only pointy-heads can understand it. While modern life does not require huge numbers of nerdy economists and statisticians, both economic and statistical literacy are necessary if a person is to fully participate in modern life.

Let's consider a society in which all property is rented, in which real (i.e. inflation-corrected) interest rates are 3% gross, and in which taxes are one- third (c.33%). A typical residential property might be worth $208,000. The landlord expects a real rate of return of 4½%, a small margin above the real rate of interest. The weekly rent on this typical property is $180. The landlord keeps $120 of that. The expected after-tax rate of return is 3%, compared to 2% for money in the bank.

If the tax rate increases, the value of the property decreases. Likewise, if the rate of interest increases the value of the property decreases.

Now consider a second society which is similar to the first in every respect except that all property is mortgaged; ie in which there are neither tenants nor owner-occupiers with equity. A mortgagee who invests $208,000 will expect approximately the same return as the landlord in society one. She pays tax, not on rent, but on interest. Assuming that mortgages are services on an interest-only basis, the mortgagors pay the same as the tenants of society one. In both societies, the income arising from residential real estate is fully taxed.

Now consider a third society which is similar to the first two in every respect except that all property is owner-occupied, meaning that the income deriving from that property is not taxed. Each owner of a typical $208,000 property saves $180 each week; a rate of return of 4½% that's equivalent to a pre-tax return of 6¾%. Or, given that the market rate of return before tax on investments with the same degree of risk as housing is 4½%, then the citizens of society 3 will be prepared to pay $312,000 for houses that would fetch $208,000 in societies' 1 and 2.

In the real world, residential property generates income to a mix of landlords, mortgagees and owner-occupiers. Some income deriving from such property will be taxed, and some will not. So the market price of such property will be somewhere between $208,000 and $312,000; eg a $208,000 property might sell for $260,000.

What it means is that first-time house buyers might have to pay around 25% more for their house than it should be worth. Home ownership would be considerably more accessible if all income deriving from residential property was taxed.

Likewise for renters. Market rents are so high in large part because properties are overvalued because landlords are competing with subsidised owner-occupiers for the same housing stock. The problem of high poverty- inducing rents that Housing Minister Mark Gosche has spent most of this year trying to fix could have been fixed, in large part, by removing the tax distortions that lead to the market overvaluation of residential property. (Gosche's income-related-rent solution has created an horrendous new poverty trap; effective tax rates on additional income approaching 130% for state house tenants paying child support and student loans.)

Tax breaks on owner-occupier equity are of course not the only reason why residential property is overvalued in New Zealand. Another reason is the lack of a capital gains tax, as the OECD report also noted. Further reasons include the market dominance of Housing New Zealand in certain suburbs, and the way monetary policy fuelled the mid-1990s real estate boom.

In principle, the Accommodation Supplement – an add-on benefit that many people are eligible for without knowing it - could also lead to the overvaluation of the housing stock. But, in practice, landlords in Auckland are certainly not profiteering; rather they, like tenants, are victims of the overvalued property market.

Who are the winners and losers from the longstanding policy of not taxing owner-occupied rents? The losers are tenants and people who are struggling to service large mortgages made necessary by inflated property values. The winners are those established property owners without mortgages or with small mortgages, especially those who live in areas which have experienced capital gains in the 1980s and 1990s. In other words, the present policy - which the Minister of Finance (in our Labour Government) would not countenance changing – serves the interests of our established property holders. The present policy serves as a barrier to property ownership, and is one of the major causes of child poverty in New Zealand.

The real reason for not changing the policy is that established property owners are a very powerful political lobby. The burghers of Remuera, Khandallah and Fendalton will not meekly accept a cut to their not inconsiderable propertied wealth. It's not just private wealth that is at stake. It's also the exclusivity of those suburbs; exclusivity predicated in large part on grossly overpriced property.

The affluent beneficiaries of the present non-taxation of housing policy are just that: beneficiaries. The people in the middle pay more so that people at both ends of the income spectrum can pay less.

Thursday column archive: http://pl.net/~keithr/thursday2000.html

© 2000 Keith Rankin ( keithr@pl.net)


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