Cullen - NZ Law Society Property Law Conference
Monday 12 June 2006 at 10am
Address to NZ Law Society Property Law Conference
Soundings Theatre, Te Papa, Wellington
This morning I want to talk about the outlook for the New Zealand economy, and in particular to touch upon the issues that will shape the property market over the medium term.
I think it is important to acknowledge that we are entering a period of slowing growth. Although we have been through cyclical downturns before, this one has a number of unique features that make it difficult to foresee exactly how things will play out over the next few quarters.
What the economic data is showing is a slowing rate of economic activity, beginning in the latter half of 2005. We expect to see a continued easing in private consumption as a result of higher interest rates, the declining New Zealand dollar and increasing fuel prices. In addition, population growth, which has for the last decade been a steady contributor to growth in the domestic economy, has been slowing since inward migration peaked in mid-2003.
Meanwhile, firms servicing the domestic economy are slowing their rate of investment, and in the labour market we are anticipating some reduction in total hours worked, and a modest increase in unemployment. In turn, the softer labour market means that wage growth is expected to peak in mid-2006.
The silver lining in this particular cloud is an anticipated recovery in exports, due in part to expected further falls in the exchange rate. That will also prompt an easing in import growth, and lead to a narrowing of the current account deficit, which has been a major concern for the last couple of years.
To put these developments in context, our economy is rather like an athlete who has just completed a marathon. We are in warm-down mode, still jogging along slowly, but feeling a few cramps.
It is important to celebrate what has been achieved in the last six years. We have turned around a moribund economy, and grown it by around 20 percent in total. In the process we have pushed our productive sector to new limits in terms of utilising our capacity.
The last six years have seen around 313,000 new jobs added, labour participation rates are at historic highs, and we have been running neck and neck with South Korea in terms of having the lowest unemployment rate in the OECD. Over the same period, we have seen a significant increase in household wealth and in household incomes.
That has of course flowed into improved government revenues and allowed us to make investments in the things New Zealanders value. We have improved important public services like health and education by increasing throughput and participation and improving access.
We have also increased very significantly the rate of investment in infrastructure, which fell behind rather badly in the 1990s. In terms of land transport, for example, we have increased the annual spend on roading by 134 per cent over the 1999 spend.
We have also been able to put the Crown's finances into a much stronger fiscal position. We have reduced gross sovereign-issued debt from 35 percent of GDP to just over 20 percent. And we recently passed an important milestone when we moved into a net positive financial asset position. This is a first step in preparing ourselves for the coming demographic change, in respect of which we are well ahead of other developed nations with aging population profiles.
Our successes are not readily appreciated at home, but are recognised overseas. Just last week Standard and Poor's endorsed our approach to building up assets in the NZ Superannuation Fund to future proof the economy to meet the challenges of an ageing population, and said that abandoning that endeavour to fund tax cuts would be a very short sighted action.
Contrary to what some would have us believe, our investment in infrastructure, improved public services and strengthened public finances have not required any marked increase in average tax rates. We have one of the developed world¡¦s simplest, fairest and lowest tax regimes. Indeed, New Zealand¡¦s tax wedge ¡V that is, the cost of labour to employers versus the net pay received by the employee ¡V is third lowest in the OECD at 20.5 percent, compared to an unweighted average of 37.3 percent.
And those clamouring for tax cuts need to be reminded that we are already giving substantial tax relief by way of our Working for Families programme. The difference, of course, is that we have targeted tax relief to families who are caring for the next generation. By next year, when it is fully underway, 350,000 families who need help the most will be getting $1.6 billion in tax relief every year. That's a total of $6.1 billion over the next four years, and it means an extra $88 a week for each family on average.
So we have a healthy, if somewhat stressed, economy and the outlook is for a period of slower growth lasting some 18 months or so, before we embark upon what we expect to be another marathon period of high growth.
How well we perform in that next race is in large part a question of whether we maintain our focus on strengthening our economic fundamentals. There are some who do not appear to see the merit in further training, and want us to borrow some money, go out on the town, engage in a bout of hearty consumption, and starting hitting each other with our handbags.
To my mind there are more serious matters to be dealt with. We need to improve our productivity through building a more skilled workforce, and improving the systems that support innovation and expand our export base. And we need to invest in our key infrastructures, such as transport, electricity, water and telecommunications.
What is more, we have to address these issues despite a worsening fiscal outlook for the next three years. In terms of expenditure, 2005/06 is expected to be the last year for some time in which we achieve a cash surplus. Indeed, we are forecasting cash deficits totalling some $7.4 billion over the forecast period. The deficit will be $1.5 billion for 2006/07, rising to a peak of $2.7 billion in 2008/09, before falling back to $1.1 billion in 2009/10.
This presents us with a very stark trade off if we want to contemplate tax cuts of the magnitude National is talking about. Cutting over $2 billion of tax revenue a year, as has been suggested, means one of three things:
- Cutting back capital expenditure on things like roading;
- Cutting hard into core government services such as health or education, or reducing funding for things like scientific research; or
- Taking on more debt.
As much as New Zealanders might like being told that they can have a free lunch, the fact is we cannot. In fact, I believe New Zealanders are becoming savvy when it comes to understanding fiscal tradeoffs. That is why a recent Colmar Brunton poll found that 75 percent of respondents placed a higher priority on expenditure on things like roads, health care and education, than they did on a personal tax cut.
As regards the outlook for the property market, the expectations is for a continued easing of the housing market, following the trend that has persisted since late 2003. How quickly and by how much remain interesting questions.
As you will be aware, New Zealand has been caught up in the remarkable surge in global property values that has occurred since the mid 1990s.
As the Economist noted in an article last year, the total value of residential property in developed economies rose by more than $30 trillion over the past five years. That figure is roughly equivalent to 100 percent of those countries' combined GDP.
House prices in New Zealand rose by 66 percent in the eight years from 1997 to 2005, slightly behind the 73 percent increase in the United States, and significantly behind Australia¡¦s 114 percent and the even higher rates of increase in several European countries.
What lies behind this global trend has been historically low interest rates and a crisis in confidence in equities in the wake of some poor stock market returns, making property look attractive to the uninitiated. Neither of these factors seems ready to abate; and I do not care to speculate as to whether the current cooling housing market in New Zealand is a symptom of a slow leak in the global property bubble, such as it is. I note the Reserve Bank's crystal ball has house prices actually falling over 2007.
One thing my crystal ball does tell me, however, is that we are likely to see some changes to the New Zealand property market in the light of changes to the taxation of investment currently before the House. These changes include the moves to have the income of particular investment entities (to be called Portfolio Investment Entities or PIEs) taxed at the tax rates of the investors in the PIEs, and the changes to the taxation of offshore investment by New Zealanders.
These changes have prompted a fair amount of debate, and some speculation as to exactly how they will impact upon various types of investment.
The changes to the taxation of PIEs, which will include some property trusts, should make these savings vehicles more attractive to small investors. Although the focus on discussion of the PIE reform has been on managed funds, real property investment companies may elect to be PIEs as long as they meet the "portfolio in" test (that is, they have at least 20 non-associated interest-holders). The property income will flow through and be taxed at the investor's marginal rate.
This will help to securitise property investment and make it more accessible for lower income investors. Another benefit is that if a real property PIE sells property for a capital gain, when the PIE distributes the gain the distribution will not be taxed, so the benefit of the capital gain flows through to the investors.
Real Property PIEs will be different from PIEs that do not invest in real property in that net losses from real property investments will not flow through to the ultimate investors. The concern was the ability of real property investment companies to produce losses (from depreciation and interest deductions) and flow these through to a large number of investors as a tax shelter. Instead, these losses will be quarantined and carried forward to offset future real property income.
This is no more restrictive than current practice in which real property investment vehicles that are companies, unit trusts, or trusts currently have their losses restricted to the entity level. However, adopting this treatment to address the tax base risk allows real property investment companies to be treated as PIEs in all other respects, thus providing the advantages of taxing income at the investor's marginal rate and the capital gain being distributed to investors without any tax.
As for the changes to the taxation of on offshore investment, some commentators have suggested that it will encourage some investors to liquidate offshore investments and invest it in New Zealand real property (as well as New Zealand and Australian shares).
It seems unlikely there would be a large effect. This is for two reasons:
„h First, by far the largest investors in foreign shares are managed funds. Currently, they generally hold shares on revenue account, so they are already paying tax on 100 percent of realised gains. Under the new rules, they would pay tax on 85 percent of accrued gains with an elective limitation of 5 percent of their opening value. This should not be a major change from their current tax position so the tax changes should not encourage liquidation of those assets and investment in NZ real property.
„h Second, individual investors will be affected only if they own more than $50,000 in foreign shares (at cost). For those who are affected, they would be taxed on dividends plus 85 percent of accrued gains limited to 5 percent of the opening value of the shares. If they were to invest in New Zealand real property they would be taxed on their rental incomes. This seems to militate against there being a significant distortion favouring investment in New Zealand real property over offshore shares.
You will be aware that some aspects of the changes to the taxation of offshore investments have been controversial, and have prompted a flurry of anxious activity by your colleagues in the field of tax law. I would point out that the major loser in the current changes is the government, which will forgo about $110 million a year in tax revenue with this reform. We believe it is important to remove distortions in investment decision making and we are willing to bear that loss.
There is a tendency amongst some economic commentators to deride property as a form of investment, and to lament the fact that New Zealanders appear to cling to bricks and mortar investments, rather than supporting the local venture capital market, for example.
I certainly sympathise with the point of view that we need to broaden the horizons of New Zealand savers and grow an indigenous venture capital industry. However, I hold strongly to the view that establishing as far as possible a level playing amongst different investment options is in the long run the best way of encouraging investors to assess their options on their merits, rather than on extraneous matters such as differential tax treatment.
That has been the guiding principle of the changes so far.
I would be happy to take any questions.