Over-investing in housing

Brian Easton

While housing obviously fills a need – people need somewhere to live – it also has an investment aspect. How this investment is treated by the tax system influences the housing market, and the investment available for other purposes, such as business ventures.


There is an implicit tax-subsidy to housing investment and it is necessary to understand this in order to understand how the housing market works. Consider two people living in identical houses. Suppose they sell their $1m house to each other, but continue living in their old homes, now as tenants. The people are both home owners and renters: they receive rent for the house they own but do not occupy and they pay rent for the house they occupy but do not own. Assume each landlord clears $20,000 a year after housing costs such as rates, insurance and maintenance. Each person’s position seems neutral from the change – paying rent and receiving rent – until they report their net rental income to the Inland Revenue Department which assesses them as liable for tax. With a marginal tax rate of 33 percent, that’s $6,600.


Of course they do not sell to each other – better to live in the house one owns and avoid paying tax on rental income. In effect, owner-occupiers receive a subsidy by not having to pay tax on the rent which owners implicitly pay to themselves for living in their own homes.


It is not the intention of this analysis to challenge the principle of this tax-break for home-owners although it will argue that it is applied over-generously. That conclusion comes from observing that the consequence of current arrangements is that we over-invest in housing, distorting the pattern of savings and investment in the economy.


Consider, as an illustrative exercise, owner-occupiers being taxed as if they were landlords – an imputed rent – with a corresponding reduction in tax rates on all income. Faced with a tax bill of, say, $6,600 for living in their own home, the household might make different decisions about housing. Older adults whose children have left home may well decide to downsize in order to reduce their tax liability. The savings from the cheaper house could be used to pay off debt or invested.


After full adjustment, across the whole economy, possible outcomes include:

– a better match between family and household size: small families would be in smaller houses and larger families would be less squeezed by having moved into the larger houses they left;

– the same number of houses (or possibly more) but eventually the average size of houses would be smaller;

– a reduction in household debt and hence offshore debt (which funds household debt on the margin);

– more wealth available for investment in other – more productive – activities;

– lower house prices;

– more young families would be able to purchase their own homes;

– a lesser need for accommodation supplements and the like.


To complete this analysis, attention needs to be given to capital gains. In fact, an owner-occupier does not make capital gains (on average) when they move from one house to another, for any capital gains they make on the sale of their old house are offset by the capital losses they make on the purchase of their new one.


What about investors who do not live in houses which they own? At present they get exactly the same tax subsidies as the owner-occupier. The current arrangements enable the investor to rort the tax system. For instant, an owner of the million-dollar house could borrow $500,000 at 4% p.a. which would be covered by the tenant’s rental payments of $20,000 p.a. The return the investor would get would be from the capital gain. Allow a 10 percent annual gain, and the investor is $100,000 up at the end of the year, which is a 20 percent return on $500,000 of equity, on which they pay no tax. For housing investors make capital gains in a way that owner-occupiers do not; they do not have to invest in another house.


There is an even more ingenious way to make a profit on investment housing in times of rising values. Why take a tenant in at all? Admittedly the landlord has to pay for the rates, insurance and maintenance but there is no hassle of a tenant. The result is houses which are untenanted but generating a return via capital gains. That certainly does not help the homeless.


Removing tax breaks for investors would have a similar impact to taxing the imputed rent of owner-occupiers, although the magnitude would be smaller. Whatever one thinks of the tax-subsidy to home-owners, the case for a similar subsidy to house investors is thin, especially as it screws up the housing market for those without their own homes, diverts resources from productive activities and increases offshore debt when investors borrow to leverage their return.


What is to be done if we want to avoid these ills?


First, the logic argues for a comprehensive capital gains tax on housing which is not owner-occupied. It need only be calculated on capital gains after the date of introduction. Taxing past gains will not get the behaviour the policy is about. An interesting possibility is that some jurisdictions only have a capital gains tax exemption on owner-occupier houses up to a limit – say double the median house price – and tax any capital gains above that. Tricky to apply, but it makes the point that the tax exemption on owner-occupied homes is for comfortable living, not for extravagance.


Is there a case for some penalty on houses which are owned but not occupied? Because it is administratively complicated one needs to know something about the size of the problem – and in any case a capital gains tax would discourage such vacancies. But in principle, if the tax treatment on owner-occupiers is to enable occupation, it is not obvious why it should be given when the houses are not occupied.


As much as they will help, changes in taxation on housing will not solve all the problems in the housing market. A building programme will still be necessary. Because it will be building fewer large houses, the available resources will be able to build more houses. We probably need to reform the accommodation supplements.


Instead this analysis finishes with attention to savings and investment. Recall that which drives these proposed changes is the distortionary effects on overall investment of the tax exemptions on housing. The intention of the package is to cut back wasteful investment in housing and channel the savings into more productive activities. New Zealanders invest in housing and property because that is the only investment they understand. They will pay off any debts as they unwind out of their investment, thereby reducing the amount of offshore borrowing, making New Zealand financially more secure. But what will they do with surplus funds?


Many will deposit them in banks or finance companies which may, or may not, route the proceeds into business investment (as well as paying off international debt). However, there is also a need for a more direct channel from households to business. Kiwisaver is an example. New Zealanders need greater confidence in investing outside property or financial institutions.

Categories: Housing, Tax policy
Brian Easton
About the author

Brian Easton

Brian Easton is one of New Zealand’s leading economists with a unique profile as an economic development practitioner, consultant, journalist and commentator. A former director of the New Zealand Institute of Economic Research and a one-time member of the Prime Minister’s Growth and Innovation Advisory Board Brian has numerous awards to his credit including being a distinguished Fellow of the New Zealand Association of Economists. Dr. Easton is an adjunct Professor of the Auckland University of Technology and is currently writing a history of New Zealand from an economic perspective, Not In Narrow Seas: A Political Economy of New Zealand’s History, to be published by Massey University Press.