Housing, the ‘Great
Income Tax
Experiment’, and the
intergenerational
consequences of the
lease
Andrew Coleman
Motu Working Paper 17-09
Motu Economic and Public Policy
Research
May 2017
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
i
Document information
Author contact details
Andrew Coleman
University of Otago
andrew.coleman@otago.ac.nz
Acknowledgements
I would like to thank several people for providing helpful comments on earlier drafts of this
paper, including Richard Braae, John Freebairn, Matthew Gan, Girol Karacaoglu, Sarah Key, Dave
Maré, and Murat Ungor, and seminar participants at the University of Otago. The views are those
of the author and do not represent the views of the University of Otago, the New Zealand
Treasury, or the New Zealand Productivity Commission. All remaining errors and omissions are
the author’s.
I would also like to thank Motu Economic Research and Public Policy for publishing this paper
and providing me with the opportunity to present the results through their Public Policy
Seminar series.
Motu Economic and Public Policy Research
PO Box 24390
Wellington
New Zealand
www.motu.org.nz
+64 4 9394250
© 2017 Motu Economic and Public Policy Research Trust and the authors. Short extracts, not exceeding
two paragraphs, may be quoted provided clear attribution is given. Motu Working Papers are research
materials circulated by their authors for purposes of information and discussion. They have not
necessarily undergone formal peer review or editorial treatment. ISSN 1176-2667 (Print), ISSN 1177-
9047 (Online).
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
ii
Abstract
This paper provides an analysis of how the New Zealand tax system may be affecting residential
property markets. Like most OECD countries, New Zealand does not tax the imputed rent or
capital gains from owner-occupied housing. Unlike most OECD countries, since 1989 New
Zealand has taxed income placed in retirement savings funds on an income basis, rather than an
expenditure basis. The result is likely to be the most distortionary tax policy towards housing in
the OECD. Since 1989, these tax distortions have provided incentives that should have lead to
significant increases in house prices and the average size of new dwellings, should have reduced
owner-occupier rates, and should have led to a worsening of the overseas net asset position. The
tax settings are likely to be regressive, and are not intergenerationally neutral, as they impose
significant costs on current and future generations of young New Zealanders (and new
migrants). Since it does not appear to be politically palatable to tax capital gains or imputed rent,
to reduce the distortionary consequences of the tax system on housing markets New Zealand
may wish to reconsider how it taxes retirement savings accounts by adopting the standard OECD
approach.
JEL codes
H20, H22, H24, I38, R28, R38
Keywords
tax policy, expenditure taxes, house construction, land prices, retirement savings,
intergenerational transfers, New Zealand economy
Summary haiku
Berlin’s wall crumbled
We taxed savings, not houses
Locking out the young.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
iii
Table of Contents
1 Introduction 1
2 Taxes and property markets: basic theoretical results. 5
2.1 The effect of income taxes on residential property owner-occupiers. 6
2.2 The effect of capital gains taxes on residential property investors. 15
2.3 Tax rules and home ownership rates 18
3 House sizes and property prices in New Zealand. 18
3.1 Trends in house prices and rents 20
3.2 International House Price Movements 22
3.3 Interest rates, rents, and house prices. 24
3.4 The size of new residential housing construction. 27
3.5 Summary 31
4 Taxes and Housing Markets: Distributional Effects. 31
4.1 Income taxes, housing markets, and distribution 33
4.2 Expenditure taxes, housing markets, and distribution 40
4.3 The Distribution Effects of the Great Income Tax Experiment 44
5 Conclusion. 47
References 50
Appendix 1: Capital gains taxes, and the distortionary effects of income taxes 52
Using accrual-based capital gains taxes to complement income taxes when inflation is non-zero. 53
Appendix 2: Regression results from section 3 57
The rent/price ratio 57
The mean size of newly constructed houses 58
Recent Motu Working Papers 61
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
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Tables and Figures
Figure 1: Schematic description of taxes on capital income 3
Figure 2: Real rents and real house prices, 1975 – 2014 17
Figure 3: Real Property Prices in New Zealand, 1923 – 2014 21
Figure 4: Rent/House-price ratio versus real mortgage rates 1975- 2014 24
Figure 5: Average new house size, Australia, New Zealand and the United States, 1974-2014. Square metres. 27
Figure 6: Average new house size, Australia, New Zealand and the United States, 28
Figure 7: Average building permit size versus real mortgage rates , 1975-2014 30
Figure 8: Tax rates across different income classes. (i) Expenditure Tax System 45
Figure 9: Tax rates across different income classes. (ii) Income Tax System 46
Table 1: The effect of taxes on the housing marginal utility/price ratio. 9
Table 2a:The effect of taxes on the marginal land price/ convenience yield ratio. Ongoing property price increases g =
0% 13
Table 2b: The effect of taxes on the marginal land price/ convenience yield ratio. Ongoing property price increases g =
1% 13
Table 3: The effect of taxes on rent/price ratios. 16
Table 4: Selected measures of Household Wealth, 1998- 2015. 19
Table 5: Annual average property price increases in New Zealand, 1923 – 2014 22
Table 6: International House Price changes, 1975 – 2016 23
Table 7: The effect of not taxing imputed rent in an environment without capital gains 34
Table 8: The effect of not taxing imputed rent in an environment with capital appreciation but no capital gains tax. 38
Table 9: Housing returns with expenditure taxes: no capital gains 42
Table 10: Housing returns with expenditure taxes: property appreciates at 1% per year 43
Appendix Table 1: Testing for cointegration between the real interest rate and the rent/price ratio. 59
Appendix Table 2: Using the Ericcson-MacKinnon ECM test to test for cointegration between the rent/price ratio, the
real interest rate, the lagged average house price change, and the lagged inflation rate. 60
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
1
1 Introduction
New Zealand currently has one of the most distortionary tax environments for housing markets
of any country in the OECD. This claim may sound odd to people used to hearing that New
Zealand has some of the lowest and least distortionary labour market taxes in the OECD. Yet
both claims can be true, and both claims have their roots in changes made to the tax system in
the 1980s. One decision in particular contributed to both. In 1989, the government changed the
way retirement income savings were taxed.
To understand this argument, it is necessary to take one step backwards. Income can
either be taxed when it is earned, or taxed when it is spent. The former taxes are called income
taxes, while the latter taxes are called expenditure taxes. Each type of tax raises revenues, and
each causes distortionary effects by altering the way people behave. It has long been understood
that income taxes applied to capital income distort investment patterns more than expenditure
taxes, partly because not all capital income is taxed at the same rate, which generates incentives
to invest in lightly taxed assets. On the other hand, the revenue raised when capital incomes are
subject to income tax can be used to reduce tax rates on labour income, reducing labour market
distortions. This creates a quandary for governments. By taxing people when income is spent,
the distortionary effects on capital markets are reduced, but taxes on labour incomes are high. In
contrast, if people are taxed when income is earned, tax rates on labour incomes are low, but the
allocation of capital is distorted unless all capital is taxed at the same rate.
While most OECD countries use a hybrid system, since the 1970s there has been a shift
towards expenditure taxes as their advantages have become clearer and implementation costs
have fallen. Expenditure taxes can take several forms. Countries can apply indirect value-added
taxes, which raise the price of goods and services. They may also apply various retail sales taxes.
And, following the insights of Fisher (1937), countries can apply cashflow taxes that tax a
person’s cashflow rather than their income. To do this, they adjust earnings for the net purchase
and sale of assets, on the basis that this total is close to a person’s expenditure on consumption
goods and services. For example, if someone earned $100,000 and saved $15,000, they would
pay tax on $85,000. Alternately, if someone earned $100,000 and sold assets for $20,000, they
would be taxed on $120,000.
Most OECD countries default to an income tax basis but provide expenditure tax treatment
to two classes of assets. The first class is earnings that are placed in a government-sanctioned
retirement saving fund. In the vast majority of OECD countries, these are taxed on an
expenditure basis by adopting an ‘Exempt-Exempt-Taxed’ (EET) rule.
1
Income that is placed in a
1
Austria, Belgium, Canada, Finland, France, Germany, Greece, Iceland, Ireland, Japan, Korea, Mexico, the Netherlands, Norway,
Poland, Portugal, the Slovak Republic, Spain, Switzerland, Turkey, the United Kingdom, and the United States all have a version of
an EET retirement income saving scheme. Hungary has its equivalent, a TEE scheme. Denmark, Italy, and Sweden have ETT
schemes. New Zealand and Australia are the obvious outliers, and Australia provides some ‘concessions’ to the taxation of
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
2
fund is not taxed when it is earned; interest and dividend earnings and any capital gains are not
taxed when they accumulate in the fund; but when assets are withdrawn from the fund upon
retirement, they are taxed. The second class is owner-occupied housing. In this case, a
prepayment or ‘Taxed-Exempt-Exempt’ (TEE) expenditure tax rule is adopted: the house is
purchased or paid off from income that is taxed when it is earned, but no tax is paid on the
imputed rent produced by the property (the value of the rent that would be earned if the owner
leased the property to someone other than themselves) or any capital gain that accrues to the
owner. If tax rates on income are constant, the ‘Taxed-Exempt-Exempt’ and the ‘Exempt-
Exempt-Taxed’ versions of expenditure taxes have the same effective tax treatment.
2
The whole
system is a hybrid because income from other investments is taxed on an income tax or ‘Taxed-
Taxed-Exempt’ (TTE) basis.
3
Nonetheless, people who spend most of their income other than
what they place within a sanctioned retirement income fund or put aside to purchase (or repay)
owner-occupied housing effectively pay taxes on an expenditure basis.
In the 1980s, New Zealand reformed its tax system in several ways. One of the reforms, the
introduction of a Goods and Services tax, pushed the tax system towards an expenditure tax
basis.
4
A second reform pushed it towards an income tax basis. Until 1989, New Zealand, like
most other OECD countries, had an ‘Exempt-Exempt-Tax’ system for funds placed in sanctioned
retirement income funds. This taxation treatment was abolished in 1989, and since then
retirement income funds have been taxed on an income tax or TTE basis.
5
Figure 1 depicts the
change. Prior to 1989, owner-occupied housing and savings placed in sanctioned retirement
funds were taxed on an expenditure basis, whereas other assets were taxed on an income basis.
This meant there was a large tax wedge between the taxation of housing and retirement funds,
on one hand, and other assets on the other. After 1989, the wedge between retirement assets
and other assets was closed but a large wedge between retirement funds and owner-occupied
housing was opened. Viewed in this light, the 1989 change can be considered New Zealand’s
great income tax experiment. It is perhaps worth noting that no other country copied New
Zealand’s move in the subsequent quarter century, and several former Eastern European
countries consciously adopted expenditure tax systems for funds placed in specified retirement
retirement income saving by having low taxes on employee contributions and low taxes on interest and dividend income. See
Whitehouse (1999) or Yoo and de Serres (2004).
2
The “Taxed-Exempt-Exempt” and “Exempt-Exempt-Taxed” forms are not strictly equivalent, in part because realised capital
gains are taxed under the latter rule but not the former, and different marginal tax rates may apply under the two forms. In
expectation, they are sufficiently similar that it is widely considered that taxing one form of income under one rule and another
form of income under the other should not distort investment choices. This issue is discussed at length by Kaldor (1955) and Batina
and Ihori (2000).
3
This means income is taxed when it is earned; any interest or dividends or profits are taxed when they accumulate, and capital
gains may be taxed on a realized rather than an accrual basis; but there is no further tax when the investment is sold.
4
The GST rate was further increased in 1989 and 2010 in response to the perceived advantages of expenditure taxes.
5
In 2007, the New Zealand Government introduced a subsidised voluntary retirement income scheme called KiwiSaver. People
placing funds in the accounts are provided with a $0.50 subsidy for each dollar placed into the account for the first $1,043
contributed per year. In principle, a subsidy on a voluntary retirement savings account could have reduced the tax distortions
favouring housing. In practice, the nature of the subsidy means retirement savings are still taxed on an income basis. Income that
is contributed to the retirement income account in excess of $1043 per year is still taxed at normal income tax rates, and the capital
income earnings of the accounts are also taxed at normal income tax rates.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
3
savings accounts. Moreover, one of the most in-depth tax reviews written since then, the 2010
Mirrlees Tax Review in the United Kingdom, recommended continuing the EET tax treatment of
pensions, and suggested additional reforms should be adopted to tax other assets on an
expenditure basis.
6
Figure 1: Schematic description of taxes on capital income
Why was the change undertaken in New Zealand? The 1987 Labour Government argued
that the EET treatment of retirement savings provided a costly, regressive tax concession to the
owners of capital. The 1988 Brash Committee, charged with investigating the proposal, agreed.
The Committee portrayed the EET treatment of retirement savings as a distortionary tax
concession that undermined the principle of tax neutrality, as it meant income placed in some
saving vehicles (sanctioned retirement-income funds) were taxed much less that others (funds
invested in businesses, or invested in other financial institutions such as banks, or used to
purchase shares or businesses). The change was implemented providing a considerable short
run increase in tax revenue.
7
At the same time, proposals to tax capital gains were not
implemented, providing an incentive to invest in long horizon assets with low pre-tax yields.
8
Nor was imputed rent taxed, providing an incentive for people with housing equity to purchase
more expensive houses than they would have if housing were taxed the same way as other
assets.
9
Consequently, rather than eliminating the distortions in the tax system that came from
taxing some assets on an income basis and other assets on an expenditure basis, the 1989
reforms accentuated the different tax treatment of owner-occupied housing and other assets by
6
Mirrlees and Adam (2010: chapter 14). This recommendation is consistent with the recommendations of the 1978 Meade Report
(Institute for Fiscal Studies and Meade (1978)).
7
From 1989 income tax was paid on all earnings when they were earned, including earnings placed in a retirement income account, and
the earnings from these accounts. Under the previous regime, taxes were paid when earnings were withdrawn at retirement.
8
Proposals to enact comprehensive changes to the taxation of capital income were forwarded in the 1989 document “Consultative
Document on the Taxation of Income from Capital,” but were ignored.
9
The proposition that imputed rent could be taxed was first raised by the 2001 McLeod Review. The idea has a long history and
imputed rent is taxed in some European countries such as Switzerland and the Netherlands.
Income Class
Owner-
occupied
housing
Sanctioned
Retirement
Fund
All other
assets
Expenditure tax
Income tax
Tax treatment
Pre-1989
post-1989
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
4
imposing income taxes on a wider class of assets. This produced a tax environment for housing
that can be considered quite distortionary relative to other OECD countries, for in most of these
countries people can invest in non-housing assets on the same tax basis as they can invest in
owner-occupied housing.
The 1988 report by the Brash Committee did not discuss the taxation of residential
housing, although it observed that it is important for the tax system to be neutral towards the
income earned by different asset classes. However, the OECD, the 2001 McLeod Review and the
2010 Tax Working Group all expressed concern about the lack of neutrality of the tax system
towards residential housing. The OECD recommended that imputed rent and capital gains
should be taxed, with deductions allowed for mortgage interest, depreciation, and repairs and
maintenance. The McLeod review preferred a different adjustment, the ‘Risk-Free Return
Method’ in which tax should be levied on the product of an agent’s equity in a property and the
risk free interest rate (McLeod Committee 2001, p iv) but perceived it would be difficult to
implement and sustain such a reform. The Tax Working Group analysed capital gains taxes, land
taxes and the risk-free return method, but there were no recommendations to change the way
owner-occupied housing is taxed, and no changes were implemented.
What are the effects of taxing housing differently from other assets? Standard analysis,
supported by the OECD, the 2001 McLeod Review and the 2010 Tax Working Group suggests
that taxing housing on an expenditure basis when other assets are taxed on an income tax basis
will lead to larger houses and higher property prices. This creates a transfer to the first
generation of owners at the expense of all future generations, who have to pay higher prices for
housing. Consequently, for a quarter of a century, New Zealand’s tax environment has imposed
costs on current and future generations of young people because of the way it taxes housing and
other assets.
10
This paper provides a review of the way New Zealand’s tax system alters the incentives to
purchase property. Its purpose is to provide a wider perspective on the relationships between
tax and housing markets than has previously been undertaken, particularly the impact on
housing of the 1989 retirement saving tax reforms. In section 2, the effects of the tax system on
the incentives of landlords to alter rent/price ratios and the incentives of owner-occupiers to
construct different quality houses and bid up the price of different quality land are analysed.
This section suggests the 1989 reform provided an incentive to construct larger houses as well
as bid up the price of land which is conveniently located to desirable amenities. Section 3
documents two aspects of New Zealand’s property markets to see if they can be explained in
terms of interest rates or taxes. The first is the rent/price ratio; the second is the size of new
10
Several smaller modifications to the tax system were adopted after 2000, partly due to concerns about the
distortionary effects of income taxes on investment choices. For instance, the top marginal tax rate was progressively
reduced from 39% to 33%; the rate of GST was increased from 12.5% to 15% in 2010; and when KiwiSaver was
introduced in 2007, the highest tax rate on investment earnings was capped at 28% to reduce the incentive to invest in
more advantaged tax classes.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
5
houses in New Zealand relative to new houses in the United States and Australia. It is shown that
there was a large increase in the size of new houses in New Zealand relative to those in Australia
and the United States after 1989, although it is not possible to be certain why this increase took
place. In section 4 some of the welfare consequences of the tax system’s effects on housing
markets are considered. While these depend on a variety of factors, particularly the rate of
ongoing house price inflation, it is reasonably clear that the current tax system has regressive
effects on younger people who wish to purchase their own homes. Moreover, standard
theoretical models suggest the distortions stemming from the partial nature of the 1989 reforms
have most likely imposed significant costs on all cohorts maturing after 1989. These cohorts
include people who are currently young, as well as all people intending to purchase property in
New Zealand in the future. Conclusions are offered in section 5.
2 Taxes and property markets: basic theoretical results.
New Zealand has taxed capital incomes using an income tax framework since 1989. All capital
incomes are subject to tax, with three main exceptions: the imputed rent associated with the
equity of an owner-occupier is not taxed; interest income earned by non-residents is taxed at
only a very low rate; and capital gains are not taxed. Each of these exemptions creates incentives
that distort the way that households and firms invest.
Samuelson (1964) analysed how investment patterns are distorted when capital incomes
are subject to income tax but capital gains are not taxed. One distortion occurs because income
taxes create an incentive to invest in low-yielding long-horizon assets that have returns in
different periods, because interest is compounded on an after-tax basis. A related distortion
occurs because income taxes create an incentive to invest too much in indefinitely lived assets
such as land. A third distortion occurs when there is inflation, because nominal interest returns
rather than real interest returns are taxed. Each of these distortions is currently a feature of the
New Zealand income tax system.
Samuelson showed these distortions could be corrected by an accrual-based capital gains
tax that allows for the deduction of depreciation and losses. If capital gains are taxed on an
accrual basis, when a firm produces an income-producing asset, (i) capital gains tax is paid at
time t on the value of the newly created asset, (ii) income tax is paid on the income stream
produced by the asset, and (iii) capital gains tax is paid on any change in value of the asset in the
year that this change takes place. This corrects the incentives to make low-yielding long-term
investments because of their tax advantages. In turn, the present value of all assets will be
independent of the tax rate, even if different agents have different tax rates, and equal to the
value of the asset in the absence of taxes. A brief mathematical treatment of Samuelson’s results
is provided in Appendix 1.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
6
Since Samuelson’s results are general, they apply to investments in residential property.
Because residential property assets are long lived, income taxes without accrual-based capital
gains taxes raise the after-tax returns relative to interest-earning debt and encourage over-
investment in property. An accrual-based capital gains tax would correct this distortion for both
owner-occupiers and landlords. But this is not the only distortion that affects New Zealand’s
property markets, as the imputed rents accruing to owner-occupiers are not taxed, providing
additional incentives to invest in real estate.
In the following subsections, three distortionary effects of New Zealand’s tax system on
housing markets are considered. The first is the effect on the incentives of owner-occupiers to
construct larger or better quality houses than otherwise. The second is the incentive for owner-
occupiers to bid up the price of land that is conveniently located to desirable amenities. These
are treated separately because supply of buildings is very elastic, whereas the supply of land is
highly inelastic. The third concerns the effect on landlords to alter the rent/price ratio for leased
property.
11
Each of these distortions is considered independently from the others. To
understand the overall effects of taxes on property prices, however, it is necessary to model
these incentives simultaneously in a general equilibrium framework, along with other factors
that affect the supply and demand for housing, such as the extent that agents are affected by
borrowing constraints and the supply elasticities of new housing. Coleman (2010) provides an
example of an equilibrium model of housing markets that simultaneously incorporates many
features of New Zealand’s tax system and banking markets.
2.1 The effect of income taxes on residential property owner-occupiers.
When an owner-occupier purchases a property, neither the imputed-rent or the capital gains
obtained from the property are subject to income tax. In these circumstances, income taxes
distort choices about the size of houses people buy, and the price they will pay for conveniently
located land. The analysis in this subsection calculates the tax distortions for households that
own a property without a mortgage. About two-thirds of New Zealand houses are owned by
owner-occupiers, about half of which are owned without a mortgage. The analysis also applies to
owner-occupiers whose mortgage interest is tax deductible, for the opportunity cost of
purchasing a larger house is the after-tax interest rate.
12
The analysis partially applies to
11
It is possible that there is a fourth effect: that the tax rules affect the number of households and thus the quantity of
houses that are demanded. For instance, young people may leave home at a different time in response to the tax rules,
because of their effect on house prices and rents, or the divorce rate may change. Coleman (2010, 2014) models how
the age at which children leave home may be affected by rents, and Coleman and Scobie (2009) provide a brief analysis
of how the rate of household formation may have been affected by rents and house prices in New Zealand. They argue
that housing demand is relatively price inelastic, which suggest the effect should be small. In any case, the effect of taxes
on housing demand should be indirect: it should occur because of the effects of taxes on prices and rents. Consequently,
it can be considered as an additional response to any price changes that occur.
12
Mortgage interest can be deducted against a taxpayer’s income if the loan is used to finance an asset that generates
taxable income, such as a rental property or an investment in a public or private business. In this case the relevant
interest rate is the mortgage rate, not the deposit rate.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
7
households that have a mortgage and who expect to be mortgage free at some point in their
lives, as the opportunity costs of purchasing a house depend on future as well as current tax
rates. The correct opportunity cost of purchasing a house for households that have a mortgage is
the average of the pre-tax interest rate and the after-tax interest rate, where the weights are the
fractions of time the person expects to have a mortgage relative to the time they expect to be
mortgage free. This weighted average is straightforward to calculate, but to enhance the clarity
of the analysis in this subsection only the case where the opportunity cost is the after-tax
interest rate is presented. It follows that the results of this section show the maximum tax-
induced housing market distortions that apply to owner-occupiers.
13
Residential property is also subject to rates – a property tax – levied by local authorities.
The tax rate is typically under 0.5%, and while most authorities levy rates on the total value of a
property, some only assess land values. A tax on land values in an open economy is largely non-
distortionary, but a tax on housing structures provides an incentive to purchase a lower quality
house. Property taxes are included in the following analysis even though they are not central to
the story as they are imposed irrespective of the central government tax regime. The following
analysis incorporates these local authority taxes, but focuses on the change in the total tax
regime that occurs when there is a change in the taxes levied by central government.
2.1.1 Taxes and the quality of houses (not land)
When purchasing a house, the opportunity cost of purchasing a larger house is the after-
tax return to lending. Consider the option of buying a house (a structure) of quality θ that costs
P
H
(θ) to build and returns an annual benefit H(θ) representing the real value of shelter. It is
convenient to think of quality as the size of a house.
Let π = inflation rate, assumed to be the rate at which P
H
(θ) increases through time;
i = nominal interest rate;
δ
= depreciation rate of houses;
τ = marginal tax rate on income;
τ
H
= tax rate paid on imputed rent (currently zero);
τ
C
= tax rate on capital gains (currently zero); and
τ
L
= local property tax on capital value.
Let
( , , , , | , , )
H H C L
i
be the after-tax value of purchasing a house relative to the
after-tax value of lending. This is equal to the sum of the value of imputed rent plus the future
value of the house adjusted for any capital gains taxes or property taxes and the opportunity
cost of lending,
13
The model Coleman (2010) uses to study the effect of capital gains taxes on housing markets uses an opportunity
cost that is the average of current and future after-tax interest rates.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
8
))1(1)(()()1)(1)(()1)(1)((
))()()(1(),,|,,,,(
iPPPP
PHi
HHH
C
H
H
LHLCHH
(1)
The quality level that maximises ω
H
is found by calculating the first order condition of
equation 1, and calculating the resultant marginal benefit to marginal price ratio:
(1 ) (1 )( )
( ) ( )
(1 )
( ) ( )
C
L
H
H
i
dH d
dP d
(2)
The marginal benefit/marginal price ratio denotes the annual marginal utility gain
someone should obtain from spending an extra dollar on the quality of a house. If a house did
not depreciate and there were no taxes, the ratio would equal the real interest rate. When all tax
rates on capital income are zero, or when the tax system is neutral towards housing, either
because taxes on imputed rent and on capital gains are equal to the tax on other income, or
because housing and other capital income is subject to expenditure taxes, the ratio is equal to
( ) ( )
( ) ( )
L
H
dH d
i
dP d
(3)
When neither imputed rent or capital gains are taxed, but interest income is taxed, the
situation currently prevailing in New Zealand, the ratio is
( ) ( )
(1 )
( ) ( )
L
H
dH d
i
dP d
(4)
Table 1 provides some sample values for the marginal utility/marginal house price ratio
for the current tax system, for a neutral tax system, and for the tax systems that would occur if
(i) capital gains were taxed but imputed rents were not taxed, and (ii) imputed rent were taxed
but capital gains were not taxed. The values are calculated under the assumptions that the
marginal tax rates are either 33% or 0%, and that the depreciation rate is 2.5%. Construction
costs are assumed to increase at the rate of inflation. The table shows the average values for the
decades of the 1990s, 2000s, and the five years to December 2015.
Table 1 indicates that the tax system in place since 1990 reduces the benefits needed to
justify an investment in better quality housing relative to other consumption by approximately
20 - 30% (Row 4). This reduction occurs because interest is taxed but the benefits of the larger
house are not: a person deciding between spending $50,000 on a larger house or purchasing
consumption goods and services each year with the interest from $50,000 will have an incentive
to favour a larger house as the interest earnings are taxed. If housing is a usual type of good,
households should increase the quality of the house until the marginal benefit of additional
expenditure falls to the marginal benefit of other consumption. To a first approximation, one
might expect the tax distortion to induce a 25% increase in the quality of the houses people
choose.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
9
Table 1: The effect of taxes on the housing marginal utility/price ratio.
( ) ( )
( ) ( )
H
dH d
dP d
1991-2000
π = 1.8 %
i = 7.0 %
2001-2010
π = 2.7 %
i = 5.9 %
2011-2015
π = 1.1 %
i = 4.0 %
(1)Neutral taxes
i
7.8%
5.8%
5.5%
(2) Neutral taxes
+property tax
L
i
8.3%
6.3%
6.0%
(3) Current
income taxes
(1 )
L
i
6.0%
4.3%
4.6%
(4) Ratio (3)/(2)
72%
69%
78%
(5) Current taxes
+ CGT
(1 )( )
L
i
5.7%
4.4%
4.2%
(6)Current taxes +
imputed rent tax
(1 )
1
L
i
8.7%
6.2%
6.7%
Source: Author’s calculations.
Rows 5 and 6 show the marginal utility/ marginal house price ratios that would occur if
either capital gains taxes or a tax on imputed rent, but not both, were added to the current tax
system. When the inflation rate is approximately the same as the depreciation rate, which has
been the case in New Zealand since 1990, there is little change in the value of a housing
structure (not the land) and a capital gains tax will have little effect on the demand for housing
structures. In these circumstances the main housing market distortion is the failure to tax
imputed rent while interest income is taxed.
How can the tax system be reformed so that it does not encourage over investment in
housing structures? There are three basic ways. If the government wishes to pursue an income
tax strategy, there should be equal taxes on interest, imputed rent, and capital gains. Alternately,
it could adopt the ‘risk free return method’, in which owner-occupiers and landlords would have
to pay tax on their equity in the property multiplied by the interest rate, for this method also
generates the neutral outcome. Thirdly, it could pursue an expenditure tax approach, which,
assuming neither imputed rent nor capital gains were taxed, would require interest income to be
taxed on an expenditure basis. The latter method is the standard approach in most OECD
countries, through the use of EET retirement income schemes. All of these reforms would
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
10
correct the current tax incentive for households to live in higher quality houses than they would
otherwise choose.
14
If the income tax increases the incentive to build large houses, does it also increase the
price of these houses? This question is difficult to answer precisely as the answer requires the
simultaneous consideration of (i) heterogeneous housing quality, (ii) a housing demand function
that depends on rents, current house prices, the expected rate of change of house prices in the
future, and other factors such as the number of people in the local housing market, their income,
interest rates and taxes, (iii) knowledge of how households form expectations about future
house prices, (iv) a supply function for new construction that is inelastic and subject to capacity
constraints, and (v) a rule that decides the order in which houses differing in terms of quality are
built when the demand to build is unusually high. Although not specifically about housing, the
classic approach was pioneered by Rosen (1974).
Rosen’s approach calculates a long-run market equilibrium that depends on long-run
supply and demand factors for goods that differ in terms of their quality, and then calculates
transition paths to this equilibrium. He observed that the demand for one particular quality of
housing depends on the prices for all quality types, as buyers make price/quality comparisons
and buy the quality type that offers them best value. In the long run, prices must reflect
production costs to ensure positive amounts of each quality level are supplied. The amount of
housing of each quality type that is produced depends on the demand for each type of housing
type when prices are equal to long-run production costs. Consequently, factors such as interest
rates or taxes should have little effect on the price of houses in the long run, except to the extent
that they directly raise construction costs.
In the short and medium terms, however, the tax system may affect house prices as well as
the quality of houses. A change in factors such as income, the local population, interest rates, or
taxes can all induce an increase in housing demand. Some of these factors, such as an increase in
population, will modestly increase demand across all quality levels, generating ordinary levels of
new construction. Other factors, such as a decrease in interest rates or a change in the tax
treatment of housing, can be expected to significantly increase most people’s demand for better
quality housing all at once. When this occurs there is a mismatch between the quality of the
existing housing stock and the desired housing stock, and prices increase to match current
demand with the available supply.
14
If an expenditure tax approach were adopted, not all of the distortions in the tax system would be
eliminated as capital income from sources other than housing or assets in retirement savings accounts would
not be taxed on an expenditure basis. In contrast, if the income tax approach were implemented, all forms
of capital income would be taxed on an equivalent basis. This might suggest an income tax approach should
be preferred. In practice, however, it has proved exceedingly difficult to tax housing income on a neutral
income tax basis. This is one of the reasons most OECD countries have chosen to tax retirement savings
on an expenditure tax basis to reduce the non-neutrality of the tax system.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
11
The extent that prices need to increase depends on the extent that future prices are
expected to reduce. When expectations are rational, and the supply imbalance is small, a small
price increase may be sufficient to equate demand with the available supply, as expected future
price declines will reduce contemporaneous demand. If expectations are not rational, or the
demand imbalance is very large, large price increases may be necessary to reduce demand to
match the available supply. When the total increase in demand is much greater than the
available building capacity, as might occur in response to a large reduction in interest rates or an
increase in tax rates, prices can remain higher than ordinary construction costs for some time,
raising profit margins.
15
For this reason, changes in interest rates and tax rates can induce
lengthy but ultimately temporary increases in construction costs and the price of houses, even if
construction costs are not affected by these factors in the long run. Consequently, while interest
rates and taxes should ultimately only affect the average quality of housing, they can affect
prices in the medium term if the induced changes in demand are large relative to construction
capacity.
2.1.2 Taxes and the value of land (not housing structures)
A similar analysis can be applied to the circumstances where agents choose locations because of
their convenience to desirable amenities. Let C(λ) be the ‘convenience yield’ obtained from living
at location λ, and let P
L
(λ) be the price of land at this location. The convenience yield of a
particular location depends on costs of going to a large range of different amenities: leisure
activities, workplaces, the airport, local schools, shopping facilities and so on. If some of these
amenities are rare and highly valued (e.g. a beach) and transport costs are high, the slope of the
convenience yield with respect to location will be large and thus the price premium paid to live
in these locations will be high. The convenience yield also increases with income and the size of
the population when transport costs are high or transport times are slow, as income raises the
value of being conveniently located and population increases congestion. Households should
choose locations where the marginal cost of changing location generates an increase in the
discounted value of the convenience yield equal to the value of goods and services that could
have otherwise been purchased.
Suppose the convenience yield increases through time at rate g, possibly because the
population is increasing and there is a rising opportunity cost of congestion, or because incomes
are growing and value of the time that is saved by living in a convenient location increases. Let
( , , , , | , , )
L R C L
ig
be the after-tax value of purchasing property at location λ relative to the
opportunity cost of lending:
16
15
In response to the increases in prices associated with the additional demand, the most profitable types of houses are built first:
these are houses at quality levels where the gap between prices and construction costs is largest.
16
Assume g+π < i(1-τ).
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
12
( , , , , | , , ) (1 )( ( ) ( ))
( )(1 )(1 ) ( ( )(1 )(1 ) ( )) ( )(1 (1 ))
L
L R C L H L
L L L L
C
i g C P
P g P g P P i
(5)
The ratio of the marginal price of land to its marginal annual convenience yield is
(1 )
( ) ( )
( ) ( ) (1 ) (1 )( ) (1 )
L
H
C H L
dP d
dC d i g g
(6)
This is the number of years of annual rent someone would be willing to pay for the
additional convenience yield obtained from a property in a particular location. When there are
no taxes, the ratio is
( ) ( ) 1
( ) ( ) ( )
L
dP d
dC d i g g
(7)
When interest income is taxed on an income tax basis, but neither imputed rent or capital
gains are taxed (the New Zealand case), the ratio is
( ) ( ) 1
( ) ( ) (1 ) ( )
L
L
dP d
dC d i g g
(8)
Table 2a and 2b show how the value of the marginal price/marginal convenience-yield
ratio varies with the tax environment. Table 2a shows the ratios when real land prices are stable
(g = 0%) but there is nominal price inflation; Table 2b shows the ratios when land prices
increase in real terms at 1% per annum. The ratios are calculated for the values of nominal
interest rates and inflation rates that prevailed between 1990 and 2015.
Consider first the case in which real property prices are stable. If the tax system were
neutral, the marginal land-price/ annual convenience yield ratio would be the reciprocal of the
real interest rate. Table 2a (row 1) indicates this ratio increased from 19 to 34 after 1990 due to
the decline in real interest rates, suggesting that real land prices in places where the marginal
convenience yield is positive might have increased by 80% over the period. (The factors that
create a high marginal convenience yield are discussed below.) New Zealand’s tax system has
not been neutral toward housing since 1990, however; the interaction of the tax system with
inflation mean that the marginal price/annual convenience yield ratios increased from 29 to 47
over the period (row 3). These ratios are at least 60% higher than they would be if New Zealand
had a neutral tax system with local government property taxes, and 50% higher than they would
be if New Zealand had a neutral tax system without property taxes. This increase in the ratios
occurs because the nominal increases in house prices resulting from inflation are not taxed,
whereas nominal interest earnings are taxed, creating an incentive for households to bid up the
price of well located property.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
13
Table 2a:The effect of taxes on the marginal land price/ convenience yield ratio. Ongoing property price
increases g = 0%
( ) ( )
( ) ( )
L
dP d
dC d
1991-2000
π = 1.8 %
i = 7.0 %
2001-2010
π = 2.7 %
i = 5.9 %
2011-2015
π = 1.1 %
i = 4.0 %
(1)Neutral taxes
1
()i g g
19.0
31.1
34.0
(2) Neutral taxes
+property tax
1
()
L
i g g
17.3
26.9
29.1
(3) Current taxes
1
(1 ) ( )
L
i g g
29.0
56.8
47.1
(4) Ratio (3)/(2)
1.6
2.1
1.6
(5) Current taxes
+ CGT
1
(1 )( )
L
i g g
24.8
37.7
40.5
(6)Current taxes +
imputed rent tax
1
(1 )( ) ( )
L
i g g
20.4
42.0
34.2
Table 2b: The effect of taxes on the marginal land price/ convenience yield ratio. Ongoing property price
increases g = 1%
( ) ( )
( ) ( )
L
dP d
dC d
1991-2000
π = 1.8 %
i = 7.0 %
2001-2010
π = 2.7 %
i = 5.9 %
2011-2015
π = 1.1 %
i = 4.0 %
(1)Neutral taxes
1
()i g g
23.5
45.7
51.8
(2) Neutral taxes
+property tax
1
()
L
i g g
21.1
37.2
41.2
(3) Current taxes
1
(1 ) ( )
L
i g g
41.2
136.4
89.9
(4) Ratio (3)/(2)
2.0
3.7
2.1
(5) Current taxes
+ CGT
1
(1 )( )
L
i g g
29.9
50.8
55.8
(6)Current taxes +
imputed rent tax
1
(1 )( ) ( )
L
i g g
29.6
117.9
70.7
Source: Author’s calculations.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
14
If real land prices consistently increase over time, even by 1% per year, the incentive to
invest in residential property is even larger. Table 2b indicates that if there were neutral taxes
(except for the property tax) and the long run annual land price growth was 1% per year, the
decline in real interest rates since 1990 will have led to an increase in the price/convenience
yield ratio from 21 to 41, somewhat more than when real property prices are stable. Under New
Zealand’s tax system, however, the ratio will have increased from 41 in the 1990s to 92 after
2010.
17
These ratios show the adoption of a non-neutral tax system significantly accentuated the
incentives for households to bid up land prices as real interest rates declined.
The extent that interest rates and taxes are capitalized into property values depends on
the supply elasticity of land that is conveniently located to desirable amenities. The supply of
conveniently located land will be large if transport costs are low or amenities are widespread,
for then people will have many potential places to live that have high amenity value. These are
circumstances that occur in some places such as the newer sun-belt cities in the United States,
but which do not appear to describe New Zealand locations such as Auckland. Conversely,
distant suburbs may not be close substitutes if transport costs are high, roads are congested,
natural amenities are unique and concentrated near the city’s centre, or they have few facilities.
In the latter circumstances it seems likely that factors that increase the demand for housing will
be strongly capitalized into land values with high convenience yield.
How can the tax distortion be reduced? The solution is to adopt one of the three reforms
that can be used to eliminate the distortions affecting the taxation of housing structures. If the
government wants to have a neutral income tax system, it could have equal taxes on interest,
imputed rent, and capital gains or it could adopt the ‘risk free return method’. If it wants to
pursue an expenditure tax approach, interest income should be taxed on an expenditure basis.
2.1.3 Combined land and house value
Table 1 and Table 2 indicate the percentage distortionary effect of New Zealand’s tax system on
land prices is larger than its effect on the quality of housing structures. This is because land does
not suffer the depreciation that reduces the rate at which the price of structures appreciates, and
because the supply of conveniently located land is usually considerably less elastic than the
supply of newly constructed buildings.
The relative importance of the dollar value of tax distortions on structures and land prices
depends of the relative importance of the price of a structure and the price of land. The dollar
value effect of the tax distortion on land is much higher in Auckland than small cities like
Dunedin as the marginal convenience yield from conveniently located land is higher than in
these cities. However, the distortionary effects of the tax system on the quality of housing
structures should be similar all around the country.
17
In the 2000s the ratio increased to 136, a number that reflects the very low after tax real interest rates prevailing due to the high
inflation rates experienced that decade.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
15
Table 2b shows that the distortionary effects of the current tax system on land would only
be partially reduced if either an accrual-based capital gains tax or a tax on imputed rent was
introduced, but that a capital gains tax would have a larger effect than a tax on imputed rent. In
contrast, Table 1 shows that a capital gains tax will do little to correct the effects of the current
tax system on housing structures. This is unfortunate, because it means a single tax reform -
either a tax on capital gains or a tax on imputed rent - is unlikely to simultaneously reduce the
distortion on land prices and structures.
2.2 The effect of capital gains taxes on residential property investors.
The distortions facing landlords are different than those facing owner-occupiers as rental
income is taxed and mortgage interest payments are tax-deductible. This means the absence of a
capital gains tax is the main distortion when capital income is taxed on an income tax basis. The
following analysis assumes landlords enter the rental market until the after-tax return from
rental housing is equal to the after-tax return from lending money. As the analysis examines the
incentives on landlords, the focus is on the rent a landlord obtains net of costs such as
depreciation and property taxes.
18
Let P
R
= taxable rent income net of costs such as property taxes;
π
h
= expected real rate of increase of property prices; and
P
= price of properties.
In the absence of tax, equating the annual return from an investment of size P in
residential housing (rent plus house price appreciation) with the annual return from lending the
sum P
means
(1 )(1 ) (1 )(1 )
R
t t h t
P P r
P
(9)
(1 )( )
R
t
h
t
r
P
P
(10)
With the current income tax system, equating the annual after-tax returns from an
investment in residential housing and lending P
means
(1 ) (1 )(1 ) (1 (1 )( ))
R
t t h t
P P r r
P
(11)
(1 ) (1 ) (1 )
1
(1 )( ) ( )
1
R
th
t
h h h
Pr
P
r
(12)
18
Landlords can deduct interest payments, property taxes, insurance costs, depreciation on furnishings, the cost of repairs and
maintenance, and any fees paid to property managers. Prior to 2011, depreciation on buildings could also be claimed. Losses made
from leased property are deductible against other income and are not ring-fenced.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
16
Consequently, the income tax reduces the rent/price ratio by an amount that is an
increasing function of the inflation rate and the rate of real house price appreciation.
This distortion is entirely corrected by an accrual-based capital gains tax on nominal
house price increases. While this correction is non-distortionary, when there is inflation it would
mean capital income from rental housing is taxed at much higher real rates than the statutory
rate, just as real interest earnings are currently taxed at higher rates than the statutory rate
when the inflation rate is positive. This distortion could be eliminated by only taxing real capital
gains and by only taxing real interest rates, for in this case
(1 ) (1 ( )(1 )) (1 ( )(1 ))
(1 )( )
tt
t
R
t h h
R
t
h
P P P r r
P
r
P
(13)
Table 3 shows the effect of the tax distortion evaluated at the interest and inflation rates
prevailing from 1990 to 2015, under the assumption that the ongoing real house price
appreciation rates are 0 or 1%. The decline in real interest rates over the period reduced the
rent/price ratio by approximately half, from 5.3% to 2.9%, if zero real house price appreciation
was expected, or from 4.2% to 1.9% if 1% annual real house price appreciation was expected
(row 1). The tax distortion is shown in rows 2 and 3 of the table. When the rate of real property
price appreciation is 1% a year and real interest rates are small relative to the inflation rate, this
distortion reduces the rent/price ratio by at least a third and often by much more. In the five
years to 2015, for instance, the tax distortion means rent/price ratios would only be 47% of
what they would be if the tax system were neutral.
Table 3: The effect of taxes on rent/price ratios.
R
P
P
1991-2000
π = 1.8 %
i = 7.0 %
2001-2010
π = 2.7 %
i = 5.9 %
2011-2015
π = 1.1 %
i = 4.0 %
long run real growth in land prices g = 0%
(1)Neutral taxes
(1 )( )
h
r
5.3%
3.2%
2.9%
(2) Current
income taxes
(1 )( )
()
1
h
hh
r
4.4%
1.9%
2.4%
(3) Ratio (2)/(1)
84%
59%
82%
long run real growth in land prices g = 1%
(1)Neutral taxes
(1 )( )
h
r
4.2%
2.2%
1.9%
(2) Current
income taxes
(1 )( )
()
1
h
hh
r
2.9%
0.3%
0.9%
(3) Ratio (2)/(1)
68%
16%
47%
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
17
Source: Author’s calculations.
The arbitrage conditions facing landlords only determine the ratio of rents to house prices.
The decline in the ratios could have taken place as a decline in rents, a rise in house prices, or a
combination of both. The extent that house prices rise rather than rents fall depends on the
overall structure of the economy, including factors such as the elasticity of supply of housing and
the elasticity of demand for rental housing with respect to rents. If the supply of housing is very
elastic, the decrease in the rent/price ratio will take place through a decline in rents, rather than
an increase in prices. Conversely, if the supply of housing is inelastic, the decrease in the
rent/price ratio will take place through an increase in house prices. Figure 2 (discussed in
section 3.2) shows the evolution of real house prices and real rents in the economy since 1975.
The data show rents have been rather stable, whereas house prices have increased sharply,
particularly since 2000. This suggests the decrease in the rent/price ratio has been dominated
by the rise in house prices.
Figure 2: Real rents and real house prices, 1975 – 2014
What is the role of the changing tax treatment of retirement savings in this analysis? Even
though there was no capital gains tax prior to 1989, rental property was not tax advantaged
because it was taxed on an income-tax basis while investments in sanctioned retirement saving
funds were taxed on an expenditure-tax basis.
19
Since 1989, the absence of a capital gains tax
19
A referee usefully pointed out that the tax system may have been less-than-neutral towards investment property in 1989 - that is,
biased against property investment - as losses were technically ring-fenced. Consequently the post-1989 changes led to an even
Real rents and real house prices, 1975 - 2014
indices: June 2000= 1000
0
300
600
900
1200
1500
1800
2100
1975
1980
1985
1990
1995
2000
2005
2010
Rents
House prices
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
18
means they are taxed more advantageously than investments in debt instruments, even though
investments in rental property are taxed on the same basis as other equity investments.
20
Consequently, the effects of the 1989 tax changes on rental property markets may be greater
than the change from neutral to tax-advantaged status indicated in Table 3, as the 1989 starting
position was not neutral but biased against rental property. In light of the relative change in the
tax system, it is perhaps not surprising that the number of private landlords in New Zealand
increased from 62,000 in 1991 to 276,000 in 2014.
2.3 Tax rules and home ownership rates
Given that the tax rules provide incentives for both owner-occupiers and landlords to purchase
property, is it possible to describe definitively the effect on owner-occupancy rates? In short, the
answer is ‘No’. There are now several theoretical papers that have tried to analyse how owner-
occupancy rates are affected by the tax system in settings in which property prices are
endogenously determined, using general equilibrium models that incorporate agents who differ
in terms of income, wealth, age, and in the amount that they can borrow. For example, Coleman
(2008, 2010, 2014) analyses the possible effects of different tax rules on owner-occupancy rates
in New Zealand, while Chambers, Garriga and Schlagenhauf (2009) and Li and Yao (2007)
provide an analysis for U.S. conditions.
21
The key insight of this literature is that when the tax
system provides incentives for both owner-occupiers and landlords to bid up house prices, the
agents with the tightest credit constraints are the least likely to purchase houses. In most cases,
young low-income households face tighter credit constraints than older, wealthier landlords, so
they are forced to delay their purchase of property and owner-occupancy rates fall. The results
depend on the tax rules and the extent that credit constraints affect different classes of people,
but it is entirely plausible that New Zealand’s current tax rules reduce home-ownership rates.
Coleman (2008, 2014) argues this is the case, and suggests that the decline in owner-occupancy
rates that took place in New Zealand after 1989 may be partly attributable to the tax rules,
although may also reflect the declines in interest rates that occurred after that date.
3 House sizes and property prices in New Zealand.
If real interest rates are an important determinant of property prices, rents and housing quality
in New Zealand, low interest rates should lead to low rent/house-price ratios, high prices for
land conveniently located to valuable amenities, and a demand for large or high quality houses.
larger improvement in the tax position of some landlords (those who borrowed sufficiently large quantities that they made losses)
than indicated here.
20
Prior to 1989, an investment in a rental property was tax disadvantaged relative to an investment in debt instruments that were
held in a sanctioned retirement income fund, but they were tax-advantaged relative to an investment in debt instruments held
outside a retirement income fund as these investments were taxed on an income tax basis. The difference occurs because income
taxes raise the effective tax rate on nominal interest income when there is inflation, but expenditure taxes do not.
21
Also see Jeske (2005) for an overview of the generic issues.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
19
In principle, the change in the tax system that occurred in 1989 should act as a natural
experiment similar to a decline in real interest rates and lead to distinct before-and-after effects.
In practice, the effects of the tax change are not easy to unpick. New Zealand experienced a raft
of reforms and macroeconomic shocks in the 1980s and early 1990s, many of which should have
significantly affected property markets. First, there was a substantial decrease in the inflation
rate and nominal interest rates after the Reserve Bank of New Zealand Act was adopted in 1989.
Real rates subsequently fell, in line with the declines in real interest rates around the rest of the
world. Secondly, inward migration surged after 1990, following a reform of migration policy.
Thirdly, New Zealand experienced a financial crisis between 1987 and 1992, beginning with the
1987 sharemarket crash. This crisis ultimately caused New Zealand’s deepest post-war
recession and made many people wary of investments in listed equities. Fourthly, there was a
sustained increase in incomes after the crisis ended in 1993. All of these events mean it is foolish
to attribute changes in real estate markets to any single macroeconomic cause.
22
Table 4: Selected measures of Household Wealth, 1998- 2015.
1998
2007
2015
Population
3,846,100
4,240,000
4,633,900
Nominal GDP
$111,157m
$183,333m
$247,436m
Housing and Land Value
$221,000m
$613,678m
$873,190m
- Ratio to GDP
1.99
3.35
3.53
Value of equity in businesses
(includes equity in rental property)
$123,618m
$303,577m
$372,844m
Equity in Superannuation and
insurance funds
$42,804m
$41,142m
$75,272m
Deposits
$44,941m
$95,079m
$151,755m
Liabilities
$44,991m
$121,320m
$163,166m
Net Financial Wealth
(includes equity in rental property)
$172,745m
$340,753m
$461,249m
Total Net Wealth
$349,149m
$817,690m
$1,118,487m
- Ratio to GDP
3.14
4.46
4.52
Net Wealth excluding value of land
$128,149m
$204,012m
$245,297m
- Ratio to GDP
1.15
1.11
0.99
Source: Population and Nominal GDP data are from Statistics New Zealand, series DPE059AA and
SNE022AA. The wealth data are from the Reserve Bank of New Zealand, Household Balance Sheet
statistics
The reforms of the late 1980s and early 1990s are considered to have profoundly changed
the New Zealand economy. Since then there has been a significant increase in population,
nominal GDP, and wealth. Table 4 provides some basic information about wealth in 1998 (the
22
A referee suggested it might be possible to analyse whether the effects of various changes in the tax system that were implemented
after 1989 might be discerned in property markets. For instance, the GST rate was increased from 12.5% to 15% in 2010, and the
top marginal tax rate was gradually reduced from 39% to 33%. The introduction of the PIE regime also limited tax payments on
certain investments, and there have been changes to the type of expenses that can be charged against income by landlords. In
principle, these suggestions could be pursued although they have not been examined in this paper. In practice, these changes are
much smaller than the change undertaken in 1989 and the low power of tests used to analyse time-series data of this nature make
it unlikely that statistically significant results (either way) could be obtained.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
20
first year for which comprehensive information about wealth is available from the Reserve Bank
of New Zealand), 2007, and 2015. The table indicates the value of housing and land wealth
relative to GDP increased from 2 to 3.5 over the period. In contrast, the value of other assets
(total wealth minus the value of housing and land) relative to GDP remained relatively stable. As
a result, the value of housing and land as a fraction of net wealth increased significantly, from 63
percent to 78 percent. (The wealth held in Superannuation and Insurance funds fell from 38% of
GDP in 1998 to 22% in 2007, before recovering to 30% in 2015 as a result of large inflows into
the new KiwiSaver accounts.)
The remainder of this section provides basic information about the behaviour of property
prices, rents, and the size of new houses in New Zealand, as well as providing a brief comparison
with house price movements in other OECD countries. As the data make clear, property prices
increased substantially more quickly after 1990 than prior to 1990, although the most rapid
increases occurred after 2000, a decade after the tax change. Indeed, between 1990 and 2016
New Zealand had the largest real increase in house prices of any of the 23 OECD countries for
which data are available from the International House Price Database. In addition, the size of
new houses increased rapidly, with the most noticeable increases taking place after 1989. This
evidence is broadly consistent with the hypothesis that the 1989 tax changes should have led to
increases in house prices, reductions in rent/price ratios, and increases in house sizes. However,
since it is not possible to control for all the other changes taking place in the New Zealand
economy, it cannot be claimed that the data confirm the hypothesis.
3.1 Trends in house prices and rents
Figure 3 shows the pattern of real house prices from 1923 to 2014. For the period 1962 to 2014
the data are a quality-adjusted property price index deflated by the consumer price index.
23
For
the period 1923 to 1962 the data are the average selling price of houses deflated by the
consumer price index.
24
As the latter data are simple averages and are not adjusted for changes
in the underlying quality of the properties, they are not directly comparable with the data from
1962 to 2014. The dominant feature of the figure is the sharp increase in real prices after 2000,
which took place in conjunction with similar increases in several other OECD countries. The
growth rates of prices in different sub periods are presented in Table 5.
From 1923 to 1962, the average selling price of houses increased by 3.3 % per year, of
which 2.2% can be attributed to generalized inflation and 1.5% represents a real increase in the
average selling price.
25
It is likely that a large fraction – perhaps 80 percent – of the real increase
23
The data refer to the price of detached houses and are based on Quotable Value data compiled by the Reserve Bank of New
Zealand. http://www.rbnz.govt.nz/statistics/key-graphs/key-graph-house-price-values
24
The average sales price is calculated as the total value of urban properties transferred under the Land Transfer Act divided by the
number of properties transferred. The original data were compiled monthly and recorded either in the New Zealand Official Year
Book or the (Monthly) Abstract of Statistics.
25
Most of the real price increase occurred in 1950 following the removal of price regulations. A similar increase occurred in Australia
in 1950, for the same reason.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
21
in the average selling price is due to changes in the quality of properties, reflecting larger houses
and the rising share of properties sold in Auckland.
26
The underlying rate of real price
appreciation was probably less than 0.5% per year.
Figure 3: Real Property Prices in New Zealand, 1923 – 2014
From 1962 to 2014, nominal property prices increased by 8.5% per annum, of which 6.0%
was the result of generalized inflation, and 2.4% represents real price appreciation. Property
prices changed quite differently before and after 1990. From 1962 to 1990, prices increased by
11.1% per year, of which 9.7% was the result of inflation and 1.3% represents a real increase,
but from 1990 to 2014 prices increased by 5.7% per year, of which 2.1% was due to inflation
and 3.5% represents a real increase. Most of the real price increase took place after 2000: real
house price increased by 2.5% per year from 1990 to 2000, whereas they increased by 4.2% per
year from 2000 to 2014.
26
When trends in the average selling price are compared with trends in the average quality-adjusted price index over the period for
which both series are available, 1962 to 1985, the average selling price increased by 1.2 percent per year faster than the quality
adjusted index, but otherwise they exhibit very similar trends.
Real house price index for New Zealand
1923- 2014
0
300
600
900
1200
1500
1800
1923
1925
1930
1935
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
Unofficial index based on
average price, not quality
adjusted
RBNZ house price index ,
quality adjusted
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
22
Table 5: Annual average property price increases in New Zealand, 1923 – 2014
House prices 1923 – 2014
Nominal increase
Inflation
Real increase
1923:2 – 1963:2
3.7%
2.2%
1.5%
1962:2 – 1990:2
11.1%
9.7%
1.3%
1990:2 – 2014:4
5.7%
2.1%
3.5%
1975:1 – 1990:2
11.3%
12.2%
-0.8%
1990:2 – 2000:1
4.3%
1.7%
2.5%
2000:1 – 2014:4
6.7%
2.4%
4.2%
Rents, 1975 – 2014
Nominal increase
Inflation
Real increase
1975:1 – 1990:2
13.2%
12.2%
0.9%
1990:2 – 2000:1
4.0%
1.7%
2.3%
2000:1 – 2014:4
1.4%
2.4%
-1.0%
Source: Author’s calculations. The raw data for the period 1923 – 1962 are the average price of urban
properties transferred under the Land Transfer Act using data obtained from the New Zealand Official
Year Book and the Abstract of Statistics published by the New Zealand Department of Statistics. The
data from 1962 – 2014 are a quality adjusted index using data compiled by the Reserve Bank of New
Zealand from Quotable Value. See section 3.1 for more details.
Data on rents are available from Statistics New Zealand for the period 1975-2014.
27
Figure
2 shows the behaviour of real rents and real house prices over this period. From 1975 to 1990,
rents increased at 0.9% per year, while house prices fell by 0.8% per year, with most of the
decline happening in the late 1970s. This means rent/price ratios increased significantly,
peaking in 1991. From 1990 to 2000 rents increased at a slightly lower rate than house prices.
Thereafter there is a decided break in the pattern, as real rents broadly stayed the same but real
house prices sharply increased.
28
It is clear, therefore, that since 2000 changes in the
rent/house-price ratio have been dominated by changes in house prices, not rents.
3.2 International House Price Movements
New Zealand has not been alone in experiencing house price increases since 1990. Table 6
shows real house price changes for 23 OECD countries, using data from the International House
Price Database provided by the Federal Reserve Bank of Dallas, based upon methodology
described in Mack and Martínez-García (2011). The countries include all members of the G-10
(the largest members of the OECD) as well as several smaller countries including Australia,
Denmark, Finland, Ireland, Israel and Norway. The data show the increase in real house prices
between 1975 (when the series begin) and 1990; the increase between 1990 and 1997 (when
27
From 1975 to 1999, the series are CPY.SE9C1, rented dwellings, from the consumer price index. From 1999 onwards the series
is CPI013AA.
28
The decrease in rents that occurred after 2000 largely reflects a decline in public, not private rents.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
23
New Zealand went into a shallow recession associated with the Asian crisis) and between 1990
and 2000; and the increase between 1990 and the end of 2016.
Table 6: International House Price changes, 1975 – 2016
Percentage change in real house prices
1975:1 – 1990:1
1990:1- 1997:1
1990:1 – 2000:1
1990:1 – 2016:3
Australia
46%
-3%
16%
157%
Belgium
24%
22%
41%
120%
Canada
46%
-20%
-15%
106%
Croatia
1%
28%
26%
23%
Denmark
-10%
22%
42%
97%
Finland
61%
-37%
-18%
21%
France
35%
-10%
4%
82%
Germany
1%
1%
-1%
1%
Ireland
24%
31%
128%
176%
Israel
14%
79%
66%
159%
Italy
3%
-16%
-13%
-8%
Japan
51%
-11%
-17%
-47%
Luxembourg
115%
12%
21%
145%
Netherlands
11%
41%
96%
111%
New Zealand
-14%
32%
30%
221%
Norway
12%
3%
25%
138%
South Korea
79%
-37%
-50%
-35%
South Africa
-35%
-21%
-12%
87%
Spain
-35%
-12%
0%
24%
Sweden
-1%
-27%
-7%
112%
Switzerland
51%
-34%
-36%
-2%
U.K.
69%
-19%
8%
104%
U.S.A.
23%
1%
12%
39%
Source: The data used to produce the table are from the International House Price Database produced
by the Federal Reserve Bank of Dallas using methodology described in Mack and Martínez-García
(2011).
The data indicate that many countries experienced large house price increases between
1990 and 2016, with real house prices increasing by more than 100 percent in eleven of the
twenty-three countries, and by more than 50 percent in a further three.
29
Over the full period,
New Zealand experienced the largest price increase, 25 percent higher than the next highest
country. Most of this increase occurred after 2000, particularly after 2010. But New Zealand also
had the fifth largest increases between 1990 and 2000, and the third largest between 1990 and
1997 before the downturn associated with the Asian Crisis took place. In contrast, New Zealand
had the third lowest increase between 1975 and 1990, possibly because real house prices
peaked in 1975, following a large immigration influx, before falling between 1977 and 1980 in
response to high emigration.
Of course, these data do not show that the reason for New Zealand’s large increase in
house prices since 1990 is the 1989 tax change. There are many possible explanations for the
29
It is widely believed these increases reflect the steep decline in interest rates that occurred after 1990, although prices did not
increase everywhere, falling in Italy, South Korea and Japan.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
24
house price increase, of which tax changes are but one. They do indicate, however, that the price
increase has been large and persistent by international standards.
3.3 Interest rates, rents, and house prices.
An implication of the analysis in section 2 is that when rent/price ratios are set relative to the
returns available from interest earning debt, they should reflect the difference between real
interest rates and the expected rate of house price inflation, adjusted for a term that reflects the
tax on the inflation component of interest rates:
(1 )( ) ( )
1
R
t
h h h
t
P
r
P
(14)
If real interest rates are unrelated to the expected inflation rate or the expected real rate of
house price increase, a matter discussed below, the rent/price ratio should be a linear function
of the real interest rate, falling when real interest rates fall and rising when real interest rates
rise.
Figure 4: Rent/House-price ratio versus real mortgage rates 1975- 2014
The blue-circle line traces the path of real interest rates and the rent/house-price ratio, 1975-1990. The
red-square line traces the path from 1990 – 2015.
Rent/price ratio vs real mortgage rate
1975-2014
400
600
800
1000
1200
1400
1600
1800
-8.0% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%
real interest rates
rent/price ratio (index)
1975
1980
1985
1990
1995
2000
2005
2010
2014
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
25
Figure 4 shows a ‘linked scatter plot’ of the relationship between real mortgage rates and
the rent/price ratio from 1975 to 2014.
30
The figures dispel the hypothesis that there was a well-
defined positive correlation between real interest rates and the rent/price ratio over the whole
period. Rather, the rent/price ratio was broadly constant between 1975 and 2000, even though
real interest rates varied between –6% and 12%. After 2000, the rent/price ratio dropped
sharply, in a manner little related to real interest rate movements. It is worth noting that the
timing of the decrease in the rent/price ratio coincides with an increase in the top marginal tax
rate from 33% to 39%, an increase that widened the after-tax wedge between the returns
available from property and interest earning debt.
31
A very similar picture is obtained when the
real deposit rate is used instead of the real mortgage rate. The lack of a relationship between the
rent/price ratio and real (or nominal) interest rates is confirmed by regression analysis. Simple
regression analysis shows that the rent/price ratio and the real interest rate both appear to be
described by unit root processes, but the two variables are not cointegrated, either over the full
period or the period since 1990. As such, any linear relationship between the series is spurious.
(See Appendix 2 for the details of these results.
32
)
These data raise considerable doubts about the extent that trends in house prices and
rents since 1975 can be explained by real mortgage rates. There are at least three possible ways
to rehabilitate the theory. The first is to observe that a linear regression between the rent/price
ratio and the real interest rate will be mis-specified if variables which affect the rent/price ratio
and which are correlated with the real interest rate series are omitted from the regression. The
two obvious variables are the expected rate of real house price inflation, and the expected
inflation rate (see equation 12). Unfortunately, series measuring the expected rate of real house
price appreciation or the expected rate of inflation amongst landlords are not available. It is of
course possible to use proxies. Landlords may have lagged expectations, for example, and expect
the future rate of real house price increases (and the expected rate of general inflation) to be
equal to past rates: perhaps the rate over the previous year or the average rate over the
preceding three years. These proxies can be used in a regression, but these are unlikely to be
accurate unless it known for sure that expectations are determined in this manner. For example,
if
3h
t
= the average real house price appreciation rate over the preceding three years, and
3
t
=
30
The house price and rent series are described in footnotes24 and 27. Nominal mortgage interest rate data are sourced from the
Reserve Bank table hb2. From 1975 to June 1998, the floating mortgage rate is used. From September 1998, the mean of the floating
rate and the 2 year rate are used. The nominal interest rate is converted into a real interest rate by deflating the inflation rate. At
time t, the inflation rate is the annual average change in the CPI from t-4 to t+4 i.e. an average of the backward looking and forward
looking inflation rate. For 2014, it is assumed the forward inflation rate is 1% pa.
31
The tax rate was increased to 39% in 2000 and progressively reduced back to 33% beginning in 2010.
32
For the period 1975 to 2014 the sample correlation coefficient between real interest rates and the real house price index is 0.10,
while for the sub-period 1990 to 2014 the correlation coefficient is 0.64 .The sample correlation coefficients are deeply misleading
as a linear regression between the rent/price ratio and the real interest rate is spurious. For either the full period or the sub-period
it is not possible to reject the hypothesis that the rent/price ratio and the real mortgage rate have unit roots; but it is possible to
reject the hypothesis that the two series are cointegrated. These regressions are reported in Appendix 2.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
26
the average inflation rate over the preceding three years, it is not possible to reject the
hypothesis that the residuals e
t
of the following equation
33
0 1 2 3
P
3
R
h
t
t t t t
t
re
P
(15)
have a unit root and thus that there is no long-run linear relationship between the variables.
33
34
(See Appendix 2 for details.)
The failure to find a relationship between the rent/price ratio and real interest rates when
these and similar proxies for expectations are included in the regression suggests one of two
alternatives. First, it could be that expectations of future real house price changes cannot be
described by lagged expectations. A better measure of expectations is needed to explain the
evolution of rent/price ratios in the last 40 years. Secondly, the relative size of the after-tax
returns from rental housing and interest earning debt may not be an important determinant of
rent/price ratios. Some other factor is important, particularly since 2000. It is possible, for
example, that the increase in the top marginal tax rate to 39% between 2000 and 2010 may have
changed attitudes towards property ownership and investment and sparked a revaluation of
house prices, although this theory cannot adequately explain why property prices remained high
after taxes were reduced in 2010.
The second explanation for why a linear relationship between rent/price ratios and real
interest rates has not existed since 1975 is based on the observation that New Zealand had
tightly controlled credit markets prior to 1985. It is plausible that any relationship between real
interest rates and the rent/house-price ratio would hold only after 1990, once credit markets
had been deregulated and inflation had been reduced to low levels. However, as indicated above,
it cannot be established that there was a linear relationship between the two variables in the
period since 1990 either. There was relatively little variation in rent/price ratios between 1990
and 2000 despite considerable falls in real interest rates; there was a steep decline in rent/price
ratios between 2000 and 2010 despite relatively little variation in real interest rates; and there
was little variation in rent/price ratios from 2010 to 2014 despite variation in real interest rates.
A third explanation for the weak relationship between real interest rates and rent/price
ratios is based on the argument that nominal rather than real interest rates are the key
determinant of property prices because when people are credit constrained they are affected by
nominal rather than real interest to income repayment ratios.
35
The sample correlation
coefficients between nominal interest rates and real house prices are 0.10 for the whole period
33
The hypothesis cannot be rejected for either the whole period 1975 to 2014 or the sub-period 1990 to 2014.
34
The failure to show there is a long-run relationship between the rent/price ratio and either the real interest rate or the lagged
change in property prices does not mean that there is not a short run relationship. Since changes in real house prices are serially
correlated, such a relationship does exist: price increases or price decreases tend to occur in runs. This issue is also discussed in
Appendix 2.
35
This argument was made in the 1970s by Modigliani (1976) and Kearl (1979) among others
.
.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
27
and 0.57 for the period 1990 to 2014, but once again these correlation coefficients are
misleading as the regressions are spurious.
What can be concluded? Real interest rates clearly affect the relative returns from
investing in rental properties and interest earning debt. However, these relative returns are not
systematically related to rent/price ratios in any simple manner. Some other factor is needed to
explain the pattern of rent/price ratios since 1990.
3.4 The size of new residential housing construction.
Internationally, there is almost no systematic analysis of the size of new residential construction.
Figure 5 traces the size of newly constructed residential houses in Australia, New Zealand, and
the United States, the three countries for which data are available.
36
(New houses in all three
countries are now considerably larger than houses in European countries.
37
) These data show
the average size of newly constructed houses increased steadily between 1980 and 2010 in all
three countries, and that new houses in the U.S. and Australia have been consistently larger than
new houses in New Zealand.
Figure 5: Average new house size, Australia, New Zealand and the United States, 1974-2014. Square
metres.
36
New Zealand data are from Statistics New Zealand, “Number, value and floor area by building type, nature and region”
BLD075AA. Australian data are from the Australian Bureau of Statistics, “Building Approvals” February 2010 8731.0 (The series
is no longer produced.) U.S data from 1999 are from http://www.census.gov/construction/chars/completed.html spreadsheet "
SFForSaleMedAvgSqFt". Earlier data are from http://www.census.gov/construction/chars/historical_data/ . This site has a
series of books with the data e.g. US Department of Commerce (2000) "Characteristics of New Housing 1999".
37
International data are not regularly compiled. The BBC reported some statistics in 2009.
http://news.bbc.co.uk/2/hi/uk_news/magazine/8201900.stm Similar data are available from Demographia
http://www.demographia.com/db-intlhouse.htm. Both sources suggest average house sizes in European countries
range from 76m
2
in the United Kingdom to 137m
2
in Denmark.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
28
Figure 6 shows the same data, but with each country’s house size normalised to equal 100
in 1989. The figure shows that the size of newly constructed housing was stable in New Zealand
from 1980 to 1989, at which point it increased sharply. (Between 1974 and 1979 newly
constructed houses were very small, reflecting various regulations that artificially reduced the
average size of new buildings.
38
) The rate of increase in New Zealand after 1989 is much higher
than in either Australia or the United States.
Figure 6: Average new house size, Australia, New Zealand and the United States,
1974-2014. Indices normalized with 1989 = 100
38
There were two different regulations. Due to the large scale immigration that took place between 1973 and 1975, people applying
for a building permit in excess of 1500 square feet (125 m
2
) were automatically delayed by 18 months. This regulation was rescinded
following the mass emigration to Australia beginning 1976. Secondly, the government offered concessional loans to young first
home buyers so long as they built or purchased a new home. This raised the demand for new houses by young, credit constrained
households; these houses tend to be small. The requirement that people could only use concessional loans to purchase new homes
was rescinded on March 15 1979.
100
120
140
160
180
200
220
240
260
1974 1979 1984 1989 1994 1999 2004 2009 2014
square metres
USA: single houses
New Zealand: all
dwellings
Australia: all dwellings
Australia: single houses
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
29
The relationship between the average quality of newly constructed houses and incomes,
interest rates and tax rates is conceptually complex. As incomes increase, there will be an
increased demand for better quality houses and a reduced demand for lesser quality houses.
This means there will be a mismatch between the distribution of two stock variables: the desired
quality distribution and the existing quality distribution. It can be expected that new
construction and alterations will take place to reduce the mismatch at each quality level.
However, there is no obvious reason why there would be a constant relationship between the
amount of new construction at different quality levels and explanatory factors such as income,
as the relationship will depend on the initial stock as well as the desired stock. Nor is it clear
which quality level will be most profitable to build first if there are large changes in explanatory
variables. All this means that the average size of new houses should be positively related to per
capita incomes and inversely related to real interest rates, but there is no reason why the
relationship should be linear.
Figure 7 shows a scatter-plot tracing the relationship between real mortgage rates and the
average floor size of new dwellings between 1975 and 2014.
39
For the post 1991 period, it
appears that there is a negative correlation between real mortgage rates and the average size of
building permits size, but from 1975 to 2014 the relationship appears rather weaker. These data
suggest that any attempt to find a consistent relationship between house sizes and real interest
39
Nominal mortgage interest rate data are sourced from the Reserve Bank table hb3. From September 1998, the preferred series is
the mean of the floating rate and the 2 year rate. From 1975 to June 1998, the fixed rate series is not available and the floating
mortgage rate is used instead. The nominal interest rate is converted into a real interest rate by deflating the inflation rate. At time
t, the inflation rate is the annual average change in the CPI from t-4 to t+4 i.e. an average of the backward looking and forward
looking inflation rate. For 2014, it is assumed the forward inflation rate is 1% pa.
50
75
100
125
150
175
1974 1979 1984 1989 1994 1999 2004 2009 2014
New Zealand: all
dwellings
Australia: single houses
USA: single houses
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
30
rates using all of the data from 1975 to 2014 will not be successful, although there is an apparent
negative correlation after 1989.
Figure 7: Average building permit size versus real mortgage rates , 1975-2014
The blue-circle line traces the path of real interest rates and the rent/house-price ratio, 1975-1990. The
red-square line traces the path from 1991 – 2015.
Can the increase in the average size of newly constructed housing beginning in 1989 be
explained by the subsequent changes in income and interest rates? In a Scottish court, the
answer would probably be “Not Proven.” Using data from 1989 onwards, there is clearly a
positive correlation between the average size of new construction and per capita incomes, and a
negative correlation with real interest rates. The problem is that interest rates have a
downwards trend for the whole period, while building size and per capita incomes have an
upward trend. Once the trends are accounted for, it is not possible to be sure that the
relationships are not spurious. Formally, when each of the three series have a unit root, testing
whether the average size of new construction is a linear function of incomes and real interest
rates is equivalent to testing whether the three series are cointegrated. Using data from 1989 to
2014 it is not possible to reject the hypothesis that the series are not cointegrated. (The results
are presented in Appendix 2.) Consequently, it is not possible to conclude statistically that the
increase in the average size of new construction since 1989 is due to the decrease in interest
rates and the increase in incomes taking place since then. Some additional explanation is needed.
Average floor size of new construction vs real interest rates
1975-2014
100.0
120.0
140.0
160.0
180.0
200.0
220.0
-8.0% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0%
real interest rates
1975-1979
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
31
3.5 Summary
What can be concluded from post 1989 housing market data? Relative to pre-1989 trends, there
has been a substantially faster increase in property prices, a substantial decline in rent/price
ratios, and a large increase in the average size of new houses. These changes are all consistent
with the change in the incentives that followed the great income tax experiment of 1989. Most of
them are also consistent with the decline in real interest rates, the reduction in inflation, and the
increase in per capita incomes that have taken place since then. Unfortunately, the statistical
relationships between the rent/price ratio and real interest rates, and between the average size
of newly constructed houses and real interest rates and incomes are too imprecisely estimated
to know how much these factors explain the changes in the housing market. For this reason, it is
not possible to estimate the residual role of the tax changes either, at least using aggregate data.
This means the data neither prove nor disprove the contention that the changes in incentives
that followed the changes to the tax system were actually responsible for the subsequent change
in the housing market.
4 Taxes and Housing Markets: Distributional Effects.
Non-neutral taxes on property have two types of distributional consequences. First, taxes
redistribute income between members of a cohort, for if tax revenues are not obtained by taxing
the capital income produced by housing they must be obtained by taxing someone or something
else. Secondly, non-neutral taxes redistribute income between cohorts, because property prices
– particularly the land component of property prices – change. When housing is tax advantaged,
land prices increase and the first generation of land owners receives a transfer at the expense of
all subsequent generations.
The theoretical literature examining the intergenerational consequences of non-neutral
taxes on property income began with Feldstein (1977). He showed that in most circumstances a
tax on land rent in a closed economy will not only reduce the price of land but will lead to a long
run increase in the capital stock. This is because young agents will have to spend less of their
savings buying land, enabling them to invest more in businesses and assets.
40
Conversely, if
land incomes are under-taxed relative to capital incomes, land prices will rise and long term
capital accumulation will decrease.
41
Chamley and Wright (1987) analysed the dynamic
properties of Feldstein’s closed economy model, also finding that taxes on property income
40
The increase in capital should increase the marginal product of land, raising the pre-tax return from land. In some circumstances,
the reduction in interest rates stemming from the greater capital levels can lead to a long run increase in the price of land, as total
production in the economy increases.
41
Calvo, Kotlikoff and Rodriguez (1979) show that the latter result will be not hold if each generation of landowners
bequeath to the subsequent generation a sum equal to the increase in land prices that stems from the concession tax
treatment of land.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
32
usually resulted in an increase in capital investment and a decline in land prices.
42
Eaton (1988)
extended this analysis by examining the effect of property income taxes in a small open
economy. He showed land prices would unambiguously fall, since interest rates were
determined in international markets, and the long run net asset position of the country would
improve as additional local savings replaced foreign savings.
In each of these cases, an intergenerational transfer takes place at the time the tax change
is introduced. If taxes on property income are increased, the first generation of land owners is
worse off as the price of land declines. The welfare consequences for subsequent generations
depend on what happens to the tax revenues that are raised. If they are refunded to
contemporaneous generations, all of these generations will be unambiguously better off as they
pay the same total amount in taxes but have to pay less for land. These generations will also be
better off if the government uses the tax revenue to purchase valued goods and services. In both
of these circumstances, standard economic theory indicates the discounted value of the gains by
subsequent generations is equal to the losses of the first generation. These conditions need not
hold if the tax revenue is wasted. Moreover, as Fane (1984) showed, if the government issued
bonds to compensate the first generation for their land price loss, there would be no gain to
subsequent generations if the subsequent tax revenues were used to pay interest on the bonds.
In contrast, if taxes on property income decrease, the first generation of land owners
would be better off as their land prices would increase. All subsequent generations would be
worse off as they would have to pay higher prices for land while still paying the same total
amount in taxes. Skinner (1996) specifically analysed the case of capital income from residential
property. He showed that when other forms of capital income were taxed more heavily than
housing, the price of housing increases, which, (in the absence of altruistic bequests) leads to
higher consumption by the first generation and lower capital accumulation and consumption by
all other generations. He argued that this intergenerational shift is the most important
consequence of taxing housing and other forms of capital asymmetrically. Gervais (2002)
examined how the tax code affects the housing market and capital accumulation when property
prices do not change. He argued that favourable tax treatment – particularly the non-taxation of
imputed rent – generates an incentive to purchase better quality houses, leading to higher
residential investment but lower business investment. He argued that the elimination of the
housing tax concessions would raise welfare in the long run. More generally, Batina and Ihori
(2000) analysed how the incidence of various combinations of income and consumption taxes
affects land prices and residential property stocks, finding generally similar results, although
they also showed that the incidence of the tax depend on details of the tax system such as
whether or not housing maintenance expenses are subject to consumption taxes.
42
However, they also showed that land prices could increase if interest rates fell sufficiently low, but that the total value
of any increase in land prices would be less than half of the tax revenue raised.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
33
The results of this literature strongly suggest that the distributional effects of New
Zealand’s non-neutral taxes on residential housing not only depend on the direct effects of the
taxes but also on the indirect effects stemming from changing land prices. It is thus necessary to
distinguish between the short run distribution effects of a tax, those that occur before property
prices change, and the long run effects that incorporate changes in land prices. To do this
analysis properly requires a full model in which land prices adjust in response to taxes, and in
which there are agents who differ by income, home-ownership status, and, if they own, the
extent they are mortgaged. The models also have to take into account the way any tax additional
taxes are raised or refunded. Typically these models can only be solved under simplifying
assumptions; for example, Coleman (2010) examines the effect of introducing a capital gains tax
under the assumptions that there are only two classes of property, that there is no population
growth, and that all households accurately anticipate future house prices and rents.
This paper does not calculate the distributional effects of the taxation of property income
in a full general equilibrium model. Rather, it focuses on the key distribution features of
property income taxes by providing a series of numerical examples that capture the key short
run and long run effects. The first example shows the effect of exempting imputed rent and
capital gains from tax within an income tax system.
4.1 Income taxes, housing markets, and distribution
What are the distributional effects of moving from a neutral income tax system to one in which
imputed rent and capital gains are exempt from tax?
43
Two scenarios are presented. To highlight
the effects of exempting imputed rent from tax, the first scenario assumes there is no ongoing
change in property prices, although prices can change in response to taxes. To demonstrate the
additional effects of exempting capital gains from tax, the second scenario assumes property
prices increase 1% per year. In each example four tables are presented. The first table shows
rents, capital incomes, and prices when there are no taxes. The second shows the effects on
renters, landlords, lenders and three classes of owner-occupiers (those with 0%, 50% and 100%
equity) when the income tax system is neutral. The third table shows what happens when
capital gains and imputed rents are exempt from tax, assuming the price of property is
unchanged. The last table shows what might happen to future generations, when property prices
have adjusted upwards by $100,000 in response to the tax changes, but the rate of capital gains
continues at either 0% or 1% per annum. The last table is illustrative; for while prices and rents
43
If the tax system were neutral with respect to property, (i) rental income net of depreciation, interest costs, repairs
and maintenance, and property taxes would be taxed; (ii) the imputed rent earned by owner-occupiers, net of
depreciation, interest costs and property taxes would be taxed; and (iii) capital gains would be taxed on an accrual
basis.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
34
are adjusted so that landlords make the same return as they would from lending money, the
marginal returns from lending and from investing in larger houses are not equated.
44
4.1.1 Exempting imputed rent from tax when property prices are stable.
Table 7a shows outcomes when there are no taxes. The annual benefits provided by housing are
valued at $22,000; rent and imputed rent are set equal to $20,000, providing a consumer surplus
of $2,000; interest rates are 5%; and the price of a house is assumed to be $400,000.
45
In these
circumstances a household with $400,000 will be indifferent between owning their own home,
or renting and either investing in interest earning debt or becoming a landlord.
Table 7b shows what happens when a neutral income tax system is introduced, with an
income tax rate of 30%. It is levied on rents or imputed rent net of other costs including interest
costs and property taxes. Rents are set at a level that mean the after-tax return to the landlord is
the same as if they earned interest on the price of a house. To reflect current practice in New
Zealand, a $2,000 property tax is also imposed on properties; this tax is separate from the
income tax, and does not alter its distributional neutrality in the sense that the incidence of the
tax falls equally on owner-occupiers and renters. To reflect the effect of the property tax, rents
are set at $22,000.
If a tax system is neutral, the relative returns to a landlord and a lender with equal capital,
and the financial returns to a person choosing either to own or rent and lend their equity, should
not depend on the tax rate. In Table 7b the tax system is neutral and has no effects on house
prices, but owners of capital have lower after-tax incomes as they pay tax. In column 1, the
renter gets $22,000 value from renting the house, but as rent is $22,000 their net value is zero.
Similarly in column 4 an owner-occupier with zero equity gets $22,000 value from owning the
house but pays $20,000 in interest and $2,000 in property taxes. They pay no income tax. In
columns 2, 3, 6, a person with $400,000 gets the same return from becoming a landlord, from
being an owner-occupier, or from lending the money. Note that in column 6 the owner-occupier
has to pay $6,000 tax to the government every year on their imputed rent. In column 5 an owner
occupier with $200,000 equity in their house pays $3,000 tax on their net equity position and is
left with $7,000 after paying tax.
Table 7: The effect of not taxing imputed rent in an environment without capital gains
Scenario
Cost/ return
1.Renter
(0%
equity)
2.Landlord
(100%
equity)
3.Lender
of
$400,00
0
4. Owner
occupier
(0%
equity)
5. Owner
occupier
(50%
equity)
6. Owner
occupier
(100%
equity)
Table 7a. No taxes: house price = $400,000 with no capital appreciation
44
The table is calculated under the assumption that landlords make the same returns from leasing property as they would from
lending money. In practice, they normally demand an additional premium to reflect the risks undertaken. These risk premiums could
be incorporated into the analysis without changing the qualitative results, but have been omitted for simplicity.
45
In general the value of housing services will be greater than the value of rent, or else people will not use the house. The numbers
are chosen to make comparisons easy when taxes are imposed, but none of the results are affected by the choice of numbers.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
35
Housing services
$22,000
$0
$0
$22,000
$22,000
$22,000
Rent/interest earning
$20,000
$20,000
Rent/interest cost
-$20,000
$0
$0
-$20,000
-$10,000
$0
Property Tax
$0
$0
$0
$0
Tax
$0
$0
$0
$0
$0
$0
Capital gain
$0
$0
$0
$0
$0
$0
Tax
$0
$0
$0
$0
$0
$0
Net return/ cost after
tax
$2,000
$20,000
$20,000
$2,000
$12,000
$22,000
Table 7b. Imputed rent is taxed (and interest payments on a mortgage are deducted): house price =
$400,000 with no capital appreciation.
Housing services
$22,000
$0
$0
$22,000
$22,000
$22,000
Rent/interest earning
$22,000
$20,000
Rent/interest cost
-$22,000
$0
$0
-$20,000
-$10,000
$0
Property Tax
-$2,000
-$2,000
-$2,000
-$2,000
Income Tax
$0
-$6,000
-$6,000
$0
-$3,000
-$6,000
Net return/ cost after
tax
$0
$14,000
$14,000
$0
$7,000
$14,000
Table 7c. Imputed rent is exempt from tax (and interest is not deducted): house price = $400,000, with no
capital appreciation.
Housing services
$22,000
$0
$0
$22,000
$22,000
$22,000
Rent/interest earning
$22,000
$20,000
Rent/interest cost
-$22,000
$0
$0
-$20,000
-$10,000
$0
Property Tax
-$2,000
-$2,000
-$2,000
-$2,000
Income Tax
$0
-$6,000
-$6,000
$0
$0
$0
Net return/ cost after
tax
$0
$14,000
$14,000
$0
$10,000
$20,000
Table 7d. Imputed rent is exempt from tax (and interest is not deducted): house price = $500,000, with no
capital appreciation.
Scenario
Cost/ return
1.Renter
(0%
equity)
2.Landlord
(100%
equity)
3.Lender
of
$500,00
0
4. Owner
occupier
(0%
equity)
5. Owner
occupier
(50%
equity)
6. Owner
occupier
(100%
equity)
Housing services
$22,000
$0
$22,000
$22,000
$22,000
Rent/interest earning
$27,000
$25,000
Rent/interest cost
-$27,000
$0
$0
-$25,000
-$12,500
$0
Property Tax
-$2,000
-$2,000
-$2,000
-$2,000
Income Tax
$0
-$7500
-$7,500
$0
$0
$0
Net return/ cost after
tax
-$5,000
$17,500
$17,500
-$5,000
$7,500
$20,000
Source: Author’s calculations.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
36
Table 7c shows what would happen if the government exempted imputed rent from tax, if
property prices did not change. This change has four main effects. First, the government would
lose tax revenue. If it increased income taxes to make up the lost revenue, renters, landlords and
lenders would pay more income tax but get no advantage from the tax exemption and so will be
worse off; but owner-occupiers as a class would be better off as their tax cuts would be larger
than their income tax increases.
46
Secondly, the tax advantage means renters with some equity
will try and become owner-occupiers to take advantage of the tax exemption. If property prices
did not change, a renter with a $200,000 deposit will gain $3,000 per year from becoming an
owner-occupier (the difference between column 1 plus half of column 3 and column 5). This
would lead to an increase in owner-occupancy rates. Thirdly, owner-occupiers with surplus
funds will have an incentive to build and buy bigger houses, because the additional benefits they
get from these houses are not taxed. As a consequence, the size and quality of the owner-
occupied housing stock should increase. Lastly, owner-occupiers will have an incentive to move
to locations that are conveniently located to desirable amenities, because these benefits are also
exempt from tax. Since the supply of conveniently located land is largely fixed, this will increase
land prices and provide a one-off capital gain to existing owners of land.
Table 7d shows the effect of exempting imputed rents on subsequent generations under
the assumption that prices are bid up to $500,000. Since the characteristics of the property do
not change, the annual value of living in the house remains the same. In aggregate, the increase
in house prices must make subsequent generations (and the first generation of renters) worse
off, assuming the government increases other taxes to offset the loss of revenue from exempting
imputed rent from tax. In aggregate, these generations face an annual loss equal to the interest
rate multiplied by the change in house prices, as they will pay the same in taxes, but will have to
pay more to rent or purchase property. This loss is not evenly shared, however.
a) The next generation of landlords and lenders will make the same after-tax percentage
returns, so they will be in an unchanged position.
47
Landlords will only make the same
returns if they increase rents to cover the higher property prices, which means rents will
increase by $5,000.
48
b) Renters will be worse off than previously. Rents will increase but the value renters will
get from the house will be the same. They also will be paying higher income taxes than
46
About one third of houses in New Zealand are owned without a mortgage, and another third are owned with a mortgage. If the
size of these mortgages was uniformly distributed, this means the government would lose tax revenue of half the imputed rent tax
levied on an average house – or $3,000 per household in this example. In practice the loss is larger as the houses owned by owner-
occupiers are larger on average than those owned by renters.
47
Table 7d has higher earnings than Table 7b or Table 7c as the amount lent has increased from $400,000 to $500,000.
48
Note that this sentence is simply a statement of equation 10, which states that landlords will only enter the property market if
they make a return similar to that which they expect elsewhere. Even though rents and prices are determined simultaneously in the
market, equation 10 will hold so long as landlords participate in the market, in which case house prices will equal the expected
present value of future rent streams. In this section it is assumed that property prices increase and therefore that rents must increase
if landlords are to participate in the market; in more complete models such as Coleman (2010), rents and house prices are determined
simultaneously subject to the landlord participation constraint.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
37
they would if imputed rent were taxed. They will have an incentive to become owner-
occupiers, but if they are restricted in the amount they can borrow, they will be renters
for longer as it takes them longer to save a deposit to purchase a property (Coleman
2010).
c) New generations of owner-occupiers will be worse off than in scenario 7c, as they will
have to pay more for property. The effects on their welfare relative to the neutral tax
regime are ambiguous, for while income taxes will increase and they will pay more for
property than they otherwise would have paid, they will not pay tax on imputed rent. If
all members of the new generation become owner-occupiers, they will be worse off, as
they will pay more for property and their total tax bill will be the same.
Overall, the extent that some members of subsequent generations will be better off by the
tax change will depend on how much house prices increase and how the income tax increase is
distributed. Renters will almost certainly be worse off relative to a neutral tax regime,
suggesting the shift from a neutral tax regime will be regressive if renters have lower average
incomes than owner-occupiers.
4.1.2 Exempting imputed rent and capital gains from tax when property prices
appreciate.
In the second scenario, the value of housing and property prices is assumed to increase at 1%
per annum, and the starting level of house prices is increased to $500,000 to reflect the higher
discounted value of rents.
Table 8a shows the outcomes when there are no taxes and
Table 8b shows the results of a neutral income tax system in which imputed rents, rents, and
capital gains are taxed. The rent/property price and imputed rent/property price ratios are less
than 5 % per annum due to the capital appreciation that property owners obtain.
When capital gains and imputed rents are both exempt from tax, landlords as well as
owner-occupiers pay less tax, but other tax rates increase. Competition between landlords to
obtain these gains leads to a reduction in the rent/price ratio, either through a reduction in rents
(if the supply of houses is elastic) or through an increase in prices (if it is not). If property prices
do not change, rents are reduced until the after tax-return from being a landlord equal those
obtained from lending and the benefits from eliminating capital gains taxes are transferred to
renters. The reduction in rents makes renters better off relative to low-equity owner-occupiers,
and reduces the incentive of people with low equity to become owner-occupiers. Consequently,
lenders and landlords are unambiguously losers from the tax change if property prices do not
change, as they face higher other taxes. The effects on other groups are ambiguous, and depend
on the size of capital gains relative to the value of imputed rent.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
38
Table 8: The effect of not taxing imputed rent in an environment with capital appreciation but no capital
gains tax.
Scenario
Cost/ return
1.Renter
(0%
equity)
2. Landlord
(100%
equity)
3.Lender
of
$500,00
0
4.Owner
occupier
(0%
equity)
5.Owner
occupier
(50%
equity)
6. Owner
occupier
(100%
equity)
Table 8a. No taxes: house price = $500,000 and increases at 1% per year
Housing services
$22,000
$0
$0
$22,000
$22,000
$22,000
Rent/interest earning
$20,000
$25,000
Rent/interest cost
-$20,000
$0
$0
-$25,000
-$12,500
$0
Property Tax
$0
$0
$0
$0
Income Tax
$0
$0
$0
$0
$0
$0
Capital gain
$0
$5,000
$0
$5,000
$5,000
$5,000
Capital Gain Tax
$0
$0
$0
$0
$0
$0
Net return/ cost after
tax
$2,000
$25,000
$25,000
$2,000
$14,500
$27,000
Table 8b. Imputed rent and capital gains are taxed: house price = $500,000 and increases at 1% per year
Housing services
$22,000
$0
$0
$22,000
$22,000
$22,000
Rent/interest earning
$22,000
$25,000
Rent/interest cost
-$22,000
$0
$0
-$25,000
-$12,500
$0
Property Tax
-$2,000
-$2,000
-$2,000
-$2,000
Income Tax
$0
-$6,000
-$7,500
$1,500
-$2,250
-$6,000
Capital gain
$0
$5,000
$0
$5,000
$5,000
$5,000
Capital Gain Tax
$0
-$1,500
$0
-$1,500
-$1,500
-$1,500
Net return/ cost after
tax
$0
$17,500
$17,500
$0
$8,750
$17,500
Table 8c. No imputed rent or capital gains tax – house price: $500,000 and increases at 1% per year
Housing services
$22,000
$0
$0
$22,000
$22,000
$22,000
Rent/interest earning
$19,857
$25,000
Rent/interest cost
-$19,857
$0
$0
-$25,000
-$12,500
$0
Property Tax
-$2,000
-$2,000
-$2,000
-$2,000
Tax
$0
-$5,357
-$7,500
$0
$0
$0
Capital gain
$0
$5,000
$0
$5,000
$5,000
$5,000
Capital Gain Tax
$0
$0
$0
$0
$0
$0
Net return/ cost after
tax
$2,143
$17,500
$17,500
$0
$12,500
$25,000
Table 8d. No imputed rent or capital gains tax: house price = $600,000 and increases at 1% per annum
Housing services
$22,000
$0
$0
$22,000
$22,000
$22,000
Rent/interest earning
$23,428
$30,000
Rent/interest cost
-$23,428
$0
$0
-$30,000
-$15,000
$0
Property Tax
-$2,000
-$2,000
-$2,000
-$2,000
Tax
$0
-$6,428
-$9,000
$0
Capital gain
$0
$6,000
$0
$6,000
$6,000
$6,000
Tax
$0
$0
$0
$0
Net return/ cost after
tax
-$1,428
$21,000
$21,000
-$4,000
$11,000
$26,000
Source: Author’s calculations.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
39
If property prices increase in response to the tax change, renters will be worse off as they will
experience higher other taxes without obtaining lower rents. In these circumstances, renters
with some equity have an incentive to become owner-occupiers, to take advantage of the tax
exemption on imputed rents and capital gains. Moreover, both landlords and owner-occupiers
have an incentive to bid up the price of land, providing a one-off capital gain to people who own
land at the time the tax cuts are introduced.
Table 8d shows the effect on subsequent generations, assuming that base level prices
increase to $600,000 in response to the incentives for households and landlords to bid up
property prices. Prices are still assumed to appreciate at 1% per year, and landlords make the
same after-tax returns from property as if they were lenders. There are three main effects.
First, rents will increase by less than the increase in house prices. As landlords are willing
to accept low rents so they can obtain tax-free capital gains, rents could even fall in absolute
terms, although they might increase because of the higher property prices.
Secondly, even ignoring the increase in other taxes which also makes them worse off, first
home owners with little equity are likely to be worse off than when taxes are neutral, because
the rise in house prices increases their interest costs by more than they gain from the tax
reductions. In contrast, the biggest winners - or the smallest losers - are those with high equity
stakes in owner occupied houses. Their after-tax returns may increase because of the tax
reduction even though they have spent more on their houses,. When the increase in other taxes
is taken into account, it is possible that owner-occupiers with high equity lose out – and if all
households become high equity owner-occupiers it is certain they will be worse off.
Thirdly, future generations collectively face a loss from the tax changes to the first
generation of property owners. Overall they pay similar amounts of tax to government, for the
reductions in property taxes are offset by increases in income taxes. However, they pay higher
prices for their properties. This leads to an overall loss of income equal to the interest rate on
the higher property prices.
4.1.3 The distribution effects of taxing imputed rents and capital gains.
Table 7 and
Table 8 show the effects of exempting imputed rent and capital gains from tax. By reversing the
chain of logic, if New Zealand decided to tax imputed rents and capital gains, with the revenue
rebated by cutting other taxes, the following distributional effects are likely.
a) The first generation of owner-occupiers with large equity positions will be worse off, as
they will pay more in imputed rent taxes than they gain from lower other taxes.
b) The effect on the first generation of renters is ambiguous. To the extent that capital gains
taxes are artificially keeping rents low, they will be worse off; to the extent that they pay
less in other taxes they will be better off.
c) There will be a decrease in land prices.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
40
d) There will be less incentive to build large or high quality houses, as imputed rent will be
taxed.
e) In the long term, new generations of renters are likely to be better off as they will pay
lower rents for the same quality rentals and other taxes will be lower.
f) In the long term, new generations of owner-occupiers will be in a mixed position to the
extent that they have lower income taxes and pay less for property, but have to pay tax
on imputed rent. Owner-occupiers with little equity are likely to gain more than owner-
occupiers with high equity.
g) In the long term, new generations overall will be better off, as they have the same total
tax bills but pay lower prices for land and for rent. The flow of gains is equal to the size of
the land price decrease multiplied by the interest rate. The original owners of the land
will suffer a loss equal to the discounted sum of the gains of all subsequent generations, a
loss that reflects the removal of tax concessions that artificially raise land prices.
The distributional results from simply imposing an imputed rent tax are clearer, as in this
case there would be no effect on short run rents and long run rents would decline in line with
the decline in property prices.
These results beg the question: if New Zealand currently taxed imputed rent, would there
be much demand to change the tax system? There is likely to be a political demand from the first
generation of owner-occupiers to exempt imputed rent from tax, as they would gain from
reducing the neutrality of the tax system, as they gain a tax break in the short run and an
increase in property prices in the long run. However, such a move would be regressive, if renters
are poorer than owner-occupiers, and would introduce distortions that lead to houses that are
too large and land prices that are too expensive. It would also reduce living standards in the long
run, by raising the price of property. Given these effects, it would be difficult to recommend such
a policy unless the administrative costs of taxing imputed rent and capital gains were extremely
high.
4.2 Expenditure taxes, housing markets, and distribution
The distributional effects when capital income from sanctioned retirement accounts is taxed on
an expenditure basis and capital gains and imputed rent are not taxed are complex as the tax
system lacks a coherent intellectual basis. The tax system is not neutral overall, not just because
owner-occupied housing and investments in sanctioned retirement schemes are taxed on an
expenditure basis whereas other asset classes including leased residential property are taxed on
an income basis, but also because the failure to tax capital gains means debt instruments held
outside retirement accounts are further disadvantaged. Moreover, most countries limit the
amounts that can be deposited in retirement schemes that are taxed on an expenditure basis.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
41
Since most people do not face binding limits on the amounts they can place in sanctioned
retirement accounts, at the margin they face a tax system that is neutral between investments in
housing and financial assets but non-neutral to investments in leased residential property or
personal businesses. In contrast, wealthy households are taxed at the margin on an income tax
basis so they face a tax system that is non-neutral between owner-occupied housing and other
assets but which is neutral to investments in leased residential property and other equity assets.
Table 9 and Table 10 show the effects of taxing rental properties on an income basis (with
an exemption for capital gains) when owner occupied housing and interest earnings in
sanctioned retirement income funds are taxed on an expenditure basis. In Table 9 there is no
increase in property prices; a house costs $400,000 and provides annual rental services valued
at $20,000. In Table 10 property prices and the value of rental services increase by 1% per year;
rental services start at $20,000, and the price of the property is $500,000. Each table is broken
into three sections and considers the returns to four classes of assets: owner-occupied property;
deposits held in retirement accounts that are taxed on an EET basis; other deposits; and rental
property. Because the difference in after-tax returns in income tax and expenditure tax systems
depends on the investment horizon, results are calculated assuming a ten year horizon.
In the first section, all assets are taxed on an expenditure basis. The tax system is neutral
and the returns to investing in owner-occupied housing, rental property, or interest earning
deposits are the same.
49
In the second section, the marginal landlord is someone who cannot place additional funds
in a sanctioned retirement scheme and whose alternative investments are taxed on an income
tax basis. Rents are set so that the after-tax returns from investing in rental property are the
same as the after tax returns from deposits taxed on an income basis. In these circumstances the
rent on a property will remain $20,000 if there is no capital appreciation or decline to $17,857 if
there is capital appreciation. The decline in rents occurs because the capital gain is not taxed,
and landlords have an incentive to reduce the rent/price ratio to obtain tax-free capital gains
rather than invest in debt securities that are subject to income tax. Irrespective of the rate of
capital appreciation, the returns to a landlord are lower than the expected returns from
investing in owner-occupied housing or from placing funds in a retirement fund that is taxed on
an EET basis. This makes it unlikely that these landlords would be the marginal players in the
property market. Nor do ordinary households have an incentive to purchase larger houses or bid
property prices above the levels that would prevail under a neutral tax system, as they are taxed
on an equal basis whether they place funds in a retirement income fund or an owner-occupied
house. Consequently, in these circumstances it seems unlikely that the tax system would
produce incentives to bid property prices above the tax-neutral level.
49
Note in the first section of Table 9 and Table 10 a landlord who has enough money to purchase an owner-occupied house out
of tax paid money has enough money to purchase 1/(1-τ) = 1.43 houses out of pretax money. The rent per house is therefore
$20,000.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
42
Table 9: Housing returns with expenditure taxes: no capital gains
Landlord
Deposit
(retirement)
Deposit
(other)
Owner
Occupier
Table 9a: Rents, housing, and all lending are taxed on an expenditure basis.
Tax
EET
EET
EET
TEE
Labour
Income
Pre-tax income
$571,429
$571,429
$571,429
$571,429
Tax
$0
$0
$0
$171,429
After tax income
$571,429
$571,429
$571,429
$400,000
Number of houses
1.43
0
0
1
Capital
Income
Rental income
$28,571
$20,000
Interest income
$0
$28,571
$28,571
$0
Tax
$0
$0
$0
$0
Capital gains
$0
$0
$0
$0
After tax income
$28,571
$28,571
$28,571
$20,000
Annual return
5.00%
5.00%
5.00%
5.00%
Total
Return
Compound return
$930,797
$930,797
$930,797
$651,558
Tax
$279,239
$279,239
$279,239
$0
After tax return
$651,558
$651,558
$651,558
$651,558
Table 9b: Rents and other lending are taxed on an income basis. Rents set to equate returns with other
lending.
Tax
TTE
EET
TTE
TEE
Labour
Income
Pre-tax income
$571,429
$571,429
$571,429
$571,429
Tax
$171,429
$0
$171,429
$171,429
After tax income
$400,000
$571,429
$400,000
$400,000
Number of houses
1.00
0
0
1
Capital
Income
Rental income
$20,000
$20,000
Interest income
$0
$28,571
$20,000
$0
Tax
$6,000
$0
$6,000
$0
Capital gains
$0
$0
th
$0
$0
After tax income
$14,000
$28,571
$14,000
$20,000
Annual return
3.50%
5.00%
3.50%
5.00%
Total
Return
Compound return
$564,240
$930,797
$564,240
$651,558
Tax
$0
$279,239
$0
$0
After tax return
$564,240
$651,558
$564,240
$651,558
Table 9c: Rents and other lending is taxed on an income basis. Rents set to equate returns with lending in
retirement scheme.
Tax
TTE
EET
TTE
TEE
Labour
Income
Pre-tax income
$571,429
$571,429
$571,429
$571,429
Tax
$171,429
$0
$171,429
$171,429
After tax income
$400,000
$571,429
$400,000
$400,000
Number of houses
1.00
0
0
1
Capital
Income
Rental income
$28,571
$20,000
Interest income
$0
$28,571
$20,000
$0
Tax
$8,571
$0
$6,000
$0
Capital gains
$0
$0
$0
$0
After tax income
$20,000
$28,571
$14,000
$20,000
Annual return
5.00%
5.00%
3.50%
5.00%
Total
Return
Compound return
$651,558
$930,797
$564,240
$651,558
Tax
$0
$279,239
$0
$0
After tax return
$651,558
$651,558
$564,240
$651,558
Source: Author’s calculations.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
43
Table 10: Housing returns with expenditure taxes: property appreciates at 1% per year
Landlord
Deposit
(retirement)
Deposit
(other)
Owner
Occupier
Table 10a: Rents and all lending is taxed on an expenditure basis
Tax
EET
EET
EET
TEE
Labour
Income
Pre-tax income
$714,286
$714,286
$714,286
$714,286
Tax
$0
$0
$0
$214,286
After tax income
$714,286
$714,286
$714,286
$500,000
Number of houses
1.43
0
0
1
Capital
Income
Rental income
$28,571
$20,000
Interest income
$0
$35,714
$35,714
$0
Tax
$0
$0
$0
$0
Capital gains
$7,143
$0
$0
$5,000
After tax income
$35,714
$35,714
$35,714
$25,000
Annual return
5.00%
5.00%
5.00%
5.00%
Total
Return
Compound return
$1,163,496
$1,163,496
$1,163,496
$814,447
Tax
$349,049
$349,049
$349,049
$0
After tax return
$814,447
$814,447
$814,447
$814,447
Table 10b: Rents and other lending is taxed on an income basis. Rents set to equate returns with other
lending
Tax
TTE
EET
TTE
TEE
Labour
Income
Pre-tax income
$714,286
$714,286
$714,286
$714,286
Tax
$214,286
$0
$214,286
$214,286
After tax income
$500,000
$714,286
$500,000
$500,000
Number of houses
1
0
0
1
Capital
Income
Rental income
$17,857
$20,000
Interest income
$0
$35,714
$25,000
$0
Tax
$5,357
$0
$7,500
$0
Capital gains
$5,000
$0
$0
$5,000
After tax income
$17,500
$35,714
$17,500
$25,000
Annual return
3.50%
5.00%
3.50%
5.00%
Total
Return
Compound return
$705,299
$1,163,496
$705,299
$814,447
Tax
$0
$349,049
$0
$0
After tax return
$705,299
$814,447
$705,299
$814,447
Table 10c: Rents and other lending is taxed on an income basis. Rents set to equate returns with lending
in retirement scheme
Tax
TTE
EET
TTE
TEE
Labour
Income
Pre-tax income
$714,286
$714,286
$714,286
$714,286
Tax
$214,286
$0
$214,286
$214,286
After tax income
$500,000
$714,286
$500,000
$500,000
Number of houses
1.00
0
0
1
Capital
Income
Rental income
$28,571
$20,000
Interest income
$0
$35,714
$25,000
$0
Tax
$8,571
$0
$7,500
$0
Capital gains
$5,000
$0
$0
$5,000
After tax income
$25,000
$35,714
$17,500
$25,000
Annual return
5.00%
5.00%
3.50%
5.00%
Total
Return
Compound return
$814,447
$1,163,496
$705,299
$814,447
Tax
$0
$349,049
$0
$0
After tax return
$814,447
$814,447
$705,299
$814,447
Source: Author’s calculations.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
44
In the third section the marginal landlord is someone whose alternative investments are
taxed on an expenditure basis. Rents are set so that the after-tax returns from investing in rental
property are the same as the after tax returns from deposits taxed on an expenditure basis. In
these circumstances, the rent/price ratio increases relative to the neutral case, as rents are
increased (to $28,571) to pay the income taxes, and the returns are higher than the returns from
investing in deposits that are taxed on an income basis.
These results show the effect on rents and property prices of a mixed expenditure and
income tax regime are crucially dependent on the identity of the marginal investor. If the
marginal investor is someone who cannot place additional funds in a sanctioned retirement
scheme, rent/price ratios will be similar or lower than in the neutral case, and overall returns
will be lower than the returns from owner-occupied housing or a sanctioned retirement scheme.
In these circumstances, residential property is likely to be a minority investment class, and
investors seem unlikely to place significant upward pressure on property prices as property is
tax-disadvantaged relative to funds in retirement schemes. Alternately, if the marginal investor
is someone whose alternative investment is a sanctioned retirement scheme, rent/price ratios
will be higher than when the tax system is neutral, either because rents are high or because
there is downward pressure on house prices. In neither case, therefore, is the tax system likely
to place the type of upward pressure on house prices generated by New Zealand’s current tax
system.
Which of the marginal conditions rent/price conditions is most likely to have
characterised New Zealand prior to 1989? At the time there were relatively few private
landlords, approximately 60,000, partly because owner-occupancy rates were high and partly
because a large number of rental properties were owned by the state. This suggests that the
returns to rental properties were probably set in reference to the returns available from
alternative investments that were taxed on an income tax basis. Given the high rates of inflation
prevailing in the 1970s and 1980s, rent/price ratios would be lower than those prevailing under
a neutral tax system; but there would be little pressure for landlords to outcompete owner-
occupiers, as after-tax returns to owner-occupiers would be higher than those to landlords.
4.3 The Distribution Effects of the Great Income Tax Experiment
What, then, are the distributional effects of taxing retirement income schemes on an expenditure
basis? The answer depends on the tax scheme to which it is compared. There are three obvious
benchmarks: a neutral expenditure tax system; a neutral income tax system; and New Zealand’s
current tax system. The comparisons are most easily made by noting that an EET retirement
income tax scheme can be transformed into New Zealand’s current tax scheme through a series
of three steps:
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
45
a) a shift from an EET retirement income tax scheme to a neutral expenditure tax scheme,
by taxing other capital income on an expenditure rather than income basis;
b) a shift from a neutral expenditure tax scheme to a neutral income tax scheme; and
c) a shift from a neutral income tax scheme to New Zealand’s current tax scheme, by
exempting imputed rent and capital gains from tax.
Figure 8 and Figure 9 indicate schematically how different classes of income would be
taxed under these tax regimes.
50
Figure 8 shows tax rates when sanctioned retirement income
schemes are taxed on an expenditure basis but other capital income is taxed on an income basis
(with an exemption for capital gains), along with a neutral expenditure tax system. The neutral
scheme should have higher statutory rates than the EET retirement income scheme, as less
revenue is received from the taxation of other capital income. Consequently an EET retirement
income tax scheme is likely to be more progressive than the neutral scheme, as it has lower tax
rates on labour incomes but higher tax rates on capital incomes earned from assets held outside
retirement scheme. As discussed in section 4.2, it may also place slight downwards pressure on
land prices.
Figure 8: Tax rates across different income classes. (i) Expenditure Tax System
Note: The tax rate on labour income when earned is lower than the tax rate on labour income (average) as
taxes are paid when the income is spent and this will be a later date if some of the income is saved.
Standard theory suggests that a neutral expenditure tax scheme will have higher tax rates
than a neutral income tax system, due to difference in the timing of income tax receipts, but
50
The diagram is schematic as the numbers are made up. They are designed to indicate how changes from neutral tax systems
affect different types of income.
0%
10%
20%
30%
40%
owner-occupier retirement
account
rental property other equity other lending labour income
(average)
labour income
(when earned)
EET neutral
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
46
neither should affect land prices.
51
The lower tax rates means a neutral income tax scheme is
likely to be more progressive than a neutral expenditure tax system, as saving rates typically
increase with income. A neutral income tax scheme is also likely to be more progressive than an
EET retirement income tax scheme since the taxes on capital gains and imputed rent will fall
disproportionately on high income people.
Figure 9: Tax rates across different income classes. (ii) Income Tax System
Figure 9 shows the effects of New Zealand’s current tax system and a neutral income tax
system in which both capital gains and imputed rent are taxed. The current tax system is more
regressive than a neutral income tax system as the exemption of imputed rent and capital gains
from tax favours high income households and leads to higher labour income taxes. For this
reason, shifting from an EET retirement income scheme to New Zealand’s current tax system has
ambiguous effects on distribution, even if the effect on land prices is ignored. It may be a
regressive change, due to the increase in labour income taxes that occurs when retirement
savings are not taxed at the time that income is earned; but it may not, as imputed rent and
capital gains are exempt from tax under the current income tax system. In either case, the
exemption of imputed rent and capital gains from taxation significantly reduces any
distributional advantages that could be achieved when a government switches the tax system
from an expenditure tax basis to an income tax basis.
It is not possible to ignore the effect on land prices, however. In line with Feldstein’s
(1977) conjecture, when retirement income schemes are taxed on an expenditure basis there is
51
See, for instance, Batina and Ihori (2000).
0%
10%
20%
30%
40%
owner-occupier retirement
account
rental property other equity other lending labour income
(average)
labour income
(when earned)
NZ neutral
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
47
likely to be slight downward pressure on property prices. In contrast, when retirement schemes
are taxed on an income basis but imputed rent and capital gains are exempt from tax, there is
likely to be upward pressure on property prices. A switch from an EET retirement income tax
scheme to New Zealand’s current tax system will therefore have a slightly larger effect on land
prices than that discussed in section 2, which compared New Zealand’s current tax system with a
neutral income tax system. According to the calculations in Table 2b, this means that the current
tax system could more than double the willingness of owner-occupiers to pay for land with a
high marginal convenience yield relative to a tax system in which retirement income schemes
are taxed on an expenditure basis.
It will be recalled that the 1987 Labour Government and the 1988 Brash Committee both
argued that it was regressive to tax retirement income schemes on an expenditure basis, as
these schemes were primarily used by people on higher incomes. They may have been wrong. It
appears they may have substantially underestimated how the incidence of the tax change could
have been shifted within cohorts and across generations by the induced change in land prices. If
so, it was a mistake that inadvertently benefited the generation of property owners alive at the
time, and probably those who purchased property in the subsequent decade while the New
Zealand economy was still reeling from the effects of the early 1990s financial crisis and a period
of extraordinarily high real interest rates. The benefits to these generations, however, come at
the expense of all subsequent generations. The losses to these generations in terms of the higher
land prices they have paid and will have to pay are most likely to be greater than any
redistribution gains stemming from taxing retirement saving accounts on an income rather an
expenditure basis.
5 Conclusion.
It is a standard adage of economists that the incidence of a tax will fall on people different to
those paying the tax whenever a tax causes prices to change. Nowhere is this adage more
important than when taxes affect the price of land, for taxes that affect the price of land shift the
incidence of the tax across generations. As Feldstein (1977) and Skinner (1996) observed, tax
incentives favouring property should be capitalized into property values, reducing the welfare of
future generations, who would prefer to buy land cheap and sell cheap rather than buy land dear
and sell dear. They further argued the higher price of land should reduce the country’s capital
stock and lower the net foreign asset position. While the intergenerational consequences of such
policies should be a central feature of fiscal policy analysis, they are frequently ignored as the
resource transfers induced by tax policy are not always directly associated with payments to the
government. A policy that exempts land income from tax will reduce the welfare of all
generations but the first generation of landowners, for instance, without ever generating
payments that are counted in standard analyses of government taxes and transfers.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
48
New Zealand’s tax changes in the late 1980s are likely to have had significant
intergenerational consequences through their effects on land prices. By taxing retirement
savings on an income basis without simultaneously taxing imputed rent or capital gains, New
Zealand adopted a tax system that differentially favours income from residential property. This
means the tax advantage of residential property relative to other asset classes is now greater in
New Zealand than it is in most OECD countries. Some of this advantage may have been
inadvertent, since it proved politically impossible to introduce simultaneously a tax on capital
gains or imputed rent, the steps needed to adopt a neutral income tax system. Inadvertent or
not, most formal models analysing the consequences of a non-neutral income tax system suggest
they will lead to an increase in the marginal price of conveniently located land. In places where
use of the transport system is close to capacity, or where amenities are concentrated, the tax
system is likely to lead to significant increases in land prices.
It is disappointing that the empirical evidence about the effect of the 1989 tax change is so
inconclusive. There is clear evidence that the average size of new construction increased sharply
relative to Australia and the United States after 1989; there is clear evidence that property
prices increased more rapidly after 1990 than before 1990, with most of the increase occurring
after 2000; and there is clear evidence that rent/price ratios decreased significantly; and the
number of private landlords increased rapidly. All these changes are consistent with the
predicted effects of the 1989 tax changes. But so many other macroeconomic changes occurred
at around the same time that the econometric evidence is not even strong enough to definitively
link the size of new construction or the rent/price ratio to real interest rates, let alone tax
changes. A different econometric approach will be needed to unpick the relationships.
Both the 2001 Tax Review and the 2010 Tax Working Group conceded it would be difficult
to gain a political consensus to tax imputed rents from owner-occupied housing or to apply a
capital gains tax to all assets including owner-occupied housing, and these taxes have not been
imposed. This means New Zealand still has a tax system that is very distortionary towards
residential property. This leaves the country with four tax reform options. The first option is to
do nothing. This option is likely to be most attractive to current land-owners, as they are
favoured by the current tax system, but it is likely to be less attractive to current and future
generations of young people who face higher housing prices. The second option is to finish the
job started in 1989 and tax all capital income consistently. This means introducing a capital
gains tax on an accrual basis and taxing imputed rent, or taxing housing using a risk free return
method, using the revenues to reduce income tax rates further. The third option is to adopt a
series of partial ‘fixes’ which reduce the tax advantage of housing but do not address the
fundamental issue. For example, the treatment of the tax losses for landlords who have extensive
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
49
debt could be changed. Or a land tax could be introduced.
52
The fourth option is to admit the
great income tax experiment of 1989 has not worked as intended, because it proved too difficult
to tax capital incomes properly, and undo the reforms. The simplest way to undo the reforms is
to tax some income placed in retirement income saving schemes on an EET basis.
53
This reform
will reduce the distortions that favour owner-occupied housing by taxing other assets on a
similar basis, but will require increases in other taxes to make up the revenue shortfall. None of
these options are entirely attractive. But, after a quarter of a century, it is surely time to evaluate
whether the great income tax experiment has succeeded as intended. If not, perhaps it is time to
urgently pursue further income tax reforms – or admit it has not worked as planned, and
consider reverting back to the tax approach adopted by the rest of the world.
This paper has not provided a full analysis of the consequences of changing the tax system,
either by taxing housing on an income basis or by taxing retirement saving on an expenditure
basis. This analysis would need to include estimates of the effects of changing taxes on labour
participation rates and labour income as well the effects of different tax systems on housing
markets and other capital investments. Such a model would be extremely technically demanding
and is beyond the scope of the current paper. Nonetheless, as it is likely that there would be
large economic consequences if retirement saving were taxed differently, a proper analysis of
these effects (including, for instance, the fiscal effects, the effects on labour supply of other
compensating tax changes, and the transitional changes that might occur as the economy moved
from one tax regime to another) would be useful. It is clear the adverse consequences of the
1989 tax regime shift were not fully anticipated or else the change may not have been
undertaken; this experience suggests that any future tax changes should be properly understood
before they are implemented. Fortunately, it should not be presumed that changing the tax
system would be detrimental to the New Zealand economy. There is a long-standing and
widespread belief amongst economists that expenditure taxes are less distorting than income
taxes, and OECD experience suggests it is easy in practice to tax retirement savings on an
expenditure basis. It is therefore to be hoped that the findings from this paper provide a basis
for a further investigation of the desirability of ending (or, perhaps, continuing) New Zealand’s
great income tax experiment.
52
Coleman and Grimes (2010) provides an analysis of the possible effects of different variants of land taxes in a New Zealand
setting. A more general treatment is provided by Dye and England (2009). These authors are favourably disposed to the introduction
of a land tax, arguing it is an efficient way of raising revenue. In most cases, a land tax can be expected to reduce land prices
(although counter-examples are possible: see Chamley and Wright (1987) or Petrucci (2005)). It should be noted that a land tax
could be introduced even if the tax treatment of capital income was not distortionary.
53
A referee pointed out that it may be possible tax retirement savings on an expenditure basis using the same pre-payment option
that is applied to housing: that is, a “Taxed-Exempt-Exempt” method. There is an attractive symmetry to this proposition so long
as households cannot borrow to place funds in a retirement income account that is taxed on this basis, but deduct interest payments
against income tax.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
50
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Appendix 1: Capital gains taxes, and the distortionary effects
of income taxes
This appendix, based on Samuelson (1964), provides a simple mathematical description of the
way income taxes distort capital income decisions by providing an incentive to invest in low-
returning long-horizon investments.
Suppose a firm undertakes an activity that generates a cash-flow return at one of three
different horizons. The firm can invest any cash it receives at an interest rate i, and pays tax on
income at rate τ. Assume that the inflation rate is zero so the real interest rate r is equal to the
nominal rate i (this assumption is modified later). The three different horizons are:
a) the activity produces a return Y
0
in period t and nothing thereafter;
b) the activity produces a return Y
T
in period t+T and nothing thereafter;
c) the activity produces an infinitely lived asset that generates a sequence of equal
dividends D each period ({Y
t+1
= D, Y
t+2
= D, Y
t+3
= D ….}).
Let V
1
(τ), V
2
(τ) and V
3
(τ) be the present value of the three assets as a function of the
income tax rate τ. In the absence of tax, the present value of the three assets is:
(i)
10
(0)VY
(1)
(ii)
2
(0)
(1 )
T
T
Y
V
r
(2)
(iii)
3
1
(0)
(1 )
j
j
j
D
D
V
r
r
(3)
To enable a comparison of the effects of inflation, assume that the three assets have the
same pre-tax values i.e.
0
(0)
(1 )
T
T
Y
VY
r
D
r
.
The value of each of the assets when there is an income tax is calculated by discounting the
after-tax return from the activities by the after-tax discount rate, as this is the rate of return that
the firm can obtain if it invests its cash flows. Since the firm gets an after-tax return of r(1-τ)
from lending money, the present after-tax value of the various activities to the agent are
(i)
10
( ) (1 ) (1 ) (0)V Y V
(4)
(ii)
2
(1 )
(1 )
( ) (1 ). (0)
1 (1 )
(1 (1 ))
T
T
T
Y
r
VV
r
r
(5)
(iii)
3
1
(1 )
( ) (0)
(1 (1 ))
j
j
j
D
D
VV
r
r
(6)
The after-tax returns are unequal, even though the tax rate on all cash flows are the same.
The after-tax returns of investments with the same pre-tax returns are different because money
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
53
lent at interest compounds at an after-tax rather than pre-tax rate of return. This provides an
incentive to invest in low-yielding long-term assets (especially indefinitely lived assets) rather
than higher-yielding short-term assets even though tax is paid on all current and future
earnings.
54
Samuelson (1964) demonstrated that this distortion could be corrected by an accrual-
based capital gains tax that allows for the deduction of depreciation and losses, as this will
ensure all activities have the same post tax returns. He further showed that if capital gains are
taxed as income, (i) the present value of all assets will be independent of the tax rate, even if
different agents have different tax rates, and equal to the value of the asset in the absence of
taxes; and (ii) assets valued as the present value of future cash flows will have an after-tax
return of r(1-τ). It is relatively straightforward to demonstrate these results for the above assets,
as the two examples in Box 1 show. In turn, it follows that a capital gains tax (i) corrects the
incentive for agents to favour the production of long lived assets over short term assets or
current activity, and thus removes the incentive to produce low yielding long term assets
because of their tax advantages; and (ii) raises additional revenue for the government.
Using accrual-based capital gains taxes to complement income taxes when
inflation is non-zero.
When there is general inflation, the taxation of the full nominal return on interest earning assets
causes a further distortion to asset allocation that can be addressed with a tax on nominal
capital gains.
55
Suppose all dividends increase at rate π, and i is the nominal interest rate,
(1 ) (1 )(1 )ir
. Recalculating cases (i) to (iii), assuming the dividend increases at the
inflation rate:
(i)
10
( ) (1 ) (1 ) (0)V Y V
(7)
(ii)
2
(1 ) (1 )
(1 )(1 )
( ) (0)
(1 (1 )) (1 (1 ))
T
T
T
TT
Y
i
VV
ii
(8)
(iii)
3
1
(1 ) (1 )
()
(1 (1 ))
j
j
j
D
V
i
(1 )(1 ) 1
(1 (1 )) 1 (1 ) (1 (1 ))
(1 )(1 )
(0)
(1 )
D
ii
r
V
i
(9)
Compared to the values when there is no tax or inflation, the incentive to produce
infinitely lived assets increases substantially as the inflation rate increases:
54
Note that when inflation is zero the value of an infinitely lived asset returning a constant dividend is independent
of the tax rate even though the future cash-flows and dividends are taxed. The value of the asset is unchanged
because the returns on alternative investments are also taxed. The case with inflation is considered below.
55
This is the case considered by Samuelson. However, his logic extends to the case that only real interest earnings are taxed, in
which case a capital gains tax should only be applied to real capital gains.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
54
31
(1 )
( ) / ( )
(1 )
r
VV
i
(10)
For example, suppose the real interest rate is 3% and the tax rate is 33%. In the absence of
a capital gains tax, the additional income from investing in infinitely lived assets rather
producing for the present and investing the proceeds ranges between 49% when inflation is
zero to 186% when the inflation rate is 3%.
If nominal capital gains were subject to tax, the distortion induced by income tax would be
corrected and the after-tax returns of investments with different horizons would be equalized –
this result is shown for the same two asset classes in Box 2. It should be noted, of course, that if a
capital gains tax were applied to nominal capital gains the effective tax rate on the real return
from the investment will be significantly higher than the statutory income tax rate, just as real
interest income is currently subject to effective tax rates that are significantly higher than the
statutory rate. If a capital gains tax were applied to real capital gains, and real interest were
taxed, the same neutrality results would be achieved but real capital income would be taxed at
the statutory rate.
The above analysis assumes a ‘pure’ accrual-based capital gains tax is introduced to
correct the distortions introduced by an income tax. In the real world, it is likely that the tax
would be realization based and introduced with significant exemptions, negating some of the
advantages of a capital gains tax. This of course does not detract from the primary points: an
income tax applied to capital income induces significant distortions in the pattern of after-tax
returns of different asset types, that these distortions are magnified by inflation, and that these
distortions can be corrected by an appropriately designed capital gains tax.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
55
Box 1: The effect of capital gains taxes on asset values in the absence of inflation
This box calculates the value of an asset when a firm undertakes an activity to produce an
income producing asset and (i) capital gains tax is paid at time t on the value of the newly
created asset, (ii) income tax is paid on the income stream produced by the asset, and (iii)
capital gains tax is paid on any change in value of the asset.
Example 1: An asset returning a sum Y
1
in period t+1 (i.e. a type 2 asset with T=1).
Let
*
2t
V
be the value at time t of the asset paying Y
1
at time t+1. In period t+1, the firm has
income Y
1,
but the asset depreciates to have zero value. Consequently tax is paid on the
income minus the loss in value of the asset. The value of the asset satisfies the following
equation:
*
*
1 1 2
2
*
1
2
*
11
2
()
1 (1 )
(1 )
1
1 (1 ) 1 (1 )
(1 )
1 (1 ) 1
t
t
t
t
Y Y V
V
r
Y
V
rr
YY
V
rr
Clearly the value of the asset is independent of the tax rate. The taxes paid by the firm
are
1
(1 )Yr
capital gains tax in period t and
*
1 2 1
( ) (1 )
t
Y V rY r
income tax in period t+1,
or a total of
1
Y
. This is the same total tax that is paid under the income tax system, although
most of the tax is paid in period t rather than period t+1 so the present value of the tax
payments is higher.
Example 2: An asset that returns a constant dividend (asset 3).
Let
*
3t
V
be the value at time t of the asset paying D in each period from t+1 onwards. The value
of the asset is constant through time: therefore no capital gains tax is paid at time t+1or
thereafter.
*
The value of the asset satisfies the following equation:
* * *
*
3 1 3 1 3
3
*
3
*
3
(1 ) ( )
1 (1 )
1 (1 )
1
1 (1 ) 1 (1 )
(1 ) (1 )
1 (1 ) 1 (1 )
t t t
t
t
t
D V V V
V
r
D
V
rr
D D D
V
r r r
The value of the asset is independent of the tax rate. As the initial investment creates
an asset with value
3
/V D r
, the firm pays capital gains tax
3
/V D r
at time t.
Subsequently income tax τD is paid on the dividend each period, but no further capital gains
tax are paid as the value of the asset is constant. Total taxes increase.
*This result is derived from an iterated forward expansion of the equation for V*3t in terms of V*3t+1. The
derivation in the more general case with inflation is provided in Box 2.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
56
Box 2: The effect of a capital gains tax on asset values with inflation.
This box derives the effect of a capital gains tax on the value of two assets considered in Box 1
when there is inflation. The nominal interest rate is i,
(1 ) (1 )(1 )ir
.
(i) An asset returning a sum Y
1
(1+π) in period t+1.
Let
*
2t
V
be the value at time t of the asset paying Y
1
(1+π) at time t+1. In period t+1, the firm has
income Y
1
(1+π)
,
but the asset depreciates to have zero value. Tax is paid on the income minus the
loss in value of the asset. The value of the asset satisfies the following equation:
*
*
1 1 2
2
*
1
2
*
1 1 1
2
(1 ) ( (1 ) )
1 (1 )
(1 )(1 )
1
1 (1 ) 1 (1 )
(1 )(1 ) (1 )
1 (1 ) 1 1
t
t
t
t
Y Y V
V
i
Y
V
ii
Y Y Y
V
i i r
As this is the value of the asset when there is no tax or inflation, the value of the asset is
independent of the tax rate or the inflation rate.
(ii)An asset that returns an infinite stream of dividends that is constant in real terms.
Let
*
3t
V
be the value at time t of the asset paying a sequence of dividends {D(1+π), D(1+π)
2
,
D(1+π)
3
….}. (The dividends are constant in real terms and increase in nominal terms at rate π.)
The value of the asset satisfies the following equation:
* * *
*
3 1 3 1 3
3
*
*
31
3
**
3 3 1
*
*
31
3
(1 ) (1 ) ( )
1 (1 )
(1 )(1 ) (1 )
1
1 (1 ) 1 (1 )
1 (1 ) (1 )(1 ) (1 )
(1 )
11
t t t
t
t
t
tt
t
t
D V V V
V
i
DV
V
ii
V i D V
V
D
V
ii
But
*
2
*
32
31
(1 )
11
t
t
V
D
V
ii
Hence iterating forward,
23
*
3
2
(1 ) (1 ) (1 )
.....
1 1 1
1 1 1
1 ....
11
11
1 1 1 (1 )
t
V D D D
i i i
D
r r r
D
rr
D
r
This is also the value of the asset when there is no tax or inflation.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
57
Appendix 2: Regression results from section 3
The rent/price ratio
In section 3.2 it was argued that there is no long term linear relationship between the rent/price
ratio and the real interest rate. The evidence for this statement is a sequence of regressions
showing that the rent/price ratio and the real interest rate are not cointegrated. The evidence is
presented in two parts. In the first part, it is shown that when only the rent/price ratio and the
real interest rate but no other variables are tested for cointegration, it is not possible to reject
the hypothesis that the two series are not cointegrated. In the second part, cointegration is
tested when two additional variables, lagged changes in the house price index and lagged
changes in the inflation rate, are added to the analysis.
Appendix Table 1 presents the regression results when only the rent/ price ratio and the
real interest rate but no other variables are analysed. The table has two parts, presenting results
for 1975 to 2014 and 1990 to 2014 respectively. The table shows the results of (i) unit root tests
for the rent/price ratio and the real interest rate; (ii) a linear regression between the rent/price
ratio and the real interest rate, which generates the residual
ˆ
t
e
; and (iii) a linear regression
between
ˆ
t
e
and
1
ˆ
t
e
.
56
For both periods, it is not possible to reject the hypothesis (at the 5%
significance level) that the real interest rate and the rent/price ratio have unit roots. Nor is it
possible to reject the hypothesis that the residual of the ordinary least squares regression
between the variables has a unit root; as such the two variables are not cointegrated.
The second set of tests is complicated because the real house price series not only appears
to have a unit root, but quarterly changes in real house prices are strongly and positively
autocorrelated. For the whole period, 1975 – 2014, the following equation shows the extent of
this correlation:
1
0.007 0.68
(0.005) (0.06)
t t t
HP HP e
2
0.45 2.11 159R DW n
A very similar regression was estimated for the sub-period 1990 – 2014.
The size of this correlation makes it likely that there is a strong negative correlation
changes in the rent/price ratio and changes in real house prices in the previous period. This is
because an increase in house prices in one period is usually followed by an increase in house
prices in the subsequent period, and will reduce the rent-price ratio unless there is an equal
increase in rents.
One method of testing whether there is a long term (cointegrating) relationship between
real interest rates, real house prices, and the rent/price ratio is to test whether an error-
correction model can be fitted to the data (Ericsson and MacKinnon 2002). If there is a long term
56
This is the Engle-Granger test; more sophisticated tests give similar results.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
58
relationship between interest rates and the rent/price ratio, the coefficient
0
in the following
regression should be statistically significant,
0 1 0 1 1 1t t i t t t i t i t
ii
RP r X RP r X e
where Xt is a set of additional long term variables, in this case the average increase in real house
prices over the previous three years, and the average inflation rate over the previous three
years. The regression results are shown in Appendix Table 2 for the periods 1975 to 2014 and
1990 to 2014. In neither case is the coefficient β0 statistically significant, and thus the
hypothesis that there is a long term linear relationship between the variables can be rejected.
57
The mean size of newly constructed houses
In section 3.3, it was claimed that it could not be proven that there is a long term cointegrating
relationship between the mean size of newly constructed houses, real interest rates, and per
capita GDP. To demonstrate this using data from 1989 to 2014, the following regressions were
estimated: (i) a unit root regression showing that all three series have a unit root and (ii) an
error correction model linking annual changes in the mean size of newly constructed houses to
changes and in the interest rates and real GDP per capita and the lag of all of the three variables.
The latter regression is an example of the Ericcson and MacKinnnon (2002) technique. Similar
results are found when the Engle- Granger test was performed.
The three unit root regressions are
Mean size of newly constructed houses: MBS (Mean building size)
1
24.7 0.87
(8.5) (0.049)
t t t
MBS MBS e
1
2
1
ˆ
ˆ
1
0.93 1.80 25 2.56
ˆ
R DW n
Real interest rates
1
0.013 0.79
(0.008) (0.12)
t t t
r r e
1
2
1
ˆ
ˆ
1
0.65 1.52 25 1.87
ˆ
R DW n
Real GDP per capita
1
600 1.00
(1240) (0.03)
t t t
y y e
1
2
1
ˆ
ˆ
1
0.98 0.98 25 0.00
ˆ
R DW n
57
The distribution of the t-ratio on the coefficient β
1
is not standard, but was tabulated by Ericcson and MacKinnnon
(2002). When there are 4 variables in the error correction regression, the asymptotic critical values at the 5% and
10% significance levels are -3.76 and -3.44 respectively.
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
59
The error correction regression is
1 1 1
61.2 127 0.0006 0.41 119 0.0006
(22.6) (85) (0.0016) (0.13) (109) (0.0006)
t t t t t t t
MBS r y MBS r y e
0
2
0
ˆ
ˆ
0.48 1.73 25 3.14
ˆ
R DW n
The test of the hypothesis that the three series are cointegrated is whether the coefficient
β
0
on the variable MBS
t-1
is zero or not. This test is performed by calculating the ratio of the
estimated coefficient to its estimated standard error. The coefficient is quite large (
0
ˆ
0.41
)
but as the ratio equals -3.14 it is not possible to reject the hypothesis that the coefficient is zero
and that there is no long-run cointegrating relationship between the three variables.
Appendix Table 1: Testing for cointegration between the real interest rate and the rent/price ratio.
Regressions between the rent/price ratio index and the real mortgage rate, 1975-2014
Rent/price ratio(RP)
0 1 1t t t
RP RP e
1
9.3 1.005
(9.3) (0.0076)
t t t
RP RP e
1
2
1
ˆ
0.99 1.23 159
ˆ
1
0.66
ˆ
R DW n
Real mortgage (r)
0 1 1t t t
r r e
1
0.0027 0.956
(0.0011) (0.0176)
t t t
r r e
1
2
1
ˆ
0.95 1.18 159
ˆ
1
2.5
ˆ
R DW n
Linear regression
01t t t
RP r e
0 1 1t t t
e e u
1146 793
(35) (574)
t t t
RP r e
1
3.3 1.005
(2.3) (0.0079)
t t t
e e u
2
0.01 0.01 160R DW n
1
2
1
ˆ
0.99 1.27 159
ˆ
1
0.63
ˆ
R DW n
Regressions between the rent/price ratio index and the real mortgage rate, 1990-2014
Rent/price ratio(RP)
0 1 1t t t
RP RP e
1
10.1 1.002
(8.3) (0.0072)
t t t
RP RP e
1
2
1
ˆ
0.99 1.31 98
ˆ
1
0.28
ˆ
R DW n
Real mortgage (r)
0 1 1t t t
r r e
1
0.0032 0.942
(0.002) (0.031)
t t t
r r e
1
2
1
ˆ
0.91 1.25 98
ˆ
1
1.9
ˆ
R DW n
Linear regression
01t t t
RP r e
0 1 1t t t
e e u
434 10954
(81) (1240)
t t t
RP r e
1
3.8 0.971
(7.4) (0.029)
t t t
e e u
2
0.45 0.08 99R DW n
1
2
1
ˆ
0.92 1.30 98
ˆ
1
1.00
ˆ
R DW n
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
60
Appendix Table 2: Using the Ericcson-MacKinnon ECM test to test for cointegration between the
rent/price ratio, the real interest rate, the lagged average house price change, and the lagged inflation rate.
Dependent
variable
t
RP
1975 - 2014
t
RP
1990 - 2014
coefficient
s.e.
t-ratio
coefficient
s.e.
t-ratio
Constant
-9.6
9.8
-1.0
-2.9
11.4
0.3
t
r
129
246
0.5
1056
380
2.8
3*
t
HP
-860
208
-4.1
-574
249
-2.3
3*
t
-1251
954
-1.3
-1742
1850
-0.9
1t
RP
-0.006
0.009
-0.7
-0.03
0.012
-2.4
1t
r
115
104
1.1
678
264
2.6
3*
1t
HP
-40
51
-0.8
-119
60
-2.0
3*
1t
84
51
1.7
-369
307
-1.2
R
2
0.17
0.27
Nobs
146
98
DW
1.70
1.84
Housing, the ‘Great Income Tax Experiment’, and the intergenerational consequences of the lease
61
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All papers in the Motu Working Paper Series are available on our website www.motu.nz, or by
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63
