Labour's Housing Policy

I am baffled by the Labour Party proposal to ban foreign speculators from owning houses in New Zealand. O.K. that is not strictly true; as Matt over at TVHE notes, the policy is easy to understand as a cynical appeal to xenophobic New Zealand First voters. But David Shearer is a better person than that, and so I would prefer to remain baffled and try to think through the logic of the proposal.

Consider a very simple model of the New Zealand housing market in which there is a fixed supply of identical houses that will not change over time, and an unchanging demand. Let there be no on-going maintenance or other costs to owning a house, just the one-off capital costs. Finally, let there be a risk-free interest rate of 5%, let demanders be risk-neutral and indifferent between renting and owning for a given cost, and let rental income to a landlord be exempt from tax so that there is no tax advantage to owner-occupied housing. In this world, there would be an unchanging equilibrium rental price for housing over time, and an unchanging price of houses that would be equal to this rental price times 20.

Now change the model a bit. Imagine that demand in one year’s time will double and then stay constant from then on, but that will not be known in the one year before the change. In this world, the equilibrium rental price and the equilibrium house price will both double in one year’s time and current owners of houses (both owner occupiers and landlords) will receive a one-off capital gain at that time.

Now make one more change. Imagine that the future increase in demand becomes known now, but for some reason only known only to people who are not citizens or permanent residents of New Zealand or Australia. In this version of the model, the rental rate would continue to remain constant for a year before doubling, but foreigners would bid up the price of houses now to the point where the capital gain between now and in one-year’s time was sufficient to exactly offset the fact that current rentals are insufficient to cover the capital cost of the house.

Now compare this model to the one where the demand increase was a surprise to everyone. Renters pay exactly the same amount of rent in each period, owner occupiers receive exactly the same capital gain, but can realise it's present value straight away. Foreign speculators receive only the market rate of return on their investments, just like any other inflow of capital that allows New Zealand to fund investment in excess of its saving. The only distributional effect would be a shift in the capital gain from those who would have bought houses during the year before the demand increase to those who would have sold, but there seems no particular reason for policy to favour one of these groups over the other.

In this world, it is hard to see what possible benefit there would be to a policy of banning overseas speculators from owning houses, which is what Labour are proposing. Of course, the assumptions in these three models are extremely unrealistic. So what changes to the model or what welfare function can make sense of this policy? We could relax all the assumptions about indifference between renting and owning, risk neutrality, homogeneity of the housing stock, no tax advantage to owner-occupancy, and no other changes over time, but it wouldn’t change the basic intuition. We could assume that supply is not perfectly elastic, but that would imply that the earlier rise in price from speculation would generate an earlier supply response and hence more housing affordability. And we could assume that, maybe, New Zealanders and Australians know at least as much about the New Zealand housing market as non-Australasians and so can bid up the price of housing without overseas help, in which case banning foreign speculators would have no effect at all.

It is easier to make sense of other parts of Labour’s housing policy. Building 100,000 houses would obviously reduce prices if it added to rather than displaced construction that would otherwise occur, although the policy is silent on how it would find the land on which to build the houses given council zoning restrictions. Similarly, a capital gains tax that excluded the family home, while doing nothing to change supply and demand, would be a way to reduce prices to owner occupiers while increasing prices to renters. Such a policy proposal wouldn’t make much sense from a party representing lower-income households (who are more likely to be renters), but it is perfectly consistent with a party that proposed exempting fresh fruit and vegetables from the GST.

But Labour’s Press release focuses mostly on speculation. The point needs emphasising: speculation that pushes up prices is only profitable if those prices were going to increase anyway for non-speculative reasons. Preventing speculation (if it were possible to do so) only delays the eventual price rise. Doing something about the future price increases by addressing supply constraints would not only be a long-term solution, it would remove the incentive for speculation at the same time. In other words, any politicians whose housing policy consists mainly of an attack on speculation is essentially conceding that they have no long-term solutions at all. 

Against capital gains taxes

The OECD having recommended that NZ adopt a capital gains tax, it's worth reviewing the case against them.

First, here's the OECD:

New Zealand belongs to a group of five OECD countries with particularly high pre-tax capital-income inequality (Figure 13). As much of this income, especially at the top levels, takes the form of capital gains, the lack of a capital gains tax in New Zealand exacerbates inequality (by reducing the redistributive power of taxation). It also reinforces a bias toward speculative housing investments and undermines housing affordability, as argued in the 2011 Survey. 

The OECD report also seems to reckon that capital gains taxes, along with other taxes and changes to Superannuation, could help debt issues when Superannuation starts getting rather expensive.

Where to begin.

First, the OECD is entirely right that NZ should be moving to increase the age of superannuation eligibility. The Productivity Commission said so, anybody economically sensible has said so, and even Labour's in favour of it. The only thing that seems to be holding it back is that Key had promised in 2008 not to do it and didn't change his mind in the last election.

Second, the OECD could be right about land taxes. As part of a revenue-neutral shift away from income taxation, it would be a really nice move. My only concern, and it is the one that would keep me from pushing the button for that particular tax shift, is that equilibrium overall tax rates are likely to wind up much higher as consequence. Open up another margin for taxation and the government will wind up getting bigger over time. Even if it's revenue neutral now, it won't be the next time a Labour/Green finance minister decides to go after the 'rich pricks' by reinstituting a 39% top marginal tax rate while keeping the land tax.

But on capital gains, well, we disagree.

First, it's hard to make the case that the absence of a capital gains tax distorts investment towards housing. Maybe you could argue that we've a distortion such that firms have incentive to avoid distributing revenues as dividends and that individuals have incentive to hold shares in firms that follow such strategies rather than interest-bearing assets, but that doesn't make a case for a housing-specific distortion - especially as the IRD has been getting more vigilant about individuals flipping houses. Buying a house, doing it up, and re-selling it at a profit will draw income tax: the gain is taxable income from your labour in fixing and marketing the house. I can't see how we get a distortion towards housing rather than towards a broad set of appreciating capital assets. We certainly have problems around housing affordability. The first order problem is Councils' restrictions on the supply of zoned land. Sort that one out, and a lot of the second order problems, like inefficiencies of scale in construction, also start going away.

Second, capital income is already taxed when it is spent: we have a 15% GST. The more we are able to shift from income to consumption taxes, with offsetting transfers to those on lower income if you like, the better.

Third, as Seamus pointed out two years ago, we need to compare the relative efficiencies of the different available tax instruments. Taxes on capital income are more distortionary than taxes on labour income, and even worse when capital gain taxes tend not to be inflation-indexed; real tax rates on capital income then easily wind up being higher than taxes on labour income. And, there's a bit of a mess in deciding how to treat realised versus unrealised gains - you're basically there choosing among rather bad consequences. Read Seamus's whole post.

Fourth, the story required for the absence of a capital-gains tax to distort choices between productive investments and some kind of unproductive investment (basically, purchasing some asset that appreciates in value over time) is especially convoluted (another Seamus post...read the whole thing....).

Fifth, Seamus noted that while you can hang a case for a capital-gains tax on an argument Samuelson made rather a while back, Samuelson's argument shows that you need a capital-gains tax to avoid the problem of distorted choices among assets whose payoffs are more than 25 years into the future; nearer-term payouts aren't affected by that kind of distortion. Seamus also hit on a couple of other potential objections.

Want to increase the redistributive potential of the tax system? Increase the GST while increasing income-based transfers to the poor. Why muck up incentives to make capital investments?

Can tax and subsidy incidence really be negative?

Imagine a country where shoes cannot be imported and furthermore the elasticity of supply of shoes is very low. Imagine that the government in this country subsidises shoes. The person on the street who doesn't understand tax incidence might think that this policy lowers the price of shoes by the amount of the subsidy. An economist, however, would be likely to point out that, because supply is fairly unresponsive to price, the subsidy mostly results in an increase in the before-subsidy price to the seller.    In our jargon, he would be saying that most of the incidence of the subsidy would be on sellers and only a bit on buyers.

So far so good, but what if that economist now explained that removing the subsidy would make shoes cheaper to consumers, by stopping buyers from bidding up the price. This would seem to now be claiming that the incidence of the subsidy on buyers would be negative. Sure removing the subsidy would reduce the price to sellers but it would be a very strange model that would have the price falling by more than the reduced subsidy. In fact, it would seem to require that the supply curve be downward-sloping. 

And now, imagine that the economist further claimed that removing the subsidy would be good, as it would result in investors switching from investing in shoe production to investing in productive assets. This would go beyond strange. Sure the subsidy might have been diverting assets to having too much shoe production and not enough other stuff, but in what sense would we say that producing shoes is unproductive? And, how is it consistent to argue at the same time that removing the subsidy would lead to less investment in shoe production at the same time as arguing that it would result in lower shoe prices for consumers? 

O.K. this country, this policy, and this economist are fictitious. But if we change "country" to "New Zealand", "shoes" to "housing", "subsidy" to "tax exemption", and "economist" to "Gareth Morgan", you pretty much get this blog piece from Gareth on Tuesday. 

Gareth argues, correctly, that owner-occupied housing receives a favourable tax treatment relative to other investment since we are not charged income tax on the implicit rental payments we receive from ourselves. But he then goes on to argue that removing this exemption would "bring affordability within reach of many more families". This is an argument I have commented on before; it really looks like arguing that tax incidence can be negative: If housing is effectively subsidised by the tax system, we can't expect removing the subsidy to make it more affordable. 

And he then says that our tax treatment of housing has "discriminated against productive investment in favour of property speculation". Now if he means that we have invested too much in building houses and other kinds of investment, then we have to ask: In what sense is it unproductive to build houses that provide housing services to people that they value enough to pay for? And, how is it possible that curtailing such investment would "bring affordability within reach of many more families"? If, in contrast, he means diverting investment resources from building new equipment to buying existing houses as speculation, I have my perennial concern that this line or argument fails to note that buying existing houses for speculation or other reasons is not "investment" at all, and the assumptions you have to make to conclude that such behaviour diverts resources away from productive investment are a stretch to say the least.  

One final curious seeming contradiction in Gareth's post. At the start, he notes "When, not if, interest rates increase, this illusion that housing is `affordable' will burst....house prices will adjust". But later he suggests that if we don't remove the tax-favoured treatement of housing, he should "go out and buy another three houses now and just wait for the rest of you to bid the prices up". Why would that be good personal investment advice if, as he says, house prices are sure to fall? What am I missing?

More on Housing Affordability: Supply versus Demand

Over at TVHE, Matt has followed up on my post here on Gareth Morgan versus the Productivity Commission, arguing that we shouldn't view supply and demand explanations as mutually exclusive. Now I think Matt and I are pretty much in total agreement, but slight differences in language might make our posts seem at cross purposes, so I thought a couple of clarifications are in order.

First, the interesting question is not whether the cause of house-price inflation in New Zealand is supply, demand, or some combination of both. Obviously, since house prices are set by mutual agreement between buyers and sellers, prices are always and everywhere the result of both supply and demand. Rather the issue is, to the extent that house prices are inappropriate for some reason, whether the source of the inappropriateness is acting through supply or demand. Matt frames this by asking whether something is pushing demand for housing beyond what is "socially optimal" (or, by extension, restricting supply below what is socially optimal). Another way of saying this is to ask whether the policy response to high house prices would work by increasing supply (say changes to zoning or consent processes) or demand (say, changes in the tax treatment of housing).

The second clarification is that saying that supply and demand are not mutually exclusive is more than just saying that influences on both sides can contribute to the final effect. In the case of tax policies, the purpoted cause of house-price inflation only makes sense if there is an underlying problem with supply. To illustrate, consider Matt's statement

The key point against supply side issues will be fact that rental growth hasn't gotten as scary at any point -- if there are "too few" houses, then we should really see the cost of housing services/rent pick up.

The idea here is that if house prices are going up faster than rent, then the opportunity cost of owning a rental property must be rising faster than the direct income derived from it, so the only motivation must be the expectation of capital gain. This is true, but the expectation of capital gain only makes sense if the underlying trend is for the demand for housing for non-investment purposes to grow faster than supply. That is, to explain house inflation today as driven by tax-favoured investment, we need to assume a problem with restrictions on supply in the future.

Furthermore, consider what we would observe if there were no favourable tax treatment for owner-occupied housing or income derived from capital gains, but still an expectation of demand growth outstripping supply growth in the future. As long as the capital gains tax rate were not set at 100%, it would still be the case that expectations of future house price inflation would drive inflation in house prices today, there would be a positive after-tax return from capital gains, and hence a slower rise in rents, exactly the observations that Matt suggests might imply the problem is not exclusively on the supply side.

The bottom line here is that the favourable-tax-treatment story simply implies that problems due to insufficient supply will bite a bit earlier than they otherwise would have done. If there is no problem with supply being unable to keep pace with underlying demand, the tax-treatment issue is irrelevant.

Gareth Morgan on Housing Affordability

Gareth Morgan takes aim here at the Productivity Commission, for emphasising land supply as the major determinant of the high cost of housing in New Zealand. He notes that

[t]here are cities in the world with five times Auckland's population, living in an area no larger than Auckland's, and with housing prices lower as a percentage of income than in New Zealand.

Gareth, in contrast, points the finger at the Reserve Bank for directing banks to emphasise mortgage lending (for prudential reasons), and the tax code for favouring housing. He says that as a result of this "toxic duo" we have

driven the price of housing from twice the average household income to six times.

He restates his call for a capital tax (not a capital gains tax) to remove a distortion in favour of housing. Now, as I wrote here, I think that a capital tax has some really horrible properties that would swamp any benefits, but this is secondary to why I don't agree with this analysis of the NZ housing market.

First, explanations don't have to be either-or. Even if we agree that there are problems in New Zealand capital markets that contribute to house inflation, surely it would be the case that those problems are going to be more acute the lower is the elasticity of supply of land for housing?

Second, one of Gareth's concerns about the tax advantage given to housing is that it encourages people to buy housing as a path to prosperity, which presumably means that it is based on expected capital gain. Now this either means that house prices have been pushed up by a bubble, which will eventually burst without any change in the tax system, or that the fundamental price of housing is rising, and speculation is just bringing those price increases forward. If that is the case, then removing any favourable tax treatment on the capital gains from home ownership might cause a one-time drop in house prices now, but a faster increase in those prices in the future.

Third, Gareth's other concern about the favourable tax treatment given to housing--and the one that motivates Gareth's call for a capital tax--is the familiar fact that the implicit income earned from selling housing services to oneself in owner-occupied housing is not subject to income tax (although the transaction is implicitly subject to GST). This distortion will indeed cause the demand for housing to be higher than it otherwise would have been. But it will not cause the after-tax price of housing services to be higher, so again, it is hard to see how removing the tax distortion would be a solution to the problem the Productivity Commission are addressing.

Finally, if looking to the tax code to explain the change in house prices over time, or differences between countries in the fraction of income devoted to housing, one needs to identify time-series or cross-section differences in the tax code. Pretty much all countries have a tax code that favours owner-occupied housing and always have done. If anything, we have moved the tax code away from favouring housing in recent years with changes in the treatment of investment properties, and a switch from income tax to a higher rate of GST. And we don't have policies like the mortgage interest rate deduction that are seen in other countries, particularly the U.S.

Ultimately, it just comes down to ECON 100 supply and demand. The New Zealand population has been rising, and land-use policies have been preventing supply from keeping up with demand. Maybe those policies are a good thing, and we should be moving away from urban sprawl to high-density living. But it is hard to counter that the cost of such policies will be a steady increase in the price per square metre of housing.