18/12: Why house prices are through the roof: Pt I
What has caused the significant growth in the capital value of housing in New Zealand over the past five years, why was it so extreme relative to other economies where house prices boomed and why was it so widespread and prolonged?
To date no entirely satisfactory explanation has emerged and yet the phenomena has been of significant influence in numerous areas not the least of which has been in monetary policy responses to inflationary expectations perceived by the Central Bank as being unduly fueled by rising house prices.
A more than plausible explanation may lie in tax policy - and more than just the capital gain story alone.....
There has long been significant concern about the distorting effects which the absence of capital gains tax on residential property creates. Not only are such distortions likely to attract "too much" investment into housing they are also likely to penalise investment in other assets, disguise the true level of saving while at the same time generating risks of equity distortions by driving up the cost of housing "services" (the non investment component of house purchase).
The distortion process is relatively simple. Even in a crudely efficient market the value of this tax break is bid into the price of houses and thus reflects the value of the tax break on top of supply, demand and premia for standard risk factors associated with the asset. Prices are thus set by the tax position of the marginal investor - the investor standing to make the most of the tax break. Should this matter? To the extent that not everyone shares the position of the marginal investor but still invests in real estate or buys housing services through investing in houses, yes it will matter since the price has gone up but not everyone shares the tax break windfall.
So far then we can expect the lack of a capital gains tax to be reflected in prices and to sit "atop" other factors driving asset value growth. Various versions of this phenomena can be observed wherever there are tax breaks of one or another kind for housing assets.
The twist in N.Z. came though when the Labour Government, near the start of its current reign introduced a higher marginal rate ($0.39 versus the previous across the board $0.33 top rate) for those earning more than $60,000. Immediately, for those facing this new marginal rate the relative attraction of tax free capital gains grew by 18% ($0.39 - $0.33) for the affected part of their income, i.e. all personal income over $60,000.
This would have immediately been impounded into house prices. The second part of the equation and compounding the initial damage was the fact that when the new $0.39 rate was first applied only a relatively small number of tax payers faced it - perhaps 10% - 15%. The last five years however has seen that proportion grow through "bracket creep" so that more like 38% now face the highest marginal rate meaning that the 18% additional relative advantage of tax free residential assets applies to a widening group.
It is this bracket creep which has kept momentum so high.
Interestingly then a strong policy prescription for taking the heat out of housing prices may well be:
1. Cut personal taxes as sharply as is possible, and,
2. Make the rates flat, flat flat.
That way the incentive to over invest in real estate is reduced, the attraction to invest in non real assets grows in a relative sense, bracket creep effects are lessened or removed and house prices have more chance of reflecting demand and supply for housing services not tax breaks.
To date no entirely satisfactory explanation has emerged and yet the phenomena has been of significant influence in numerous areas not the least of which has been in monetary policy responses to inflationary expectations perceived by the Central Bank as being unduly fueled by rising house prices.
A more than plausible explanation may lie in tax policy - and more than just the capital gain story alone.....
There has long been significant concern about the distorting effects which the absence of capital gains tax on residential property creates. Not only are such distortions likely to attract "too much" investment into housing they are also likely to penalise investment in other assets, disguise the true level of saving while at the same time generating risks of equity distortions by driving up the cost of housing "services" (the non investment component of house purchase).
The distortion process is relatively simple. Even in a crudely efficient market the value of this tax break is bid into the price of houses and thus reflects the value of the tax break on top of supply, demand and premia for standard risk factors associated with the asset. Prices are thus set by the tax position of the marginal investor - the investor standing to make the most of the tax break. Should this matter? To the extent that not everyone shares the position of the marginal investor but still invests in real estate or buys housing services through investing in houses, yes it will matter since the price has gone up but not everyone shares the tax break windfall.
So far then we can expect the lack of a capital gains tax to be reflected in prices and to sit "atop" other factors driving asset value growth. Various versions of this phenomena can be observed wherever there are tax breaks of one or another kind for housing assets.
The twist in N.Z. came though when the Labour Government, near the start of its current reign introduced a higher marginal rate ($0.39 versus the previous across the board $0.33 top rate) for those earning more than $60,000. Immediately, for those facing this new marginal rate the relative attraction of tax free capital gains grew by 18% ($0.39 - $0.33) for the affected part of their income, i.e. all personal income over $60,000.
This would have immediately been impounded into house prices. The second part of the equation and compounding the initial damage was the fact that when the new $0.39 rate was first applied only a relatively small number of tax payers faced it - perhaps 10% - 15%. The last five years however has seen that proportion grow through "bracket creep" so that more like 38% now face the highest marginal rate meaning that the 18% additional relative advantage of tax free residential assets applies to a widening group.
It is this bracket creep which has kept momentum so high.
Interestingly then a strong policy prescription for taking the heat out of housing prices may well be:
1. Cut personal taxes as sharply as is possible, and,
2. Make the rates flat, flat flat.
That way the incentive to over invest in real estate is reduced, the attraction to invest in non real assets grows in a relative sense, bracket creep effects are lessened or removed and house prices have more chance of reflecting demand and supply for housing services not tax breaks.
