As the new ‘bright line test’ on residential property sales below 2-years of ownership has taken effect, we are yet again reminded of the potential ‘benefits’ of a Capital Gains Tax (for which the bright line test is not – it’s intended to provide some clarification around what’s the difference between trading in property – an income activity – and what’s investing with the potential for a capital gain). Kiwiblog has gotten involved* (Farrar is an honest proponent of a CGT) and I thought it important to deal with some of the matters, particularly providing a comparison to the alternative of a property tax to reduce housing market distortions (the main justification which tends to be employed – along with ‘fairness’ – which I find far less persuasive).
CAPITAL GAINS TAX
A couple of points upfront:
- A CGT, in any form proposed in NZ, is based on realised gains (actual disposals) and not on unrealised gains (a simple appreciation in value);
- No proposal seems to take into account the potential distortions caused (which happen whether you have a ‘simple’ or ‘complex’ system) – so even if $40bn of net gains occur a year (worth $10bn in tax at 25%), that doesn’t mean you will continue this once a CGT is introduced; and
- The actual complexity of even a ‘simple’ tax is beyond what most people realise (there are a myriad of problems, along with the need to keep records which currently we do not even need to think about – unless we wish to).
Now, to the meat of it: a CGT which does not exempt the primary residence will either need to be a ‘flat’ tax or it will likely cause people to automatically jump into the maximum tax bracket whenever they move. Farrar’s estimate, lacking any exemptions, is that this could allow us to lower the maximum tax rate to 25% (for incomes currently caught in the 30% and 33% rates). So if I sell my house today, and I make a $400,000 gain, we’re talking about this being hit with a $100,000 tax charge. How this would be administered is already problematic (in my case, it would go onto my income tax return, but for most people, how would they comply? How do we know how much they paid? Will this be a new service of the government?) The same problem arises if you own $10,000 worth of shares and now want to sell them. How much is your gain? When you bought them, obviously you kept detailed records and these have been passed between your old broker and new broker. What about bonds? This is supposed to be a simple system, yet there is quite a bit of additional administration, and unlike most employment income, it isn’t ‘simply’ a by-product of paying your staff and PAYE at the same time (and I bet employers, even as a by-product, would be happy to see that requirement go).
What is worse: you are not obliged to take your gain. If I ‘defer’ income from employment (let’s say I agree to a ‘bonus’ at the end of the year rather than taking an ordinary stream of income during the year) the taxman will happily advise me that a bonus is still income for the purposes of the Income Tax. If I keep the money, as a shareholder employee, in my company, he’ll advise me that it counts towards my ordinary income (and if I’m not, that it’s still subject to the company rate of income tax). By comparison, if I don’t like my potential for CGT, I can simply avoid disposing of the asset (potentially indefinitely). This could mean the ex-family home becomes a rental and families gradually accumulate ever more properties (through trusts or companies), as they will face significant tax penalties otherwise, and there is little reason to do so. That will, inevitably, lead to demands for an inheritance tax.
The problems with a CGT are simple (unlike the tax itself): it is inevitably complex and it does not create a stable source of revenue (as it can lead to changed behaviour, in some cases quite significantly, which is also economically distortionary). It does not mean that it’s ‘fair’ – not taxing capital gains means that the rich can keep growing their capital stock without facing tax on any eventual gain (if there is any). But what lacking a CGT does do is encourage that if there is a gain, it is likely to be realised and the capital stock made available for others to purchase (which means home, shares, and so forth being actually purchasable by others – who may not have any at the time of acquisition).
The question that seems to elude the debate is: what are we actually trying to achieve? People don’t seem to mind that someone makes a gain of buying shares and, at a much later time, sells it (we already have provisions for trading in shares, rather than for investment). If anything, we want to encourage more ownership of assets through higher savings. But we don’t seem to want everyone piling squillions into residential property (that is, both physical structures and land zoned to residential property). The Reserve Bank’s data** indicates that residential property (excluding zoned land) was worth $821.3bn at the end of June 2015. Even if unutilized land is only worth 50% of a property and 5% of existing stock, that’s another $20.5bn in the land-bank so we’re closing in on $850bn (I’ll round up for simplicity).
That means a 1% property tax (on the value of residential property and zoned land) would be worth around $8.5bn per annum. It would have no impact on businesses or farmland (there would be some interesting discussions around mixed use properties, but the RV of a flat should suffice, without needing complex separate valuations). The tax would be far harder to avoid, beyond actual property prices reducing, as while an individual can change their behaviour (I can live in a smaller / cheaper house), the reality is that the total quantity of residential property won’t shrink by my own personal choices.
What would the effect of this be? To begin with, it would allow $8.5bn of other tax cuts to be achieved (Kiwiblog has already outlined an example of the potential scope*) and it would have an interesting effect on people: there would now be a disincentive to have your property’s capital value increase. For every $10,000 of ‘gain’ you’ll face an annual levy of $100 (with no corresponding increase in income or ability to actually realise the gain). That happens whether you’re an owner-occupier or a tenant (in fact, for the first time, tenants might be encouraged to vote in favour of policies to expand housing and land supply, as they’ll be directly impacted by property value increases with no direct benefit to themselves).
As a caveat, house prices will probably drop as a consequence of this policy (even a 20% price drop would still yield $6.8bn in tax take). People will start to demand sufficient housing be consented to keep prices from rising, otherwise they’ll face an ever higher tax burden (although relieving them of income tax, assuming the amounts are net-neutral, which is always a problem). Equally, every time you look at a house, the taxable value will become a consideration. That will, hopefully, supress some demand, or at least willingness to big up, in the market, and thus add another tool to keeping house prices subdued (if the market starts overheating, the Government could simply increase the property tax rate, which should provide reasonably linear suppression).
This is not a silver bullet for the housing market, but it will encourage greater economic use of residential property (rather than people sitting in houses which are actually larger than they need) and will encourage people to use land more efficiently (why do I need to live in the centre of the city, where property is expensive per sqm, compared with cheaper somewhere else). The same applies to ‘regional development’ (the Waikato and Northland are going to start looking even more tempting to Aucklanders). The effect could be kept neutral and the reduction in income tax would encourage people to earn more and not save it into property.