Dominick Stephens
Wellington, June 19, 2018
The Tax Working Group (TWG) is investigating whether changes to the tax system will affect house prices.
The answer is a definite ‘Yes.’
Property prices in New Zealand are profoundly affected by the tax system.
It follows that changing the tax system would change property prices.
It would also change the rate of home ownership.
We estimate here how various new taxes might affect house prices and rents using our Investment Value of Housing model.
We also discuss how these tax changes might affect the rate of home ownership.
The Tax System and Property Investment
In New Zealand, property is more lightly taxed than other forms of investment.
Treasury and the IRD estimate that property investors pay 29.4% of their after-inflation returns in tax, whereas bank depositors and owners of dividend-paying shares pay 55.7%.
This is mainly because income from investments is taxed, whereas capital gains are tax free.
Bank deposits yield only income, and are therefore taxed heavily.
By contrast, property investments return little in the way of taxable net income and more in the way of capital gain, which is tax free.
The kicker is the fact that expenses, including mortgage interest, are tax deductible.
This feature of the tax system is especially useful for property investors, who find it easier to borrow against their investments than other businesses.
Landlords benefit
Landlords’ debt loadings can be so high that their expenses outweigh their rental income, meaning they can declare zero or negative taxable income.
Meanwhile, they can collect tax-free capital gains.
Naturally, this has made property investment incredibly popular.
And that popularity has been one factor pushing house prices higher.
The tax advantages of property investment have been factored into the price of property.
Another quirk of New Zealand’s tax system is that property investors enjoy more favourable tax treatment than heavily indebted owner occupiers (first homebuyers).
Property investors enjoy tax deductions for mortgage interest and property maintenance, whereas owner occupiers do not.
This boosts the amount property investors are willing to pay for property.
Consequently, fewer aspiring owner occupiers are willing or able to outbid aspiring investors to secure a dwelling.
Not surprisingly, after the tax rules granting landlords this advantage were introduced in the early 1990s, New Zealand’s home ownership rate fell.
If the tax system has affected the price of property and the rate of home ownership in New Zealand, it stands to reason that further changes to the tax system could once again alter both.
The investment value of housing
This bulletin uses our Investment Value of Housing model to estimate the impact that various tax changes would have on house prices and rents.
The model estimates the value of an average New Zealand house to a rational investor, based on the net present value of the rent that the property could generate less the expenses.
The Investment Value of Housing model is sensitive to inflation, interest rates, and the tax system, and gives excellent signals as to what might happen to house prices when one of these factors change.
For example, from 2014 to 2017 mortgage rates fell sharply.
The Investment Value of Housing model correctly predicts that this was a period of strong house price growth.
The model is calibrated to a median house in New Zealand, currently worth $560,000, being rented out for $464 per week and financed over the long term at a mortgage interest rate of 5.25%. It is a model of fair value and takes no account of pre-existing undervaluation or overvaluation in the market.
One key uncertainty is how rents would respond to tax reform for landlords.
simple assumption that one-third of the adjustment to a tax change would come about via higher rents, and two-thirds of the adjustment would come about via lower house prices.
If rents in fact adjusted by less, the adjustment in house prices will be larger than we have estimated. Finally, in this bulletin we estimate the change in long-run fair value that could result from tax changes. The analysis in this bulletin has nothing to say about how long such an adjustment might take to play out. A 10% drop in fair value might play out as a sudden drop in prices, or as a long period of price stagnation while the fundamentals catch up – the model does not tell us which is more likely.
Dominick Stephens is Chief Economist at Westpac Bank New Zealand. The above is an edition version of his article. For full text, please visit economics
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