Ewen McCann looks at rising house prices as a symptom of deeper policy issues, which we must deal with first if we are to tame the rising distortions

By Ewen McCann*

The Government’s policy towards rising house prices is to expand the supply of houses. This is in the expectation that an increased supply it will slow the rate of increase in house prices.

Supply and demand analysis is the most powerful tool that economists have but it works best from a position of market equilibrium.

The housing market is not in equilibrium so an increase in supply need not lower the rate of increase in house prices. This is why the Government’s supply side policy is naïve.

This article considers some of the disequilibrium economic forces operating in the housing market. The forces are not related to each other, other than being a part of the price equilibrating process. They will be treated in turn and not every disequilibrium force will be investigated. Together they determine the disequilibrium path of house prices as they approach their equilibrium value in the housing markets.

Rising house prices are, nonetheless, largely the wrong issue to complain of. Only where the price path is in part the result of wrong-headed policy or of the outcome of monopoly power is there room for complaint. Then the complaint should be about the daft policy or the monopoly. Price rises otherwise are the result of other economic forces.

Wealth accumulation

The increase in the price of housing, I argue, is the result of attempts to accumulate wealth. The dynamics of wealth accumulation can take generations to work themselves through. This is partly because houses are such long lived assets but also because new shocks are probable over the long period of adjustment in house prices. Picketty writing Capital in the Twenty-First Century has demonstrated these effects and their durability.

A well enough known feature of the New Zealand housing market is the high multiple that average and median house prices are of average and median incomes compared with other countries. This seems not to have explained and an explanation for is offered here that links wealth accumulation to the high trajectory of house prices.

Housing is probably the largest part of household wealth in NZ. In our case the shocks to planned wealth accumulation, especially in housing, over the past two generations have been:

(1) the appearance in the housing market of double income families.

(2) A long period of inflation-induced flight from liquid assets.

(3) The entry of one set of parents into the market in partnership with their children.

(4) The next shock will be the entry and impact of a second set of parents helping fund their children’s demand for houses.

(5) Longer working lives.

(6) Children staying longer at home keeping older people from selling the family home.

(7) Tax loopholes.

(8) The inwards and outwards migration of people and the natural increase.

(9) Foreign buyers entering the market.

The time path that housing prices are taking are the outcome of target wealth levels, income and the nine factors listed. As any of these factors vary, the housing market sets off on a different, largely rising, time path towards a new equilibrium value that it takes a long time to reach.

All of the nine effects are real, meaning that they are, in principle, measurable and not a matter of the claimed psychology of the market which is unmeasurable and thus practically meaningless. This psychology is said to induce bubbles which are identifiable only after the event and not amenable to policy prescription. It is these eight real effects, most of which have a long response time, which makes the supply side response naïve. Those effects would still operate on house prices were new house construction to expand.

Tax loopholes

We first examine the effect on the price path of the tax loopholes in the housing market. These tax loopholes are real features of local capital markets which contribute to the upward motion of NZ house prices. The first loophole is the tax concession available to foreign borrowing when it is undertaken by way of debentures. This is available to NZ corporations, but not to individuals. In itself, this is distortionary because one legal entity should not be economically preferred to another.

Companies which borrow abroad through debentures in effect receive a tax advantage over and above the tax deduction available when they borrow locally. New Zealand banks doubtless exploit this tax advantage. It makes foreign borrowing cheaper for them than borrowing from locals. In other words, NZ individual lenders are being done in the eye. This tax concession thereby increases the foreign borrowing by banks which is fed into the NZ property market.

Without explaining how it happens, this tax privilege artificially lowers NZ interest rates and increases the level of borrowing. That inevitably contributes to the rising level of house prices. The whole practice severely distorts NZ capital markets. It also appreciates the currency.

Closing the tax loophole on foreign debenture capital would raise interest rates which would be beneficial because capital would then be used more productively. For example, at higher interest rates each borrower would borrow less so a total of $10m would build more, though smaller, houses and that amount of capital would house more families. More families in houses for $10m is an improvement in the productivity of capital. Similar effects would apply in businesses.

Foreign borrowing by banks, destined for the local housing market helps raise house prices. Capital gains are income which is clearly being earned in the housing market. One of the other deficiencies in the tax system is that capital gains to household real estate are not, on the whole, subject to income tax. This income could be readily taxed at normal rates of income tax by using the annual differences in local body property valuations as a proxy for the increase in the market price of houses. The whole housing and other stocks of real estate would be income taxed on the annual incremental increases in rateable values at normal rates of income tax. This would steady the rises in house prices.

Income in kind

The accommodation services flowing from an owner occupied house constitute income in kind, i.e. non-cash income. Mortgage interest is one of the cash costs of earning this imputed income. Neither of these amounts enter the tax system and their net value is an un-taxed benefit to home owners. Other assets do not enjoy such a tax privilege. This tax preference to the housing sector distorts households’ investment choices in favour of housing and adds to the long run equilibrium price of housing.

The increased commercialisation of attitudes in NZ over the past generation will have caused NZers to seize upon theses tax loopholes and make them invest more heavily in housing than previously. It is another driver of the house price trajectory. Closing the imputed rental loophole would result in a sell off of baches.

The taxation of the imputed rent with a tax deduction for mortgage interest, and perhaps the other costs of home ownership, would lower the long run price of housing and lower its disequilibrium price path. Some readers may sob in their soup over this. The sobbers will be the ones enjoying their free ride on other tax payers.

The extra tax revenue from all foregoing proposals could be directed to a reduction in income tax rates. Each income tax bracket could receive a tax rate reduction that is proportional to the amount of total tax revenue that it contributes.

Households’ accumulation of wealth is directed towards the most profitable risk adjusted investment opportunities. The tax advantages of housing over other investments make housing the best risk adjusted alternative for households. These tax features of the housing market contribute strongly to that high and rising price path of houses. It will be a mighty contributor to the high multiple that housing values bear to average and median incomes compared with other countries.

Three serious tax distortions

The Inland Revenue Department, the Treasury, the Prime Minister’s Department, the Reserve Bank and ultimately the Government should clean out the three serious tax distortions in NZ capital markets. The three distortions are

(1) the tax concession to foreign debenture capital and

(2) the absence of a capital gains tax.

(3) the non-taxation of net imputed rentals.

That would go a fair distance towards reducing the long run equilibrium value of house prices. It would lower the long run target level of wealth and thus the ratio of average house price to average income. This is because a smaller fraction of wealth would be held as housing, absent the tax distortions.

Despite shocks (1) – (9) above, one can still think conceptually of movements towards an equilibrium relation between wealth and income over the long haul. Because NZ is a poor country, houses are a major part of household’s wealth and financial assets are a relatively unimportant part of their wealth. This is why house prices are such a high multiple of incomes in NZ. In short, one views the history of house prices in NZ as the outcome of the adjustments between income and desired wealth levels.

Leveling the playing field

The wrong issue is being raised in New Zealand about the housing market.

The tizzy is about the rising price of houses. This complaint usually comes from one side of the market, the buyers’ side. Sellers seldom complain about rising prices. Holders of houses are seldom upset by an increase in their values. At root, far and away more people are content with the increase in house prices than are upset by it.

Part of the complaints about rising house prices will be coming from the DINKS (Double Income No Kids) and their parents who want a government policy to ease the path to first home ownership. A possible policy would be to restrict the contribution of parents to their children’s housing deposits. Were it feasible, such a policy would lower house prices, rewarding to some extent the DINKs who refrained from taking their OE and saved instead.

A workable way of restricting parents’ contributions of capital to their children’s houses would be to re-instate gift duties and extend to them to disbursements from trusts. The interest differential on low interest rate loans would also be dutiable in a special way. The whole differential would be taxed away. This would bring the interest rate that the children paid up to the market rate and so reduce the amount of financial capital borrowed for housing.

There would be no valid transfer of title where associated gift duties are unpaid and there would be tax penalties for evasion. The lender on first mortgage would responsible for ensuring that all duties are paid and, if they are not, the lender would lose first mortgage priority. This policing would involve fees that would further reduce the demand for housing finance. Investment in the housing market would be less attractive to banks.

Objections to foreigners trading in the local housing market are misplaced because the economic value of NZ resources needs must reflect their international values. If the economy is to be competitive with the rest of the world its prices must be aligned with prices in the world economy. This is the lesson of the Nash-Muldoon epoch when distortionary pricing policies made the country virtually incapable of efficient international trade.

The economic issue is not that house prices are too high. The economic issue is: What is the appropriate policy if house prices fall? House prices fell dramatically in the USA, Ireland, Greece and in other countries after the Great Financial Crisis. What, one may ask, should the Reserve Bank do if that happened here? Is the Reserve Bank even thinking about this issue?

There is a second article to follow dealing with the policy response to a fall in house prices, which is the right question to be asking about the housing market instead of the one that is being asked. If house prices continue to rise due to the equilibration process, there is no policy problem to address – other than the mal-distribution of wealth and the tax distortions. Why, after all, are rising house prices more important than the welfare of poor children whose families will never own a home anyway? A drastic fall in NZ house prices, however, entails a policy problem – as other countries’ experiences have shown. It would have grave consequences for rich and poor alike.

The second article will show how New Zealand may cushion the effects of a future decline in house prices, if it occurs. It will show that it should not follow the policies that other countries adopted after the Great Financial Crisis. It will be argued that NZ is in a strong position to adopt a policy to partly counter the effects of a house price induced recession.


Ewen McCann was formerly Head of the Department of Economics, University of Canterbury and latterly Principal Economist at the Inland Revenue Department.