By Geoff Simmons*
Bright Line Test not deterring speculation
Last weekend’s Q&A revealed that the most common length of time for an Aucklander to hold a property at the moment is less than one year, followed by 2-3 years, then 1-2 years. Under the ‘bright line test’ the Government passed last year, anyone holding a property for less than 2 years has to pay capital gains tax when they sell, though owner-occupiers are exempt.
As was discussed on Q&A this shows that investors are willing to pay tax on their gains instead of waiting for 2 years to cash in. In other words, the bright line test is not deterring speculation in the Auckland housing market. Investors are happy to pay the tax on the stellar capital gains they are seeing.
Capital gains taxes don’t stop speculation
This insight puts pay to the idea that a capital gains tax would end speculation in our housing market. It might make a small dent, but it certainly won’t stop it in its tracks.
This accords well with overseas experience. A capital gains tax has done little to prevent housing bubbles overseas. At best it slows the bubble or prevents it getting bigger than it would. There are three reasons for this; capital gains taxes can be easily avoided, they usually exempt owner-occupiers, and a capital gains tax is just one of the many tax loopholes associated with housing.
Avoiding capital gains
There is one easy way to avoid paying a capital gains tax – or in fact any other tax based on a financial transaction – simply don’t sell.
It is well documented overseas that capital gains taxes distort the market by encouraging people not to sell their houses. In other words if you don’t make the sale, you don’t pay the tax. The trouble is that selling is sometimes the best option – anything that discourages selling means that expensive assets can end up being used in a less than ideal way. Economists have long singled out capital gains taxes and stamp duties as a handbrake to ensuring assets end up in the right hands.
A Comprehensive Capital Income Tax on the other hand doesn’t discourage assets from changing hands. In fact, they encourage all investments to be used in the most efficient way possible, rather than as a way to minimise a tax bill.
Most proponents of a capital gains tax want to exclude the family home; an approach that is commonplace overseas. The trouble is that this hugely reduces the effectiveness of a capital gains tax.
Even with the growth in interest from investors in the Auckland housing market, they are still only purchasing 45% of homes. Nationwide some 65% of households own their own home, still the majority of the market. While some people might consider owner occupiers as more ‘worthy’ owners of a property than investors, any tax is going to be far less effective if it excludes the majority of the market. Owner-occupiers – whether buying their first home or moving – are adding to the speculative bubble like every other buyer. When someone makes a capital gain on the family home that is income like any other.
As we have seen overseas, any exemption in a tax makes it far less effective, particularly an exemption this large. Rich people can afford accountants, so they are far better at exploiting exemptions than the average taxpayer. To be effective, a tax system has to be kept simple.
There are other loopholes
Capital gains is just one of the many loopholes associated with land and housing. The ability for owners to write off expenses – even to the extent of making tax losses that reduce their taxable income – is another. However the big tax loophole is imputed rental – the benefit you get from living in a house. This concept is well accepted in economics and is even included in our national GDP accounts. Imputed rental is at least partially taxed in some countries.
To explain the concept try this little mind experiment. Imagine you have $1m and need a place to live. You have a choice – buy a house in Auckland or put the money in the bank and use the interest to pay your rent. If you buy a house you get the shelter and you pay no tax. If you put the money in the bank you pay tax on your interest before you pay your rent.
These other loopholes are important drivers of the demand for housing, both here and around the world. How we deal with them is at least as important as how we deal with capital gains. Our proposal of a Comprehensive Capital Income Tax closes all these loopholes at the same time, putting housing on an equal footing with other investments.
Ultimately what we want to see is stable house prices. Housing should be seen as a place to live rather than a speculative investment. Instead of getting rich by buying houses off each other, our money should be invested in things that are actually going to earn us a real return in the world. A CCIT is the most effective way to achieve all that.
Geoff Simmons is a senior economist at the Morgan Foundation. This article was first published on the Morgan Foundation blog and is re-published here with permission.