At home with tax breaks

If politicians genuinely wish to address the perennial issues in the New Zealand housing market they need to get brave and address the tax status of home ownership.  And I am not talking about capital gains tax here.  Although a comprehensive and consistent capital gains tax system would be of help to New Zealand’s economic performance, in terms of the housing market a more critical issue is the lack of a tax on imputed rent.

The usefulness of taxing imputed rent may not be immediately obvious to many.  It will also be objectionable to the vested interests of home-owners as they have benefitted from the lack of this tax.  The introduction of taxes on imputed rent will most likely reduce the financial incentive to own one’s own home (although non-financial reasons such as security of tenure and the ability to customise living conditions to one’s specific requirements will persist).  As a home owner myself I recognise that at first blush, the introduction of taxes on imputed rent are not necessarily in my best interests immediately.  But as a New Zealander I realise that a more efficient tax system will improve the wealth of New Zealand as a whole and that this is ultimately better for me and my family than being on the right side of an inefficient and unfair tax system.

What is imputed rent?  It is the rent that one effectively pays to oneself for renting one’s own house.  There is no financial transaction but there is a real benefit.  If one does not own a house, one has to pay rent or lodging to the owner of your residence.  In this situation the owner receives direct income from the tenant, which after factoring in costs is liable to normal income taxes.  But when the owner is also the tenant, the lack of financial transaction allows the owner to escape this tax liability.  The owner-occupier is implicitly receiving the same income as the landlord, but they face a lower tax liability.  The implication is that home ownership enjoys an exalted tax status, and it is this preferential tax status that is the root cause of many housing market issues.

The preferential tax treatment creates a wedge between home ownership and other forms of investment (eg buying into a business).  If one buys into a business, one faces initial finance costs and ongoing running costs, which are offset by the income one earns from the business.  But any revenue in excess of these costs is subject to income tax.  If instead one buy’s a house which becomes your home, one receives no revenue but one receives the valuable service of living in the house.  From a financial perspective, the homeowner must service the mortgage borrowed to fund the house purchase.  As one does not pay any tax for the imputed rental service received, there is a strong incentive to pay down the mortgage as fast as possible to minimise finance payments.  Effectively this reduction in the size of one’s mortgage is an alternative to investing in other activities (like a business).  But the difference is that the net income from a business investment is taxable, but the reduction in mortgage payments effectively represents a tax-free reduction in living costs.  The implication is that the best use of spare cash for a home owner is to use it to pay down one’s mortgage.  People may not think through the issue explicitly like this, but paying down their mortgage as fast as possible is what most people do and few would argue that this was not a sensible strategy for homeowners. 

The outcome of these incentives, as well as the lack of tax on capital gains, is that home ownership provides fantastic after tax returns, which makes home ownership a divide in wealth status for New Zealanders.  Home owners are typically better off than non-owners, not so much because home ownership is an intrinsic source of wealth, but because the tax system confers this wealth gain to homeowners.  This is what lies at the heart of New Zealanders deep interest in the importance of home ownership; home ownership confers disproportionate increases in household wealth, thus inducing ongoing demand for home ownership and ongoing concern about home affordability. 

The tax treatment also induces another distortion in the New Zealand economy, by encouraging people to quickly pay down their mortgage, it means that New Zealanders savings portfolios are typically heavily skewed and concentrated in home ownership.  As a result the wealth of retiring New Zealanders are typically asset rich but their ability to liquidise their wealth is overly exposed to the state of the housing market (again reinforcing our focus on housing).  Finally by concentrating wealth in an inflated housing market the tax system is effectively making access to capital more difficult for other activities.  Businesses end up paying more for finance than they would otherwise, thus reducing non-housing market business activity. 

A tax on the imputed rent of home ownership is usually coupled with tax deductions on mortgage interest payments.  The implication is that a tax on imputed rent is not usually associated with large tax payments.  Instead, the main impact is to slow the haste with which people pay off their mortgages – the increase in tax liability from lower interest payments offsets the incentive to pay down mortgages so quickly.  This in turn will make people more willing to make their investment decisions based on the economic merits of alternatives rather than on their tax status – encouraging both a more efficient allocation of capital for the economy and a more diversified investment portfolio for savers. 

So why do we not have taxes on imputed rent in New Zealand?  It is not because they need to be overly complicated taxes – the Netherlands enforces a reasonably simple version.  The key reason is entrenched self-interest.  The introduction of such a tax would induce a reduction in house prices that will result in an effective transfer of wealth from home-owners (like myself) to owners of other assets.  Of course, many will have assets on both sides of the ledger, and these people may come out reasonably even.  Eventually a better performing economy will have a more material impact on wellbeing, but this will mean that the people who have already invested in houses based on existing tax rules would discover that they paid too much for the houses they live in and as a result they would not be as wealthy as they now consider themselves to be. 

This perhaps leads us to the main area of entrenched self-interest: political inertia.  We elect our politicians to deliver policies that will enhance the wellbeing of New Zealanders.  In many cases the democratic process encourages an alignment of the interest of politicians and society in general.  But situations involving structural changes to the economy and wealth transfers, like those induced through major reforms of the tax system, are areas where the long term interest of New Zealand are not met by the short term interests of elected officials.  The beneficiaries of better tax policies are diffuse and opaque – they may not benefit for many years, and when they do they may be totally unaware of the benefit they have gained.  Yet the initial losers are very obvious.  The political cost today far outweighs the future political benefit – even though the result of the economic analysis is the opposite.

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