Richard Inder: Capital gains tax will level investing field

The Government's attack on the housing market this week looks like a knee-jerk reaction.

The proposals are either fraught with problems or are just plain barmy.

The first suggestion was for tinkering with rules governing banks. This presumably would involve increasing the amount of capital the banks must hold to back up their loans or, perhaps, limiting the amount they can lend on a property's value.

Using banks' capital requirements to regulate the economy is analogous to the tool already available to the Reserve Bank - lowering or raising the official cash rate.

Both are broad-based, limiting consumer and business credit. However, the official cash rate has the added advantage that its moves are much more easily understood in the wider economy.

Limiting lending on property is deservedly described as "Muldoonist". It amounts to the Government saying it is a better judge of risk than the banks. Such a system would limit banks' ability to assess individual circumstances.

Why shouldn't a person in a stable job earning $500,000 a year be able to take out a 100 per cent mortgage on a $350,000 house?

Assessing credit risk is what banks do. They have invested huge sums in systems to monitor risk.

Limits on borrowing are likely to result in anomalies that will only undermine confidence in the banking system and promote rorts aimed at circumventing the regulations - under-the-table loans or convoluted structures designed to exploit the inevitable loopholes.

Also mooted was a crackdown on loss-attributing qualifying companies. Property investors set up these so that rents are insufficient to cover the interest payments. The investment needed to cover the losses is largely tax-exempt.

The structure, however, was set up to give small businesses limited liability protections and this rationale remains.

Meanwhile, the review has explicitly ruled out examination of savings incentives and a capital gains tax on investment property. Only the latter has the real potential to begin to cool the overheated housing market.

A policy exempting the family home from such a tax - a regime similar to the one operating in Australia - would target professional property investors who bear some responsibility for the froth in housing markets.

This would level the playing field with other investment classes such as shares or bonds. Indeed, much of the weakness of the NZX is attributed to the tax advantages enjoyed by property investment.

This is not an argument for tipping the balance in favour of shares; instead it is aimed at ensuring that capital earns a return commensurate with risk and not because of an anomaly in government policy.

A broad-based capital gains tax would also solve an emerging problem in the taxation of shares.

Earlier this year, the Government signalled plans to introduce a capital gains tax on foreign shares. It also promised to remove capital gains on cash invested in local shares through managed funds. Professional traders investing on their own account would remain subject to capital gains. This regime tips the balance in favour of New Zealand managed funds over foreign shares while those with the wisdom and gall to test their wits in the local sharemarket are penalised.

Taxing shares equally ensures the most efficient allocation of capital and a capital gains tax on at least one of these classes of shares looks inevitable.

A capital gains tax regime is not without problems. If family homes are exempt, what about farms? Farmers - as my in-laws would attest - make most of their cash from the capital gain of their land. What about antiques or art?

Exempting the family home also only solves part of the problem.

Many buy the family home in the expectation that an increase in it its value will help them prepare for retirement. Such a capital gains tax regime does not capture this investment - a big contributor to the growth in house values.

Moreover, the introduction of such a tax would have to be accompanied by tax relief in other areas. If the latest election has shown anything, it is that New Zealanders believe they are already over-taxed.

In any case, an overheated housing market is not by itself a reason to start tinkering with policy settings. Good governance demands constant attention to ensure the playing field is fair to all asset classes. Anything less will create problems elsewhere in the economy.

Ultimately, the Government has to let the market run its course. Property in New Zealand has so far been a one-way bet and, over the long term, it still may be.

However, data showing sharp falls in housing affordability and stretched rental yields suggest that some people believe these gains are in some way divorced from the underlying economy.

Such beliefs are only likely to be dislodged when they are proved untrue - and this means a sharp correction in the housing market, mortgages higher than the value of the underlying property and mortgagee sales.

These eventualities are the downside of a free market, but they must be accepted, as they are as much a symbol of a market's health as rising wealth.