Brian Fallow: Tax rules bad for economy

Photo / Hawkes Bay Today

Chances are quite a few people will be unhappy with the Government after the Prime Minister's agenda-setting speech on Tuesday.

Chances are a lot of them will be property investors.

Why have all eyes swivelled in their direction?

It is not just that relief elsewhere in the tax system requires expansion of the tax base. It is not that someone has to fund it, and they will do.

It is that the tax rules which are so good for landlords, and to which investors have quite rationally responded, are bad for the rest of the economy.

John Key has referred at least a couple of times to the Tax Working Group's startling discovery that the $200 billion or so invested in residential investment properties yields in aggregate less than nothing in tax revenue.

In 2008 the deductions claimed exceeded taxable income from the sector by about $500 million.

Not for everyone, of course, but overall it is one big tax shelter.

One consequence has been to push up the prices it is rational for an investor to pay for rental properties way beyond what would be justified by their rental yields alone.

Clearly much of the return investors expect to get is from the tax system, not their tenants.

During the most recent boom when house prices doubled, rents increased much more slowly and rental yields fell.

In much of the housing market it is investors who are the marginal buyers who set the price.

The more they are prepared to pay, the more owner-occupiers have to pay, pushing traditional measures of housing affordability to historically high levels.

Like other forms of inflation it creates losers as well as winners and leads to a misallocation of resources.

It has fostered a mindset that the best way to provide for your old age is not to save money but to borrow money and engage in highly leveraged plays in the property market, chasing untaxed capital gains and sheltering other income in the meantime.

For the individual, while the present rules prevail, it makes perfect sense.

For the economy as a whole, no sense at all. It diverts capital which might otherwise flow into businesses which help the country earn its living in the wider world. We have ended up with an overdeveloped property market and underdeveloped capital markets.

And the doubling of house prices which occurred during the 2002 to 2007 property boom had unfortunate spillover effects.

The wealth effect as homeowners saw the value of the equity in their properties climb turbocharged consumption and stoked inflation, driving up interest rates and the dollar in the process.

The legacy of household debt built up in that period will be a drag on the economy for years.

Landlords should not be demonised, of course. They provide a valuable service and have merely responded rationally to the signals the tax laws have given them for years.

Those signals need to change, but the interests vested in the status quo are large.

Tuesday's speech should give us an indication of whether the Government can muster the political will to take them on, in the cause of making the economic boat go faster.