Brian Fallow: Time to add GST to rents and mortgages

Taxing mortgage payments and rents would bring in a useful amount of money. Photo / Herald on Sunday

Here's a suggestion for the tax working group set up to figure out how to put the tax system on a more durable and efficient footing to consider: scrap the provision exempting mortgage payments and rents from GST.

People tend to snort derisively when first presented with this proposition and utter various phrases ending in "off". The reaction would be reasonable if that was all that changed.

But remember, any recommendations the working group comes up with are expected to be revenue-neutral, taken as a whole. And the broader the tax base the lower rates can be.

The biggest problem the tax system faces is that in a globalised era we are taxing all the wrong things. Tax economists at the OECD and elsewhere tell us that property and consumption are the best things to tax, and corporate and personal incomes the worst, in terms of their impact on economic growth.

More than 40 per cent of the income tax - much the biggest single source of Government revenue - comes from the top 10 per cent of taxpayers ranked by income, which is dangerous when labour is as mobile as it is and the income gap with Australia and most other developed countries is as large as it is.

New Zealand loses almost as many Kiwis every year through net migration as it gains through natural increase (births minus deaths).

Emigration is not just about taxation, of course, but tax should go into the balance as a reason to stay, not a reason to go.

Also a country as reliant as New Zealand is on importing capital cannot afford to be uncompetitive in the way it taxes corporate profits.

Meanwhile, we treat housing as a no-go zone for the tax man. One way or another any overhaul for the tax system worth the effort will have to find a way of bringing housing into the tax net. Substantial tax relief elsewhere will require a substantial increase in the tax base.

What is so special about expenditure on housing that warrants exemption from a consumption tax? Other necessities like food, clothing and electricity attract GST.

It would bring in a useful amount of money, enough to fund serious cuts elsewhere in the tax system, like the income tax scale.

According to Statistics New Zealand's household economic survey the average household expends just over $10,000 a year on rents or mortgage payments (including principal).

With nearly 1.6 million households, at the current GST rate and ignoring any second round effects, that would yield about $2 billion a year. That is also about what an increase in the GST rate to 15 per cent would yield and is reportedly enough to fund, for example, a cut in the top income tax rate to 30c in the dollar - an avowed goal of the Government.

Would such a change boost the economy's efficiency? It would mainly depend on what kind of tax relief they funded with the extra $2 billion coming in, but hopefully it would increase incentives to earn and to invest.

But that is not all. Applying GST to mortgage payments deals with one of the biggest distortions in the current tax system, the problem of "imputed rentals". Avoiding the need to pay rent is a large part of the return on investing in the roof over your head. An untaxed capital gain is the rest.

If you put the same amount of equity into a bank deposit you pay tax on the interest. Invest in a company and your share of its profits is taxed.

Rent has to be paid from after-tax income. Little wonder, then, that New Zealanders have such a large portion of their assets in housing or that our last housing bubble (measured by the increase in the ratio of house prices to incomes) was particularly large by international standards. People responded rationally to biases in the tax system.

But this form of investment does nothing to boost productivity and incomes, or help the country earn a living as a trading nation - which as a country with net foreign debt approaching 100 per cent of GDP we cannot be indifferent to.

Compared with a land tax or the McLeod review's wealth tax, attacking housing through the GST system has the advantage of not relying on what someone from Quotable Value - however professional and incorruptible - estimates a property is worth. How much you pay a bank or landlord is cut-and-dried, not a matter of opinion.

What about the other big yardstick for appraising tax changes: equity or fairness?

Roughly two-thirds of households either pay rent or are owner-occupiers with a mortgage. The remaining third have paid off a mortgage. So over time such a tax would catch everyone.

The group that would initially escape it includes a lot of superannuitants, who are unlikely to benefit from any associated changes to the income tax scales.

But the general problem with any increase in the GST take applies. It is liable to be regressive, falling disproportionately on those on lower incomes, especially if it is designed to fund, for the sake of improving incentives and boosting efficiency, a reduction in marginal income tax rates.

The tax working group understands this perfectly well, as the minutes of their meeting last month indicate. Although they say GST is less regressive than generally believed, particularly if measured over a lifetime, they think this can be addressed by automatic compensation mechanisms for most of those on low incomes and by other tax changes for those on middle incomes.

The brutal reality is that if politicians set their face against a shift in the tax mix from direct to indirect taxation because they think the short-term distributional effects are too hard to deal with, then they are bequeathing to their successors a tax system that resembles an iceberg drifting slowly northwards. It will just not deliver the revenue required to provide the services people have come to expect from the state.

Any change of this magnitude to the tax laws would inevitably create difficult boundary issues. It would involve imposing GST on some sorts of interest payments and capital repayments while others remained exempt.

But an economy has a lot of moving parts. It would adjust to such a change.

All else being equal, like incomes and interest rates, you would expect the application of GST to mortgage payments and rents to reduce the amount buyers, whether owner occupiers or investors, are willing to pay for a property. It should reduce the chances of another housing bubble, or its diameter.

That would be a good thing. In dollar terms the value of New Zealand's housing stock doubled between 2002 and 2007. Does that mean we are twice as wealthy as we were? No. Like other forms of inflation it creates losers as well as winners and encourages a misallocation of resources.

And if timed right, the introduction of such a measure might spare the economy some official cash rate rises - and the collateral damage they do to the tradeable sector.