KEY POINTS:
The Reserve Bank has called for a more neutral tax system, saying the current law favours housing, and advantages borrowers over savers.
Its submission to the parliamentary inquiry into monetary policy does not explicitly advocate a capital gains tax.
It says distortions are smaller in other countries because most have more generous tax treatment of savings and a capital gains tax.
Tax has to be paid on all interest earned, both the real return and the part that is compensation for inflation.
Likewise those who can deduct interest costs - businesses and property investors - can deduct the lot.
If inflation is 2 per cent and a saver is in the top tax bracket the current treatment "overtaxes" him 0.8 percentage points (2 per cent times 39 per cent tax) and lowers the cost of borrowing for investment by the same amount.
Another effect is a distortion between the taxation on financial assets such as deposits and real assets like property.
"On real assets the compensation for inflation takes the form of capital gains. New Zealand has no capital gains tax so that the inflation component of the return to real assets [for example houses] goes untaxed."
Correcting these anomalies, in particular adjusting the system for inflation, would not be easy, it concedes.
"But these challenges would have to be set against the real distortions created by the current practice which over the long term skews savers' choices towards real assets and encourages a greater degree of indebtedness than otherwise."
The Reserve Bank notes that some European countries have a lower tax rate for income earned from capital - interest, profits and rent - and that the OECD has recommended such an approach for New Zealand.
The inquiry is also asked to consider "ring-fencing", that is, limiting the ability to offset investment losses against wage and salary income.
It does not, however, argue that biases in the tax system have been the main driver of the current housing cycle, as other countries with different systems have also had booms and that New Zealand's tax treatment of housing has not changed much recently.
Other measures the bank thinks might make its task easier include ensuring that the development of new subdivisions is not unduly restricted by regulatory constraints, for example on the supply of land.
It would like "higher thresholds" before the Government increases spending or cuts taxes, particularly when the economy is strong. It also asks for approvals for new migrants to be cut back when the economy is already struggling to meet demand.
