Gareth Morgan argues the Government’s 'Capital Gains Tax' is too little, too late

By Gareth Morgan

The good thing about John Key’s announcement of a selective capital gains tax on Auckland housing is that he has responded to the Reserve Bank’s call to “do something” about the tax distortion around property ownership.

There are two bad things though – firstly capital gains is not a smart tax, and secondly the PM is addressing the symptom of the disease not the illness itself. Substantially, a tax loophole around property remains.

Key’s response is a start…

The Government’s announcement means that anyone selling a house within two years of buying it will be assumed to be doing so for capital gain, and so will pay tax. This won’t apply to primary dwellings (the family home), however that is defined. It doesn’t take too much thought to spot some of the ways to get around this.

But hey, for the PM to finally acknowledge that his policies are even part of the problem around property in New Zealand, is a giant step forward for any ruling politician, no matter what hue. The Reserve Bank needs to be thanked for at last being able to get some acknowledgement from a government that its tax regime with respect to taxing the returns to capital is distortionary and little more than a giant loophole for property owners to exploit.

… but flawed

However, the policy reaction is piecemeal, complex to administer and easy enough to get around; if investors aren’t sophisticated enough to have multiple legal entities, they can always just wait two years before selling the property. We have commented previously on the problems of a capital gains tax, which this policy is despite the Government’s claims to the contrary.

Ultimately this change will encourage the money to focus on more and more expensive houses rather than multiple dwellings (as we saw when the tax was introduced in Australia).

This is quite clearly just a temporary measure to quieten the political noise. Together with the Reserve Bank’s recent measures, they should have some impact, but the disease remains.

Reining in property prices (and inequality) is a much larger challenge

It’s ironic that the Government’s belated acknowledgement of an issue that’s been around for ever comes the same week that The Economist magazine is calling for the end of tax deductibility of interest paid by corporates, property investors and home owners. This is in response to the gross distortion of wealth distribution and inequity in developed countries, which is largely driven by ballooning property prices.

While I would debate the wisdom of such an indiscriminate measure, it does reflect the frustration the economics profession is having with governments that have sponsored an unbridled explosion of debt since financial deregulation, and the obvious consequence of that – a global bubble that threatens to bring down the world’s financial system.

Unfortunately the risk for any single country that tries to swim upstream against this global affliction is it could suffer substantial capital outflows and a collapse of economic growth. The dilemma is of course the longer the distortion persists, the more likely that collapse is anyway – for everyone. In fact we have already seen this play out once in the Global Financial Crisis.

The Economist’s despair about the unbridled explosion of leverage globally is well founded and as we all know, one consequence of that has been the vast enrichment of those in the financial system that has facilitated the debt explosion. That enrichment is well beyond any national productivity gains and so by definition has been the driver of a major surge in inequality within economies of the developed world.

A few weeks ago The Economist proposed that to address this, ideas such as a universal basic income were well overdue, along with taxation of all returns to capital. Both of these measures Susan Guthrie and I proposed in our 2011 book, “The Big Kahuna”.

Change will only come from the people

It is many years since New Zealand showed leadership on anything and so it is unrealistic to expect too much in this sphere. In short, the pressure for change has to come from the people and countries’ independent institutions. Only then will politicians – whose raison d’etre is to remain popular, act.

This is precisely what has happened on this occasion – the cacophony of disquiet over the orgy that is the Auckland property market, has risen to such a level that a shrewd PM has at last swallowed his pride and acknowledged the consequences from continuing to sit on his hands.

Removing interest deductability is also not the answer

What change is needed to remedy the underlying disease? The Economist’s recommendation to try and cap this debt explosion by removing all deductibility of interest, while understandable, is drastic. It would be better framed as removing deductibility of interest paid to any related party. It’s long been a sport to load businesses and investment property up with debt, and use offshore entities as the lender.

This in effect is using thin capitalisation to transfer profits beyond the reach of the local tax authority, and into the clutches of a corporate residing in a low tax area. I write this column as I sit in Monaco, marvelling at all the super yachts in the marina and tiny little apartments where all the tax exiles reside.

Such behaviour is a global phenomenon, all I’m saying is the role of foreign investors in our property and corporate space is not insignificant, and this is a common trick.

A Comprehensive Capital Income Tax is a better solution

The Comprehensive Capital Income Tax proposed in our book The Big Kahuna thwarts a lot of these loopholes because all capital is taxed (every year) at source, at least insofar as it is assumed to yield the owner at least the bank rate (like a deposit). Whether the value of the capital has gone up or down that year is irrelevant, there is a minimum return assumed and that is taxable.

Sadly, for any change to have an impact on house prices and inequality, it needs to include the family home, which is dangerous territory for politicians. Until we actually get politicians that actually lead on correcting the tax and leverage distortions unleashed since the days of financial deregulation, there is no chance of arresting the increased polarisation of income, and more pointedly wealth, that has exploded over recent years.

The John Key measure is belated, begrudging, and defective. It is better than nothing but no more than a temporary patch.

--------------

This article was first published on his blog, Gareth's World. It is here with permission.