Keith Woodford reflects as to whether the farming rules of the game, including the importance of cash flow versus capital gain, have changed, irrespective of any capital gains tax, and what this means for the future

Regardless of whether or not a capital gains tax is introduced, the rules of farming have changed.  Cash is becoming a lot more important.

I recall going to a conference in late 2000 or thereabouts, soon after my return to New Zealand after an absence of close on 20 years. I recall a lecturer from Massey University expounding how farming in New Zealand involved two separate businesses.

The story went that there was a cash business based on production that was all about survival. And there was a capital gain business that was how wealth was generated.

This was something that I had known from my earlier days in New Zealand, but it was something I had also largely forgotten about while working overseas, where things were very different.

I am not trying to imply that capital gain was not relevant where I was working overseas, but its importance was much less. And so now that I was back in New Zealand, I spent some time thinking about the reasons why things were different in New Zealand.

The answers were not hard to find. It was the lending policy of the banks and the lack of a capital gains tax, combined with inflation, that were together driving the New Zealand reality. And I often wondered if this was leading to a mis-allocation of resources.

However, when I was lecturing to Lincoln University students in farm management, I cast aside the question of whether or not the rules of the game were leading to mis-allocation. My job was to teach them how to play the game according to the rules that society had set.

The rules were not hard to understand. With no capital gains tax, plenty of interest-only finance, and inflation quietly doing its thing in the background, there was a big incentive to get on the ladder. Survive the first few years and time would look after things from there.

The biggest problem was to get onto the first rung of the ladder.  Those who were already on the ladder were able to use their growing equity combined with financial leverage to crowd out new entrants and so the established farmers expanded their holdings.

From the turn of the century through to when the GFC hit in late 2008, the land-price pump was working well.  Product prices were good, dairy was flavour of the decade, and most people seemed happy.  Those people who could not get onto the first rung by themselves had new options to join syndicates or become equity partners. They could also play the same game in the rental-housing market, where the first rung was easier to climb aboard.

The result was that as long as there were enough believers, then the model became self-fulfilling.  Land became more and more expensive.

The model worked across many rural industries, but it worked best in dairy. DairyNZ itself got on the bandwagon. Courses in ‘building your business’ combined with courses in ‘mark and measure’ became all of the rage. Actually, they still exist.

As with all games, there were winners and losers. Sharemilkers were particularly at risk, and some lost everything. Sometimes it was a lack of skill but other times it was just bad luck with timing. But losers tend to go quietly, whereas winners take all and become exemplars for others to model themselves on. 

During this period, the most successful players were able to increase their wealth at 20 percent per annum and even more. At 20 percent per annum compounding, it only takes 3.5 years to double one’s wealth. They were great times for the winners.

 Since the GFC of 2008/9 and through until recently, the rules were tweaked a little, but the overall model still worked.  The combination of reducing interest rates and ongoing willingness to lend on an interest-only basis was enough to keep land prices heading north, although perhaps at lower rates.

It is hard to identify the precise turning point, but some cool breezes that started blowing around 2016 have now picked up speed. With the exception of land that has potential for kiwifruit or other big-income crops, or has special locality value, then rural land prices are at best static and in most cases declining. Indeed, many land markets are totally dead at this current time.

So what has caused the change?

The two biggest changes are that banks are now requiring capital repayments and overseas investors are no longer welcome.  Kiwis themselves lack the new equity capital to invest. There is also a lack of confidence related to the impact of new and prospective environmental regulations.

There is a huge irony in all of this. That irony is that product prices for many of our agricultural products have never looked better. So, the cash returns could be strong, although some of this will be required to repay bank loans using tax-paid funds plus capital expenditure on environmental management.

Someone smarter than me once made the comment that predictions are always risky, particularly when they relate to the future.  And as the famous Murphy once said, what can go wrong will go wrong. And as one of the many Smith’s said, Murphy was an optimist.  So indeed, nothing is for sure.

Nevertheless, there is reason to believe that we may be moving into an era where inflation remains muted, where cash returns from agriculture are reasonable, and capital gain might at best be modest.

Inflation, of course, will be determined by Government monetary and fiscal policy. And with governments, there are always uncertainties.

In all of this we need to keep reminding ourselves that we have an export-led economy. Europe does not need us – with or without Britain. Also, America does not need us. Africa cannot afford us. That leaves Asia. We wouldn’t want to mess that up.

Some months back a former New Zealand Prime Minister said to me that even from a narrow economic perspective, there were more important things than a capital gains tax for Government to focus on. I am coming around to that perspective. A capital gains tax would indeed mean new rules of the farming game, and all sorts of sneaky ploys to get around those rules. There might be smarter ways to achieve a fairer society.

*Keith Woodford was Professor of Farm Management and Agribusiness at Lincoln University for 15 years through to 2015. He is now Principal Consultant at AgriFood Systems Ltd. His articles are archived at http://keithwoodford.wordpress.com. You can contact him directly here.