Housing and the Deputy Governor

I had been going to write something about housing this morning, but got distracted in the WEO database.  House prices, especially in Auckland, are a political and social scandal.

But now Grant Spencer, Deputy Governor of the Reserve Bank with responsibility for financial stability, is out with a speech on housing, “Action needed to reduce housing imbalances”.  It is difficult to know where to start in commenting on the speech, although the title will do.  The tone  of “Action needed” seems to inject the Bank into politics, and the political debate, rather more than is prudent or than its two main statutory responsibilities, price stability and prudential supervision to promote the soundness and efficiency of the financial system would warrant.  For better or worse, the Reserve Bank has a variety of statutory powers it can exercise.  If it judges those powers should be used it should lay out its case for our scrutiny, and then act.  Instead we have a long, but once-over-lightly, rehearsal of a bunch of mostly familiar material, with little or no in-depth analysis of the issues in the Reserve Bank’s own areas of responsibility.

We should expect the Reserve Bank to provide in-depth analysis to back its claims around the housing market.  But in a 19 page speech, only five paragraphs are devoted to the “housing pressures are a threat to stability” section.  And if not everything can elaborated in a speech, we might expect to see links to recent Reserve Bank research in the area – but there are no such links, and not even references to the issue of the Bulletin published only a few weeks ago which cited international research suggesting that housing mortgage loans have rarely played a major role in systemic banking crises.  Issues of the Bulletin are generally regarded as speaking for the Bank, so it might be useful for the Bank to clarify just where it stands, and why.  New Zealand might be different, but if so why does the Bank think this is likely?   Perhaps the Bank can point us to countries in which private sector credit growth of around 5 per cent per annum, from starting levels of PSC/GDP that are still materially below the peaks reached 7-8 years ago, have led to serious threats to financial system soundness, or even to wider economic stability.

The Deputy Governor has been consistently reluctant to engage with the proposition that any financial stability risks must have been much greater in 2007 than they are now.  In the years leading up to 2007 we had seen:

  • Very rapid nationwide growth in real house prices, on a scale not seen previously in modern New Zealand history
  • Very rapid growth in credit and credit-to-GDP, on scales consistent with some of the international indicators that have been taken as suggesting heightened risk of crisis.
  • Much lower overall bank capital ratios (actual and required)
  • A move (in the adoption of Basle II) towards lower risk weights on housing.
  • A long-running period of economic expansion and consistently high levels of optimism
  • High levels of real investment in housing
  • Rapid growth in commercial property and farm prices, and in the associated stocks of credit.

All of which was followed by one of the nastier recessions New Zealand has seen in the post-war period, and a double-dip recession in 2010.  GDP per capita (real and nominal) settled onto a much lower track than had previously been expected – so that many borrowers’ income expectations proved to be quite severely disappointed.    Nominal house prices did fall during the recession, and by more than the Reserve Bank projected at the time.  And yet with all these factors, the soundness of our systemic institutions was never questioned (even in the midst of a global panic centred on concerns around housing) and the level of impaired housing loans rose only modestly to extremely low levels.

The current climate just does not bear comparison.  If the Reserve Bank disagrees, it would be helpful for them to lay out their arguments and evidence.  All the crisis literature is clear that big changes in credit stocks in short periods are the biggest crisis threat.  Not only are we seeing nothing of the sort at present, but – thanks to market pressures and the Bank’s efforts – buffers are much bigger than they were before.  In many areas of the country – barely mentioned in the Reserve Bank material – real house prices have been falling.
The one other bit of the Deputy Governor’s speech I’m going to touch on today is tax.  In his speech Grant states:

The tax treatment of housing is a major factor with potential to influence the demand/supply imbalance in the housing market. As reflected in our submission to the Productivity Commission’s inquiry on housing affordability, housing is the most tax-preferred form of investment, particularly when it is highly leveraged. Investors are often setting the marginal market prices that are then applied to the full housing stock within a regional market. Indicators point to an increasing presence of investors in the Auckland market and this trend is no doubt being reinforced by the expectation of high rates of return based on untaxed capital gains. While there are difficult issues and trade-offs to consider in this area, the Reserve Bank would like to see fresh consideration of possible policy measures to address the tax-preferred status of housing, especially investor related housing.

This reference to the Bank’s submission to the housing affordability inquiry took me by surprise, as I had had some involvement with that submission. So I went back and read it.

Tax issues

Housing is a favoured investment from a tax treatment perspective. This is especially so for unleveraged owner occupiers (see Hargreaves 2008), since owner-occupiers do not pay tax on the imputed rental value of the equity in their houses (although they do pay rates). The inadequate tax treatment of the inflation component of interest, whereby all interest received is taxed and all interest payments by investors are deductible, compounds the distortion and extends it to the rental property sector. With an inflation target centred on 2 percent per annum, a significant chunk of the any interest rate reflects simply the expected general rise in the price level (rather than a real income or real cost).

The tax treatment of housing and savings products varies widely across countries. Tax regimes can be shown to influence both the level and volatility of house prices (see Hargreaves 2008 and van den Noord 2003, for example), especially when supply responses are sluggish. But countries with a variety of tax regimes experienced similar housing booms in the mid to late 2000s. Moreover, it is not clear that, in aggregate, housing is more tax favoured in New Zealand than in other countries. For example, householders in the US can deduct owner-occupier interest payments for tax purposes and in most cases face no capital gains tax. In addition, relatively high local government rates in New Zealand compared to other countries, act as a tax on property ownership.

Some have also argued that the increase in the maximum marginal tax rate in 2000 (perhaps in combination with the change in the inflation target in 2002) played a major role in the last cycle. We are sceptical for a variety of reasons outlined in our 2007 work. At most, we believe it was an exacerbating and amplifying factor. At the time, the underlying regulatory model made new housing supply relatively slow to respond and expectations of persistent future price increases became entrenched for a time. We also doubt that loss-offsetting in and of itself, was more than an amplifying factor, because rental yields at the start of the housing boom were high enough (and interest rates relatively low) that large losses were limited. More generally, however, correcting the tax treatment of interest to assess or deduct only real interest would remove the distortion in this area.

One tax issue that periodically receives considerable attention is capital gains taxation. Houses bought by investors with the intention to resell are already, in principle, caught by the income tax net, but New Zealand does not have a general capital gains tax. The Reserve Bank has never taken a stance on the general merits or otherwise of capital gains taxes. We have fairly consistently noted (including in the Supplementary Stabilisation Instruments report (Blackmore et al 2006) and the 2007 submission to the Commerce Committee) that there is little evidence internationally that countries with capital gains taxes have experienced less marked cycles in house prices. In the 2007 document, we noted that, in practice, capital gains taxes are only levied on realised gains (rather than accruals), which creates additional distortions and that capital gains taxes usually largely exclude owner occupied houses, even though unleveraged owner-occupied housing is the most lightly taxed component of the housing stock. We summed up that “capital gains taxes are common internationally but are hard to design and implement in a way that works well”. To avoid establishing new distortions, any capital gains tax should only tax real capital gains and needs to treat gains and losses relatively symmetrically.

Perhaps the Reserve Bank now reads the evidence differently – but, if so, perhaps they could lay it out for us. For now, the submission they themselves pointed us to makes a couple of important points:
◾To the extent that the tax system favours home ownership the advantage is greatest not for investors, but for unleveraged owner-occupiers.
◾It is not clear that housing is more tax-favoured in New Zealand than in other advanced countries.
◾Tax systems, and the treatment of housing, vary widely across countries and don’t seem to explain differences in house price cycles
◾Some distortions arise from the existence of positive expected inflation (combined with the non-indexation of the tax system) and yet this issue is not even touched on in the speech.

As a final point, it is worth remembering that the broad features of the tax system have been in place for a long time. If anything, most relatively recent changes – including lower maximum marginal tax rates, the introduction of the PIE regime, and successive reductions (and the eventual elimination) of depreciation allowances (on assets than manifestly do deteriorate) have worked to reduce any advantages to owning/investing in residential property.

So when the Bank talks loosely about how it “like to see fresh consideration of possible policy measures to address the tax-preferred status of housing”, it would be helpful if they could be more specific. Do they now favour a real-world capital gains tax (including on owner-occupied houses?), and think it would make a useful material difference to housing markets? Do they favour indexation of the tax system? Do they favour abolishing loss-offsetting provisions in respect of housing investment, thus treating housing differently than any other small businesses? Do they favour a tax on the imputed rental, and if so would they also favour allowing full interest deductibility on owner-occupied mortgages?

Without more detailed and extensive analysis, it is still difficult to escape the conclusion that the Reserve Bank’s approach to housing is being shaped more by impressions of the US last decade than by robust in-depth analysis of the sorts of specific risks the New Zealand economy and, in particular, New Zealand banks and the New Zealand financial system face.

16 thoughts on “Housing and the Deputy Governor

  1. One reading of this speech is “as the government is not going to change immigration or tax, and we are we are going to intensify credit rationing”.

    (I’m assuming they can’t hold out on rate cuts much longer.)


    • I think they will as the one off drop from fuel lowering has come through in terms of lower prices at the pump and international travel (15% this quarter). I suspect inflation will raise back near the normal level next quarter


  2. I am as puzzled as you are on all the fronts you mention. Plus another couple.
    1. Just what is a “housing imbalance”. We have a bunch of houses, we have a bunch of people wanting to live in them, and prices are adjusting to equate the quantity demanded to the quantity supplied. What is the imbalance?
    2. If “imbalance” means people are paying too much for accommodation, how would removing tax favourable status help?


    • Yes there is *a* market that clears but is it the market we want?

      The way that the imbalance is expressed is not in the smooth operation of buying and selling but in what you may view as various pathologies. As an aside the reason that building consent numbers are not rocketing within the Special Housing Accord in Auckland is that construction is adjusting down to meet the rump market that can afford to buy a house. I.e it’s working exactly as a market should work: the number of houses being built matches the number of people who can afford to buy them.

      The two pathologies that come to mind are (i) the lower than average home ownership rate in Auckland and (ii) the higher than national average occupancy rate. In New Zealand, because of the traditional antipathy towards renters, becoming a renter also condemns you to being a second-class citizen. In Auckland, from memory, rents have not appreciated at the same rate as house prices. So as households are priced out of ownership they are forced into renting. This in turn has a number of negative consequences for both the individual households and the wider community. The Auckland region has average occupancy rates of 3.0 people per dwelling compared to the national average of 2.4. In the Tamaki-Manakau corridor the average occupancy is 4.0/dwelling.

      So Auckland is chock full of people living in over-crowded, unhealthy conditions or being partially marginalised as renters. Yes the market works but it is pretty ugly.


  3. Thanks Mike, very interesting. I remember having a discussion with someone (you?) about the same point you made, that “It is not clear that housing is more tax-favoured in New Zealand than in other advanced countries”, especially when you look at mortgage interest (often tax favoured overseas, but not here) as well as capital gains.
    FWIW I’m inclined to a fairly simple S/D story (something like Seamus’s), constrained S, rising D, what do you expect? Esp if the S curve is practically vertical. I was at an IoD function this morning and my tablemate, in the property development basis in a large way, mentioned one large project that took 13 years from greenfield to first sale, and claimed the timing was not unusual for AKL.
    There is though one overlay which somewhat worries me (I’m Irish so its story is one I tend to look at) and that is that clearly one element on the demand side is interest rates that are too low for the buoyant economy. The Irish got too low a set of rates when they joined the euro and had German rates for the Celtic Tiger, and we’ve got too low a set of rates because we’ve imported (to some loose but real degree) the zero cash rates and the post QE low bond rates adopted post-GFC elsewhere. There’s a fundamental mismatch between the rates appropriate for them and the rates appropriate for us, but we’re stuck with them (esp at the long end)


    • Thanks Donal

      I guess I would be more worried about a fevered demand side if activity in the housing market were at very high (feverish?) levels. I noted that other day that mortgage approvals per capita, nationwide, were still pretty low (and slightly behind last year’s levels) and housing turnover per capita is also nothing like the rate seen during the pre-2007 boom.

      As for long rates, the gap between our long rates and those in the rest of the advanced world remains large – indeed as large as it ever was. Day to day the world changes our bond rates, but in the longer-term our short rates have pretty much determined the level of our long rates.



      • Think again, the amount of loans going to investors has taken off since the last quarter of 2014, this is why the RBNZ is considering very seriously the need to make banks retain more capital for such loans


  4. Two points to ponder:

    First, an extension on Michael’s question regarding whether capital losses would deductible. As Lord King, until 2013 the Governor of the Bank of England, points out, capital gains from houses generally do not amount to economic income at all; rather, they are a transfer, to those who own houses from those who do not (yet). It is not as though there is any economic income if the houses remain the same houses, on the same streets, with the same views and the same surrounding amenities. For every dollar of gain homeowners accrue from house price inflation, someone else has lost a dollar.

    If that does not sound right, consider if house price inflation really did deliver economic income. Wouldn’t we then want even more house price inflation than we already have? Clearly a nonsense!

    Second, do tax preferences for housing – if there are any, Michael makes some good points suggesting that may be more myth than reality – drive house price inflation, or is it the other way around? The logic to support the former view seems to be that because (virtually certain) capital gains are not taxed, people climb into housing more than they otherwise would. But if capital gains from housing were not a reasonably sure bet – in other words, if supply constraints in the face of growing demand were not driving up house prices – then investors would not have nearly as much reason to expect capital gains and, therefore, neither a tax benefit. They might even be as concerned about the non-deductibility of capital losses as they relish the prospect of tax free capital gains! Doesn’t that suggest that that what we have is much more a case of house price inflation being driven by supply constraints than tax benefits?

    If that does not sound right, consider if the supply problem, but not the (supposed) tax problem, was effectively addressed, would we still have strongly rising house prices? – almost certainly not. But if the government solves the ‘tax problem’, whilst making little progress on the supply problem, would we still have strongly rising house prices – definitely!


    • Thanks Bruce

      One other aspect of the CGT debate is that a symmetric CGT reduces the variance of future expected returns (since the government shares gains and losses). In principle, lower variance (risk) could lead to a higher price for the asset. Mind you, I don’t think we’d see it – for minimising avoidance, symmetry is never perfect (losses can often only be offset against future gains).



    • “For every dollar of gain homeowners accrue from house price inflation, someone else has lost a dollar” would be correct only if the money supply remained constant. But under government control (directly or through central bank surrogacy) it doesn’t. We have new money directly from QE and indirectly from government promoted low interest rates (see how the latter happens in http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf). RBNZ is promoting low interest rates but much of the ‘cheap money’ comes from outside (hence low fixed interest loans, for example) about which RBNZ can do little or nothing. These days new money flows around the world and finds its way into increased prices somewhere in the system. The dollar which is represented in house price inflation has been produced by the new money, not by an immediate transfer from someone else. The loss will occur when the inevitable crash occurs and it will probably occur by house price deflation and bank losses. The RBNZ does have cause for concern but fiddling with tax is not the remedy. Unfortunately because of the global nature of the problem RBNZ is probably powerless to do anything much about it. Moreover like the GFC the crash will originate elsewhere.


  5. Thank you for your thoughtful comments Michael.

    I am not so certain as you are that financial stability risks are not approaching 2007 levels. I am hoping you may be able to come back on these points:

    1. Household debt to income levels are back to 2007 levels. Why use private debt to GDP as the relevant indicator when looking at housing markets? Or is it the rate of growth that concerns you? Source: http://www.rbnz.govt.nz/statistics/key_graphs/household_debt/

    2. Yes, nationwide housing prices are not growing like they were in 2007. But a third of the population lives in Auckland, and there prices are at unprecedented levels and growth rates, especially when measured by price to rent or price to income metrics.

    And third. Even if you remain unconvinced that there is a threat to financial stability, surely there is a threat to economic stability. The ability of the economy to absorb macroeconomic shocks is reduced as housing costs become a higher proportion of household budgets.


    • Ryan

      Thanks for those comments Ryan. Just briefly in response:

      I focus on total private sector credit mostly because banks fail not individual portfolios within banks (or if the latter it matters only if it brings the bank down) but also because most crisis early-warning research studies (eg those by the BIS) use private sector credit to GDP, But even if one restricted attention to housing, no one has any good idea what an equilibrium ratio of household debt to income is, and so much of the research focuses on “credit gaps” or deviations from trend. When household debt to disposable income has been more or less flat for 7 years, there are no early warning indicator lights flashing. The RB may have the chart somewhere on their website but the “credit gap” is probably negative at present – given the multi-decade upward historical trend in credit/GDP or household debt/income.

      Yes, there is certainly a problem in Auckland – but the banks are nationwide lenders. I imagine the Bank could have reason for more intense concern if any major lender were mainly focused on Auckland.

      On your final point, debt servicing as a share of income must be materially lower than it has been for quite a long time: debt to income has been essentially going sideways and interest rates are much lower than they have been, on average, for decades. If interest rates rose sharply the picture could look different, but the prospects of material rate rise from here look pretty slim.

      Remember that risk is highest on new loans – people stretch themselves to the limit when they take on debt – and the fact that the debt stock isn’t growing rapidly should give people a great deal of comfort, relative to the situation in the few years leading up to 2007.


  6. As a property investor I think your understanding and points are spot on. I wonder at times why New Zealand does not give home owners interest deduct-ability the same as the USA. This would certainly favour the young home owners and improve affordability fairly. This would produce a level playing field. I also wonder why non resident tax payers get such favoured tax treatment on their interest earnings. Foreigners bond investments in New Zealand must surely be a major source of the surplus money flowing into property. Why should my daughter only pay 10% tax on her investments while I pay 33%.


    • Thanks. I wouldn’t favour US-style interest deductibility for owner-occupiers without a commensurate tax liability on the imputed rental value of the house. That would then be a symmetric arrangement to the one investors face: interest (and other expenses) are deductible, but rental income is taxable. Past Reserve Bank analysis illustrated that any advantages in property ownership are greatest for unleveraged owner-occupiers.


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