I was exploring joining the Reserve Bank in late 1982, and as the then Deputy Chief Economist was walking me round the floor he commented that one of the attractions of the Reserve Bank was getting involved in all sorts of housing issues. It struck me at the time as slightly odd. I don’t recall housing coming up as an issue in the previous years of macro-oriented university study.
But, sure enough, housing issues came up a lot in the course of my time at the Bank. Rapid housing credit growth in the years after the share market crash (we concluded that it couldn’t go on for long), the mid 1990s housing boom and Don Brash’s hankering for “tweaky tools”, the treatment of housing in the CPI (and in early Policy Targets Agreements), the Supplementary Stabilisation Instruments Report, the Mortgage Interest Levy, more work on possible alternative instruments including tax options, arguments about appropriate risk weights for housing, connections (or the absence of them) between house price booms and savings, reviewing OECD reports on this, that, and the other dimensions of housing, 2025 Taskforce reports, “macro-prudential” policy frameworks, and most recently – and terminal to my relationship with Graeme Wheeler – the LVR speed limit.
This was never intended to be, and won’t be, a housing blog. When I left the Bank a couple of weeks ago, I’d put together a large pile of items I wanted to write about – some of which will interest many, and others few – and so far I’ve got to only few of those topics.
But housing has become the topic of the week. An anonymous commenter yesterday suggested that:
The tone of the blog suggests you have an emotional attachment to not wanting housing to be considered over valued, subject or likely to unwind, and resistant to anything to curb further inflation. Sounds venal. Own a few investment properties – or just one of those people who becomes emotionally invested into an issue and starts becoming irrational?
I don’t own, and have never owned, an investment property. As it happens, Welllington looks like one of those places where investment properties would not have offered a very attractive return in the last decade. I grew up mostly in “tied cottages” (my father became a Baptist minister when I was young) and I’ve owned two houses, in succession, in the same seaside suburb. I hope that the executors of my estate (several decades hence I hope) will do the next property transaction.
But if I have an emotional investment in this issue at all, it is to be scandalised at the way in which a succession of no doubt well-intentioned political choices have been pushing home ownership beyond the reach of a growing number of young and middle-aged New Zealanders. Good intentions do not excuse bad outcomes.
It is not that accommodation itself is beyond the reach of those people. One of the striking features of the last 10-15 years is that rents have not increased that much. Partly as a result, the cost of consumption (the private consumption deflator) has increased much less than the CPI. I also don’t have an instrumental view of home ownership – that we should promote it because it is good for societal cohesion or any number of worthy outcomes that are often argued. I don’t think home ownership should be promoted at all, as a matter of public policy – and, while I wouldn’t push the case, I would have no principled objection to a tax on imputed rentals, provided that the costs of home ownership, including the interest cost of the debt finance component, were deductible.
But we should not stand in the way of home ownership, by adopting policies which put high hurdles in the face of young people getting into purchasing a house, if that is what they want to do. And nor should we be settling for the diminished ambitions I heard in a discussion on National Radio yesterday – two panellists talking of how perhaps we should all get used to living in small apartments, and well, really, well-designed apartments could be surprisingly spacious. Perhaps they do if they want to live in the inner-city, with all the other amenity value than can offer to some people. But there is no reason why it should be the norm. Most people still want the backyard, where the kids can kick a ball.
If New Zealand isn’t one of the most successful advanced economies, we are a rich and fairly prosperous country, with real incomes well above those 50 or 100 years ago. Housing is a normal good: when we get richer we generally want more of it, not less, and in a country with lots of land per capita, there is no obvious reason why we can’t have more of it. My parents were like many of their generation: they bought a first house in the early 1960s in the then outer suburbs of Christchurch. It was new, and quite small. As people did, they landscaped it themselves over time. And they serviced it on one income. Incomes today are much higher than they were then. But despite the higher income, land prices would put that beyond reach of the typical young family today.
No doubt some planning restrictions are an efficient coordination device (thoroughgoing libertarians might disagree). I have no particular problem with the idea that new factories shouldn’t be allowed to set up in residential areas. Perhaps too there is a case for some basic government building standards for houses – though we and our children live in our houses (and take any risks), not central or local government officials. And, yes, new housing does involve infrastructure requirements, and we need good models for ensuring that the costs of that infrastructure are borne (upfront or over time) by those who create the additional demand. But when land and building costs have got so high – and ownership of a basic family home has got beyond so many – surely it is time for an urgent rethink.
Good dairy land sells for perhaps $50000 per hectare. I just googled Upper Hutt sections – not exactly central Wellington, let alone Auckland – and it looks as though one would pay $250000 there for not much more than 500 square metres of a residential section. The two aren’t the same – services, streets etc cost money – but the gap between the two should be a reproach to our politicians. The 2025 Taskforce some years ago suggested that councils should have to publish regular reports documenting the cost of land in their area, explicitly comparing land zoned residential with otherwise similar land not zoned for residential purposes. Information helps change things, and this still looks like a modestly useful recommendation to me. Better still might be some sort of statutory presumption that landowners can build houses (perhaps to three floors high) on any land (not, for example, seriously geologically unstable). It isn’t the full answer, but we need to shift the presumption towards the rights of landowners (and the interests of potential purchasers/residents) rather than agendas of central or local government officials and politicians.
Land use restrictions are much less binding in communities/countries in which there is little population growth. I’m sceptical of New Zealand’s immigration policy for other reasons, but if we are going to target large inflows of non-citizens, and we know that a large proportion will end up in our largest city (which is what happens with migrants around the world), we owe it to our own people to ensure that they aren’t inadvertent victims of this policy choice. Again, good intentions don’t excuse bad outcomes. New Zealand governments should make policy for New Zealanders: we should allow/promote non-citizen migration to the extent that it benefits New Zealanders. There is no necessary conflict between rapid population growth and affordable urban house prices – cities such as Houston have illustrated the point. But if, for whatever reasons, the New Zealand political process can’t or won’t make urban land supply much more responsive, we need to think much harder about medium-term target levels of non –citizen inflows. Trying to combine rapid population growth and fairly tight land use restrictions comes at great cost to younger generations of poorer (and often browner) Aucklanders (in particular). That is simply unjust.
Perhaps because I don’t know when to stop I want to comment briefly on foreign ownership restrictions on residential property. My general starting point is that foreign investment should be welcomed, and that New Zealanders should be free to sell their houses (or farms, or businesses) to pretty much whomever they prefer. And when someone migrates to New Zealand of course they should be free to buy a house. But Auckland (in particular) is now a hugely distorted market, and the policy priority has to be minimising the damage those policies are doing to ordinary New Zealanders (and approved residents). Auckland houses (and land) shouldn’t be particularly scarce, but government choices have made them so.
I haven’t seen convincing evidence that there is yet much purchasing of Auckland (or New Zealand more generally) residential property by non-resident foreigners, but it would not surprise me if it were gradually becoming more of an issue. We know that there is a lot of private capital flowing out of China, and jurisdictions with secure property rights will look attractive. If there were evidence of significant non-resident buying in New Zealand, I would somewhat reluctantly support tax or regulatory restrictions. Yes, doing so restricts the sales opportunities of New Zealanders, but that scarcity value (in the land price) has only arisen from the supply restrictions interacting with government choices about population/immigration pressures. There was no good economic case for the supply restrictions in the first place. So the lost opportunity to sell this artificially scarce asset is not something that should unduly trouble New Zealand policymakers.
I haven’t touched much here on the tax treatment of housing. My views were pretty much summed up in various earlier Reserve Bank documents (eg here or here). There is no perfect tax system, and no doubt the tax treatment of housing isn’t ideal or fully “neutral”. But the key features of the tax system have been in place for a long time, and if anything have become less supportive of housing in the last decade or so. They cannot credibly explain the transition from affordable to severely unaffordable urban land and house purchases.
So , finally, do I have an emotional attachment to some of these issues? Of course. These things matter. Good intentions have produced shocking outcomes, and that really needs to change. House and land prices should come down, in real terms. But there isn’t anything obviously irrational about house prices as they are – they look a lot like the rational outcome of a badly chosen combination of policies. And who knows when, or if, they will change.
croaking cassandra 
Bravo.
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Hello Michael
First, congratulations on your stimulating new blog. I look forward to your “what i have been reading” section, so long as it mainly deals in your collection of books more than 50 years old.
With regards to tax and housing, I am not convinced you are correct that the tax system had a neutral effect on housing over the last decade. As you know, the basic problem with the tax system is not that New Zealand doesn’t have a capital gains tax, but that the way New Zealand applies income taxes to capital incomes induces various distortions into the price of assets. These distortions favour investment in low yielding long lived assets rather than high yielding short term assets, as well as investments in asset classes that are lightly taxed. As Samuelson pointed out in 1964, an accrual based capital gains tax is one way to correct these distortions. But there are other ways to correct the worst aspects of these distortions that may be easier to implement, particularly if it is politically difficult to introduce a capital gains tax on all residential .housing on an accrual basis.
Standard, admittedly simplified, models of the effect of income tax on price rent ratios suggest that when (1) interest income is taxed at a marginal rate t, or interest can be deducted from a landlord’s profit at rate t; (2) net rent is taxed (3) house price appreciation is not taxed, (4) landlords bid up house prices or bid down rents until the after tax return from investments in rental housing are equal to the after tax return from lending money; then the price rent ratio is higher when capital income is taxed than when it is not. The ratio depends on the real interest rate and the inflation rate, and can increase quickly as real interest rates fall and the rate of inflation rises. In the decade to December 2010, nominal 6 month deposit rates in New Zealand averaged 5.9%, the average inflation rate was 2.7%, and the average real rate was 3.1%. In the decade to December 2000, nominal 6 month deposit rates averaged 7.0%, the average inflation rate was 1.8%, and the average real rate was 5.1%. If people expect no further ongoing real house price appreciation, and if there were no income taxes, the decline in real interest rates and rise in inflation mean the price/rent ratio would have increased from 19.6 to 33.3 between the decades, an increase of 65 percent, However under the current income tax regime, the price rent ratio would increase by 135% – essentially because the distortionary effect of taxing interest income has gotten worse. These calculations suggest that price rent ratios may have increased so much during the 2000s because of the way the size of the income tax distortion depends on real interest rates and inflation: they would have increased without income tax, but they increased much more due to income tax. Also note the top marginal tax rate were increased in 2000, which may have been responsible for further increasing the demand for property as an investment. Note that if there were a capital gains tax, the increase in the price rent ratio would be the same as if there were no income tax.
These calculations help explain the change in price rent ratios, but don’t explain why prices increased rather than rents fell. Prices and rents depend on a variety of supply and demand factors, and the slow rate of supply increases does not help matters in New Zealand – furniture prices, whose supply is elastic, didn’t go up as real interest rates fell, and a house can be seen as a particularly sophisticated piece of furniture situated on a piece of land. But there are good reasons to expect the price of conveniently located land to depend on the tax system, and to increase as real interest rates decline, as the supply of conveniently located land can be expected to be somewhat inelastic. In an era of increasing population and incomes, and thus of rising prices of conveniently located land, a capital gains tax would reduce the amount households are prepared to pay for conveniently located land, reducing land prices. (Indeed, the effect of the different treatment of capital gains taxes in different countries may not primarily be seen by whether these countries have housing cycles, but by the level of land prices.) Thus, in addition to the tax system affecting the price rent ratio, there are some grounds for believing it puts upward pressure on New Zealand urban land prices as well, and that these pressures may have increased during the 2000s decade due to falling real interest rates.
Is a capital gains tax the answer? I couldn’t possibly comment these days, although I am on record as saying that it may be easier to shoot for easier reforms that help correct the worst aspects of the way we tax capital income rather than impose a less-than-perfect capital gains tax. Exempting the inflation component of interest income from income tax is the most obvious policy, and one advocated by economists at least since Fisher. But it is worth noting at least one reason why the need to do something is possibly more acute in New Zealand than other places. Many other countries have EET (exempt, exempt, Taxed) retirement saving schemes, such as the 401k scheme in the US. This provides most households (except the very rich, who typically are not landlords) with an avenue to accumulate assets without being affected by the distortionary effects of income tax, particularly as these retirement income schemes provide an equivalent tax treatment as investments in residential property. New Zealand changed its tax treatment on retirement income schemes in 1988, reducing the extent citizens could avoid the distortionary effects of income tax on capital incomes except by investing in residential housing. I can’t claim that this was the reason for the post 1990s house price boom, as so many other things changed post 1990 (falling real interest rates, falling inflation, rising incomes……) but it can’t have helped.
This is long enough for a comment! To reiterate, you should not conclude that just because we did not materially change our tax system in the 2000s (other that the 39% top marginal tax rate, and Working for families) its effect on the housing market did not change. The distortions induced into the housing market by the income tax system depend on real interest rates and the inflation rate, and because these changed a lot in the 2000s there are reasons to believe our tax system may have exacerbated the increase in house prices.
Andrew
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Thanks very much for the stimulating comment Andrew. I had been uneasily (and hazily) recalling our past discussions about the Samuelson article when I wrote.
I would certainly favour dealing with the tax distortions around inflation (and was a little disappointed Grant didn’t touch on these last week, when the Bank has done so previously) and agree that our TTE system exacerbates the issues. I think capital income taxation is overdue for reform more generally. On dealing with the inflation problems, Stephen Toplis recently put out a piece suggesting lowering the inflation target. I would favour that in principle, but in practice think it would be prudent only when the obstacle posed by the near zero lower bound is largely removed.
Having said all this, and accepting your specific points, I remain a little sceptical about how much tax effects can explain of housing booms, once one takes a cross-country perspective into account. I wrote a lengthy discussion note on this while I was at Treasury. Perhaps I’ll OIA it, and post it for discussion.
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Firstly, this is an excellent article. So thanks.
I’ve been a massive housing market bear for the past decade, but this article, in conjunction with another excellent set of posts in the Economist in the last few weeks, have changed my mind. I would now be inclined to agree that high house prices are largely a rational price response to choked off supply, rather than a tulip bulb style price bubble.
From a public policy perspective, this situation is almost worse than the bubble theory. At least under a bubble theory prices will eventually correct and people will be able to afford houses again, but if this is right, then that’s never going to happen until those supply restrictions are fixed. That’s a very sad thought.
The big puzzle which has always confounded me is that if housing markets (in either Australia or NZ, they’re closely linked) were correctly pricing in scarcity values generated through limited supply, then why are rental yields so low? One would expect that if there were a shortage in demand it should be reflected on both sides of the market. Perhaps the answer is that investors have bid down rental yields from expected capital appreciation, which has historically delivered – and it would take a substantial shock for investors to change their minds about the durability of that capital appreciation. I’d be interested in your views on that theory.
The other one is the upper limits of affordability. That old saw ‘trends which cant continue wont’ seems pretty apt here, you can’t keep getting double digit growth in prices forever. If house prices continue to increase, who is buying at those levels? Certainly not first home buyers, but presumably the pool of buyers gets thinner as prices rise and an increasing amount of housing gets consolidated in fewer and fewer hands. Surely there is an upper bound somewhere, somehow?
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Thanks. On your question in the penultimate paragraph, yes I think the expectation of capital gains has to be a big part of what makes the situation endure. But, of course, the other element is likely to be the fall in global yields across all sorts of asset classes. of course, gross rental yields should be higher than government bond yields, and in AKld they aren’t really at present, but it will be part of the reason why rents have not risen faster in the last decade. I (and others) have sometimes run the story that there can’t be a shortage of physical accommodation or rents would be rising more strongly than they are, but I suspect that a better take is that absent the interaction of supply restrictions and population pressures, we would (and should) have seen real rents falling the last decade. It is the dog that didn’t bark – we look at rents roughly keeping pace with the CPI and don’t see a problem. when in a climate of steadily falling yields, there should be a material gap, with rents growing much less rapidly than prices generally.
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Falling rents with falling mortgage rates? Now that’s an interesting thought. My gut tells me that it just seems hard to believe – one would think that rents would be pretty sticky downwards and if prices (and incomes presumably) are rising because of the effect of rates falling, then it seems doubly unlikely that a landlord would pass on a lower rent in a rising market. But I take your point.
My other thought on that is that rental yields have been low for some time, not just post GFC. With a bit of work and a good dataset perhaps this theory could be tested.
Did you have any views of the limits of affordability and the upper bound on prices?
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Sorry, I meant to respond to the questions in your final para last time.
I think the limit is probably political rather than narrowly economic. In the last Demographia survey, Auckland prices were at 8x income and Sydney and Vancouver were at about 10x. There is not any very obvious technical limit, although presumably at some point landlords became very worried that prices might not rise much further or might even fall – but I’m not aware of any useful model to tell you when that change might be. But eventually there will be more political pressure for action, and in a sense it is easier for it to happen in NZ, since the Akld share of the electorate is so much greater than the Sydney/Vancouver share of the Aus/Canada electorates (altho I think planning law is state/provincial, immigration policy is not). Voters will eventually demand action – free up land supply, legislate a presumptive right to build, shift to land value rating, markedly cut target levels of immigration, tax foreign buyers, or even a CGT (which would probably have an announcement effect).
Personally, I think the most likely near-term way that price pressures in Auckland will ease is if/when the net population outflow to Aus picks up again. But that doesn’t change the long-term issues, just puts a bit of cycle in Auckland prices.
A pessimist – me on a bad day – will highlight the risks in the world economy which could yet take the OCR to zero. If that were to happen, with existing land supply and migration policies, urban land prices in Akld could go a lot higher yet.
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