Wednesday 5 June 2013

Against capital gains taxes

The OECD having recommended that NZ adopt a capital gains tax, it's worth reviewing the case against them.

First, here's the OECD:
New Zealand belongs to a group of five OECD countries with particularly high pre-tax capital-income inequality (Figure 13). As much of this income, especially at the top levels, takes the form of capital gains, the lack of a capital gains tax in New Zealand exacerbates inequality (by reducing the redistributive power of taxation). It also reinforces a bias toward speculative housing investments and undermines housing affordability, as argued in the 2011 Survey. 
The OECD report also seems to reckon that capital gains taxes, along with other taxes and changes to Superannuation, could help debt issues when Superannuation starts getting rather expensive.

Where to begin.

First, the OECD is entirely right that NZ should be moving to increase the age of superannuation eligibility. The Productivity Commission said so, anybody economically sensible has said so, and even Labour's in favour of it. The only thing that seems to be holding it back is that Key had promised in 2008 not to do it and didn't change his mind in the last election.

Second, the OECD could be right about land taxes. As part of a revenue-neutral shift away from income taxation, it would be a really nice move. My only concern, and it is the one that would keep me from pushing the button for that particular tax shift, is that equilibrium overall tax rates are likely to wind up much higher as consequence. Open up another margin for taxation and the government will wind up getting bigger over time. Even if it's revenue neutral now, it won't be the next time a Labour/Green finance minister decides to go after the 'rich pricks' by reinstituting a 39% top marginal tax rate while keeping the land tax.

But on capital gains, well, we disagree.

First, it's hard to make the case that the absence of a capital gains tax distorts investment towards housing. Maybe you could argue that we've a distortion such that firms have incentive to avoid distributing revenues as dividends and that individuals have incentive to hold shares in firms that follow such strategies rather than interest-bearing assets, but that doesn't make a case for a housing-specific distortion - especially as the IRD has been getting more vigilant about individuals flipping houses. Buying a house, doing it up, and re-selling it at a profit will draw income tax: the gain is taxable income from your labour in fixing and marketing the house. I can't see how we get a distortion towards housing rather than towards a broad set of appreciating capital assets. We certainly have problems around housing affordability. The first order problem is Councils' restrictions on the supply of zoned land. Sort that one out, and a lot of the second order problems, like inefficiencies of scale in construction, also start going away.

Second, capital income is already taxed when it is spent: we have a 15% GST. The more we are able to shift from income to consumption taxes, with offsetting transfers to those on lower income if you like, the better.

Third, as Seamus pointed out two years ago, we need to compare the relative efficiencies of the different available tax instruments. Taxes on capital income are more distortionary than taxes on labour income, and even worse when capital gain taxes tend not to be inflation-indexed; real tax rates on capital income then easily wind up being higher than taxes on labour income. And, there's a bit of a mess in deciding how to treat realised versus unrealised gains - you're basically there choosing among rather bad consequences. Read Seamus's whole post.

Fourth, the story required for the absence of a capital-gains tax to distort choices between productive investments and some kind of unproductive investment (basically, purchasing some asset that appreciates in value over time) is especially convoluted (another Seamus the whole thing....).

Fifth, Seamus noted that while you can hang a case for a capital-gains tax on an argument Samuelson made rather a while back, Samuelson's argument shows that you need a capital-gains tax to avoid the problem of distorted choices among assets whose payoffs are more than 25 years into the future; nearer-term payouts aren't affected by that kind of distortion. Seamus also hit on a couple of other potential objections.

Want to increase the redistributive potential of the tax system? Increase the GST while increasing income-based transfers to the poor. Why muck up incentives to make capital investments?


  1. I agree with you that the argument that a lack of capital gains tax distorts investment towards housing.and I dont think, as some others do, that a capital gains tax would reduce housing costs. But I do think a capital gains tax is warranted for the following... The reasons some properties gain value more than the average is seldom to do with the efforts of the householder. Its either to do with the scarcity value of the land its built upon or it because the area surrounding it has acquired new facilities - better infrastructure, new zoning rules, a fancy cafe etc. But the householder has not paid for the new broadband facilities down his/her street or the public transport system that gives his/her property its improved value. For these reasons I think there is a strong argument for setting a tax on realised gains when the gain has been due to reasons outside the owner of the property's activities.

  2. Hit the Seamus post linked in point 4, above.

  3. Yup. He puts up the conditions under which failure to tax capital gains yields a distortion towards 'unproductive' investment.

  4. WRT increasing the age for super I think we hit a potential brick wall when Maori die about 8 years earlier than Pakeha. There's a fairness issue there that needs discussing.. possibly various people could take a lower and earlier income from the state to overcome this whilst the rest could work much longer and take a higher income later.

    WRT capital gains.. why is there an assumption that the state must benefit from a good decision and/or luck of a homeowner?

    We can test this further by saying the problem is rising house prices and we need a CGT.. but has there ever been a CGT offered of late that related to houses only and only in the areas where houses are considered too expensive?.. of course not.. they are all about more tax regardless of the situation in Auckland.

    Someone reproduced some facts the other day that 26% of NZers moved from one place to another in the last five years.. what would be the effect of a CGT on selling a house in Invercargle and the owner moving to Auckland?

    To me a CGT looks more like a bracelet over an infected wound.. looks good for a short time but things are going manky underneath.


  5. I'm sure I've seen proposals that would allow people to choose to take Super earlier and on a lower rate or later and on a higher rate; so long as the net effect works out, it doesn't seem an unreasonable solution, if we think it's politically sustainable. If instead we'd wind up a decade later topping up payments going to 70 year olds who'd chosen the earlier/cheaper options because some Auckland U economist says it isn't fair that two 70 year olds should receive different payments simply because they made different choices....

  6. Has any research been done in New Zealand showing the line of causality from restrictive zoning practices to higher property prices. In a market this small there is ample opportunity and incentive for the development community to exercise oligopolistic behaviours that would have a similar outcome.

  7. Productivity Commission report of last year

    Arthur Grimes on Auckland's metropolitan urban limit

  8. Thanks for that.With all due respect to the Productivity Commission their work relies on a very small sample of international research and not NZ data (for which they apologise in part on p115). The Grimes & Liang research is more compelling although, given the furore over Rogoff/Reinhart, I would feel more assured if their work had been tested and/or replicated by someone else.

    I guess I was hoping someone had pulled the development industry apart to find out what percentage of the final cost of build-ready land was attributable to each of raw land, infrastructure, finance, regulatory compliance and profit. The Productivity Commission had a go on the construction side but nothing on the development side.

    You seem pretty convinced that it is all about the impact of zoning on raw land costs and the government has just granted itself draconian powers to override local zoning regulations on the same assumption.

    If there was real knowledge available on the cost structures of the development industry then we could go beyond assertions to confident predictions of how much a policy change would knock off the price of a section.

  9. A replication of the Grimes study for Christchurch would be awfully interesting, if somebody could get the data. I'd love to assign it as an honours project. It would be especially fun to see what happens to the value of near-ChCh land as things looked likely to be zoned in or zoned out with the changes in plans and judicial review.

  10. Might have to make it Masters level. I think we have enumerated this before but CIAL and eCan are major players in hindering expansion in an arc from the SW to the NW. Also CCC, SDC and WDC collaborated through the Urban Development Strategy project on a co-ordinated Smart Growth strategy covering land beyond Rolleston to the south and Rangiora to the north.

    The valuation rolls are public registers so they are (technically) available simply for the asking.