GST back to councils?

If a localist agenda involves punting more responsibility down to councils, then central government assistance in funding some of those responsibilities could make sense. 

If councils were only responsible for core infrastructure, that can and should be covered by rates revenue and user charges on use of the infrastructure. If the resulting rates charges are unaffordable because of low income in the district, that's generally a problem for central government redistribution policy. Central government takes a lot of money from higher earning households and redistributes it to lower earning households, particularly lower income households with children. 

And if central government wants the council to provide infrastructure services to a higher standard than the council's residents would choose for themselves, because of central government priorities, it's appropriate for central government to assist with the cost difference. 

But if a more localist approach would have councils taking on more responsibilities over social services, that should not be funded through rates. Social services are inherently part of the state's vast redistribution mechanism. If local councils funded education, or health, or other such services out of local revenues, then central government would need to look to mechanisms like those used in Canada for topping up the accounts of poorer councils so that comparable bundles of those services could be provided in different places. The education system is already fairly redistributive, with a lot more central government funding for schools serving poorer communities' needs than those serving richer communities - whether it's done through decile measures or the more recent index measure. 

Anyway, that's just background and what I've thought is fairly settled standard local public finance in NZ. 

A couple years before I joined the Initiative, Jason Krupp at the Initiative had been arguing for giving the GST on new housing builds back to councils. I argued against it because it's impossible to track GST that way. But they were simply using GST as shorthand. What they were, and have continued, to suggest is taking the value of new housing construction in a district, multiplying it by the current GST rate, and sending it to council as a grant to help encourage them to build more housing. They could put it toward defraying the cost of necessary infrastructure; they could build a golden statue of the mayor with it. So long as it made councils more likely to say yes to housing. And I think that all makes sense - there are substantial spillover costs on the rest of the country and on central government when councils don't enable enough housing in places where people want to live - up and out.

Yesterday, Politik newsletter reported on some work by Infometrics on returning the GST charged on local council rates back to councils.

This seems a tremendously bad idea. 

Brad Olson was quoted:

"Rates should still be charged GST, as councils are providing goods and services for local residents, ratepayers, and others. But given the constant discussion about the need to fund local Government differently, perhaps GST on rates should be collected and then returned to local councils," says Mr Olsen.

I completely agree with the first line. There's a populist line about GST on rates being a tax on a tax, but if it weren't there, it would cause no end of distortions. There are all kinds of margins on which ratepayers might prefer to shift service delivery from the private sector or from households over to council provision if council-provided services had a preferential tax treatment, and from user-charges set by council to general rates funding for things already provided by council. 

As simple example, Wellington currently charges a per-bag collection fee for trash and people can choose to contract with private waste collection services if they prefer that instead. It's all fine. User charging like this recovers the cost of landfill services while providing incentive to avoid generating more trash than would otherwise be optimal. I don't know whether council is charging the right amount relative to a full cost recovery model, but the bones of the thing are right.

And suppose that an average household spent $100 per year plus GST on trashbags from council for collection services. 

If council shifted that service to just being rates funded - put out as much trash as you like, and it's covered in your standard rates bill! - and if households did not change the amount of trash they put out, then council could charge the $100 extra on rates and get $15 back from central government. Or charge a bit less and get a bit less back such that they were back to cost-recovery. 

If households put out more trash because they faced no marginal cost, council would still be better off - so long as they didn't increase trash generation by more than 15%. But more likely, households would generate more trash than that, and then either rates would have to increase by a greater amount, or councils would start rationing trash bags by non-price mechanisms, or some combination of the two. It would be a mess. 

Don't do this.

Basic drill on local public finance, or as best I've understood it, is:

1. Set appropriate user charges on everything that can reasonably be user charged.
2. Use rates to cover the cost of services that cannot reasonably be user-charged. 

Rebating GST on rates to council pushes councils away from user charging on stuff that can reasonably be user-charged. It also distorts toward council over private service delivery - at the margin, some things best provided privately get shifted into council's wheelhouse because council provision is tax-preferred. 

And if you set it instead such that councils get a GST rebate on both rates and user charges, you still have the distortion toward council over private provision. 

Afternoon roundup

The afternoon's worthies:

• How universities killed the academic. Great piece. 
• NZ Drug Foundation's report on drug use in 2022/23. One fun bit if you check back against the NZ Health Survey data: more people aged 15-24 (7.7%) use cannabis at least weekly than smoke tobacco (5.8%) at least monthly.
• Making Kiwisaver compulsory will be great for the default providers who get to clip tickets on fees I suppose. Not so hot for those with US tax entanglements. 
• Mayor Whanau presides over a council that blew hundreds of millions of dollars on town hall, library, convention centre, and is turning itself into a bank to provide cut-rate loans to a multinational movie theatre company, and blames stingy ratepayers for the pipes falling apart.
• Probably not good that Russia's still occupying that Ukrainian nuclear plant.
• Really neat paper on the adoption of property tax codes across Canadian First Nations, along with institutional detail on the First Nations Tax Commission and the First Nations Fiscal Management Act. 

What's a capital improvement?

Councils apportion rates across their ratings base: the value of land and capital improvements in their district.

Newsroom reports that Gisborne District Council is considering particular types of Kiwifruit licences to be part of the assessed capital value. 

Zespri owns the rights to some proprietary cultivars: Sungold G3 is the one here in play. 

There had been little consultation with affected farmers, and although the council had prepared a report in 2020 and got the changes signed off by the valuer general, the information was buried on pages 116-119 of the chunky document. It wasn’t even mentioned in the introduction to that report.

Still the impact for growers was clear enough, when it came through.

The rates bill for Tietjen’s orchard went from $4,364 for the 2020-2021 cycle to $8,221 in 2021-2022.

Some other Gisborne kiwifruit growers saw their bills triple.

“Kiwifruit is going through a boom time, which is why I think the council was maybe targeting kiwifruit growers,” Tietjen told Newsroom. “We can’t say we can’t afford it, but it makes things tougher. And kiwifruit is a risky business.”

I could see this being part of the land rating if the licence were tied to the land. Like if Zespri had to do some complex site suitability evaluation that then followed the land title.  

But that doesn't seem to be how this works:

“The licence is personal to the grower, not fixed to the land. A lot of people use a separate legal entity which owns the licence, separate to the landowner,” he says.

If a grower sells their property, they sell the rootstock, the irrigation systems and the fencing, but the licence goes back to Zespri, which then issues a new licence to the new owner.

The Court sided with the growers, who didn't want to pay council rates on the Zespri licence. But: 

With the appeal due to be heard in the High Court later this year, Gisborne District Council didn’t want to comment to Newsroom. However, its statement confirms the action comes from the top – New Zealand’s Valuer-General, Neill Sullivan:

“The decision to appeal comes on the advice and support of the Valuer-General, who considers that the Land Valuation Tribunal’s decision is inconsistent with past case law decisions and the Rating Valuations Act 1998 requirement to value established vines as improvements. 

“Removal of the gold kiwifruit vine value due to the existence of a licence creates an inequitable outcome for ratepayers, unfairly reducing the rating valuation and rates burden for some property owners and increasing the rates burden for others.”

The Valuer-General will bear the full cost of the appeal, the council says, as he “considers it to be in the national public interest for the matter to be heard”. 

The Valuer-General will also be joining the proceeding as an interested party.

The licence to grow this Gold kiwifruit variety costs about half a million dollars.

I wonder if they're viewing the "give the licence back to Zespri who will issue a new one to the new owner" as a convenience. If, on selling a piece of land with an irrigation consent, I formally gave the irrigation consent back to Regional Council, who issued a new one to the new owner, and everyone knew that the consent just stayed with the land, then the value of the irrigation consent should be part of the land valuation. 

Fun stuff though.   

Brownean motion

There is one big rule in local public finance. Do not use local income taxes to fund city governments. Ed Glaeser helps explain why:

In addition, some cities, like New York and Philadelphia, also have income or wage taxes that generate significant revenues. Typically smaller jurisdictions are not granted the authority to  levy these taxes, and many would not want to anyway, given the fears of repelling businesses and wealthier individuals. Indeed, Haughwout et al. (2004) estimate that the elasticity of earnings in cities with respect to the tax rate is so high that income tax rates quickly become counter-productive for producing revenue. 

...But the property tax also has several key virtues for a locality. First, property is considerably less mobile than income or other forms of wealth. Even the tiniest community, like a business improvement district, can levy a charge based on the amount of real property in the community. That property will not just get up and walk away, while an attempt to have a neighborhood level income tax would surely lead to considerable out-migration by the wealthy. 

...Income taxes, of course, can be far more redistributive than sales taxes and that is one of the reasons for their attraction to many cities. The problem with local income taxes, of course, is that they potentially repel wealthier individuals. That provides one reason why many forms of local redistributive services are actually funded by higher levels of government. 

Bottom line: income taxes are a reasonable way of funding redistribution from rich to poor. Rich people prefer not having to pay them. So, run your big income redistribution programmes at the national level, funded by income taxes, and leave local government to provide local public goods, funded by land or property taxes.

Glaeser and Shleifer also showed that Detroit's Coleman Young and Boston's James Michael Curley's use of high local income taxes encouraged their richer opponents to move outside of their cities' limits, beggaring their cities but helping to ensure their continued re-election.

Here's Auckland mayor Len Brown [ht @MarkHubbard33]:

Making all Aucklanders pay a council income tax may help elderly people in affluent areas who can't afford their rates, mayor Len Brown says.
The current system is "inherently unfair" on people living on fixed incomes and paying high rates because of the value of their properties in areas like Devonport-Takapuna, Brown says.
Introducing an income-related tax for local council services that everyone pays is an option, he says.
Only property owners pay rates but the council is spending money on infrastructure and services for everyone, Brown says.
He believes the only way to mitigate the rates burden as property prices rise is to rethink how local government is funded.
Brown won't express a view on what alternative might work saying he is "quite open minded".
Options could include funding through income tax, GST, user pays charges, or bed taxes from hotel.

A few things worth noting:

1. Everyone in Auckland pays property taxes, though only homeowners and business owners make direct payments to councils. Renters bear some of the burden through their rental payments. Shoppers bear some of the burden through their purchases from local taxed establishments. 
2. An income tax is only feasible if Auckland Council is now large enough that commuting in to Auckland from outside of its rating zone is infeasible, or if the amenities it provides to rich folks are just super-awesome and don't do much for commuters. Otherwise, the richest folks keep their residence just outside of town and maybe have a small commuter apartment in town.
3. Property taxes are a way of taxing wealth rather than income. They're then a nice complement to existing national taxes on income and consumption. The elderly person on a fixed income, sitting on a million-dollar Davenport property, is really really rich, even if she has little income. Getting rid of the only wealth tax we have in favour of more taxes on income does even more to screw up the system. The existing system already has big transfers from less wealthy people on high current income to very wealthy people on low current income: superannuation payments going from young mortgage-holders to old homeowners. Brown is proposing to make this even worse. 
4. Further, a reverse mortgage can solve the problem for many wealthy but low income elderly. 
5. For those for whom the annuity wouldn't be enough, well, is it really worse to have a few wealthy but low-income elderly move to a smaller house or apartment than to wreck your local council's ratings base with an income tax? And you know that Councils can, in some cases, put in a limited property tax abatement scheme for those on lower incomes, right? 

User charges for some Council services can make sense. If Gerry Brownlee hadn't somehow banned Auckland from putting in congestion charging, that would have been a good one for Auckland. But local income taxes are a pretty bad idea.

Can tax and subsidy incidence really be negative?

Imagine a country where shoes cannot be imported and furthermore the elasticity of supply of shoes is very low. Imagine that the government in this country subsidises shoes. The person on the street who doesn't understand tax incidence might think that this policy lowers the price of shoes by the amount of the subsidy. An economist, however, would be likely to point out that, because supply is fairly unresponsive to price, the subsidy mostly results in an increase in the before-subsidy price to the seller.    In our jargon, he would be saying that most of the incidence of the subsidy would be on sellers and only a bit on buyers.

So far so good, but what if that economist now explained that removing the subsidy would make shoes cheaper to consumers, by stopping buyers from bidding up the price. This would seem to now be claiming that the incidence of the subsidy on buyers would be negative. Sure removing the subsidy would reduce the price to sellers but it would be a very strange model that would have the price falling by more than the reduced subsidy. In fact, it would seem to require that the supply curve be downward-sloping. 

And now, imagine that the economist further claimed that removing the subsidy would be good, as it would result in investors switching from investing in shoe production to investing in productive assets. This would go beyond strange. Sure the subsidy might have been diverting assets to having too much shoe production and not enough other stuff, but in what sense would we say that producing shoes is unproductive? And, how is it consistent to argue at the same time that removing the subsidy would lead to less investment in shoe production at the same time as arguing that it would result in lower shoe prices for consumers? 

O.K. this country, this policy, and this economist are fictitious. But if we change "country" to "New Zealand", "shoes" to "housing", "subsidy" to "tax exemption", and "economist" to "Gareth Morgan", you pretty much get this blog piece from Gareth on Tuesday. 

Gareth argues, correctly, that owner-occupied housing receives a favourable tax treatment relative to other investment since we are not charged income tax on the implicit rental payments we receive from ourselves. But he then goes on to argue that removing this exemption would "bring affordability within reach of many more families". This is an argument I have commented on before; it really looks like arguing that tax incidence can be negative: If housing is effectively subsidised by the tax system, we can't expect removing the subsidy to make it more affordable. 

And he then says that our tax treatment of housing has "discriminated against productive investment in favour of property speculation". Now if he means that we have invested too much in building houses and other kinds of investment, then we have to ask: In what sense is it unproductive to build houses that provide housing services to people that they value enough to pay for? And, how is it possible that curtailing such investment would "bring affordability within reach of many more families"? If, in contrast, he means diverting investment resources from building new equipment to buying existing houses as speculation, I have my perennial concern that this line or argument fails to note that buying existing houses for speculation or other reasons is not "investment" at all, and the assumptions you have to make to conclude that such behaviour diverts resources away from productive investment are a stretch to say the least.  

One final curious seeming contradiction in Gareth's post. At the start, he notes "When, not if, interest rates increase, this illusion that housing is `affordable' will burst....house prices will adjust". But later he suggests that if we don't remove the tax-favoured treatement of housing, he should "go out and buy another three houses now and just wait for the rest of you to bid the prices up". Why would that be good personal investment advice if, as he says, house prices are sure to fall? What am I missing?

What is wrong with housing anyway? (Warning: wonkish)

This is a post I have been meaning to write for some time, but the current spur is the Treasury briefing for the incoming minister. It is mostly very good, but included in it is the canard about over-investment in housing. This is a refrain we hear repeatedly, usually in phrases like “New Zealanders love affair with housing”, but I think the theoretical and empirical basis for the assertion of overinvestment is weak at best.

The main issue is one of tax-induced distortions. With owner-occupied housing, the purchase of a house is an investment, which generates an inputed rent that the owner pays to himself. The payment of this imputed rent is not subject to GST, nor is the rental income subject to income tax. There is also the issue of whether the absence of a capital gains tax is a further distortion, but I have discussed that issue here, here, here, and here. In this post, I want to explain why I don’t find it obvious that there is a distortion due to the lack of tax on inputed payments of a homeowner to himself. In part, this is a response to comments by Phil Meguire in the first of the capital gains posts.

To start with, let’s get an obvious point out of the way. Housing is a good thing, and nicer housing is better than worse housing, holding all else the same: If non-neutral taxes induce more investment in housing and less in other forms of investment than a neutral system, there is a cost, but it is the difference between the value of the flow of goods that would have been produced and the value of the flow of services produced by the housing, a difference which is not necessarily significant. I suspect that some of those decrying our love affair with housing are making the mistake of thinking that just because the purchase of housing services is a non-market transaction it doesn’t contribute to economic well-being. Similarly, it is irrelevant if the alternative investment would increase labour productivity, increase exports, etc. productivity and exports are just means to increasing the value of the goods the economy can consume; so is building houses. (Surprisingly, Greg Mankiw appears to make this mistake here, but to be fair we can attribute this to the need for simplification in an op-ed article, and his basic point—that the U.S. should get rid of the crazy mortgage-interest deduction—is sound.)

The next point to note is that the optimal tax rate on owner-occupied housing has to be considered in the context of an existing distortion: With an income tax, saving is subject to double taxation. If I choose to work today in order to buy consumption goods today, there is a difference between the value of what I produce and the value of what I consume, because of an income tax. But if I choose to work today in order to buy consumption goods in the future, there is an even bigger distortion between the value of what I produce and the value of what I consume, because the value of my work is taxed twice, once on my labour income and again when the interest income is taxed. We then have a classic second-best Ramsey taxation problem. The theoretical optimal tax on the return from investing in owner occupied saving will be somewhere between having no taxation on the saving (so as not to distort the decision between consumption today and investment in housing), and the full double-taxation rate applying to other forms of saving (so as not to distort the decision between investment in housing and other investment). So if normal investment returns are taxed at, say, 33%, the optimal housing tax will be positive but less than 33%.

And finally, here is the point that is overlooked in all the commentary on housing investment that I have seen. The flow of services from owner-occupied housing is currently subject to a tax. In other words, this graph, taken from the Treasury’s briefing to the incoming-minister, is wrong.

To see why, consider how a value-added tax like the GST works. Businesses charge GST on their sales, but deduct from their net tax liability the GST they have paid on purchases of goods and services. Expenditure on investment therefore reduces their tax liability, which is what makes the GST ultimately a tax on consumption and not investment income. When consumers buys a new house, they are making an investment, the return for which is the flow of housing services they will receive over time. The inputed payments they make to themselves are not subject to the GST, but unlike other business investment, the initial house purchase is, which has the same effect. (And, as I noted in an earlier post, the existence of a GST pushes up the prices of second-hand goods by the rate of the tax, so the argument is no different for owners who purchase an existing rather than newly built house.)

This is another example of the beauty of pure value-added taxes. By shifting in part from an income tax to a value-added tax, the rate of double taxation on delayed consumption is reduced. At the same time, the effective rate of taxation on the consumption of owner-occupied housing is increased from zero. We end up with a system where the tax rate on owner occupied housing is somewhere between 0 and the rate applying to other investment, just as Ramsey tax theory would stipulate. Whether it is higher or lower than the optimal rate is a difficult empirical question to which I don’t know the answer. But I have not seen any of “New Zealander’s love-affair with housing” commentators seek to address it. Furthermore, given that there are no simple methods of increasing the tax rate on owner-occupied housing that don’t bring their own problems (we have no mortgage-interest deduction to get rid of, for instance), I find it hard to believe that we have an over-investment problem that is worth solving.

Morgan and Guthrie’s Modest Taxation Proposal

Gareth Morgan and Susan Guthrie have proposed a radical shake-up of New Zealand’s tax and welfare system, summarised in this article in the Herald last week. The main features are as follows:

• an “unconditional basic income” (UBI) of $11,000 for every adult, applying to everyone and replacing all other benefits including superannuation;
• a flat income tax rate of 30% applying to all income earned by individuals, trusts, or companies; and
• a “comprehensive capital tax” (CCT), which effectively imposes a minimum tax on all capital excluding financial assets equal to the tax that would apply if the capital earned a rate of return of 6%.

I assume also that they assume maintenance of a broad-based GST, and full dividend imputation of corporate tax.

Some things in their proposal I like. Having a single system implementing transfers and income taxes is long overdue. I wouldn’t go so far as to have a single minimum income that is the same for every adult, irrespective of need, as the level that would be needed to guarantee an acceptable income to the most needy would be unaffordably high if given to all. An integrated tax and transfer system, however, needn’t be as hands off as in their proposal; there could still be a role for a body like WINZ to adjudicate on levels of benefits according to need, and provide other support services; the most important thing is to integrate the systems so that the impacts of policy changes on horizontal equity and effective marginal tax rates are transparent.

Aligning the corporate tax rate, tax rates on trusts, and the marginal rate of income tax for the majority of taxpayers is also long overdue. I wouldn’t have a single rate all the way down to zero income, in order to allow differences in the guaranteed minimum income based on need to be phased out at higher incomes. Again, the point of difference here is small relative to the main point. A system in which there was a common rate applying to corporate income, trusts, and the income above, say, $30,000 would probably achieve almost all of the benefits of a single rate in terms of eliminating the distortions and compliance costs that multiple rates can bring.

On the other hand, the comprehensive capital tax has me flabbergasted, for a number of reasons:

First, the contrasting motivations for the UBI and CCT seem incongruous. Under the UBI, an able-bodied pre-retirement adult with no dependents would be entitled to choose to not work and still receive the UBI, and pay no tax. Their justification for this is that “[w]e are a rich society so to compel people to opt for paid work or face the stigma of qualifying for a benefit has no logic.” At the same time, however, their CCT does not regard it as a matter of personal choice how people should invest their savings; instead it implies a moral imperative to earn a return of at least 6%. There seems to be an underlying value judgement that earning a high return on capital is a social obligation, but one that only applies to those who choose to save at all.

Second, an effective minimum tax represents a massive deviation from the admirable principle of having a common rate of tax on all income, and brings with it the distorting effects of multiple rates. As an illustrative example, consider someone choosing whether to invest in an asset with a guaranteed return of 6%, or one with even odds of returning either 0% or 15%. The risky asset has a higher expected return to the economy, but under the non-linear tax system it would have a lower expected after-tax return. This is a strange incentive structure for a proposal designed to better allocate capital.

Third, a CCT seems likely to have some quite insidious properties. The proposal calls for the CCT to be applied to all non-financial assets including the family home. They don’t specify in the article how the capital value of the asset is to be determined. Is it the purchase price or the current market value? If it is the purchase price, then the tax would create the same sort of distortion as a capital gains tax applying only to realised gains—an incentive to hold on to appreciated assets in order to avoid the tax rather than choosing a portfolio because of their underlying value. If it is on the market value, then homeowners would be subject to large fluctuations in their tax liabilities from year to year independent of their income streams, at the whim of property valuers. This, of course, is already an issue with local-body rates, but the amount levied in rates each year is trivial compared to a 30% tax on 6% of the valuation of a house.

Finally, a CCT would bring about a one-off capital loss on the value of houses, as future purchasers would have to consider their ability to pay the tax when calculating how large a mortgage they could afford. That is, the shift to the proposed tax system from the status quo would start with a massive takings from property owners. This needs to be borne in mind when thinking about the benefits of a system with a high UGI and low marginal tax rate: Of course, we can have low taxes and generous benefits, if the government can fund its activities from an initial property theft. But I’d rather have a clunky and inefficient tax system coupled with a respect for property rights.

Efficient taxes

Sinclair Davidson spoke against efficient taxes at this year's Mont Pelerin meetings. My summary of that portion of his talk: you want the duck to squawk when it's being plucked lest the bird be completely denuded. If we take a leviathan model of taxation rather than a public interest model, then high excess burden can be a plus rather than a minus.

Colby Cosh writes in favour of Georgist land taxes. A tax based on the unimproved value of land would be about as efficient as can be achieved. But as I suggested here last year, switching from income to land tax is a risky game. It's politically easy to reinstitute punitive tax rates on higher income cohorts. Unless this kind of tax switch is accompanied by credible long term cuts to overall spending, the size of government is likely to creep up.

If I could push a button that would flip our current tax structure to a pure Georgist land tax, with a guarantee that the move wouldn't affect the overall size of government, I'd push the button. As is, I'd prefer to snip the wires to keep others from pushing the button.

More on incidence and elasticities

Last week, the Property Investors' Federation got a lot of press arguing that tightening up depreciation on rental properties would push rents up considerably; I suggested that unlikely as supply is almost certainly less elastic downwards than is demand, in which case supply bears the burden of the tax.

I'm sure I had the Coleman and Scobie paper floating around in the back of my head when I posted; Andrew Coleman helpfully sends me his work for Motu and Treasury showing that indeed rents are unlikely to change much. He there found that a ten percent increase in the tax concession to landlords would result in a 0.3 percent decrease in rents in the short term assuming that supply of rental housing with respect to rents (and other returns) is unitary and demand for rental housing with respect to rent is -2.

In short, it's unlikely that rental prices would move much if landlords could no longer write off depreciation. We might expect some transitional difficulties as landlords under money strain let properties fall into disrepair before selling them on, but equilibrium would return with lower house prices.

I'm still pretty surprised that the media just took the lobbyists' numbers on this one. Of course, we shouldn't just dismiss findings because of source, but it does suggest our antennae should be up....

Incidence and elasticities

Last night's news brought a story of the horrors to be visited on renters when and if the government moves to limit landlords' depreciation expenses. Lots of interviews with unhappy renters, lots of shots of the Labour Party's Trevor Mallard and his back of the envelope calculations of the effects on poor people.

The study was funded by the Property Investors' Federation.

I didn't see any counterpoint interviews with any economists asking if they'd seen the study or whether it made any kind of sense at all (I can't find the study online). Just shots of unhappy renters asked just how unhappy they'd be if their rents went up by the amount their landlords' lobby group claims rents will go up with the regulatory change.

Let's recall that the incidence of any tax will depend not on who the statute says has to pay it but rather on relative elasticity of demand and supply. The supply of rental houses is relatively inelastic: new houses are built only slowly due to resource consent issues, though that constraint is of course less binding in recession. But adjusting supply downwards is more difficult: properties can be shifted from rental to owner-occupied, but they're rarely bulldozed. They can be provided with less maintenance and allowed to erode over time, but that's slower. The demand for rental houses isn't all that elastic, but I'd be very surprised if it were less elastic than supply: renters can double up and rent with friends if prices increase. When the supply curve is more inelastic than the demand curve, the incidence of the tax falls mainly on supply.

The likely scenario:

After depreciation treatment is tightened up, landlords try to hike rents to keep their rates of return on even keel. Some tenants exit the rental market with the price hike (they're relatively more elastic). Some property owners can't find tenants and either eat the loss, lowering rents, or sell off the property. The rental property won't sell for a price that would earn the new property investor losses if he can only earn through rental income plus capital gain rather than rental income plus capital gain plus depreciation expenses that are never counted against capital gain. So the property sells for less, the new landlord charges a lower rent but one that covers his bills, and other properties follow suit over time.

So, Public Address seems likely right. Unless I'm very wrong about relative elasticities, the bulk of the burden cannot be passed on to tenants.

And it's mildly amusing to watch a po-faced Trevor Mallard talk about the horrible harms that will befall renters when he's the unwitting tool of the rentiers.

Good news and bad [updated]

Updated (below)

Well, the good news from Key's speech is that we're not going to get a land tax.

The bad news, surprisingly, also is that we're not going to get a land tax. Or, rather, Key has given himself no room to make the tax system more efficient. I was hoping for a bigger GST hike to pay for some bigger cuts to marginal income tax rates [hopes for spending cuts are a hope too far]. Instead, we're getting a relatively small GST increase (2.5 percentage points) that will be coupled with increases to low income benefits to offset any (dubiously proven) harms to poor people - in other words, not enough to be able to do anything on marginal tax rates. I'd be surprised if whatever moves they make on tightening up rules around tax treatment of investment properties give them space to do much on marginal income tax rates either.

So, we've mostly ruled out anything interesting on the tax front. But we may yet see interesting moves in social policy. Key's hinted at work requirements for the Domestic Purposes Benefit, tightening up the sickness benefit, and knocking out some tertiary education rorts in non-degree programs (rather interested to see specifics!). I like this one:

Accordingly, this year the Government will appoint a working group of experts to recommend ways in which we can reduce long-term welfare dependency and thereby reduce the welfare bill future generations will face.

I wonder if he'll pay it any more attention than he's paid to either of the previously commissioned expert working groups on productivity and taxes, both of which seem consigned to the shredder. It would be foolhardy to expect any of this to amount to much given the track record. This time, I'm going to revise my expectations sufficiently downwards that I won't be disappointed again.

Oh, and there's also this:

Part of our ongoing work to address the drivers of crime will be the introduction of legislation to reform liquor licensing laws. The purpose of this legislation will be to reduce the crime and harm caused by binge drinking, by stopping the excessive proliferation of liquor outlets in many of our communities.

That seems to preempt Palmer's report. Again, I'll need to see details. If it's just not allowing new liquor outlets opening in low decile areas (because poor people apparently can't be trusted to have too much liquor available for purchase within easy walking distance), it's perhaps one of the less bad anti-alcohol initiatives. Confers rents on existing owners, imposes losses on folks who need to travel farther, but otherwise not awful. If it means that folks in those areas will have their licences cancelled - that's a rather nasty stunt to pull on legitimate businesses who'd see almost complete regulatory expropriation of their investments. We'll see.

TVHE and Bernard Hickey also aren't terribly impressed. Farrar gives Key a B, but he's an easy grader (nice to see his blog post quoted by the Opposition Leader 20 minutes later in the House though!). I'd treat it as a first draft and give the student, who you know is capable of better work, the necessary kick in the pants to make sure the final draft is up to scratch: C- (with provision for upwards revision by higher weighting on the final draft).

Update: I'm giving a rare upwards grade revision. C+/B-, with a big downwards revision on the weight put on the statement and a big upwards revision on what comes out of the budget. If he's serious on welfare reform, that could easily move up into the A ranges.

Update 2: I'm somewhat skeptical, but I'm absolutely not an accounting guy or a NZ tax expert. If this is right, then the minor changes in property tax administration could bring in sufficient funds for substantial changes to the income tax structure. In that case, the grade is further revised upwards.

Bollard on capital gains

A month ago, I said

Now, it could be the case that some property investors who improve and resell properties quickly are able to disguise normal income as capital gains by this mechanism, but I'd be surprised if the efficient solution were a broad capital gains tax rather than IRD just watching things a bit more closely.

From the National Business Review, we find that Reserve Bank Governor Bollard agrees.

“We’re particularly interested in the prospect of seeing a flattening of the tax incentive structure around housing investment.

“It seems to me the most obvious part of that would be around taxation on people who intend to flick on investor housing.”

And, asked by Mr Cunliffe whether he believed the current tax system favours of property investment, Dr Bollard drew a big breath and said, “the short answer is yes.”

That though is somewhat short of calling for anything, let along a capital gains tax. As Dr Bollard well knows there are existing provisions in the income Tax Act which allow the Commissioner for Inland Revenue to treat the gains on the sale of property by people who are consistently buying and selling properties as income.

What it boils down to is determining those people are buying and selling property so frequently they are essentially traders, and any capital gain is treated as part of their income.

There is no need for a capital gains tax to remove purported distortions in the housing market. I can imagine a case for a move from an income tax to a land tax as efficiency-augmenting, but I have a hard time believing that such a move would be an equilibrium.

Self-enforcing protocols: property tax edition

The excellent Bruce Schneier posts today on Self-Enforcing Protocols and points to one I'd not heard of before:

Here’s a self-enforcing protocol for determining property tax: the homeowner decides the value of the property and calculates the resultant tax, and the government can either accept the tax or buy the home for that price. Sounds unrealistic, but the Greek government implemented exactly that system for the taxation of antiquities. It was the easiest way to motivate people to accurately report the value of antiquities.

This makes a lot of sense to me for things like Greek antiquities, where the owner of the object has a lot of private and expensive knowledge about the true market value of the good. I'm not sure that it makes sense for housing. Right now, city councils hire assessors to make their tax assessments; it's unclear that distributing the burden of assessment more efficiently extracts information about market prices. I'd expect that the administrative cost minimizing solution is the one where the council hires assessors rather than having every household privately either hire assessors or otherwise come up with a figure.

I wonder if anyone's ever done formal modeling of this arrangement. In contrast to the case with antiquities, the valuer/owner experiences massive transactions costs if the government unexpectedly decides to exercise its option to buy. Consequently, folks would have an incentive to bid willingness to accept rather than expected market price. And that means we'd then be taxing folks' sentimental attachment to pieces of property. However, if market value (presumably the government's strike price for the call option) is below willingness to accept, folks will shade their valuations down to market value. If there's uncertainty about what the government thinks actual market value is, risk-neutral folks will shade their bids such that the probability-weighted sums of utility across keeping the house with a lower tax bill and losing the house are maximized; risk-averse folks might overvalue their house for fear that the government will exercise the call option, though they shouldn't go above willingness to accept.

Another complication is whether the government would really ever be able to exercise its call option. Could they really evict the little old lady who came up with her valuation number using the recommended rule-of-thumb but whose property experienced idiosyncratic appreciation? If not, the system falls apart.

Leaving aside those problems, I can see two reasons for wanting to move to such a system, but I'm not sure that they're sufficient bases for such a move.

First, if the government wanted to base property taxes on the owner's willingness to accept rather than on market value, then this system would be preferable. In a world where official assessments are updated infrequently but are always updated in the case of a market sale, tax assessments can induce inefficiently low turnover in housing: if your property has appreciated since the last assessment, you'll be more reluctant to move than if your property were taxed based on a current assessment. Moving to regular owner-assessment could solve this problem, but so too could more frequent official assessments.

Second, if the system did induce truthful revelation of willingness to accept, with a call option for government based on that price, eminent domain would be a heck of a lot simpler. But again, I'm not sure that these benefits would beat the costs. You could argue that it's an erosion of property rights in giving the government a call option on all our property; it's unclear to me that this system has that much effect at the margin. Kelo v. City of New London is the current precedent in the US; New Zealand also seems plenty able to expropriate property owners for public works as well. At least this system would force payment closer to actual willingness to accept.

Finally, if valuations were in the public domain and folks were posting their real willingness to accept, the real estate market would be a heck of a lot more interesting. If you always fancied that house down the road, you'd know what you'd need to pay for it.

A more worrying downside would be that it would allow an unscrupulous government to force its opponents to pay higher property taxes: if your property tax is based on how far from average valuation your house is, and the government uses a rule of thumb that it exercises its call option if reported valuation is say 5% below market value, you might rightly fear that the rule of thumb in your case would be actual market value, or some higher number. You then have to report a valuation closer to your true willingness to accept than do others; in equilibrium, you pay slightly higher property taxes.

Working out the formal modeling and likely effects of such a rule would be an interesting project for someone, if it hasn't already been done. I have a hard time seeing it being a worthwhile move in property taxation though.