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The tax system and housing demand in New Zealand

David Hargreaves

This paper uses a simple model to illustrate the influence of the tax system on New Zealand’s housing market and analyses several alternative tax treatments. This analysis informed the Reserve Bank’s (2007) comments on the tax system and housing in a recent submission to the New Zealand Parliament’s Finance and Expenditure Committee. Reflecting present tax policy, two key tax distortions that encourage property investment are factored into our model. First, capital gains on property are often not taxed, but all interest earnings are (and interest payments are fully tax deductible for geared landlords). Second, owner occupiers do not pay rent out of their after tax income. All else equal, these distortions imply it is often more tax efficient to accrue capital gains than interest earnings, and it is tax efficient to own your own home if it is unmortgaged or lightly mortgaged. Moreover, inflation makes the distortions more significant as real assets like houses will tend to rise in capital value over time in an inflationary environment. In the simple model used in this paper, these distortions have important effects on house prices. However, various simplistic features of the model imply it likely overstates the implications of the distortions and no particular connection is made from these distortions to the recent housing cycle. That said, shifting to a system where only real (instead of nominal) interest flows are taxable or deductible would substantially reduce the tax distortions. A range of other possible policies are examined, but they tend to either be less effective in reducing the distortion, or appear harder to implement.