And it’s not the only existing provision the Inland Revenue could look at enforcing in the face of runaway house prices and wealth inequality, writes Terry Baucher. 

Thirty-one years ago this month, then-Labour finance minister David Caygill proposed a comprehensive capital gains tax including the family home. The proposal was made following the release of the Consultative Document on the Taxation of Income from Capital which recommended it was time for the general exemption from tax of “capital income” (sound familiar?) to go. As one justification for the move the Consultative Document declared:

“Removal of the exemptions would not amount to a tax aimed at the wealthy. Rather, it should be seen as the removal of an exemption currently disproportionately enjoyed by the wealthy — an exemption that does not appear to meet any of the equity criteria that New Zealand as a society generally upholds … The result is that the direct beneficiaries of the current exemption for capital income are the richer sections of society. Most people may benefit from the exemption to a small extent, but it is the rich who benefit the most.”

Unsurprisingly, the proposal was not popular. In March 1990, Caygill announced the proposed capital gains tax “was off the agenda.” It would not be the last retreat on a capital gains tax a Labour politician would make. 

Looking back, quite apart from how radical to 2020 eyes the proposed capital income regime appears, the focus on inflation and its taxation implications is striking. The Consultative Document references “inflation” 601 times.  By contrast, the 2019 Tax Working Group’s final report mentioned inflation only 20 times. Furthermore, the TWG’s proposed capital gains tax regime would not have adjusted capital gains for inflation.  This is a very significant difference from its 1989 counterpart which intended to only tax inflation-adjusted gains.

But the inflation the 1989 Consultative Document was concerned with was general inflation and not house price inflation. Between 1962 and 1989 the consumer price index had risen 1108.2%.  

In relation to house prices according to the Consultative Document, these increased by an average of 10.1% per year, between 1961 and 1988 but once adjusted for inflation, they had increased on average by only 0.7% per year.  Wage inflation over the same period had also risen in real terms but not quite as fast as house prices.  The Consultative Document felt that an appropriate inflation adjustment “would ensure that most ordinary homes would not generate a tax liability on sale”.

The general concern with inflation resulted in a cross-party agreement in 1989 to amend the Reserve Bank Act to give it the mandate of ensuring inflation was reduced to a target range of 0-2%.  Based on the Reserve Bank’s inflation calculator it appears to have succeeded in this mandate with the Consumer Price Index rising over the past 30 years by 85.3% or 2% compounding each year.

However, unlike the period prior to 1989, housing price inflation in the past 30 years has vastly outstripped both CPI and wages. 

The key problem with housing over that time has been its supply, but it’s hard to avoid the conclusion that various Reserve Bank governors perhaps should have moved earlier on loan-value ratios for investors. 

So, 31 years later, another Labour government has found a CGT politically impossible, even though the equity argument for a CGT is still as valid as in 1989. In the absence of a general CGT, what tax measures could a government take to address the issues of wealth inequality and runaway house prices?

The current government has introduced loss ring-fencing and extended the bright-line test (a de facto CGT) to property sales made within five years. But what else could be done?

As the bright-line test is already in existence, it hardly would be a new tax to extend its scope. That happens with taxes all the time. Although doing so would also be bending the political position.

But it’s also worth pointing out that the bright-line test is actually a fallback test. It applies if none of the other taxing provisions apply. As John Key noted a number of times, a capital gains tax provision already exists in the form of Section CB 6 of the Income Tax Act. This taxes any person who acquires land with an intention or purpose of disposal. Section CB 6 has been part of the income tax legislation for over a century. However, as a newly released Auckland University report notes, the provision has been rarely applied because of the difficulty of proving intent.

As one of the co-authors of the report Dr Michal Rehm points out, a decade-long analysis of Auckland rental home purchases showed nearly all made initial losses and relied on a profit at resale to be considered wise financial investments. “These things on a cashflow basis are complete dogs … The only rhyme or reason you would invest in property is you are hoping to get some sort of payout at the end.”

Applying this logic would mean investors who were negatively geared at the time of purchase would be taxed on a future sale even if it happened outside the five-year bright-line period. Given a rampant housing market and a cash-strapped government, it can only be a matter of time before a diligent Inland Revenue investigator runs this argument. 

Alongside section CB 6 there’s another provision which if I was a rather shrewd Inland Revenue official, I’d be closely looking at applying. And this is Section CB 14 of the Income Tax Act.

Now, under Section CB 14 where a person sells land within 10 years of acquisition, any gains from that sale that are not taxed under other provisions will be taxable if at least 20% of the gain results from one or more factors that occurred after the land was acquired. Those factors include a change or a likelihood of change in the operative district plan.

Section CB14 almost certainly applies to properties which are rezoned for higher density or may have been brought into the special housing areas if you remember those.  It’s a little applied provision which is one reason last year’s Tax Working Group recommended that it be repealed.  For the moment it’s still on the books and therefore available to Inland Revenue.

Another obvious option to ease price pressure would be restricting the access of funds through re-imposing loan to value ratios (LVRs) for all but first-time buyers.  A tax-related measure with a similar potential effect would be to apply the thin capitalisation regime to investment properties.  

At present, if a business such as Microsoft wanted to invest substantially in New Zealand, the interest deductions that it can claim on any debt funding provided are restricted if the debt to asset ratio exceeds 60%. Restrictions also apply to the interest rate that can be charged on the debt funding.  

Applying the thin capitalisation regime would tackle the ability of investors to use debt to leverage up their investments which is another way first home buyers can be priced out of the market.  

But more direct action could be taken to address a strange anomaly under our tax rules.  As Clint Smith notes, interest deductions at present are, with the exception of the thin capitalisation rules, generally fully allowable if incurred in deriving gross income.  The deduction relates to the rental income that is being earned from the underlying property being financed.  

However, as the argument for greater application of section CB 6 notes the economic returns from property are twofold.  Firstly, in the form of taxed rental income and secondly in untaxed capital growth.  The present treatment, therefore, gives an allowable interest deduction for both taxed and untaxed gains.  

This generous treatment together with the banks’ willingness to lend freely practically makes property a one-way bet. An interest restriction rule, whether it is in the form of thin capitalisation or some other means, seems to me to be both an equitable approach and a good means of putting a handbrake on housing prices. 

Such a move would complicate the tax system. The first draft of the ring-fencing rules eventually introduced last year were so complicated they had to be redrafted entirely. An alternative and simpler approach would be to remove the loss ring-fencing rules and allow interest deductions in full, but the eventual property disposal would be taxable. In other words, an investor can get the value of the deductions now in exchange for a future tax liability.  

The government and Inland Revenue either have or can deploy most of the tools needed to tax property speculation without introducing a formal capital gains tax.  However, these would not address the issue of equity and fairness the 1989 Consultative Document identified. Some form of comprehensive wealth tax/capital gains tax is required to deal with growing wealth inequality.  As a Deutsche Bank report last month rather dramatically put it: “To save capitalism we must help the young”.

Prior to the election, I suggested it was time politicians stopped kicking the capital taxation can down the road, although I was doubtful whether that would happen. My view was that continued inaction would mean an increasing likelihood that another attempt to kick the capital taxation can further down the road might just see it rebound and hit the kicker, something which appears to be the case.