Owner-Occupied Housing and Hidden Subsidies

Keith Rankin, 29 December 1998


One of the most consistent themes in Gareth Morgan's Herald columns this year has been his insistence that housing "tax breaks" for owner occupiers is a middle class subsidy that distorts the economy, leading to overinvestment in housing (especially middle class housing) and underinvestment in the areas of the economy (eg creative enterprise) that lead to economic growth.

In "New Zealand; a Lifestyle Block?" (29 September) he said: "The non-neutrality of tax with respect to the investment in owner-occupied housing has seen the well-documented excess flow of capital into that sector. Coupled with the selective application of a capital gains tax there's little wonder that Kiwi's invest so much of their savings in their own house."

In "The Hikoi for Handouts" (Herald 6 October) he said that "we could attend to the tax loophole that shifts wealth from tenants to owner occupiers". In "Labour and the Yen for Mother's Milk" (Herald, 1 December) he talks about "generating as much heat, passion, and illogic as any inculpable query over the net national benefit of taxpayer funding of the arts, welfare subsidies for the middle class, or the tax breaks for owner occupation of real estate". I haven't noticed much passionate discussion about the issue of tax breaks for owner occupation of real estate, but I am sure it would be passionately debated (with more heat than light) if such tax breaks were to be seriously questioned.

In his summary of the year "Year out; year in" (Herald 22 December, "Get set for a year of pork-barrel politics") he harps back on his principal theme for the year; overinvestment in favoured activities: "Over-investment in residential property and forestry driven by tax breaks, and in some parts of agriculture due to the regulatory protection afforded by producer boards are obvious candidates for critical audit."

I generally agree with Morgan on the issue of tax breaks for owner occupied housing, and wonder why he never devoted a full column to it. Certainly there can be little doubt that far too much bank credit has funded residential housing, with the main effect of inflating house prices and depressing small businesses that might have made better use of the credit. But what exactly is Morgan on about?

The market economy represents all items of production and exchange, plus a bit more. It is best understood by regarding all factors of production (ie "labour", "capital", "land") as being hired. Thus production (ie the addition of value) occurs when an entrepreneur buys raw material imports, hires factor inputs and sells the resulting product (a good or a service).

The hire charge (rent) for labour is called "wages", the hire charge for financial capital is called "interest", and the hire charge for land and other forms of property is called "rent". The entrepreneur's surplus, after payment of a wage to himself or herself, is called "profit". These, taken together are called factor payments, and the total value of all factor payments equals the total value-added in the market economy. (Taxes should be included as factor payments - the rent payable for the property of the sovereign - but are not formally included. Thus, we account for other factor payments "before tax", then tax factor payments, and then make an adjustment for indirect taxes. In public domain economics - see my "A New Fiscal Contract?" - income taxes are formally classed as factor payments. The theory of national accounting is not without its shortcomings.)

[We might note that the word "rent" has three meanings in economics: (i) a general name for a factor payment; (ii) a payment to the specific factor that we call "land", and (iii) "economic rent" which is a form of profit payable to someone who owns a "scarce" resource or who has a degree of monopoly power. The different meanings of this term - and others - lead to confusion even among professional economists.]

Once we think of the normal housing situation as being one of a tenant paying rent to a landlord, it is easy to understand that landlords provide housing services to tenants, in return for rent. Thus rent represents the wages of the landlord. It may be that the property is mortgaged, so the rent is split between mortgagor (the landlord) and mortgagee (who receives it as interest). Both rent and interest are taxable income, and are taxed. There may also be income paid by both mortgagor and mortgagee to a bank or other financial institution, for financial services in managing the mortgage; maybe a lawyer as well. Thus the lawyer and the employees of the bank receive wages (often called salaries), which are taxed, and the shareholders of the bank and the law firm receive taxable dividends (which are better regarded as interest than as profit). The bank and law firm pay company tax on undistributed surpluses.

What happens when the tenant and landlord are one and the same person(s)? This situation applies to many farmers as well as town dwellers. The economic theory of national accounting says that landlords who let their land to themselves are as much participants in the market economy as are landlords who let their land to other persons. Thus, it follows that landlords should pay tax on their rental income, whether or not they are the also the tenants.

There is no problem when a mortgage is involved. Clearly, tax is payable on the income received by the mortgagee, exactly as if the mortgagor was a landlord rather than an occupier.

It is only the equity of the owner-occupier that goes untaxed; a clear example of a tax break. This tax break is the equivalent of a benefit that strongly favours the upper middle classes, and the older generation. It is one of the major reasons why house prices are so high in the more affluent suburbs of our towns. And it is one reason why farmland is expensive even if the farm itself is only marginally profitable.

It is also a reason why rents are high. Landowners who move out in favour of tenants must charge enough so as to make their new taxable incomes high enough to compensate for the loss of untaxed rental income.

Some recipients of untaxed owner-occupier land/housing rents will object to proposals to tax their untaxed rental income. (For the people who campaigned against the New Zealand Superannuation surtax, this would affect them much more. It would however put them onto a much more equitable basis re their peers who are renting their homes.) They will argue that they pay local body rates in lieu of taxes on their residential property.

This argument fails, because the occupiers of mortgaged property (the income from which is subjected to income tax) also pay rates, either directly, or as an increment in the rent they pay to their mortgaged landlords.

Local body rates are in fact a simple wealth tax that is borne by everyone in a community, even if it is only levied on land owners (with or without equity). The inequity here is that communities with lowly valued property must pay more in rates per dollar of property in that community. Thus the people living in the more affluent communities - ie the communities with a high proportion of owner-occupied equity - pay lower rates than people with properties of similar value in communities where average property values are lower. This system of rating is itself an additional subsidy to the upper middle class residents of Karori, Remuera and Takapuna (but not to those of Pakuranga who would like their suburb to secede from Manukau City for just that reason).

There is no economic argument in favour of our present subsidies to those with equity in the land that they occupy. Nor is there an argument on the basis of social justice.

There is a huge political argument, however, in not addressing the issue. The sensitivity in New Zealand is particularly pronounced in New Zealand for four or five reasons. The first reason is that part of the New Zealand egalitarian ideal is based around home-ownership as an institution, and reform in this area would be seen a further threat to the ideal of the property-owning democracy. (In fact reform would make it easier for non-property owners to acquire property, by making it cheaper.) The second reason is the political power of "Grey Power"; the power we saw at work in getting Winston Peters into Treasury and therefore able to scrap the superannuation surtax.

The third reason relates to the position of Maori. Income distribution for Maori is more inequitable than for other groups, and Treaty settlements have probably aggravated that problem. Taxing Maori land on the imputed rental income on that land would be seen as insensitive in the present political climate. Furthermore, removing owner-occupier subsidies could open up the issue about the alternative uses of land. Should the imputed rental income of land be based on what that land could be earning (ie on the basis of "opportunity cost"), or on the basis of the revenue being actually being gained from the current use of that land? (Market values are in fact based on opportunity cost; ie on what a prospective buyer for that land would do with the land, and not on what the current occupier is doing.)

A fourth political reason in favour of avoiding the issue is that a similar issue arises with respect to the taxation treatment of homemakers vis-à-vis paid housekeepers (see Morgan's "Mother at home: ripped off or free to choose?", 12 May). The issue can be resolved easily at present, because the national accounts do include rents for owner-occupied housing in the country's gross domestic product, but, to the chagrin of many feminists, do not include the domestic work of homemakers.

[I will say that there are good reasons for treating "selfpaid" property income differently from unpaid labour income: (i) selfpaid land income frequently takes the form of a scarcity rent (ie it is "unearned") whereas unpaid labour rarely does; (ii) much unpaid labour (eg child raising) constitutes a public as well as a private contribution, and that contribution can be said to offset unpaid taxes on unpaid domestic or community work.]

The fifth reason why a proposal to remove the tax-break to owner-occupiers is that many people would have trouble agreeing with something that the controversial Gareth Morgan strongly favours! New Zealanders often make up their minds about a policy proposal not on the basis of the argument, but on the basis of whether they like the person who is presenting the argument. Morgan rankles with many more than most (see my "Gareth Morgan (Economist): a Boon to the Left?").


© 1998

Rankin File | 1998 titles