Tax policy is usually about picking your poison. Set company taxes too high relative to international norms and firms will want to set up abroad. Set them too low relative to personal income taxes and Kiwis will want to set up companies to retain earnings. Either way, imputation credits mute the effects of any changes. 

The trade-offs with capital gains taxes are nastier and they would do less to fix Auckland’s broken housing markets than you might think.

Let’s start with those trade-offs.

There are two basic ways of assessing tax on capital gains. They both result in problems. 

If you tax capital gains on a realisation basis, meaning the tax is based on the difference between the price at which you bought the asset and its selling price, you will inefficiently lock people into their homes. 

How does that work? Suppose it’s time to downsize your Auckland home after the kids have moved out. You bought it for $400,000 20 years ago and it is now worth $1.4 million. If you sell it, you might be liable for tax on the million dollars in capital gains. 

If you stay in the house, there is no tax. Some owners will then decide to stay in their house rather than sell and move on, potentially worsening the housing shortage by encouraging people to stay in houses that are too big for too long. 

The 2001 McLeod Tax Review agreed capital gains taxes assessed on realisation are a rather bad idea. While the review pointed to distortions in the tax treatment of housing, it concluded this kind of capital gains tax would increase tax complexity to no benefit: no increase in fairness, no increase in efficiency, no reduction in tax avoidance and no substantial increase in revenues. But, on the plus side, realisation-based capital gains taxes at least mean you have the cash available to pay the tax bill. 

If you tax capital gains on accrual, there is a different problem. Lots of asset-rich but cash-poor homeowners would get a substantial tax bill, every year, because the value of Auckland housing had gone up. Kicking grandmothers out of the family home to pay the capital gains tax would rarely make for popular policy. 

Rising tide

Similar things can happen with council rates but at a much smaller scale. A rising Auckland tide can lift all house values but will only increase your rates if your house appreciates faster than other houses. Capital gains taxes are based on the absolute gain in house prices while rates are based on change in your house’s relative value. 

The McLeod review pitched a third potential way of taxing capital gains. That tax would be based neither on accrual nor on realisation but on imagination. Each household would be taxed based on a notional return on its total stock of capital – say 6%, as some later variants suggested. 

So a million dollar property would draw an imaginary $60,000 annual return and would be taxed at the owner’s marginal tax rate. At 33%, the tax on that house would be just under $20,000 per year.

But this too is far from clean. Like capital gains taxes based on accrual, the system would not be particularly kind to retirees on low income sitting in the median Auckland house. If the capital charge is based on the purchase price of the house, the same lock-in distortions would apply as are found in realisation-based capital gains taxes. If they are based on current market prices, then homeowners would be subject to wild variation in their annual tax bill depending on the state of the housing market. 

The system would introduce other distortions into the tax system. If all investments will be taxed as though they earn, say, 6%, riskier investments may look less attractive, even if the expected return is higher. Paying taxes on a deemed 6% return, when you’ve lost your shirt, is not particularly attractive. 

Future consumption

More broadly, though, capital gains taxes of all forms tax future consumption more heavily than present consumption. Taxes on wages and salary incomes do not affect choices of whether to save or spend from today’s income. Taxes on consumption, if they are not expected to change over time, are also neutral between spending today and spending tomorrow. But taxes on savings mean that tomorrow’s consumption is more heavily taxed than today’s. 

Real world implementation issues abound. Investment in New Zealand does not enjoy tax-preferred status, so the case for taxing capital gains is far weaker than where investors can defer income taxes by placing income into sheltered investments. And every dollar spent out of capital income draws 15% GST.

It would be near impossible for Inland Revenue to implement a capital gains taxation regime before its systems refresh. What descriptions I have heard around Wellington suggest the tax computers are held together by No 8 wire and the world’s last remaining stock of COBOL programmers. Any substantial tax changes could make the system’s 50 million lines of code collapse in a flaming heap. 

If capital gains taxes are meant as solution to Auckland’s housing problem, it may well be impossible to implement it within the next six or seven years. It could well be faster to get new apartments consented in Epsom. 

Nor will taxes make Auckland housing more affordable for a simple reason: they do not get more houses built. The fundamental problem in Auckland remains a zoning-induced shortage of housing. 

Tax reform, over the longer term and after the IRD systems refresh, is well worth looking into. There are poisonous fishhooks in a lot of proposals that look attractive but shifting to the kind of land taxes suggested by Arthur Grimes has clearer merit. 

At best, tax reform fails to help a housing shortage. At worst, it distracts from the more important problem of getting new houses built. 

Dr Eric Crampton is head of research with the New Zealand Initiative.