Reserve Bank warns of risks to financial stability

The Reserve Bank has pointed out the key threats to the financial stability of our economy; housing investors in Auckland and the risk that some dairy farmers could be under the hammer if prices stay low. It is stating the bleeding obvious but it is always nice to hear the bank speaking up.

On Auckland housing investors it has taken some action, lifting the loan to value ratios for investors. Sadly, the horse has bolted on both problems – they are much bigger than the bank itself can resolve. The only way to stop the rot is to close tax loopholes around housing and land.

Investor LVRs won’t solve the problem

Auckland property investors will need to stump up 30% deposits from October but we will have to wait and see the full impact. On top of previous loan to value ratios, this is the Reserve Bank recognising that housing isn’t as riskfree an investment as they have assumed in the past.

This will no doubt dent the hopes of the Mum and Dad investors, looking to get a second property as a retirement plan, but what about the seasoned investors? Cashed up investors (including foreigners) will have no need to blink – in fact they are being offered a gift by the bank, which is removing their competition for houses. Given the amount of equity seasoned investors have in their existing assets, 30% deposits won’t be a problem for many. Some investors don’t even bother to rent their places out – they could claim it is owner-occupied, a ‘city crash-pad’ or ‘bach’ and therefore unaffected by the change.

Then of course there are perverse consequences. We’ve already seen the story of a couple that doesn’t own a home but wanted to buy an investment property, and will be shut out of the market. Investors could also turn to other sources to borrow the 30% deposit, so the risk to the economy won’t necessarily reduce.

What do farming and investment in housing have in common? 

Both of these industries – probably the two biggest parts of our economy – have geared themselves around generating low cash returns. Instead they get their income through non-cash means – capital gains, in-kind services and writeoffs. This is a deliberate strategy to minimise their tax bill because non-cash income doesn’t get taxed but cash income does. So the ideal is to have a low cash income, and get your returns other ways.

As a result of the tax loopholes, these two sectors attract more than their fair share of investment. We can’t blame the people doing it – they aren’t doing anything illegal – they are just responding to the incentives in our tax system. But it doesn’t mean that it is the best thing for our economy. Money invested in housing and farms means less money invested elsewhere. This overinvestment starves the rest of the economy, and puts the rest of the economy at risk because of the huge level of debt that is run up. There are other perverse consequences from these incentives, such as the impact of conversions to dairy (chasing non-taxable capital gains) on water quality.

You’ve probably heard of capital gains but might not understand what in kind services or write-offs are. Farms give a good explanation of both.

Non-cash benefits explained – ever wondered why the children of farmers get student allowances? 

How can the child of people who own multi-million dollar assets still qualify for a student allowance? This is an apocryphal example of what is wrong with our tax system. The answer is simple; we don’t tax the non-cash benefits that come from having wealth and assets, we only tax cash income. That means our tax system hits PAYE earners hardest.

Those who own assets will often get non-cash benefits. The best example is owner-occupiers of houses, who get rent-free accommodation. Farmers are often owner-occupiers, and also get many other benefits from their farm – food and recreation – that others would normally have to pay for. Finally, farmers are also business owners, so many of the day-to-day expenses that PAYE earners face can be legally written off as a business expense. Hence why your farmer cousin always has the latest model ute.

All these tax-free benefits (as well as capital gains) are just as real as the cash income PAYE earners receive. As a result, they get built into the price of the assets – housing and farms. This is the major reason both these assets have values that are so far above the value that would reflect a fair market return on the asset. As a result the returns from rentals and farms are often below that of a bank deposit rate.

Tax is the only way to resolve both problems

With the farm price bubble already inflated, the Reserve Bank (and banks) have little option other than to wait and hope that commodity prices pick up before the bubble pops. If commodity prices continue to boom and bust, there is no reason to expect we won’t be in this situation again.

Meanwhile, like the LVR restrictions that hit first home-buyers last year, these restrictions on investors are unlikely to be anything but a speed bump for Auckland house prices. The fundamental driver for both these problems – our tax loopholes – remain in place and there is nothing the Reserve Bank can do about them.

Only a comprehensive capital income tax – which taxes the equity in farms and housing as if they are a bank deposit – can solve both these issues. This would remove the incentive to overinvest in these assets, removing the asset bubbles and the inequities in our tax system in one fell swoop.

Gareth Morgan is a New Zealand economist and commentator who in previous lives has been in business as an investment manager. He is also a motor cycle adventurer and philanthropist. Gareth and his wife Joanne have a charitable foundation, the Morgan Foundation, which has three main stands of philanthropic endeavour – public interest research, conservation and social investment. This post first appeared on Gareth's World.