The Long-Term Effects of Capital Gains Taxes in New Zealand

Coleman, Andrew, New Zealand Economic Papers

1. Introduction

This paper develops a micro-founded macroeconomic model to analyse the long-term effects of capital gains taxes on New Zealand's residential property markets. The model is a version of the overlapping generations lifecycle model pioneered by Modigliani and Brumberg (1980), and adapted to analyse housing issues by Ortalo-Magne and Rady (1998, 2006). The heart of the model is a series of dynamic, forward-looking microeconomic maximization problems in which agents make choices about the type of housing in which they live, how much they consume and save, and how much they borrow and lend. These agents, who differ by income, age, and wealth, have choices over whether to rent or buy, to live in large or small houses, or to share housing with other people. They face realistic bank imposed constraints on the amount they can borrow and the repayment schedule they face if they a purchase a house, and they face a tax system that closely reflects that prevailing in New Zealand. Particular attention is paid to the various ways that taxes on housing income differ according to whether one is an owner-occupier of housing or a landlord. The model is macroeconomic as dynamic steady-state paths for house prices and rents are determined endogenously, and reflect the interaction of decisions by households, landlords, and a construction sector to demand or supply housing. The solution of the model is a set of housing prices and ownership patterns that depend on fundamental parameters such as interest rates, construction sector supply elasticities, the inflation rate, and the particulars of the tax system.

The paper examines how these prices and ownership patterns change as taxes and the inflation rate change, and uses these results to evaluate the consequences of different possible tax systems. Four variants of a capital gains tax regime are examined. While all four are accruals based, they differ according to whether owner-occupied housing is taxed or exempt, and whether capital gains are treated as income or simply taxed at a flat rate. Many of the results of the four variants are similar, although there are important differences, particularly in the amount of revenue that is raised by the tax. In general, when the inflation rate is moderate, capital gains taxes lead to an increase in rents, an increase in the home-ownership rate, a small reduction in number of large houses in the economy, and an increase in the net foreign asset position. However, the effects on economic welfare are ambiguous, for many low-income households suffer a welfare loss from the increase in rents. The simulations suggests the welfare consequences will be worse for low income households if owner-occupied housing is exempt from the tax, although this result is dependent on the revenue from a capital gains tax being refunded to households (including low income households) through a reduction in the GST rate.

The paper is organised as follows. Section 2 outlines the structure of the model. Section 3 discusses the results of the simulations, beginning with an exploration of the welfare consequences of the effects of inflation on the housing market, and concluding with a discussion of the welfare consequences of different capital gains tax systems. Conclusions are offered in Section 4.

2. An intergenerational model of housing demand

2.1. The basic framework

The model is an extension of the model used by Coleman (2008) to analyse the effect of inflation, credit constraints and New Zealand's tax system on the housing market. In turn, it is based on the overlapping generations housing model of Ortalo-Magne and Rady (1998, 2006). The basic structure of the model, outlined below, has four key parts: the demand for rental housing; the demand for owner-occupied housing; the supply of rental housing; and the total supply of housing. The mathematical details of the model are described in the longer working paper version of the paper. (1)

The demand for housing is based on an intertemporal utility maximisation model of consumer demand applied to a large number of agents who differ by age, income, and wealth. In the model, there are four cohorts each containing 400 agents, with each agent passing through four distinct stages (two young stages, one middle-aged stage, and one stage in retirement) before dying. The agents have different exogenously determined labour income, which follows a life-cycle pattern. The agents consume a single non-storable good, pay tax, save for retirement, and have choices over different types of housing at each stage of their lives--whether they share housing with other agents, rent a small house (an apartment), buy a small house or buy a large house. The agents choose their most preferred housing options, given their age, wealth and after-tax incomes, the cost of renting or buying different houses, and their ability to raise a mortgage. Agents can borrow or lend at exogenously determined interest rates, although young agents face bank-imposed credit constraints limiting the amount they can borrow. In the last period of life agents consume all wealth except their house, which is inherited by a younger generation.

The model is dynamic and house prices and rents can change through time. Indeed, when choosing their housing options agents take into account both the rate at which house prices appreciate and the tax treatment on any capital gains that they make. Strictly speaking, in the model house prices and rents comprise two parts: a price level at some base period (t = 0); and a price (or rent) appreciation rate. The model calculates the rate of property price appreciation as part of the process by which it calculates equilibrium prices; while it is normally the general inflation rate, it does not need to be.

Agents are assumed to be forward looking, so when they choose housing in a particular period they take into account not only their current income and current housing prices, but their remaining length of life, future house prices, their future income stream, and their desired future housing patterns. The model includes a careful representation of the conditions imposed by banks on those obtaining mortgage finance to purchase a house, including realistic constraints on the minimum deposit and the maximum mortgage repayment to income ratio. These constraints mean that young households may choose to rent rather than buy a house when inflation and nominal interest rates are high, because they cannot obtain suitable financing.

The utility maximisation model generates housing demand for each of the agents during each of their life stages, for a given set of rent and house price paths. These different housing demand functions are then aggregated together. The resulting aggregate demand functions describe how the demand to rent, the demand for small houses, and the demand for large houses varies as a function of the rent and the price of each type of house, as well as all the basic parameters of the model such as income, interest rates, and tax rates. The basic parameters are listed in Table 4.

Rental accommodation is supplied by agents who become landlords. It is assumed that entry into the rental sector is competitive, so landlords bid for houses and set rents at levels that leave them indifferent between the after-tax returns from lending money and the after-tax returns from investing in residential property. The marginal competitive landlord is assumed to be a middle aged agent who is on the top marginal income tax rate. Particular care has been taken to ensure that taxes in the model replicate the taxes currently imposed on housing in New Zealand. If house prices increase over time, a capital gains tax will lower returns to landlords, and, for a given level of house prices, rents will be higher than they would otherwise have been.

Prices are determined endogenously in the model by equating the total demand for different types of houses with the supply of different types of houses. Cost functions describing the costs of building large and small houses are specified exogenously in the model, and can take any form. In this paper, I focus on the case that there are separate upward sloping supply curves for the quantity of large and small houses, each with approximately unit elasticities. An elasticity of 1 is broadly consistent with the long run increase in prices and the quantity of houses in New Zealand between 1960 and 2005. Two different parameterisations that reflect house prices that are relatively high or relatively low in comparison to income because of high or low construction costs are examined. Several other combinations of supply elasticities have also been analysed, including the cases when the supply of both classes of houses are either perfectly elastic or perfectly inelastic, and the case that the supply of small houses is more elastic than the supply of large houses.

A solution to the model is obtained by finding a set of prices that equate the aggregate demand for different types of housing with the aggregate supply of these types of housing. The prices are solved using a complex numerical routine that calculates the housing demand for each of the 1600 different households for a set of prices, and then chooses a sequence of prices until a set is found at which aggregate demand equals aggregate supply. For this equilibrium set of prices, overall demand patterns are calculated.

As Coleman and Scobie (2009) argue, the effect of taxes, inflation, and interest rates on the housing market depends on a few crucial elasticities, including (i) the elasticity of the total supply of houses to the price of houses (the elasticity of the supply of housing); (ii) …

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Publication information: Article title: The Long-Term Effects of Capital Gains Taxes in New Zealand. Contributors: Coleman, Andrew - Author. Journal title: New Zealand Economic Papers. Volume: 44. Issue: 2 Publication date: August 2010. Page number: 159+. © 1998 New Zealand Association of Economists. COPYRIGHT 2010 Gale Group.

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