Wednesday, November 23, 2005

Taxing To The Hilt: The Failed Socialist Experiment

The great mistake that Socialists make about the world is that individuals behaviour does not change by altering the tax system. This is their justification for not cutting taxes when tax cuts are affordable: that they refuse to acknowledge the overwhelming evidence that tax changes influence individual economic activities, which have a massive cumulative effect on the overall economy.

The most startling case in point is the current state of the property market. The principal reason that that the Auckland residential property market has been running so hot over the last few years has nothing to do with sound macroeconomics; even the most basic economist will tell you that housing is not a productive investment. It does not, of itself, create wealth. But it is a sensible individual choice, based in large part to the peculiarities of the tax system that Michael Cullen governs.

The reality is that while it is nonsensical that investment property attracts so much individual investment, compared to productive assets, it is very sensible at the individual level. The reason it makes sense is that for small, individual investors, capital gains on investment properties are not taxed.

Personal income is taxed. At sixty thousand dollars, an investor is paying twice the marginal tax than somebody earning thirty-eight thousand dollars a year. The Socialist mantra claims, for some reason, that this is a fair arrangement. The individual taxpayer, who is by no means wealthy, but is striving hard to earn sixty thousand a year, does not feel that same degree of fairness. Unfairness soon leads to resentment. And resentment leads to people looking at ways of behaving differently.

There are various, widely-known mechanisms and financial products in the market to deliver tax-free capital gains to off-set personal income tax. And there are many individual investors—principally those who are earning over $60,000 per year—who are taking advantage of their legal entitlements.

Gone are the days when investment in residential property was a time-consuming affair, associated with the pitfalls of finding a good tenant to a property. There are several companies in the market that provide an end-to-end property investment service, from development of the property, financing, provision of legal advice, valuation of the property, tenancy and maintenance management, and guarantees of rental returns. An ordinary investor can enter the residential property market, having expended no greater energy than he would if he had simply gone down to the bank and made a deposit.

These are not the rich fat cats of society. This is not a scandal of winebox proportions. This is not a story of a handful of high net-worth individuals exploiting cunningly-devised, and little-known tax legislation, to rip the tax base of a few million dollars here and there. Rather, it is a matter of ordinary, mum-and-dad investors making the use of basic investment vehicles to reduce their tax liabilities, to the tune of hundreds of millions, if not billions, of dollars a year. They are not even small business owners who can take advantage of this situation, but ordinary, average, middle-income salary and wage earners.

The average income for a university-educated, full-time worker in paid employment is morme than $60,000 per year. In Auckland, that person earns more. Consequently, there is a massive market for property-based financial products that are designed to reduce tax.

The property market in New Zealand is effectively a state-sanctioned, and profitable grand pyramid scheme. Demand for residential property investment, propelled by high marginal tax rates, is largely immune to incremental interest rate rises, as the higher the finance cost of a property, the greater that property losses can be attributed against personal income tax. High marginal tax rates at low threshholds, through the property market, have created a degree of structural inflation.

Michael Cullen argues that reducing tax across the board has inflationary effects. Roger Kerr has written extensively on this, pointing out that in an open, competitive, trading economy, the effect of increasing the money supply is less inflationary than in a protected market. The reason for this is that the price of most goods and services in New Zealand is directly related to international commodity prices: New Zealand is too small a market to effect an increase in international commodity prices.

And what Cullen's argument doesn't address is that high marginal tax rates are a key component in both structural inflation, and high interest rates: housing investment is normally financed by fixed-term interest rates that are immune to increases in the Reserve Bank's OCR. House price inflation, driven by increased demand for investment property, to off-set personal income tax, is the key player in the structural inflationary mix.

This, of course, constitutes on its own, a massive potential threat to the tax base. It is guided, for no other reason, than that individual investors feel resentful towards the Government for the amount of money they are paying in tax, for little service.

The result is four-fold: that the Socialists’ attempt to punish the well-off doesn’t actually work, that the tax base is reduced, and that economic activity is distorted: that individuals will cumulatively invest in non-productive assets, rather than productive businesses. Further, low-income New Zealanders are priced out of owning their own homes, as structural inflation locks them out.

That is entirely the situation in the New Zealand economy today.

The Reserve Bank has responded that it is looking at the arrangements of Loss Attributing Qualifying Companies. Again, these are not intricate devices reserved only for the very wealthy who can afford complex legal advice; they can be set up by any one of many mortgage-brokers in New Zealand. They are the prime instrument for reducing an individual’s tax liability. These products are easily accessible, and inexpensive to set up.

Tens of thousands of LAQCs function to fuel and maintain the value of the property market. The effect of any changes to the tax system relating to LAQCs would have an immediate and catastrophic effect on the Auckland housing market, in particular. The consequence of that is a potential threat to the banking system as a whole. But before the Socialists suggest that such a correction would be a good thing, consider this: the working capital of most small businesses in New Zealand is financed by equity in residential property. Start pinging the housing market, and small companies--and therefore jobs--go down the drain.

The only means to safely amend this situation is not to look at a capital gains tax on property. Capital gains have come about because of the distortionary nature of the tax system, which is driving investors into property ahead of other asset classes.

A far more practical approach to encourage investors to move into productive assets is to reduce high marginal tax rates. It’s not something Michael Cullen would like to tell his voters—who believe that middle-income New Zealanders are actually being punished for working hard and earning more. The reality for many of them is that the punishment doesn’t exist. Instead, the tax system fuels higher housing prices, making it unaffordable for low-income New Zealanders to live in places like Auckland and Wellington. Yet again, the Socialist formula cheats low-income New Zealanders who aren’t paying sufficient tax to benefit from tax write-offs in order to leverage them into the property market.

By reducing marginal tax rates and increasing the threshholds to which those rates apply, the Government would remove this perverse incentive to over-invest in the property market. Residential property would still be a viable investment option, but it would no longer be the only investment option for many New Zealanders. House prices would rise at a slower rate, and the structural inflation, and higher interest rates to attempt to counter those price rises, would disappear.

This morning I was having breakfast with a mate, who earns around a hundred grand a year. He’s not wealthy, except in the eyes of the non-working poor, but he is comfortable. I asked him about his property investments. He responded that he had none. I said to him: “Are you fucking mad? Why not?”

He answers: “Because I’m not sure about where the market’s at, right now.”

So I give him a three-minute spiel around the fact the Auckland property market has doubled in value, every seven years, for the last hundred years. That a very simply-devised mechanism would provide him with an additional income stream of twenty thousand dollars a year, plus capital gains over the medium-term.

By the time we got to our second coffee, I had made a call to another mate to see him at lunchtime. By dinner this evening, my breakfast companion was the proud investor in two residential properties, and Dr Cullen was some twenty thousand dollars a year poorer.

New Zealanders don’t have to go off-shore to pay lower taxes. They can do that right here. Of course, it doesn’t make our economy as a whole more robust, and low-income New Zealanders don’t share in that wealth—but that is the necessary consequence of Socialism and rampant taxation.

The Labour Government has slowly, but surely, created this situation due to their dogmatic insistence that it is right and fair to punish middle-income New Zealanders. Over the last six years wage rises have pushed middle New Zealand into high marginal tax brackets. This has encouraged New Zealanders to seek alternative investment options to reduce that tax liability.

10 comments:

Insolent Prick said...

The point I was making, LCL, was precisely that: that the existence of high marginal tax rates on moderate incomes has diverted investment flows into the residential property sector, at the expense of more productive asset classes. It is a situation that has arisen out of tax distortions.

As you point out, the answer is not to create new tax distortions through a CGT, or limit the transfers between LAQCs and personal income. That will just create further economic distortions, and lead to a catastrophic collapse in the housing market generally, and provoke a massive loss of equity across the entire economy. Given the reliance on property investment at the moment, such a move would be tantamount to economic suicide.

The only viable solution to reducing the weighting of residential property investment over other asset classes is to reduce the tax incentive to do so: raise marginal tax threshholds, and flatten tax levels, so that people are less likely to favour property investment over other investment vehicles.

Anonymous said...

Change of subject: Don't you have some fuckwit theory about vegetarians?

Check this out:

http://www.nzherald.co.nz/section/story.cfm?c_id=1&objectid=10356738

Anonymous said...

Tax breaks etc, though aren't the only reason people invest in property. They are seen (somewhat falsely) as reliable investments which are subject to market forces to a lesser extent. In order to dampen the property market, or to encourage people to invest elsewhere, it would require, not only tax incentives, but public education. Especially because people will be reluctant to move the funds they invested in property elsewhere.

Although, as you rightly pointed out, a mass exit from the property market would deflate it completely.

In order to force the public to reevaluate their investments in a balanced way, one must ensure that incentives are not so strong as to deflate the property market, yet strong enough to encourage those who can afford it, to reinvest. This can only be achieved through a combination of public education and revaluation of tax rates.

sagenz said...

most interesting post IP. The other reason people invest in residential property is the fact private investors habitually lose a bundle in the stockmarket or kiwifruit/deer/apples/forests schemes set up by under regulated wide boys.


cathy - Unless the law has changed real estate costs must be ring fenced and cannot be offset against PAYE.

Anonymous said...

About the only time you should use a LAQC for property is when you live in a debt free property and wish to rent this debt free home out move into a new home borrowing money for the new home to live in. The interest on money borrowed for the new home which you live in would be non deductible.

To claim the interest as an expense against PAYE the debt free home (to be rented) needs to be sold to an LAQC which for losses are is treated like a partnership ie the losses flow to the shareholders. The LAQC raises a loan on its new asset and pays the vendors ie the LAQC shareholders who then use this money to pay for their new home to live in.

This is about the only time you would need to use a LAQC for rental property. Otherwise a complete waste of time at best or very dumb if you sold the house you continue to live in to a LAQC to claim the interest as expense.

Bollard is a complete fuckup as his recent panty wetting episode has shown and Cullen has had to bring in Treasury to try and save his sorry arse. Problem is doctor brainy act is going to fuck it up as well. By time Cullen gets his landlord hate legalization through some time in 2006 /07 the property market will be going backwards anyway and interest rates will be in double figures. This third term government has got fuck up written all over it.

Anonymous said...

Cathy and IP,

to my understanding, LAQC is quite beneficial if your income is much higher/lower than your partner.

So, instead of having the loss offset 50-50 against both income (say one on a 39% tax bracket, the other one is on 19%) you can offset it say 99% against the higher income and just 1% against the lower income.

For example, if your loss for the year is $10,000, in the first instance you will get 39% of $5000 and 19% of $5000 which equals to $2900.

If you have LAQC and you set it up right, then you will get 39% of $9900 and 19% of $100, which equals to $3880.

This way you can maximize your tax rebate.

I do work in the home loan/ mortgage industry and to my understanding this is one of the best reason why you would want to set up an LAQC.

And yes, you are right, some of us do not know about the tax law etc, and that is why we always refer them to their accountants for advice regarding tax structure on their investment property.

I would always refer my clients to solicitors and accountants to get the best advice.

-pucca (i'm struggling to get a blogger identity! can anyone help me? )

Anonymous said...

Very odd the way that the peculiarly New Zealand form of libertarianism combined with social conservatism (like IP's dogma) calls everything non-right "socialist". It's like the American label of "liberal" applied to everything that is not going Bush's way. It shows a personality type that sees only black and white, not subtle enough to pick up shades in between. There's a real provincialism about this type of analysis, a definite lack of worldliness and certainly no ability to see the value of pluralism in modern society.

Anonymous said...

Did you really suggest that domestic violence was a good thing? That is the most offensive thing I have ever seen on a blog....

Anonymous said...

In addition to the benefits of using LAQC as stated by pucca, another one is that you can change the % of shareholding between shareholders easily, which makes much more flexible for claiming of losses. And when you're ready to sell your houses the depreciation clawback could be minimised by the same way... i.e. the partner that makes the least will have the most shares...

Anonymous said...

I doubt that LAQC could be closed down as it's used legitimately by many other kinds of business other than rental investments. A friend of mine has a software startup (which is setup as a LAQC) and all losses are claimed by his wife who has a high salary job via this LAQC for better cashflow during the early and difficult time.