Politics

1989 was year zero for Generation Rent

Bernard Hickey argues 1989 was the year when New Zealand's housing costs took off and started a massive inter-generational wealth transfer that is showing few signs of being reversed.

It was the year 1989 and just as the first millennials were turning eight, New Zealand's major economic and planning rules were about to change in ways that made home ownership vastly more expensive for them than for their parents. No one planned or expected it, but it happened anyway.

1989 was effectively year zero for New Zealand's house price boom and its house building bust, and the beginning of a structural shift away from the home ownership rates that were rising through the 1960s, 1970s and 1980s towards the lower home ownership rates of Generation Rent .

1989 was the year New Zealand's leaders and voters accidentally-on-purpose decided to change the rules of the system in a way that made property owners vastly wealthier. They made three big changes that made it much harder for children being born around that period to buy a home under their own steam by the late 2000s. These changes have also in more recent times made it harder for those renters to afford to rent, let alone save for a deposit.

The rapid increase in housing costs relative to incomes is also now playing out across New Zealand's social and economic landscape, with high rates of child poverty and skill shortages in the biggest (and most expensive) cities despite still-high youth unemployment.

So how and why did it happen? Surely this wasn't the plan?

The consequences were unintended, but the causes and the fallout are now clear in hindsight.

There were three major changes that either passed through Parliament or were launched in Parliament in 1989 just as the fourth Labour Government was coming to an end.

However, the then Labour Government cannot take all the credit or blame because the changes were broadly accepted as a consensus across politics at the time and were not reversed when National won power in 1990.

First, in 1989, the Government quietly changed some tax rules that were to massively advantage investing in housing over other types of investing.

Otago University economist Andrew Coleman demonstrated in a research paper released this month how this decision alone contributed to New Zealand having the fastest-rising house prices in the OECD since 1990.

"New Zealand has one of the most distortionary tax environments for housing markets of any country in the OECD," Coleman said in presentation of the paper to a MOTU event last week.

"The root cause is the tax changes made to retirement savings in 1989," he said.

In 1989 the Government changed the tax rules so that investments in pensions and other savings accounts lost their tax-exempt status. This didn't directly change the way housing was taxed, but it effectively gave investing in housing and land a major advantage.

Before 1989, income that was put into a private pension or insurances schemes was not taxed, and neither was the income earned in the schemes. But then the Labour Government changed the rules so that income was taxed before it was put into private schemes and any income earned by the savings was also taxed. This helped save the Government $800 million a year in tax exemptions at the time - in effect pulling forward tax revenue in one-off way. That's because the system at that time taxed income from pension schemes on the way out as it was being spent, which is still also the case in most other countries.

"Unlike most OECD countries, since 1989 New Zealand has taxed income placed in retirement savings funds on an income basis, rather than an expenditure basis. The result is likely to be the most distortionary tax policy towards housing in the OECD," Coleman said.

That is because income earned from capital gains or from imputed rent for owner occupiers is not taxed in New Zealand. The change to taxing income for investments and from investments should have been linked to a shift to an accruals-based capital gains tax, but this never happened.

Unless capital gains are taxed on an accrual basis, this provides an incentive to invest in low yielding and long lasting assets such as land, rather than higher yielding short term investments with cash returns that are taxed as they earn.

"Since 1989, these tax distortions have provided incentives that should have lead to significant increases in house prices and the average size of new dwellings, should have reduced owner-occupier rates, and should have led to a worsening of the overseas net asset position," he said.

Coleman said he cannot be definitive that this tax system distortion was the only reason for the sharp rise in house prices since then, but it is a major contributing factor, along with falling interest rates and restrictions on the availability of land for new house building.

He proposes moving gradually to taxing investments in the same way they are in most of the rest of the OECD -- where money from investments is taxed as expenditure as it is withdrawn.

The second big change

Secondly, in December 1989, the passing of Reserve Bank Act signified a major shift in the way the economy was run to drive down inflation and interest rates in a way that structurally lifted house prices.

This also meant it made more sense to invest in housing, where the tax free returns from home ownership were much more attractive than the taxed cash returns from putting money in the bank or a pension fund. A shift in the way banks put aside capital in line with new international capital allocation rules meant banks found it much more attractive to lend to home buyers, who could afford to spend more as interest rates fell.

Coleman said the fall in interest rates had the same effect on house prices as the difference in tax treatments of savings versus housing. Lower interest rates on savings and mortgages make mortgages more attractive because capital gains are not taxed.

"The tax effects work through same mechanism as the interest rate effects," he said.

The third big change

And finally, also in December 1989, then Prime Minister Geoffrey Palmer introduced the Resource Management Act (RMA) into Parliament. It was not passed through the committee stages by the time Labour lost to National in 1990, but it was then ushered through into law in 1991 by then Environment Minister Simon Upton (who is set to become the Parliamentary Commissioner for the Environment later this year).

As the Productivity Commission and the current government has pointed out repeatedly in recent years, the RMA ushered in an era where councils and residents were more reluctant to open up land for housing, partly because it was easier to object to new developments, and partly because the funding arrangements for councils made it more difficult.

The end result was New Zealand's house building rate dropped from around nine homes per 1,000 people per year during the 1950s, 1960s and 1970s to around five homes per 1,000 people through the 1990s and 2000s. The potential for extra housing supply to both respond to higher house prices and then soften the growth was ripped out by the effects of the RMA and council funding mechanisms.

So why can't the status quo be changed?

The unnerving thing is that property owning voters (as opposed to tenants who vote less) have no intention of changing it.

There is no consensus for change towards either a capital gains tax or a land tax.

Coleman has proposed changing the tax treatment of other savings to make housing less advantageous as a more politically palatable option.

"If we can’t tax housing more for political reasons, we could reform the way we tax other assets," he said.

"If we don’t reform our tax system, the tax system will keep imposing large costs on new generations of young people."

There is also not a political consensus to change the RMA or the Reserve Bank Act in any substantial way that would reverse the one-off shift lower in interest rates, or increase the house building rate. The current Government has tried and failed to substantially change the RMA for eight years because of a lack of consensus, and recent proposals for change to the Reserve Bank Act are more cosmetic than real.

If anything, the forces stopping the building of new homes are as powerful as ever as central and local government bicker over who will pay for the infrastructure for these houses, and voters in both central and local Government resist the tax or rate increases needed to fund that infrastructure.

The status quo is in charge because the $1.2 trillion in household net worth built up during the boom is too big an obstacle for politicians to threaten with policy change.

So, for now, no one is planning to change planning and financing mechanisms.

1989 is alive and well in the policy settings of 2017.