Afternoon roundup

I cannot count the tabs. A pruning:

• Danyl Mclauchlan on the depressing kludgeocratic budget.
• I still don't like that they're subsidising videogames.
• Peter Dunne expects capital gains taxes and wealth taxes to feature in Labour's platform
• V as classic and excellent antifascism
• Officials are looking at a carbon dividend. I sure hope it's in place before the government stops auctioning NZU. 
• A few bits from me on the budget, over at Interest.co.nz
• Hooked on Phonics worked for the UK. An older piece in AEJ: Ec Policy.
• The San Francisco Doom Loop
• New report out, covered at Newsroom, on failings in freshwater management. There still are better options...
• Don Brash is appropriately scathing about housing policy.
• For a new Great Exhibition.
• One advantage of being at a think tank: I can say what I believe to be true. 
• The government still doesn't fully understand that Covid is airborne. No mention of ventilation in the winter health plan. 
• My column in last week's Insights newsletter, on government public health forgetting there's still a pandemic on and turning back to telling us what to eat and drink...

Tax Working Group

The Spinoff asked for a few words on today's Tax Working Group report. They're here, and copied below.

The Tax Working Group’s proposed capital gains tax would exclude the family home, making for a more politically saleable tax but one which makes far less economic sense.

Not only would it provide incentives to invest in the family home instead of other assets, it also has the potential to encourage couples to ‘divorce’ for tax purposes to be able to exempt two houses rather than just one. If you’re laughing, note that family friends back in the United States would divorce and remarry semi-regularly for tax purposes. They’d have a small party each time they did. Good luck to IRD in policing that.

It would also provide a strong tax incentive to pass the family farm along to the kids rather than sell it, even if the kids aren’t all that interested in farming. Because passing it on rather than selling it allows any capital gains tax to be deferred. We can expect complicated tax arrangements to make selling to the kids to fund the retirement look a lot more like inheritance.

And it hardly applies only to homes. KiwiSaver and other investment portfolios will feel the pinch. While Sir Michael Cullen’s group is certainly right that those assets are disproportionately owned by those on higher incomes, the effect of the tax is far more complicated.

Because the tax would be assessed on nominal investment gains rather than inflation-adjusted gains, the real effective tax rate on investment portfolios could be very high indeed. And the effect of that on business access to capital for investment will have flow-on effects throughout the economy.

Since the group proposed exempting the New Zealand Superannuation Fund from capital gains taxes, the fund would be at a strong advantage over private investors when bidding for assets. One might wonder how long it would be until the Super Fund winds up owning much of the economy.

But I’m sure that others will write many more column inches on the real-world difficulties of trying to bolt a capital gains regime onto a tax system that has, for the past 30 years, evolved around the absence of one. There’s a reason prior tax working groups concluded that it is, on balance, too messy to be worth the effort and that there were strong dissenters within this latest group.

Let’s look instead at some of the less-expected features in the report.

The Tax Working Group recommends shifting towards environmental taxation. In principle, this has a lot of merit. Taxes that correct underlying distortions provide a double dividend. Not only do they raise revenue, but they also improve overall economic efficiency if they’re done well.

The group recommended strengthening the Emissions Trading Scheme and having it shift, in effect, to being more like a tax by having the government sell more of the permits over the longer term. That recommendation should be supported if implemented well.

So too should its recommendation to use congestion charging to help fund the roads – it makes a lot more sense, and is far more equitable, than measures like the Auckland petrol levy that fall very heavily on poorer families with less fuel-efficient cars.

The group also recommended using taxes to improve water quality if the government isn’t able to find better ways of dealing with the problem soon. It suggested water taxes and taxes on fertiliser as potential measures.

Making sure that water users face the cost of that use is important, but tax is a blunt instrument. A tonne of nitrogen fertiliser has very different effects depending on where it’s used. And water taxes have a hard time recognising regional differences in water scarcity. Water should surely be more expensive in Canterbury than on the West Coast, but the government would have a hard time finding the right prices. A cap-and-trade system like the Emissions Trading Scheme is more appropriate.

Other suggestions, like hunting for reasons to justify increasing existing waste levies, or giving tax preference to buildings constructed to tighter environmental standards, might give the appearance of doing good for the environment but seem destined to be a boondoggle if pursued.

Complicated Gains Tax

Newsroom reports on a talk by two members of the Tax Working Group that lays out the difficulties with any capital gains tax.

One part that's probably underappreciated: the extent to which everything in the tax system is built around the rules as they're currently structured, and how much would need to be rejigged if a CGT were put in place. 

One example:

The report itself highlights this complexity in the application of a capital gains tax to KiwiSaver and Portfolio Investment Entities (PIEs). Most KiwiSaver schemes take the form of multi-rate PIEs (MRPIEs). While there are a number of features in the MRPIE tax regime the group would not want to see disturbed by any new rules, a CGT would affect MRPIEs that invest in property, or Australasian shares. An individual would be subject to a tax on those asset types, so it follows that the MRPIEs should similarly be taxed.

However, these are open-ended funds into which investors come and go. That means a fund would have to allocate gains and losses to an individual investor by taking into account the change in value during the time that investor was actually involved in the fund. It would require detailed record-keeping, as well as various adjustments for gains and losses already recognised due to redemptions from the fund. And while that’s not simple, it’s even more complex in reality. This is because units are issued and redeemed on a daily basis, MRPIEs often invest in other MRPIEs, and a retail KiwiSaver scheme may invest in a wholesale PIE that in turn invests in a specialist PIE.

Having a CGT is complicated. Not having a CGT is complicated too because the tax system has to adapt to make sure that labour income doesn't pretend it's capital gain. The latter isn't perfect, but it's in place - the system's kinda built around the absence of a CGT and tries to account for it. That means that 'just' putting in a CGT means going back over everything that's been designed around the absence of one.

NB: I do not pretend to understand MRPIEs. But I'm not the one insisting on changes to a complex system that's evolved since the 80s reforms.

Taxes don't build houses

I'm still not a fan of capital gains taxes as a way of digging our way out of a shortage of houses. Taxes don't build houses. Me at The NBR (ungated, but dated - you should subscribe - their coverage is worth paying for). A snippet:

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.

Against capital gains taxes: Sumner edition

Capital gains taxes still do not make economic sense.

Here's Scott Sumner explaining that while wage and consumption taxes can be equivalent, capital gains taxes are effectively a distortionary tax on future consumption relative to present consumption.

The biggest confusion is that people don’t understand why capital income should not be taxed, and why a wage tax is equivalent to a consumption tax. Consider someone with $100,000 in income, who can choose to consume, or invest in a fund that will double in value over 20 years. Suppose we want to raise revenue with a present value of $20,000, from this person. We could have a wage tax of 20%, and raise $20,000 right now. Let’s also assume that this person decided to spend 1/2 of his after-tax income—leading to $40,000 in consumption today, and save the other $40,000, leading to $80,000 in consumption in 20 years. Note that both current and future consumption are reduced by 20% relative to the no tax case.

Alternatively, we could directly tax consumption at the same rate (say with a VAT). Let’s assume the person saved $50,000 and spent $50,000 on consumer goods. After paying VAT they consume $40,000 today, and the government gets the other $10,000. After 20 years the $50,000 saved turns into $100,000, but you must pay $20,000 in VAT, leaving consumption of $80,000. Exactly the same as with a wage tax. The total revenue to the government looks bigger, but is the same in present value terms.

In contrast, an income tax doubles taxes the money saved, once as wages, and again as capital income. So now it’s $40,000 consumption this year, and only $72,000 in 20 years ($80,000 minus 20% tax on the $40,000 in investment income), an effective tax rate of 28% on future consumption. And of course with inflation the effective real tax rate is still higher. Income taxes make no sense at all; if you want progressivity, tax big consumption more than little consumption.

What's a progressive consumption tax? A tax on income minus savings. In that set-up, you'd want to tax returns on investments (capital gains or interest or dividends) that were made in tax-preferred savings vehicles (and effectively then came from before-the-line pre-tax income). As Scott points out, that's not a tax on capital gains or capital income, it's a deferred tax on labour income.

Sumner proposes something pretty close to what New Zealand has. We get progressivity via the income tax rather than via a progressive consumption tax, but we don't tax capital gains, and we doimpose a fringe benefit tax that helps in avoiding nonsense: he proposes that company cars that can be used in off-hours are consumption, not investment; I'm pretty sure those here would attract FBT. Capital income is taxed though, and investment yielding capital income coming out of wage earnings is then double-taxed.

And all of it is highly reminiscent of Seamus's series of posts explaining how capital gains taxes are a bad idea. I get tired of commentators who point to National's reluctance to impose capital gains taxes as evidence that they're somehow bought out by moneyed interests when the economics on capital gains taxation are at best pretty iffy.

Previously:

• A diatribe against Capital Gains Taxes - Part I (Seamus)
• A diatribe against Capital Gains Taxes - Part II (Seamus)
• CGT Redux (Seamus)
• Capital Gains Tax Bleg (Seamus)
• OECD report and CGT
• NZIER on fiscal sustainability and CGT (Seamus)
• Parker vs NZIER on CGT (Seamus)
• Fraser Institute on NZ's lack of CGT
• Bollard on capital gains
• What is wrong with housing anyway (Seamus)
• Gareth Morgan on housing affordability (Seamus)

Quotes of the Day: Capital Gains Taxes Edition

The Fraser Institute has just released a paper, looking at lessons from around the world for capital gains taxation in Canada. The section on New Zealand's non-adoption of a CGT, was written by Australia's Stephen Kirchner. The following are some excellent quotes

The incentive to convert income into capital gains does not necessarily translate into the ability to do so, and the opportunity for avoidance via this mechanism is asserted far more often than it is demonstrated. 

While it is true that capital gains tend to be concentrated at the upper end of the income distribution, so are capital losses. Net capital gains are thus more correctly viewed as compensation for bearing risk than can be left untaxed without compromising efficiency or equity. 

Rather than expanding the scope of the capital taxation to include housing assets, a better approach would be to reduce the tax burden on other assets to alleviate the double taxation of saving that occurs through the existing tax system. The introduction of a CGT that exempted owner-occupied housing would only increase the bias in favour of saving via owner-occupied housing.

As Tyler Cowen would say, read the whole thing. The overall paper is aimed at a Canadian policy makers, so it is unlikely to get much exposure here in New Zealand, but that is a shame.

Capital Gains Tax Bleg

When I first started writing posts on capital gains taxes three years ago, starting with this post and this one, they were sort of a bleg. I have never understood the rationale for CGT, as the arguments that are usually put seem to involve shifting definitions, or incomplete partial-equilibrium analysis. So I wrote those two posts to explain why I thought the arguments in favour don't add up, hoping that someone could counter with a coherent argument. With a CGT defended within the context of a coherent model, it should be possible to phrase the debate in terms of differences in either values or empirical beliefs about the economy. Three years on, I have seen a lot of public discussion of capital gains taxes, but still don't understand what is the model from which proponents draw their conclusions.

But now I have a different bleg. I would like to know how actual CGTs that have been implemented elsewhere (or the ones proposed by opposition parties in New Zealand) would deal with a particular issue. This issue is easiest explained with a series of examples:

1. Imagine that you are a householder with a portfolio of $2,000 of shares in a single company that is earning a 5% rate of return on its capital. At the start of a new year, you decide that you want to save some more, so you buy $100 in a different company using money you have earned in the previous year but not spent. You now have a portfolio of $2,100. This increase in the value of your portfolio would not be classified as a capital gain. It simply represents increased savings.
2. Now imagine that instead of putting the $100 into a different company, you bought $100 of freshly issued shares in the same company that you already have a shareholding of $2,000.  That still doesn't count as a capital gain, right? The company uses the money from its new share issue to buy some capital equipment, which will also earn a 5% rate of return, but what they do with the money is irrelevant.
3. Now, imagine that in the previous year, you were paid a dividend of $100 by the company in which you own $2,000 of shares, and you bought $100 of freshly issued shared by the same company. Again, this makes no difference. The fact that your purchase of new shares was in exactly the same amount as your dividend payment, is irrelevant; the additional $100 was paid for out of your total income and was available for buying shares because of a choice not to use it on consumption. 
4. Now make one more change. Instead of paying out $100 in dividends and then issuing $100 of new shares, the company simply retains the profit, pays a dividend of $0, and uses the money to pay for the new capital, as above. The company has increased its ownership of capital equipment by 5%, and so the value of the existing shares will increase by 5%. So now our shareholder sees that his shareholding portfolio has increased from $2,000 to $2,100, just as in all the previous cases, except in this case he hasn't bought any new shares; he has seen what looks like a capital gain of 5%. Except, it is not really a capital gain; the reinvestment of profits by the company instead of paying out a dividend is a form of saving that is imposed on its shareholders.  

In the absence of taxes, the only difference between example 3 and 4 is in the default position. In 3, the shareholder receives the dividend and needs to make a decision to buy new shares to turn that dividend into saving. In 4, the default is that the dividend is saved, and the shareholder would need to sell $100 of shares to convert that saving into consumption.

But what if we add capital gains taxation. Wouldn't a CGT induce a difference between example 3 and example 4, adding additional taxation in the latter but not the former. And wouldn't this induce a distortion in which the tax system created an incentive for firms to pay out all their profits as dividends and then raise new capital rather than retaining profits for investment? What I would like to know is how to other countries deal with this distortion in their CGTs (if at all), and how would the opposition parties in New Zealand plan to deal with it.

It is also interesting to note that currently in New Zealand, there is a slight tax distortion that favours retained income over dividend payout (as the corporate income tax rate is lower than the top rate of income tax). At the time the rate was lowered from .33 to .30 in 2008, the then Labour government said this was a deliberate distortion as a kind of nudge to encourage retained earnings and hence make saving the default. Does Labour now think that we should be changing the nudge to consumption by moving the tax advantage the other way?

Parker versus NZIER on Capital Gains Taxes

Labour finance spokesperson, David Parker, sent this letter to the New Zealand Institute of Economic Research, regarding a report they wrote for Federated Farmers on Labour's proposed captial gains tax policy. 

I don't have time to read the original report or the earlier one by BERL referred to in the letter. What struck me, however, is that the points of disagreement are really quite tangential to the issues that should be at the heart of a debate on the merits of a capital gains tax (CGT). Let's take these in turn.

1. Parker believes the tax will raise more revenue than NZIER do. A CGT that is designed to ensure savings is directed to the most productive investments rather than be motivated by differential tax treatments is one that would raise zero revenue. Any CGT that increases revenue is one that increases the existing tax distortion penalising saving relative to consumption. Of course, one might have the objective of increasing the tax on saving for the equity objective of increasing the tax paid by the rich, but that is a different objective. Either claim the tax will raise revenue, or claim it is about encouraging productive investment, not both.
2. Parker believes the proposed CGT will be more progressive than NZIER do. This may be true, but if the objective is to increase the progressivity of the tax system, the policy question is whether it would be better to achieve this through increasing the income tax rates that would target high levels of wage and salary income as well, rather than just one component of capital income. 
3. Parker believes the current income-tax paid on trading is not important enough to make the claim that we currently have a CGT. That is possibly true, but it misses the point: We do have a perfect, all-of-the-advantages, none-of-the-disadvantages 13% CGT. It is called GST. 
4. Parker believes that a CGT will have more impact on housing speculation than NZIER. Again, this is possibly true, but why is that a good thing? Let's reiterate some points made previously, here and here: 
• Housing speculation is only profitable if house prices are expected to rise in the future. That is, speculation can't permanently increase house prices; it can only bring the increases forward in time. A policy designed to make speculation less profitable is a policy that admits that nothing will be done to curb the underlying drivers of house-price inflation. 
• To the extent that bringing forward future house price increases creates an incentive to build more houses, speculation will actually lower future prices. One can claim that the tax distortion that means home owners pay no income tax on the imputed rental they earn from themselves leads to a country having too large a housing stock, but not if your rhetoric is about making home ownership more affordable. 
• And curbing speculation in home ownership, to the extent that it has an impact on home affordability must operate through making renting more expensive. Again, this might be an objective, but not one that is easily squared with rhetoric concerned with poverty levels. 

One final point. Parker claims that the Australian experience is illustrative, because they had a CGT excluding the family home, their "home ownership rate was lower than New Zealand's. Now it is higher and ours is at a 60-year low". Is the claim that Australia's CGT had an impact on New Zealand's home-ownership rate? Or is this a difference-in-difference estimation that assumes as a control that Australia's rate would have fallen like New Zealand's but for the CGT? 

Why do all political parties hate renters so much?

There are two main ways people can meet their accommodation needs: renting and owner occupancy. Both involve making annual payments for housing services either in rental payments, interest payments on a mortgage, or to the extent that an owner occupier has paid of his or her mortgage, in the opportunity cost of forgone interest from having money tied up in the ownership of a house. A lot of people, myself included, prefer to own their own home rather than renting. For others, renting is the preferred method of meeting accommodation, and a third group would prefer to own but rent due to not being able to secure a large enough loan.

Now I can understand a desire to help those in the that third group, particularly since they are likely to be disproportionately drawn from the poorer members of society, but if the mechanism for doing so is to make buying a house cheaper while simultaneously making renting more expensive, the mechanism will actually be hurting the most vulnerable members of the group it is seeking to assist--those sufficiently liquidity constrained that even with the assistance house purchase will still be out of reach.

And yet, the three main political parties' policies on housing seek to penalise this group of renters. The reason for this is that rental accommodation and owner-occupied accommodation are pretty close substitutes on both the demand and supply side of the market, and so their prices are very closely linked. Any policy that either makes it easier to purchase a house for owner occupancy or more costly to own a house that is rented out, while not doing anything to increase the total stock of housing, must make renting more expensive.

So, for example, a policy (Labour-Greens) to level a capital gains tax on residences but exempt residents' first homes, will make it more expensive to be a landlord in a market where house prices are expected to increase in the future requiring a higher rental rate to compensate. A policy (Labour) to prevent foreign non-residents from owning domestic residences to be rented out will have the same effect. And a policy (National) to give tax breaks to first-time house buyers will similarly favour owner-occupiers at the expense of renters, operating here through the demand side.

I would love to see each of the leaders questioned in the televised debates on why they think the effect of their proposed policies on renters would be an acceptable cost.

Treasury on Capital Gains Taxes

I haven’t been following the debate about loan-to-value-ratio (LVR) regulations as closely as Matt and Eric, but this article in the Herald yesterday (HT: Matt) caught my eye because of the following quote:

Treasury suggested introducing a capital gains tax and restrictions on foreign buyers as part of a long term prescription to curb house prices increases, documents released today show.

So, as always whenever someone recommends a CGT, I rushed to the Treasury document to see what the justification was and whether it can convince me that the benefits would outweigh the costs.

First a clarification. In the document, Treasury list a capital gains tax as one of a set of longer term measures that “might be feasible” and that “could have an impact on housing demand but would require more detailed design and lead time to implement” [emphasis added], which certainly fall short of being a recommendation.

But even with that caveat, I am struggling to see a coherent view in the Treasury’s document. The document’s focus is on rapid house price inflation, but it is not clear just what they see as the policy relevant issue there. They note a concern with financial stability, macro stability, and housing affordability; they acknowledge that the main factor determining house prices in New Zealand are supply constraints and that recent policy changes are addressing that; and so they then focus on policies to restrict demand.

One of the first things we teach our students in economics is that economic analysis should never start with price. Resources can be consumed, prices cannot; prices change in response to other changes in the economy, but whether the outcome is good or bad depends on what caused the change and what determines good and bad. So a statement like 

additionally, high prices may also affect broader economic performance over time by diverting resources into sectors of the economy that tend to exhibit lower productivity

immediately raises the question: How will a particular policy designed to reduce prices (or restrict price growth), succeed in diverting resources into high productivity sectors (or make housing more affordable, or promote macro and financial stability)? What is needed is a view of what is causing demand for houses to increase, what aspect of that demand increase is a bad thing, how a particular policy would act on that bad aspect, and what would be other possible effects of the policy that would need to be considered.

For the suggestion of a capital gains tax, all that is given in the Treasury document is the statement quoted above that it is something that “might be feasible”. Sadly, I am none the wiser (nor better informed). 

NZIER on Fiscal Sustainability and Capital Gains Taxes

Bill at Groping Towards Bethlehem posted today on the NZIER report on New Zealand's fiscal sustainability. This is mostly about short-run and long-run projections for debt and whether we have room to raise additional revenue by increasing tax rates without hitting Laffer curve effects. Bill takes issue with a comment in the press release by one of the report's co-authors, Kirdan Lees, saying that we need to take action now to avoid reaching a U.S. like situation. I agree with Bill that major differences in political systems between the U.S. and New Zealand mean that the U.S. is not a good comparison. But that is because our system (probably) leaves us better positioned to respond to unpleasant projections before the situation becomes dire, and therefore doesn't negate the value of making those projections.

But what really caught my eye, via David Farrar's comment on the same report (here and here) is that it called for taxes on land or capital gains as a way to broaden the tax base. Now capital gains taxes (or at least gaps in the arguments in favour of them) are a bit of a hobby horse of mine (various posts archived here), so I went to the report to see what the justification was. After reading it through (and then searching for "capital gains" to see if I'd missed anything), the best I can see for the justification is as follows:

1. if we continue with the current path, growth in government expenditure as a result of an ageing population will exceed growth in tax revenue pushing out the debt to GDP ratio;
2. this will necessitate either tax increases or expenditure reductions;
3. we have room to increase tax revenue by increasing tax rates (that is, we are on the right side of the Laffer curve);
4. taxes, however, do have disincentive effects;
5. ????;
6. a tax on capital gains or land would be a good option to explore. 

Now Kirdan is a very good economist, so I am sure he has something in mind for step 5. I wish it had been included in the report, however. Based on the rest of the report, it seems that the argument is not about reducing tax distortions between capital gains and other sources of income, but rather about a general broadening of the tax base. This only makes sense if a capital gains tax is expected to raise positive revenue, in which case it would represent an increase in the effective tax rate on capital which is already triple taxed relative to labour income (by being taxed once when the original money saved was earned, again as it accrues interest, and a third time when the portion of the nominal return that just represents adjustment for inflation is also taxed). Maybe this effect is outweighed by other benefits of a capital-gains tax, but I would really like to see what these benefits are believed to be.

Postscript: While writing this post, I have come across a news story saying that Treasury are now recommending a capital gains tax and or land tax as an alternative to or supplement to (I'm not sure, I need to check the source documents) the Reserve Bank's loan-value-ratio policy. I will be interested to see what Treasury's justification for a CGT is.

Labour's Housing Policy

I am baffled by the Labour Party proposal to ban foreign speculators from owning houses in New Zealand. O.K. that is not strictly true; as Matt over at TVHE notes, the policy is easy to understand as a cynical appeal to xenophobic New Zealand First voters. But David Shearer is a better person than that, and so I would prefer to remain baffled and try to think through the logic of the proposal.

Consider a very simple model of the New Zealand housing market in which there is a fixed supply of identical houses that will not change over time, and an unchanging demand. Let there be no on-going maintenance or other costs to owning a house, just the one-off capital costs. Finally, let there be a risk-free interest rate of 5%, let demanders be risk-neutral and indifferent between renting and owning for a given cost, and let rental income to a landlord be exempt from tax so that there is no tax advantage to owner-occupied housing. In this world, there would be an unchanging equilibrium rental price for housing over time, and an unchanging price of houses that would be equal to this rental price times 20.

Now change the model a bit. Imagine that demand in one year’s time will double and then stay constant from then on, but that will not be known in the one year before the change. In this world, the equilibrium rental price and the equilibrium house price will both double in one year’s time and current owners of houses (both owner occupiers and landlords) will receive a one-off capital gain at that time.

Now make one more change. Imagine that the future increase in demand becomes known now, but for some reason only known only to people who are not citizens or permanent residents of New Zealand or Australia. In this version of the model, the rental rate would continue to remain constant for a year before doubling, but foreigners would bid up the price of houses now to the point where the capital gain between now and in one-year’s time was sufficient to exactly offset the fact that current rentals are insufficient to cover the capital cost of the house.

Now compare this model to the one where the demand increase was a surprise to everyone. Renters pay exactly the same amount of rent in each period, owner occupiers receive exactly the same capital gain, but can realise it's present value straight away. Foreign speculators receive only the market rate of return on their investments, just like any other inflow of capital that allows New Zealand to fund investment in excess of its saving. The only distributional effect would be a shift in the capital gain from those who would have bought houses during the year before the demand increase to those who would have sold, but there seems no particular reason for policy to favour one of these groups over the other.

In this world, it is hard to see what possible benefit there would be to a policy of banning overseas speculators from owning houses, which is what Labour are proposing. Of course, the assumptions in these three models are extremely unrealistic. So what changes to the model or what welfare function can make sense of this policy? We could relax all the assumptions about indifference between renting and owning, risk neutrality, homogeneity of the housing stock, no tax advantage to owner-occupancy, and no other changes over time, but it wouldn’t change the basic intuition. We could assume that supply is not perfectly elastic, but that would imply that the earlier rise in price from speculation would generate an earlier supply response and hence more housing affordability. And we could assume that, maybe, New Zealanders and Australians know at least as much about the New Zealand housing market as non-Australasians and so can bid up the price of housing without overseas help, in which case banning foreign speculators would have no effect at all.

It is easier to make sense of other parts of Labour’s housing policy. Building 100,000 houses would obviously reduce prices if it added to rather than displaced construction that would otherwise occur, although the policy is silent on how it would find the land on which to build the houses given council zoning restrictions. Similarly, a capital gains tax that excluded the family home, while doing nothing to change supply and demand, would be a way to reduce prices to owner occupiers while increasing prices to renters. Such a policy proposal wouldn’t make much sense from a party representing lower-income households (who are more likely to be renters), but it is perfectly consistent with a party that proposed exempting fresh fruit and vegetables from the GST.

But Labour’s Press release focuses mostly on speculation. The point needs emphasising: speculation that pushes up prices is only profitable if those prices were going to increase anyway for non-speculative reasons. Preventing speculation (if it were possible to do so) only delays the eventual price rise. Doing something about the future price increases by addressing supply constraints would not only be a long-term solution, it would remove the incentive for speculation at the same time. In other words, any politicians whose housing policy consists mainly of an attack on speculation is essentially conceding that they have no long-term solutions at all. 

Against capital gains taxes

The OECD having recommended that NZ adopt a capital gains tax, it's worth reviewing the case against them.

First, here's the OECD:

New Zealand belongs to a group of five OECD countries with particularly high pre-tax capital-income inequality (Figure 13). As much of this income, especially at the top levels, takes the form of capital gains, the lack of a capital gains tax in New Zealand exacerbates inequality (by reducing the redistributive power of taxation). It also reinforces a bias toward speculative housing investments and undermines housing affordability, as argued in the 2011 Survey. 

The OECD report also seems to reckon that capital gains taxes, along with other taxes and changes to Superannuation, could help debt issues when Superannuation starts getting rather expensive.

Where to begin.

First, the OECD is entirely right that NZ should be moving to increase the age of superannuation eligibility. The Productivity Commission said so, anybody economically sensible has said so, and even Labour's in favour of it. The only thing that seems to be holding it back is that Key had promised in 2008 not to do it and didn't change his mind in the last election.

Second, the OECD could be right about land taxes. As part of a revenue-neutral shift away from income taxation, it would be a really nice move. My only concern, and it is the one that would keep me from pushing the button for that particular tax shift, is that equilibrium overall tax rates are likely to wind up much higher as consequence. Open up another margin for taxation and the government will wind up getting bigger over time. Even if it's revenue neutral now, it won't be the next time a Labour/Green finance minister decides to go after the 'rich pricks' by reinstituting a 39% top marginal tax rate while keeping the land tax.

But on capital gains, well, we disagree.

First, it's hard to make the case that the absence of a capital gains tax distorts investment towards housing. Maybe you could argue that we've a distortion such that firms have incentive to avoid distributing revenues as dividends and that individuals have incentive to hold shares in firms that follow such strategies rather than interest-bearing assets, but that doesn't make a case for a housing-specific distortion - especially as the IRD has been getting more vigilant about individuals flipping houses. Buying a house, doing it up, and re-selling it at a profit will draw income tax: the gain is taxable income from your labour in fixing and marketing the house. I can't see how we get a distortion towards housing rather than towards a broad set of appreciating capital assets. We certainly have problems around housing affordability. The first order problem is Councils' restrictions on the supply of zoned land. Sort that one out, and a lot of the second order problems, like inefficiencies of scale in construction, also start going away.

Second, capital income is already taxed when it is spent: we have a 15% GST. The more we are able to shift from income to consumption taxes, with offsetting transfers to those on lower income if you like, the better.

Third, as Seamus pointed out two years ago, we need to compare the relative efficiencies of the different available tax instruments. Taxes on capital income are more distortionary than taxes on labour income, and even worse when capital gain taxes tend not to be inflation-indexed; real tax rates on capital income then easily wind up being higher than taxes on labour income. And, there's a bit of a mess in deciding how to treat realised versus unrealised gains - you're basically there choosing among rather bad consequences. Read Seamus's whole post.

Fourth, the story required for the absence of a capital-gains tax to distort choices between productive investments and some kind of unproductive investment (basically, purchasing some asset that appreciates in value over time) is especially convoluted (another Seamus post...read the whole thing....).

Fifth, Seamus noted that while you can hang a case for a capital-gains tax on an argument Samuelson made rather a while back, Samuelson's argument shows that you need a capital-gains tax to avoid the problem of distorted choices among assets whose payoffs are more than 25 years into the future; nearer-term payouts aren't affected by that kind of distortion. Seamus also hit on a couple of other potential objections.

Want to increase the redistributive potential of the tax system? Increase the GST while increasing income-based transfers to the poor. Why muck up incentives to make capital investments?

Can tax and subsidy incidence really be negative?

Imagine a country where shoes cannot be imported and furthermore the elasticity of supply of shoes is very low. Imagine that the government in this country subsidises shoes. The person on the street who doesn't understand tax incidence might think that this policy lowers the price of shoes by the amount of the subsidy. An economist, however, would be likely to point out that, because supply is fairly unresponsive to price, the subsidy mostly results in an increase in the before-subsidy price to the seller.    In our jargon, he would be saying that most of the incidence of the subsidy would be on sellers and only a bit on buyers.

So far so good, but what if that economist now explained that removing the subsidy would make shoes cheaper to consumers, by stopping buyers from bidding up the price. This would seem to now be claiming that the incidence of the subsidy on buyers would be negative. Sure removing the subsidy would reduce the price to sellers but it would be a very strange model that would have the price falling by more than the reduced subsidy. In fact, it would seem to require that the supply curve be downward-sloping. 

And now, imagine that the economist further claimed that removing the subsidy would be good, as it would result in investors switching from investing in shoe production to investing in productive assets. This would go beyond strange. Sure the subsidy might have been diverting assets to having too much shoe production and not enough other stuff, but in what sense would we say that producing shoes is unproductive? And, how is it consistent to argue at the same time that removing the subsidy would lead to less investment in shoe production at the same time as arguing that it would result in lower shoe prices for consumers? 

O.K. this country, this policy, and this economist are fictitious. But if we change "country" to "New Zealand", "shoes" to "housing", "subsidy" to "tax exemption", and "economist" to "Gareth Morgan", you pretty much get this blog piece from Gareth on Tuesday. 

Gareth argues, correctly, that owner-occupied housing receives a favourable tax treatment relative to other investment since we are not charged income tax on the implicit rental payments we receive from ourselves. But he then goes on to argue that removing this exemption would "bring affordability within reach of many more families". This is an argument I have commented on before; it really looks like arguing that tax incidence can be negative: If housing is effectively subsidised by the tax system, we can't expect removing the subsidy to make it more affordable. 

And he then says that our tax treatment of housing has "discriminated against productive investment in favour of property speculation". Now if he means that we have invested too much in building houses and other kinds of investment, then we have to ask: In what sense is it unproductive to build houses that provide housing services to people that they value enough to pay for? And, how is it possible that curtailing such investment would "bring affordability within reach of many more families"? If, in contrast, he means diverting investment resources from building new equipment to buying existing houses as speculation, I have my perennial concern that this line or argument fails to note that buying existing houses for speculation or other reasons is not "investment" at all, and the assumptions you have to make to conclude that such behaviour diverts resources away from productive investment are a stretch to say the least.  

One final curious seeming contradiction in Gareth's post. At the start, he notes "When, not if, interest rates increase, this illusion that housing is `affordable' will burst....house prices will adjust". But later he suggests that if we don't remove the tax-favoured treatement of housing, he should "go out and buy another three houses now and just wait for the rest of you to bid the prices up". Why would that be good personal investment advice if, as he says, house prices are sure to fall? What am I missing?

More on Housing Affordability: Supply versus Demand

Over at TVHE, Matt has followed up on my post here on Gareth Morgan versus the Productivity Commission, arguing that we shouldn't view supply and demand explanations as mutually exclusive. Now I think Matt and I are pretty much in total agreement, but slight differences in language might make our posts seem at cross purposes, so I thought a couple of clarifications are in order.

First, the interesting question is not whether the cause of house-price inflation in New Zealand is supply, demand, or some combination of both. Obviously, since house prices are set by mutual agreement between buyers and sellers, prices are always and everywhere the result of both supply and demand. Rather the issue is, to the extent that house prices are inappropriate for some reason, whether the source of the inappropriateness is acting through supply or demand. Matt frames this by asking whether something is pushing demand for housing beyond what is "socially optimal" (or, by extension, restricting supply below what is socially optimal). Another way of saying this is to ask whether the policy response to high house prices would work by increasing supply (say changes to zoning or consent processes) or demand (say, changes in the tax treatment of housing).

The second clarification is that saying that supply and demand are not mutually exclusive is more than just saying that influences on both sides can contribute to the final effect. In the case of tax policies, the purpoted cause of house-price inflation only makes sense if there is an underlying problem with supply. To illustrate, consider Matt's statement

The key point against supply side issues will be fact that rental growth hasn't gotten as scary at any point -- if there are "too few" houses, then we should really see the cost of housing services/rent pick up.

The idea here is that if house prices are going up faster than rent, then the opportunity cost of owning a rental property must be rising faster than the direct income derived from it, so the only motivation must be the expectation of capital gain. This is true, but the expectation of capital gain only makes sense if the underlying trend is for the demand for housing for non-investment purposes to grow faster than supply. That is, to explain house inflation today as driven by tax-favoured investment, we need to assume a problem with restrictions on supply in the future.

Furthermore, consider what we would observe if there were no favourable tax treatment for owner-occupied housing or income derived from capital gains, but still an expectation of demand growth outstripping supply growth in the future. As long as the capital gains tax rate were not set at 100%, it would still be the case that expectations of future house price inflation would drive inflation in house prices today, there would be a positive after-tax return from capital gains, and hence a slower rise in rents, exactly the observations that Matt suggests might imply the problem is not exclusively on the supply side.

The bottom line here is that the favourable-tax-treatment story simply implies that problems due to insufficient supply will bite a bit earlier than they otherwise would have done. If there is no problem with supply being unable to keep pace with underlying demand, the tax-treatment issue is irrelevant.

Gareth Morgan on Housing Affordability

Gareth Morgan takes aim here at the Productivity Commission, for emphasising land supply as the major determinant of the high cost of housing in New Zealand. He notes that

[t]here are cities in the world with five times Auckland's population, living in an area no larger than Auckland's, and with housing prices lower as a percentage of income than in New Zealand.

Gareth, in contrast, points the finger at the Reserve Bank for directing banks to emphasise mortgage lending (for prudential reasons), and the tax code for favouring housing. He says that as a result of this "toxic duo" we have

driven the price of housing from twice the average household income to six times.

He restates his call for a capital tax (not a capital gains tax) to remove a distortion in favour of housing. Now, as I wrote here, I think that a capital tax has some really horrible properties that would swamp any benefits, but this is secondary to why I don't agree with this analysis of the NZ housing market.

First, explanations don't have to be either-or. Even if we agree that there are problems in New Zealand capital markets that contribute to house inflation, surely it would be the case that those problems are going to be more acute the lower is the elasticity of supply of land for housing?

Second, one of Gareth's concerns about the tax advantage given to housing is that it encourages people to buy housing as a path to prosperity, which presumably means that it is based on expected capital gain. Now this either means that house prices have been pushed up by a bubble, which will eventually burst without any change in the tax system, or that the fundamental price of housing is rising, and speculation is just bringing those price increases forward. If that is the case, then removing any favourable tax treatment on the capital gains from home ownership might cause a one-time drop in house prices now, but a faster increase in those prices in the future.

Third, Gareth's other concern about the favourable tax treatment given to housing--and the one that motivates Gareth's call for a capital tax--is the familiar fact that the implicit income earned from selling housing services to oneself in owner-occupied housing is not subject to income tax (although the transaction is implicitly subject to GST). This distortion will indeed cause the demand for housing to be higher than it otherwise would have been. But it will not cause the after-tax price of housing services to be higher, so again, it is hard to see how removing the tax distortion would be a solution to the problem the Productivity Commission are addressing.

Finally, if looking to the tax code to explain the change in house prices over time, or differences between countries in the fraction of income devoted to housing, one needs to identify time-series or cross-section differences in the tax code. Pretty much all countries have a tax code that favours owner-occupied housing and always have done. If anything, we have moved the tax code away from favouring housing in recent years with changes in the treatment of investment properties, and a switch from income tax to a higher rate of GST. And we don't have policies like the mortgage interest rate deduction that are seen in other countries, particularly the U.S.

Ultimately, it just comes down to ECON 100 supply and demand. The New Zealand population has been rising, and land-use policies have been preventing supply from keeping up with demand. Maybe those policies are a good thing, and we should be moving away from urban sprawl to high-density living. But it is hard to counter that the cost of such policies will be a steady increase in the price per square metre of housing.

What is wrong with housing anyway? (Warning: wonkish)

This is a post I have been meaning to write for some time, but the current spur is the Treasury briefing for the incoming minister. It is mostly very good, but included in it is the canard about over-investment in housing. This is a refrain we hear repeatedly, usually in phrases like “New Zealanders love affair with housing”, but I think the theoretical and empirical basis for the assertion of overinvestment is weak at best.

The main issue is one of tax-induced distortions. With owner-occupied housing, the purchase of a house is an investment, which generates an inputed rent that the owner pays to himself. The payment of this imputed rent is not subject to GST, nor is the rental income subject to income tax. There is also the issue of whether the absence of a capital gains tax is a further distortion, but I have discussed that issue here, here, here, and here. In this post, I want to explain why I don’t find it obvious that there is a distortion due to the lack of tax on inputed payments of a homeowner to himself. In part, this is a response to comments by Phil Meguire in the first of the capital gains posts.

To start with, let’s get an obvious point out of the way. Housing is a good thing, and nicer housing is better than worse housing, holding all else the same: If non-neutral taxes induce more investment in housing and less in other forms of investment than a neutral system, there is a cost, but it is the difference between the value of the flow of goods that would have been produced and the value of the flow of services produced by the housing, a difference which is not necessarily significant. I suspect that some of those decrying our love affair with housing are making the mistake of thinking that just because the purchase of housing services is a non-market transaction it doesn’t contribute to economic well-being. Similarly, it is irrelevant if the alternative investment would increase labour productivity, increase exports, etc. productivity and exports are just means to increasing the value of the goods the economy can consume; so is building houses. (Surprisingly, Greg Mankiw appears to make this mistake here, but to be fair we can attribute this to the need for simplification in an op-ed article, and his basic point—that the U.S. should get rid of the crazy mortgage-interest deduction—is sound.)

The next point to note is that the optimal tax rate on owner-occupied housing has to be considered in the context of an existing distortion: With an income tax, saving is subject to double taxation. If I choose to work today in order to buy consumption goods today, there is a difference between the value of what I produce and the value of what I consume, because of an income tax. But if I choose to work today in order to buy consumption goods in the future, there is an even bigger distortion between the value of what I produce and the value of what I consume, because the value of my work is taxed twice, once on my labour income and again when the interest income is taxed. We then have a classic second-best Ramsey taxation problem. The theoretical optimal tax on the return from investing in owner occupied saving will be somewhere between having no taxation on the saving (so as not to distort the decision between consumption today and investment in housing), and the full double-taxation rate applying to other forms of saving (so as not to distort the decision between investment in housing and other investment). So if normal investment returns are taxed at, say, 33%, the optimal housing tax will be positive but less than 33%.

And finally, here is the point that is overlooked in all the commentary on housing investment that I have seen. The flow of services from owner-occupied housing is currently subject to a tax. In other words, this graph, taken from the Treasury’s briefing to the incoming-minister, is wrong.

To see why, consider how a value-added tax like the GST works. Businesses charge GST on their sales, but deduct from their net tax liability the GST they have paid on purchases of goods and services. Expenditure on investment therefore reduces their tax liability, which is what makes the GST ultimately a tax on consumption and not investment income. When consumers buys a new house, they are making an investment, the return for which is the flow of housing services they will receive over time. The inputed payments they make to themselves are not subject to the GST, but unlike other business investment, the initial house purchase is, which has the same effect. (And, as I noted in an earlier post, the existence of a GST pushes up the prices of second-hand goods by the rate of the tax, so the argument is no different for owners who purchase an existing rather than newly built house.)

This is another example of the beauty of pure value-added taxes. By shifting in part from an income tax to a value-added tax, the rate of double taxation on delayed consumption is reduced. At the same time, the effective rate of taxation on the consumption of owner-occupied housing is increased from zero. We end up with a system where the tax rate on owner occupied housing is somewhere between 0 and the rate applying to other investment, just as Ramsey tax theory would stipulate. Whether it is higher or lower than the optimal rate is a difficult empirical question to which I don’t know the answer. But I have not seen any of “New Zealander’s love-affair with housing” commentators seek to address it. Furthermore, given that there are no simple methods of increasing the tax rate on owner-occupied housing that don’t bring their own problems (we have no mortgage-interest deduction to get rid of, for instance), I find it hard to believe that we have an over-investment problem that is worth solving.

Should Capital Gains be Taxed

This was the headline on an article in the Press on Saturday (no on-line version that I can find). The sub- head says that the article reports on both sides of the debate. This is a bit of an obsession of mine (see my earlier posts, here, here, and here), as most of the arguments I have seen on this seem to be making incorrect partial-equilibrium arguments.

So I was keen to see what arguments would be put forward by the expert economists interviewed for this article. In a telling, but perhaps not surprising, commentary on the relevance of our profession for public policy, the number of economists cited in the article on either side of the issue was zero.

There was a quote from an Auckland professor of taxation law and policy to the effect that the absence of a capital gains tax causes "over-investment in property", but as I noted in the second of the posts linked to above, the chain of reasoning needed to get this conclusion is a lot more complicated than one might think, and the combined assumptions needed are somewhat heroic.

I continue to search for a coherent economist rationale for a CGT.

The impossible trifecta

Kevin Milligan says a Guaranteed Annual Income cannot simultaneously satisfy three goals. Instead, you have to pick two among the following:

1. low tax rate
2. high benefit
3. balanced budget*

Treasury here in New Zealand modelled a GAI for New Zealand on the request of the Welfare Working Group (HT: Lindsay Mitchell). What did they find? A GMI paying $300 per week - the mean benefit income among those on benefits - would cost $44.5 billion, or $52.6 billion if we extended it to superannuitants as a replacement for NZ Super. The former could be covered by a flat personal income tax rate of 45.4%; the latter, 48.6%. But full fiscal neutrality would require tax rates of 50.6% and 54.4% - the lower tax rates would be just enough to cover the transfers, but income tax revenues are currently also used to fund more than just transfers.

If we recognize that most parents are beneficiaries via Working for Families and compensate them for the loss of our version of EITC with a $86 per child per week payment, we get a $57.1 billion fiscal cost and a personal tax rate of 50% (or 55.7% for fiscal neutrality).

And, even this rather expensive system leaves the worst off worse off, as it kinda has to. Treasury notes:

Although the Gini coefficient improves under all models, many beneficiaries (including the disabled, carers and sole parents) currently receive more than $300 per week and would be made financially worse off under a GMI scheme. Therefore the GMIs considered could distribute money away from those most in need of government assistance and toward those who have choices and opportunities but choose not to work.

Treasury also warned about potential adverse labour supply responses to the necessary personal tax rates. And, the induced gap between company and personal tax rates would increase IRD's enforcement costs.

Treasury concludes by reiterating Milligan's impossibility:

From the international examples it is apparent that the more equal a society is in the beginning, the lower the returns to a GMI scheme. That is, a New Zealand specific GMI would either be at a level of income too low to reduce poverty, or a level of income that is high enough to reduce poverty but is therefore expensive and hence distortionary through higher tax rates. 

I don't think Gareth Morgan's Big Kahuna scheme is able to escape the trifecta by imposing new taxes on capital or land. Why? Because those aren't free lunches either. If it's worth having a land tax, it's worth doing it regardless of whether we have a GAI. So in the first stage we set the optimal tax structure - and I'm completely unconvinced that a capital gains tax is all that hot an idea anyway (see Seamus's posts here here and here.) But whatever the optimal tax structure, we implement it in stage one. Then, we still have to increase all the tax rates by enough to pay for a GAI if we're going to have a GAI. And the impossibility reasserts itself.

Morgan squares things with a cheaper GAI paying $11k instead of Treasury's $15k. But I have a hard time believing that's a stable political equilibrium. Could NZ politicos really avoid the temptation of adding targeted benefits for the many folks currently on benefits totalling well over $15k? If not, how quickly do we wind up having a GAI on top of a targeted benefit system?

* Update: Milligan's updated this in a more recent tweet. I think there are a few possible impossibilities here.

@EmmMacfarlane Again, the impossible trinity: choose two of:

* low phaseout rate
* Big basic benefit
* same cost as current system.

— Kevin Milligan (@kevinmilligan) February 5, 2016

Capital Gains Taxes Redux

A couple of comments on my previous posts have suggested two possible efficiency motivations for having capital gains taxes. Both are theoretically correct, but neither makes a convincing case for a real-world CGT, in my opinion.

First, Bill Kaye-Blake suggests they can be a way of capturing otherwise untaxable non-market activity. The idea here is that DIY work does not involve a market exchange and so is taken out of the tax net. The whole optimal tax literature from Ramsey on is predicated on how to minimise the inefficiency arising from this inability to tax some goods. As an example, I had an uncle who was a keen DIYer. He liked buying houses in need of repair and then doing them up. Once finished, he would sell and move on to a new fixer-upper. For him it was just a hobby, but an unintended consequence was that he was able to move into better and better houses through the untaxed return on his DIY labour that manifested itself as a capital gain. The argument here is perfectly valid, but as a reason or having a CGT, it would be like giving yourself acupuncture with a fork (Ron Jones’ expression). For the very small amount of non-market income-generating activity that would be captured indirectly by a CGT (not my uncle, if first houses are exempt), one would have to bear the other costs of the tax. Even if the net efficiency and equity benefits of the tax for all other reasons were zero and not negative, it is pretty hard to see that this benefit would outweigh the enforcement and compliance costs.

Second, Michael Reddell cites the 1990 consultative committee on the taxation of capital income as stating that capital-gains taxes can be efficiency enhancing when the changes in gains or losses in asset values are not windfall changes. I have not been able to track this document down, but I am guessing that the idea here is related to a 1964 paper by Samuleson, which Andrew Coleman has pointed me to. Samuelson’s paper is very elegant, but it isn’t an easy read, so let me try to illustrate his result with a simple model. Those who don't like models expressed without equations just jump two paragraphs at this point.

Consider a world in which there is a perfectly elastic demand for domestic saving in international markets at an interest rate of 5%. This means that, in the absence of taxes, there is an opportunity cost to both a saver and the country of investing in the creation of a local physical asset in the form of an ongoing return of 5%. It will therefore only be efficient for the country to invest in the asset if the present value of the future payments from the asset exceed the cost of the creating the asset, when the future is discounted at 5%. If we now put on a 40% tax on interest income, then local savers will use the after-tax interest rate of 3% to discount payments, which will lead to a higher present value of a given flow of payments from an asset. If, however, the 40% tax is also levied on the payments from the asset, there will be an offsetting reduction in the present value. In the special case where there is a constant flow of payments, these two effects will exactly offset. In this case, private incentives will lead to the efficient level of investment in local assets—namely invest only if the social rate of return is in excess of 5%.

Now consider an asset which will produce a constant payment in perpetuity but starting in one year’s time, with zero payment before then. The price of the asset in one year will be unaffected by the tax, but the private saver will discount this value back one year at a rate of 3% rather than the socially optimal 5%. As a result, the present value will be overstated and there may well be overinvestment. The reverse situation applied for assets whose payments fall over time. The problem arises because of the compounding of interest, which means that taxes on interest imply a larger proportionate reduction in the rate at which values are discounted at longer time horizons than in the near term.

The bottom line of this is that the tax system creates a distortion in which there is an incentive to invest too much for long-term gain, and not enough for shorter term gain.

Now, if payments from an asset are going to predictably increase over time, then so will the market value of the asset—that is, there will be capital gains. Similarly, predictable decreasing payments will lead to predictable capital losses. Samuelson’s very neat mathematics shows that if you tax capital gains and subsidise capital losses at the same rate of tax as is applied to interest and payments from the asset, then the distortion in favour of long-term returns over short-term returns is removed.

So why is this not a strong argument in favour of capital gains taxes: I can see three reasons:

1. Samuelson’s result requires symmetric treatment of capital losses and capital gains, and no distinction between realised and unrealised gains. If this is not going to be the system implemented (which real-world capital-gains-taxation regimes ever are), the result does not apply.
2. The result is partial equilibrium, dealing only with the distortion across time horizons. But the excess discounting that arises from the magic of compounding is exactly the reason that capital taxation is found to have greater efficiency costs than labour taxation. A regime without capital-gains taxation, may lead to some inefficiency in the time horizon of investments, while enhancing efficiency in the margin between consumption and saving.
3. With a 5% before-tax interest rate and a 40% tax rate, it takes a horizon of 25 years before the future is excessively discounted. Do we really need a complicated tax regime to dampen the amount of saving going into investments with payoffs beyond 25 years? Can any proponent of capital gains taxes state with a straight face that this is the problem they are seeking to solve?

I am definitely not an expert in capital taxation, and so am open to being convinced by counter-arguments. My problem with much of what I have read in public discussions, however, is that the putative benefits are couched in vague terms (like “productive investment”), which I have a hard time converting into a model that lays bare the underlying assumptions. I would love to see the models made explicit.