The boldest element of the housing package the Government announced this week is the plan to eliminate the tax deductibility of interest for residential property investors.
Underpinning that are a couple of things it believes to be true.
One is that in the parts of the market relevant to first home buyers, investors are the marginal buyers who set the price.
The other is that investors have an advantage arising from the increasingly artificial assumption — which has become an article of faith nonetheless — that to buy an investment property is to go into business, the rental accommodation business.
And that therefore the investor is entitled to claim a tax deduction for any costs incurred in earning their new source of taxable income — rents — the top of the list being interest.
The Government is willing to shoot that sacred cow.
The reasons are obvious and valid.
Runaway house price inflation threatens the bursting of a bubble at some point and the bigger its diameter, the worse the damage. The Real Estate Institute's house price index has risen at a compound annual rate of 9.6 per cent over the past five years, including an eye-watering 21.5 per cent in the past year, resulting in house-price-to-income multiples and household debt levels that are in many cases perilously high.
A sharp drop in house prices would be unpleasant.
But worse would be the hardening of a perception that vested interest in the status quo is now so widespread as to create a "third rail" issue like New Zealand Superannuation — touch it and you die.
The risk is that people come to believe policymakers will do whatever they must to keep a ratchet under house prices. The consequences of that intergenerational inequity would include, post-Covid, a swelling of the diaspora and a lot of people watching their grandchildren grow up via Skype.
There is a tedious tendency to dismiss demand-side measures, which dominated this week's announcements, as irrelevant when "The Problem" is lack of supply. As if we were only allowed one problem and one solution.
Clearly the physical imbalance between the supply of, and demand for, housing is now extreme. It has been years in the making and will take years, and a raft of policy changes, to resolve.
In the meantime, upward pressure on prices and rents will persist. The question is how high those prices go before they burn off or frustrate that excess demand.
In a seller's market, how much the marginal buyer is able and willing to pay sets the price. At what point does the second highest bidder in an auction drop out?
So measures to curb that in the case of investors, who don't need to be in the market, are highly relevant.
The principled case for at least limiting deductibility of interest would be that you should only allow a deduction for costs incurred in earning income that is taxable.
Rents are taxable income; in general, capital gains are not. (Set aside the bright line test for a moment.) Typically these days, it is the capital gain that is the larger part of the expected return for someone buying an investment property.
For the tax system to treat that investor, who may well have engaged the services of a property manager to deal with the tenants, the same as someone building up a business to provide a livelihood for himself and other people is artificial.
The capital gain pocketed by an investor who sells is purely inflation. One who sells today a property bought five years ago — assuming its value rose in line with the national rate — would be looking at a 50 per cent profit at least, and mostly likely much more if amplified by leverage (a startlingly high share of which is in the form of interest-only loans).
But it is not like a proper business where a capital gain might represent the fruits of shrewd use of retained earnings resulting in an increase in the goods or services the business provides. The landlord is not likely to be housing 50 per cent more people in his rental property.
That invites the response that by extending the bright line test for when the profit on the sale of a property (other than the family home) is taxable income, from the National Government's original two years to five years and now to 10, the Labour Government has implemented the de facto equivalent of a capital gains tax on rental properties. To deny that is specious semantics.
Finance Minister Grant Robertson said the average time a house is owned is between seven and eight years, but owners of a single investment property — often as a form of retirement saving — were more likely to hold it for longer. So they should escape the tax.
In any case, the Government says it will consult on "whether people who are taxed on the sale of a property (for example under the bright line tests) should be able to deduct their interest expense at the time of the sale". That would make sense. Otherwise property investors would flip from the privileged position of no capital gains tax and interest 100 per cent deductible, to the double whammy of taxed capital gains and no offsetting interest deduction if — but only if — the property is sold within the relevant bright line period.
There is, however, an element of retrospectivity — something normally considered odious in tax policy — in the proposals around interest deductibility.
It is that the ability to deduct interest expenses on investment properties acquired before tomorrow will be progressively phased out over the next four years.
The Government says this is "to give owners the time to adjust to the removal of the loophole".
To call it a loophole is tendentious, but more importantly this aspect of the policy begs the question of how that adjustment will take place.
Will it mean some investors sell sooner than they would have wished as their tax position has been retrospectively worsened? If so, it would offset some of the "lock-in" effects of landlords holding on to properties to wait out the 10-year bright line.
Or will it mean rents are raised to give the investor something closer to their expected after-tax rental yield? That assumes they have not already been charging all the market (their tenants' incomes) will bear.
The official line on this seems to be: (a) that it would be somehow "unfair" to have two groups of landlords, some of whom could claim a deduction for 100 per cent of their interest costs while the others could claim nothing; and (b) this is how the British did it.
Westpac's acting chief economist Michael Gordon believes that the likely response is that highly leveraged investors will sell out, at a reduced price, to owner-occupiers or less leveraged investors.
"We saw similar outcomes in the UK, which began to phase out interest deductibility from 2017. House price growth slowed to zero, rents rose to some degree, and housing construction slowed. More recently, the resulting shortage of housing had started to lift prices again, at least until Covid struck." On a more positive note, the Government it says it will also consult on whether there should be an exemption from the intended non-deductibility rule for new builds acquired as a residential investment properties.
It seems minded to go that way. Much of the Prime Minister's rhetoric has been about encouraging people who want to become property investors to do so by building a property and renting it out, rather than bidding for existing ones in competition with would-be first home buyers and existing owner-occupiers looking to trade up or down.
The incentives would be the ability to deduct interest costs and that the bright line for paying tax on a realised profit would remain at five years.