New Zealand has a tax problem. We know this because we are having our third tax review since 2000 and because Inland Revenue keeps fiddling with the way capital incomes such as profits, interest, dividends and capital gains are taxed.

Since 1990 there have been new rules for taxing foreign earnings, new rules for taxing rental property, new rules for taxing portfolio investment entities, new rules for a lot of things. Systems that work properly don't need new rules all the time.

Much of the debate concerns the way housing is taxed. This is not surprising, because property prices have increased faster in New Zealand since 1990 than in other OECD countries, the rich countries' club.

Yet New Zealand does not tax residential property much differently than other countries. People do not pay capital gains taxes on their own homes in most countries. Nor do they pay tax on the implicit rent they earn from owning their home, something advocated by The Opportunities Party.


Even though New Zealand taxes housing like other countries, there is still a housing tax problem. What matters is the way housing income is taxed relative to the way other capital income is taxed. New Zealand may tax housing like other countries, but it taxes savings, particularly retirement savings, very differently.

Retirement saving is taxed much more than housing in New Zealand than other countries, and that is the cause of the problem.

When overseas people save in a retirement account like KiwiSaver, they don't pay tax on the money their savings earns, they don't pay tax on any interest or dividends or capital gains as they accumulate, but they pay tax on withdrawals when they retire.

For example, if you earned $60,000 and placed $5000 in a KiwiSaver account, you would pay tax on only $55,000, you wouldn't pay tax on your KiwiSaver earnings as they accumulate, but you would pay tax on the total sum when you withdrew funds at age 65 or 70.

This means income is taxed when it is spent, not when it is earned. This simple change substantially increases the returns to saving, by perhaps 50 per cent for a person first entering the workforce.

Why do many other countries, including the US, Japan, the UK, and Germany, but not Australia, tax retirement savings in this way? Because it allows them to have the efficiency advantages of an expenditure tax system like our GST with the social advantages of a tax system that taxes low-income people at lower rates.

Moreover, because it reduces the effective tax on retirement savings to a similar level as the tax on owner-occupied housing, it does not make it more profitable to buy a house than place money in a retirement savings scheme.

New Zealand's tax system was not always like this. In 1989 the Lange-Douglas government changed the taxation of retirement savings from the standard OECD system to the system we have now. If they had also taxed imputed rent and capital gains taxes, the change would have made sense. But they did not.

If you tax one class of assets less than other classes, you increase its price. Martin Feldstein, the famous Harvard economist, also showed that if property income is taxed less than other income, significant costs are imposed on young people as they have to buy property at artificially high prices.

If you are under 40, you are a loser from the 1989 tax reform, because it means you face, will face, or have faced artificially high property prices that either keep you out of the property market or saddle you with a large mortgage. In contrast, if you are over 55 you have probably benefited from the reforms because they have artificially increased the price of your property or properties.

This provides a challenge to baby boomers – will they agree to change a system that has disproportionately favoured themselves even though it imposes losses on all subsequent generations?

Perhaps something can be done. One of the challenges confronting the Tax Working Group is to find a politically acceptable way to lower artificially high property prices by reducing the gap between the way housing and other assets are taxed.

Previous tax groups have considered closing the gap by raising taxes on housing. An alternative strategy is to reduce taxes on retirement savings, perhaps for those born after 1980.

This change wouldn't fix everything that is wrong with New Zealand's property markets but it should slowly reduce the extent the tax system artificially increases property prices.

It will bring us back in line with standard OECD practice. And it may even solve the growing angst, shared by young and old alike, that not all is right with our housing markets or our taxes.

Andrew Coleman is in the department of economics at the University of Otago.