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Property's grail status is pulling the economy off balance, writes Gareth Morgan.

In its election campaign Labour promoted a capital gains tax. That at least recognises that we have a terrible hole in our tax base, and what results is a misallocation of capital to the detriment of the economy.

Investors quite rationally invest to maximise their after-tax returns, and when you have a hole in your tax regime they will gravitate to opportunities where tax can be avoided totally. That is seldom the same place where the benefit for the economy as a whole can be maximised. It is in the interest of policymakers then to ensure these effects are minimised.

In New Zealand over recent years there has been a gross over-investment in property, caused not just by the tax loopholes but by the uncontrolled expansion of credit that the global deterioration of central banking prudential standards underwrote.

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New Zealand is well known for the unaffordability of housing, blamed too frequently on not opening enough farmland for urban sprawl. More likely it is because housing is entrenched as the holy grail of unearned wealth accumulation so in essence the speculative demand has outstripped any demand for housing to meet accommodation needs.

As long as this is the case of course the "affordability" of housing will remain low - purchasers of property for their accommodation needs are but a small portion of the market demand.

Part though not all of that is because of the tax loophole that housing offers, particularly the tax-free nature of the return from owner occupation. This was highlighted in the McLeod Review of 2001. In fact, in the first draft of McLeod's work the recommendation was that the tax on all capital (not just housing) be extended to include income earned whether it is cash or imputed. That was a sound taxation principle that politicians couldn't stomach, and for whose neglect we are now paying a high price.

In the book The Big Kahuna we expanded on the concept of a comprehensive annual capital tax designed to fix the loopholes in our current selective income tax regime. The benefits are that owners are forced to use capital efficiently and low-return uses of capital face a higher tax penalty to discourage that inefficiency. An effective 1.8 per cent tax on the value of a house year in, year out would recognise that owner-occupiers are receiving free rent in effect. That would knock the wind from the sails of speculative investment in housing that accrues courtesy of its tax-free status.

Labour's capital gains tax was a big improvement on the status quo but nowhere near the optimal approach for taxing the return to capital.

It is unfortunate that the comprehensive capital tax proposed in The Big Kahuna still gets referred to as a "capital gains" tax by uninformed commentators. The confusion with a capital gains tax as proposed by Labour has caused serial misreporting of this topic.

For example, it's been reported that I favoured a capital gains tax on the sale of my investment business, and even Phil Goff toured the country claiming Sam Morgan advocated a capital gains tax on the sale of Trade Me. Nothing could be further from the truth. The prices paid for both those assets reflected the reality that tax is paid on company earnings each and every year. If that annual tax wasn't paid, net earnings would be higher and so would the price the buyers paid for the asset. It would be helpful if commentators could get their heads around this.

The objection I have to the tax regime is based simply on the reality that for some forms of capital not all of the return is taxed. Put $400,000 in the bank and you pay tax on the interest, and then from those after-tax proceeds you can pay your rent. Buy your house with that $400,000 instead and you enjoy a rent-free life.

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As long as we all can see that this tax loophole is a no-brainer we all buy property for the tax advantage and of course the more we do that the more certain it becomes that the price of the asset will rise more than inflation over time. And if I think this to be the reality then as a committed speculator I'll buy four more houses on debt, gear them up just so I can offset the rent with interest and then enjoy a tax-free capital gain. It is a national obsession. And of course it's self-fulfilling until finally your lender says "no more". Then you are terribly exposed. But as we've seen it can take decades to come to that.

Apart from the inequities that arise from the tax-favoured status on this particular asset type - pity the poor souls that never manage to get aboard the property-owning gravy train - the extent of investment that is misallocated and consequently the GDP growth that is forgone, manifests in incomes lower than they could otherwise be, and more people unemployed than needs be.

The concept of the annual capital tax is to ensure all forms of capital (land, buildings, equipment, structures) attract tax in an equal manner every year and that capital that doesn't make a minimum required return (the government stock rate) faces an increased tax burden while capital that does is unaffected by the presence of this tax. It negates the need for any capital gains tax.

And what of the situation when it is time to sell a business? Changes of ownership do not trigger a tax liability under an annual capital tax. The business would have been paying tax annually on capital it owns anyway.

Dr Gareth Morgan is an economist, author, portfolio investor and philanthropist.