Tax, credit constraints and the big costs of small inflation Andrew Coleman University of Otago

Reserve Bank of New Zealand Act Taxation of Retirement Savings

Two tax philosophies Income Tax Expenditure tax Income is taxed when it is earned Broad coverage allows low rates Distorts saving choices Distorts investment choices unless there is an accrual based capital gains tax. Distorts investment choices if some assets are exempt. Expenditure tax Income is taxed when it is spent Requires higher rates when there is saving Does not distort saving Does not distort investment unless some asset classes are exempt.

The Great income tax experiment ` Pre 1989 Post 1990 Owner Occupied Housing TEE Bought from after tax income Imputed rent tax-exempt Sale tax-exempt Retirement Savings EET Contributions tax exempt Earnings tax-exempt Withdrawals are taxed TTE Earnings are taxed Sale is tax exempt No capital gains tax Rental housing Other assets

Figure 1: Schematic description of taxes on capital income Introduction Figure 1: Schematic description of taxes on capital income

Figure 1: Schematic description of taxes on capital income Introduction Figure 1: Schematic description of taxes on capital income

Figure 1: Schematic description of taxes on capital income Introduction Figure 1: Schematic description of taxes on capital income Income tax applied without capital gains taxes

Purpose of the paper This paper “calculates” the distributional incidence of the tax, taking into account the endogenous effect on house prices Its purpose is to examine how the interaction of monetary and fiscal policy affects welfare in the long term. It is partly sparked by concern about declining home ownership rates among lower income, young households. falling ownership rates are not welcomed by younger, poorer households it has been argued that landlords are out-competing potential owner-occupiers at auctions in part because of the tax advantages of investment in property over investment in interest earning assets.

The paper builds a model of the economy that integrates the analysis of Modigliani (1976) and Feldstein (1977) on the ways that inflation affects credit constraints; inflation affects capital income tax rates; these factors affect individual economic choices these choices determine land prices ; and land prices alter the intergenerational distribution of welfare. Feldstein, M. (1977) “The surprising incidence of a tax on pure rent: a new answer to an old question.” Journal of Political Economy 85 349 – 360. (Skinner 1996, Gervais 2002, Chambers, Garriga, and Schlagenhauf, 2009)

The key mechanism is that nominal interest rates increase when the long term inflation rate increases. Because there are nominal rigidities in the tax and banking systems, increases in the inflation rate cause real distortions. The distortions have effects that differ by age and income.

Inflation distorts the housing market in three ways (a) it increases nominal interest rates and makes it harder for young, credit constrained agents to buy a house without having very low consumption (if a bank will give them a loan at all): Essential problem is that while higher inflation and interest rates increase real debt repayment at the start of a mortgage, banks don’t lend the additional nominal mortgage payments and households have to reduce consumption to make the higher payments if they borrow.

(b) it creates incentives for landlords to enter the property market because the inflation component of interest earnings are taxed but capital gains are taxed lightly or not at all. Major problem is the asymmetric treatment of capital gains and interest income. In NZ capital gains are not taxed, but nominal interest payments are deductible

(c)it creates incentives for households to buy large houses because the inflation component of interest earnings are taxed but capital gains are not. Imputed rent is not taxed either Hence big tax incentives to buy big houses

(Ortalo-Magne and Rady 2006, Coleman 2007) The Model (Ortalo-Magne and Rady 2006, Coleman 2007) Two types of houses, large (H) and small (F). Small houses can be rented or shared. Based around 4 long term equations Demand for rental housing Total demand for houses both large and small Supply of rental housing Supply of houses, normally elastic

Demand to own and demand to rent The demand side is based on a forward looking overlapping generation model of consumers. 4 cohorts (two young, one middle aged, one in retirement) Lifecycle income 400 agents in each cohort to have income diversity Model has realistic bank imposed credit constraints that bind on young agents Agents pay tax, consume, save for retirement Agents consume different housing each period They can live with parents, rent a whole flat, own a small house or own a large house.

Agents choose housing that maximises lifetime utility Take into account current prices and rate of price appreciation Take into account tax rules Imputed rent not taxed Capital gains not taxed (for households) Interest income is taxed Interest payments are not tax deductible Multiple tax rates Credit constraints may mean they have very low consumption if they purchase a house Credit constraints mean there is a housing ladder

Utility The basic utility function is vR = 0.33, vF = 0.35, vH = 0.45 are utilities from living in a rented flat, an owned flat, and a house

Agents borrow at interest rate r. Banking Agents borrow at interest rate r. They are taxed on nominal interest earnings In year 0 and 1 agents face realistic borrowing constraints: A maximum loan to value ratio θ A maximum mortgage repayment to income ratio δ A requirement to make regular (monthly?) cash payments, not just a payment at the end of the loan

Supply of houses Two versions: (a) The long run supply of houses is inelastic with respect to prices (Fixed supply of two house types.) (b) The long run supply of houses is elastic with respect to prices because of construction. Main elasticity ~ 1 In further work, have varied these parameters a lot to explore the effect of high and low construction costs and prices

Supply of rental housing Competitive landlords enter the market until the after- tax return from housing equals the after tax return from interest earning assets. Return is rent plus capital appreciation Tax paid on interest, including inflation component Landlords pay tax on rent Landlords’ interest payments deductible Note that landlords are on high marginal tax rates

Indirect taxes There is a GST tax The rate is altered endogenously so that as inflation or taxes are changed, the same total tax is raised.

Inflation and interest rates The inflation rate is exogenous, 0 – 3% It is an open economy model with real interest rates set exogenously (5% pretax) Foreign borrowing and lending allowed Properties are bequeathed (to close model)

The solution is a set of ….. rents Endogenously determined prices for large and small houses Property appreciation rate GST ….that equate the market: Housing demand = supply Goods demand = supply Tax target achieved

Dynamic steady state solution I find a dynamic steady state solution. It is fully intertemporal Typically, I find the initial price and the price growth path as a function of exogenous variables. In the following results I focus on the initial price. Eg price of a small house is: $140 000 at t= 0 and grows at 0% pa when inflation rate = 0 $163 000 at t= 0 and grows at 2% pa when inflation rate = 2

Broadly calibrated to NZ economy around 2000 AD Calibration Broadly calibrated to NZ economy around 2000 AD year 0 household income is $20 000 - $80 000 3% discount rate main scenarios have 90% loan-to-value ratio and 30% mortgage servicing – income ratio examines inflation in 0-3% range Main tax rates are 20% < $50000 and 33% > $50000 (also calculates (0,0), (10,10) (20,20) (20,39) real mortgage rate is 5%

The results focus on the way inflation affects the housing market. The models suggests the results can be large. When inflation increases from 0 – 3%, nominal mortgage rates increase from 5% to 8%, or by ~15 - 20% per 1% increase in the inflation rate. the real after tax interest rate falls from 3.33% to 2.33%: Given 3% discount rate, inflation can change the incentive to save for capital accumulation

The interaction of tax, credit constraints, and inflation is key Key Result The interaction of tax, credit constraints, and inflation is key If there were no credit constraints – you can borrow to pay interest – inflation has little effect. This is because everyone buys a house first period, so there are no distortions between ownership and rental But houses are too big If the tax system were neutral, no incentive to choose one class of assets over the other Income tax with capital gains Expenditure tax treatment of retirement savings

Inelastic Housing Supply (Solved with beta = 0.97 and real interest = 5. These are varied later.)

The interaction of tax and inflation has large effects 1% increase in inflation lowers home-ownership rates by 10%! Young households are squeezed by higher nominal mortgage payments and competition from capital-gain seeking landlords. What happens if the inflation component of interest is tax free?

This model suggests the real problem is the “widow’s tax” – the tax on the inflation component of interest income. (It is called the widow’s tax because most domestic lenders are retired people – and therefore disproportionately widows.)

Elastic Housing Supply Parameterised to produce similar results to inelastic supply at zero inflation

Similar results on home ownership, but a very different mechanism. small house prices change by little in response to inflation rents are bid down by landlords total number of houses increases number of large houses declines as credit constraints stop young people living in them (this dominates attractiveness of tax free gains) What happens if we exempt inflation component of interest earnings from tax?

When the inflation component of interest is exempt from tax, home-ownership rate is little affected by inflation The mechanism is different: rent is higher fewer houses are built more young people staying at home. higher home ownership rates

These results suggest (when B= 0 These results suggest (when B= 0.97, r = 5) the effect of inflation on home-ownership rates can be enormous. Is this merely a function of the chosen parameters? Yes and No

Real interest rates and discount rates have a large effect The results are the more or less the same for inelastic and elastic cases. The extent of credit constraints, the number of houses, the utility value of housing, construction costs have little effect. Real interest rates and discount rates have a large effect Inflation has almost no effect when real interest rates are more than 6%, and a huge effect when they are less than 4%.

Welfare Analysis We can calculate the welfare of the households under different inflation rates, and express the change in welfare as the loss (or gain) in consumption necessary to achieve the welfare obtained under zero inflation

When housing supply is inelastic, 3% inflation reduces welfare by 2-4% for all income levels These effects are largely mitigated if inflation component of interest is exempt from income tax When housing supply is elastic, inflation improves welfare of low income (increasing number of houses and by lowering rents) but lowers welfare of moderate and high income. These effects are also mitigated by if inflation component of interest income is exempt from income tax.

Empirics Basic Facts New Zealand house prices increased much faster after 1990 than before 1990 Rent/price ratio declined rapidly, particularly after 2000 New building size increased sharply after 1989 Largest increase in house prices in OECD, 1990 – 2016 Faster increase in new house sizes than Australia or the U.S.

Figure 2: Real Property Prices in New Zealand, 1923 – 2014 Empirics Figure 2: Real Property Prices in New Zealand, 1923 – 2014

(5) Conclusions In this model: Inflation can have a very large effect on home ownership rates of young households. The effect is decreasing in the level of real interest rates (maybe why it only became important in 2000s?) These effects would disappear if the inflation component of interest income is exempt from income tax (for it is not income) The effects on house prices and rents depend on the elasticity of the housing supply When supply is inelastic, inflation leads to higher house prices When supply is elastic, inflation leads to lower rents, more houses, and a larger proportion of small houses