 The following is the text of a letter sent to Minister
of Finance Michael Cullen by Reserve Bank governor Alan Bollard and
the Secretary to the Treasury John Whitehead.The letter outlines
their recommendations around tools they could use to supplement the
role of interest rates in managing demand pressures and
inflation.
Hon Dr Michael Cullen
Minister of Finance
Parliament
WELLINGTON
Dear Dr Cullen
Supplementary Stabilisation Instruments
As you will be aware, in November 2005 we commissioned a team of
senior Reserve Bank and Treasury staff to undertake the
Supplementary Stabilisation Instruments project. The review looked
at whether there might be useful tools, directly affecting the
housing market and/or the market for residential mortgage credit,
which could supplement the central role of interest rates in
managing inflation. If such additional instruments were available,
which were targeted more closely to the housing sector than the
Official Cash Rate is, they might alleviate some of the pressures
on the exchange rate which has been adversely affecting the
performance of the traded goods sector.
In recent years housing market pressures have been particularly
intense (indeed, on a number of measures the housing market is
currently more stretched than at any time since the housing boom of
the early 1970s). Large increases in house prices, and in
construction costs, have been reflected both directly in the CPI,
and indirectly through the impact that perceptions of rising
housing wealth appear to have had on consumer demand and activity
across the entire economy. We have sought to ensure that any
measures would be applicable not only to the current cycle but also
useful and robust in any future cycles in which housing-related
pressures were to play an important role. The review team operated
under relatively tight deadlines and was asked to provide an
initial report to us by the end of January. We undertook to report
to you subsequently.
We have attached the full initial report, which focuses on six
main policy options. These take a variety of forms. Several involve
permanent changes to features of the tax system or other regulatory
arrangements. The thinking here is to identify any structural
changes which might help dampen the magnitude of housing cycles,
without requiring ongoing discretionary involvement. The review
team also explore two possible options for additional discretionary
stabilisation instruments, which could be used to supplement the
OCR in periods of particular pressure in the housing market. Many
other possible options have been quickly ruled out, on the grounds
either that they offered few cyclical benefits or that they were
outside the Terms of Reference for the project. Among the latter,
we did not consider a capital gains tax on housing or a more active
counter-cyclical approach to fiscal policy.
Having reviewed the report, we share the view of the authors that
there are no simple, or readily implemented, options that would
provide large payoffs in the near-term. Moreover, it is important
to stress that significant house price cycles have been a feature
of many, perhaps most, developed market economies in the last
decade or so. However, there are some specific measures that we
recommend be adopted and a number of areas where we believe more
work would be warranted. Any changes to the tax system would need
to be discussed with the Minister of Revenue.
Two features of the tax treatment of investment properties have
been considered in the review. Under current tax law, income tax
applies to gains realised on property sold when the property was
acquired with the purpose or intention of resale (with an
exemption, broadly speaking, for owner-occupied property). In
practice, however, Inland Revenue has identified a variable level
of non-compliance with the existing rules. In response, Inland
Revenue has been actively raising the profile of these rules to
improve taxpayers' understanding of them and this is planned to
continue. In choosing how to allocate resources, we recognise that
the Commissioner of Inland Revenue's current audit strategy is
based with good reason on assessing revenue risks to the tax
system. However, we consider that there could be merit in
encouraging Inland Revenue to consider broader cyclical
stabilisation objectives when determining the allocation of audit
resources and the effort made to publicise the application of tax
law to property sales. As the report notes, Inland Revenue has a
number of concerns with this proposal and there are a number of
issues to be worked through, including the impact on the department
and the integrity of the tax system of having multiple objectives
and the legislative basis for the Commissioner adopting such an
approach. To the extent, this does not require legislative change,
we think this option offers the best prospect for having some
quick, albeit modest, impact on the current cycle.
The report notes that further measures could be employed to
reinforce the existing income tax law applying to capital gains on
housing. For example, a reporting requirement could be imposed in
respect of all sales of residential properties occurring within
(say) two years of acquisition, or the exemption for owner-occupied
housing could be removed for properties sold within two years of
acquisition.
As requested in the Terms of Reference, the project team also
explored the option of ring-fencing operating losses on investment
properties (that is, allowing losses on investment properties to be
offset only against other property income, but not against, say,
wage and salary income). This approach is adopted in a variety of
other countries. At this stage, we do not consider that such
changes would be warranted for reasons laid out in the report, but
recommend that further work be undertaken to better understand the
role of short-term holdings of investment and owner-occupied
properties in accentuating housing cycles.
Overseas literature highlights the importance of regulatory
provisions in shaping the ability of the supply of new housing to
respond to signs of increasing demand. Locally, there is some
suggestive evidence that such constraints may have exacerbated
housing inflation pressures in certain regions. Were such pressures
to be alleviated, the amplitude of housing cycles might be
diminished. We welcome the work programme that the Department of
Building and Housing and Housing New Zealand Corporation already
have underway to help identify a variety of measures that might
increase the responsiveness of housing supply, and we would expect
Treasury to have an active role in encouraging and shaping the work
programme.
The Reserve Bank is currently implementing a new capital
adequacy regime for banks (Basel II) designed to better align
capital requirements with the underlying risks that banks take. An
important part of implementing that framework will be working with
banks to ensure that the risk models they are using appropriately
reflect risk profiles through the business cycle as a whole (and
avoid generating incentives to assume larger and riskier loans near
the peak of the cycle). The Reserve Bank will also be exploring the
extent to which capital requirements under this regime may be
designed to provide counter-cyclical macroeconomic benefits,
consistent with the paramount consideration of promoting financial
stability.
The report examines two discretionary tools that could be
applied, to supplement the OCR, at periods of particular stress in
the housing market. Both could provide some cyclical management
benefits, easing house price inflation and hence reducing the need
for higher interest rates and potentially reducing the extent of
upward pressure on the exchange rate. However, both would also pose
significant ongoing enforcement challenges. The first discretionary
option is a comprehensive loan to value ratio limit, applicable to
all loans secured on residential property by all lenders. This
measure would have a direct impact on the most leveraged portion of
the housing market. However, the rules for such a limit would be
difficult to define and difficult to enforce. The pressure for
disintermediation would be very great. The report also notes that
the segment of the market most affected by this measure contains a
high proportion of low income earners and first home buyers.
The second discretionary option is an adjustable mortgage
interest levy, which could be imposed on all mortgages on
residential property and designed to force a wedge between the
price paid for credit by mortgage borrowers and the returns
available to the savers financing those loans (especially the
interest-sensitive foreign savers). While such a measure might be
expected to dampen the exchange rate cycle, it would be a step well
beyond the mainstream of policy thinking, with no international
precedent. In addition to significant disintermediation pressures,
enforcement challenges and adverse distributional impacts, this
measure would also raise a number of issues around the delegation
of power to impose such a levy. Even if Parliament were to agree to
it being set by the Minister of Finance on the recommendation of
the Reserve Bank, this could impinge adversely on the Bank's
operational independence, by involving the Minister and Treasury
more closely in short-term assessments of inflation pressures and
the need for discretionary policy adjustments.
Were you to wish to explore this option seriously, a
considerable amount of further development work would be required,
making such a tool an option for future cycles rather than for the
present one. We would also advise that any further consideration of
the mortgage interest levy should also include an assessment of
other potential discretionary fiscal instruments. Some of these
alternatives, for example, a variable expenditure or property tax,
might achieve the overall demand management benefits of a mortgage
interest levy, without giving rise to such significant ongoing
enforcement and implementation challenges. These broader
non-housing options were beyond the scope of the Terms of Reference
for the current study.
To summarise, we recommend that you:
a. Agree in principle that the Commissioner of Inland
Revenue should be encouraged to have regard to broader cyclical
stabilisation considerations when assessing the priority given to
enforcement of the existing income tax provisions relating to
capital gains on residential properties purchased with the
intention of resale.
b. Note that the Inland Revenue has a number of policy
concerns with this proposal.
c. Note that Treasury and Inland Revenue are discussing the
legislative basis for an approach as per (a) above.
d. Agree, if you agreed with (a), that the issue be
discussed with the Minister of Revenue and a suitable basis for
proceeding determined.
e. Note that undertaking additional enforcement activity may
involve additional resources.
f. Note that the Reserve Bank and Treasury intend to
undertake further work to better understand the role in the housing
cycle of property investment for short-term capital gain.
g. Note that, depending on the results of this work, it may
be appropriate to consider further tax measures such as tightening
the tax net on profits made on properties held for relatively short
periods and/or the ring-fencing of operating losses on investment
properties.
h. Agree that the Treasury should take an active role in
encouraging, and shaping, the work currently being undertaken by
the Department of Building and Housing and Housing New Zealand
Corporation on potential factors that may be slowing the supply
response of new housing at times of strong demand.
i. Note that as the Reserve Bank implements the new Basel II
international capital adequacy regime for banks it will be working
to ensure that the regime does not have a pro-cyclical impact on
the supply of housing credit, and to explore the potential for
counter-cyclical elements, consistent with the aim of financial
stability.
j. Note that a discretionary mortgage interest levy could
offer some benefit in terms of relieving exchange rate pressure at
cyclical housing peaks. However, extensive further work would need
to be done around the serious implementation and enforcement issues
(including consultation with the Minister of Revenue), and to
ensure that the operational independence of the Reserve Bank in the
conduct of monetary policy was not adversely affected.
k. Note that we will further consider discretionary fiscal
instruments of this nature in the context of our research programme
on the broad macroeconomic policy mix. In particular we will be
assessing the potential scope to assign a demand management role to
fiscal policy.
We expect that the report will be publicly released (we already
have several requests for it under the Official Information Act)
and would be keen to discuss with you the timing and management of
that release.
Yours sincerely
Dr A E Bollard
Governor
Reserve Bank of New Zealand
John Whitehead
Secretary to the Treasury
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