Horses for courses

Dr Eric Crampton
The National Business Review
19 May, 2017

When economist Paul Samuelson was challenged to come up with an economic principle that was both true and non-obvious, he cited comparative advantage.

That two people, or countries, can be made better off by trading, even if one of them is better at producing everything that they might trade, is hardly intuitive.

President Donald Trump gets it wrong on a near daily basis when he frames trade as being about winners and losers.

But there is another important true and non-obvious lesson of economics: tax incidence.

The person who bears the burden of a tax, or who ultimately pays the tax, has nothing to do with who sends payment to Inland Revenue. It depends instead on supply and demand conditions in the market. The side of the market that is less responsive to price changes bears the greater share of the burden.

And that matters when we start thinking about the tax treatment of rental housing, rental warrants of fitness and regulations such as minimum apartment size.

Perverse outcomes

Because the tax incidence lesson is far from obvious, it easily yields perverse policy outcomes. Economists Jean-Robert Tyran and Rupert Sausgruber put undergraduates into an experimental economics lab and offered them the chance to vote on a tax and transfer setup that made the student traders, on average, far worse off.

When the tax was framed as a levy on the student buyers, traders voted against it; when it was framed as a tax on the computerised seller, the traders supported it. The effects of the tax in both cases was identical – but counterintuitive.

Suppose that the Resource Management Act and district plans banned all new construction. In that hypothetical world, whenever demand changes, prices move a lot because supply cannot easily respond. Homeowners can rent out a spare room, or illegally turn garages into rental units, but new dwellings are not built.

When supply is fixed, any increase in demand for housing turns into increases in the price of land. As rents and expected future rents increase, people are willing to pay more for investment properties. That expectation of future earnings is capitalised into the value of land. Similarly, more generous accommodation supplements translate into capital gains for landlords.

Reduction in returns

But on the flipside, any reduction in the expected return to owning a rental property bids down the value of land. Things like rental warrants of fitness, or less favourable tax treatment for landlords, result in capital losses for landlords but cannot affect the number of houses out there – because we started out by saying supply is fixed.

Some owners will sell off investment properties, reducing rental supply. But if it’s former renters buying those properties, rents overall would not be much affected. The relatively inelastic side of the market – in this case, supply – bears the burden of tax or regulation.

Flexible housing markets change everything. Imagine a utopia in which owners could easily tear down houses and put up terraced housing or apartments, and in which paddocks could easily become subdivisions.

Whenever demand increases, new housing gets built. The price of rental property is determined by construction costs, proximity to amenities and interest rates. Rental warrants of fitness, or less favourable tax treatment for landlords, then wind up hurting renters. When the returns to renting property drop, fewer new dwellings get built.

Elastic market

Auckland’s housing markets are a mess but they are not the hell of perfectly inelastic supply. The burden of taxes and regulation in housing markets are shared between buyer and seller. If we expect that housing will become relatively more elastic as the unitary plan takes effect and as central government policy around infrastructure improves, then effects of other policies change.

Measures like rental warrants of fitness could actually provide net benefits to tenants – if we do not expect supply conditions to improve. But as soon as regulations around housing and infrastructure shift to allow more supply, then those same rules flip to making tenants worse off.

When supply is working properly, tenants sort into the quality and price tier that best suits their preferences and budgets. Rental warrants of fitness then at best compel landlords to provide what tenants were already demonstrating that they wanted, and at worst make rental accommodation too expensive for some tenants.

And so politics makes for strange policy bundles.

Labour's proposals

Labour proposes fixing regulation so that more housing can be built: abolishing the rural-urban boundary and improving infrastructure financing. But Labour’s promised Healthy Homes Guarantee makes the most sense if housing supply issues are not addressed. And if zoning and infrastructure are sorted out, there is little need for the government to be directly involved in building more houses.

Meanwhile, National has spent the past nine years avoiding fixing the underlying urban planning and infrastructure financing problems. It has blamed coalition politics but has remarkably managed to fail to take up those opportunities that have arisen.

Its general preference to avoid undue intervention into rental markets should really be coupled with policies that would allow new development.

Tax incidence can yield counterintuitive conclusions about who benefits from policy. A simpler question for voters to ask: will this policy make it easier for new housing to be built? If it does, then builders could get on with the important task of exercising their comparative advantage: easing the housing shortage.

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