In this morning’s NZ Herald, Auckland accountant Alan Dudson proposes a simple way of sorting out the property market. By that he means making housing cheaper and easier to get into for families (evidently single people need not apply). We should stop allowing a deduction for interest costs incurred by residential investors. At present, he says, we subsidise residential property investors by allowing them to claim a tax deduction for interest. So they can afford to pay more to buy a house, because their tax bill is reduced by the interest deduction. If we stop them being able to claim interest deductions, then they won’t pay as much, and the price of housing will fall, and ordinary people will be able to buy houses again.

It’s a bad idea. For starters, it’s not clear why interest expenses are the culprit. Property owners bear a variety of expenses, such as repairs and maintenance, rates, insurance, management feeds and others, in addition to interest. Those expenses are all deductible. Should interest suddenly become non-deductable, then banks and other institutions will find ways shift ‘interest’ expense into another form. Moreover, it’s not clear why interest should be singled out as the non-deductible expense. Why not rates, or insurance? On top of that, there is a general principle in our tax law that allows people to deduct the expenses they incur in earning assessable income. Removing interest deducibility for residential property investment would be an ad hoc change to that principle. It’s an arbitrary rule, designed to achieve a non-tax purpose.

Second, there are some serious design issues. It’s worth remembering that a reasonable proportion of rental property owners are “accidental investors.” These are people who have had to shift from one place to another for work purposes, and have been unable to sell their homes, so they’ve rented them out. These people would be caught in Alan Dudson’s tax net too, even though they are not speculative property investors. Perhaps you might just say, well, thems the breaks, but it still points to a problem: introducing this measure will affect the ability of people to move in pursuit of employment. In other words, the proposal has a nasty side effect.

You could mitigate this nasty side effect by having an exemption for houses that have been the family home, and you could have a time limit on the exemption, say five years. This would give people enough time to sort their finances and housing out. However, it would open the way for investors to move from house to house, living in each of them for a few months or a year or two, and then transferring them to the rental market. It would be a laborious way of exploiting the loophole, but the loophole would nevertheless exist. And you could design your way out of the loophole, by limiting the number of houses for which you could claim the exemption at any one time, but what started out as a simple rule (you can’t deduct interest) starts to get administratively complex.

Third, how do we deal with people who supply short term accommodation, such as furnished apartments in hotel complexes? These people are providing residential accommodation, sometimes on a comparatively long term basis, for somewhat transitory workers (for example, for the Christchurch rebuild)? They could conceivably be caught by this too. Again, you could design rules to exclude some residential accommodation, perhaps accommodation that is available for less than six months at a time. But all that would do is shift all leases to 180 days. Or you could say that it doesn’t apply to apartments in apartment complexes. But then how do you deal with an old villa that has been separated into say, three flats. Is it or isn’t it subject to the residential rental accommodation rules? Again, you could try writing some more rules around this, and perhaps the rules for the supply of residential accommodation and commercial dwellings in the GST Act might provide a workable model. However, it’s still an administratively complex mechanism which will be needed in order to shore up an arbitrary rule.

Mr Dudson thinks that if interest deductibility is removed, “It would flood the market with thousands or tens of thousands of houses for sale.” Maybe. I suspect that plenty of residential property investors would simply increase rents instead, to the extent that the market would bear it. And it’s worth bearing in mind that the tax advantage to be gained, assuming that investors would otherwise be paying the top tax rate, is about $1,700 for every $100,000 of mortgage. No one likes paying extra tax, but my guess is that plenty of investors would find ways to manage it. So I don’t think that there would be an immediate flood of houses onto the market, and that means that there would be no drop in the price of housing. It’s worth remembering that there was no flood of houses onto the market when depreciation deductions were removed.

But the real problem with Mr Dudson’s solution is that it is a demand-side solution. His objective is to make housing more affordable in Auckland in particular. However, the reason that prices are high in Auckland is that demand is very high. All those properties that are snapped up by property investors are promptly filled with tenants who are happy, or at least prepared, to pay high rents for it. That demand won’t go away just by changing the rules around interest deductibility. If we really want to make housing in Auckland more affordable, then we need to look at the supply side of the equation, and build many more houses.