Thursday, May 10, 2007

A Tax for All Seasons

At present New Zealand is experiencing inflationary pressures stemming mostly from a bulging housing market bubble. To counter this, the Reserve Bank has raised interest rates but this isn't doing much because, as I understand it, the potential to borrow overseas means that Reserve Bank interest rates are not strongly connected to bank lending rates. The high interest rates do lead to currency appreciation as international speculators move in to take advantage of thiss. An overvalued currency is harming our exporters.

What is to be done?

To suggestions from the fiscal side of things:

(1) actually enforce our very flimsy capital gains tax (modify it so it has some teeth).

(2) come up with some sort of hot money currency tax similar to that that Chile used. I'm not an economist so don't know if this is possible in our situation but I'd love to think that someone had at least investigated the idea...


Tim said...

That's a 'Tobin tax' and the idea has been around for a long time. As is the case in an economics degree, we don't learn anything about useful, practical things, so I can't really contribute anything much about it.

My 5-second reasoning is that such a tax wouldn't do anything to lower interest rates in NZ or reduce inflationary pressure, unless the tax was very high. You can suppose that if the tax was low then flows of 'very hot' money would be reduced - ie day to day (minute to minute) currency trading driven by news events. But a low level tax wouldn't stop money chasing after big interest rate differentials, because the gain from investing in the place with high short term interest rates (NZ) would still be larger than the loss paid as your transaction was taxed when you withdrew your money.

I'm no expert, but I think the tax would have to be very big to stop NZ's much higher short term interest rates from dragging in the capital that is washing around the rest of the world. For the tax to affect long-term interest rates, which are the most relevant rates for determining mortgage rates (and hence housing market demand), it would need to be large enough that the overseas investors willing to park their money in NZ for long periods of time would no longer be willing to do so. And because NZ's short term rates will stay quite high, and the rest of the world's short term rates will stay low for the next few years at the least, those people are very willing to invest in NZ and would need a large tax to be put off doing so.

I think one of the problems with trying to dampen the housing market with the Official Cash Rate is that many mortgages are now fixed-rate, meaning the borrower pays a constant rate determined by the rate at which banks can borrow at over the long term, rather than paying the rate of the day. Long term rates are much lower than today's rates (because no-one expects the very high OCR to stay like that), and a change in the OCR today only changes the long term rate by a little.

So, instead, the RBNZ governor did what everyone agrees is the wierdest thing ever, and basically asked the banks to all raise their fixed-rate rates:

Which basically amounts to 'organising' a collusive, or price fixing agreement, and would be really really illegal if any of the banks had organised the meetings themselves! Quite perverse stuff.

I agree the capital gains tax enforcement is a much better idea.

Sorry about the length of the rant

Terence said...

hey there Tim,

Thanks for that - technically, what I was suggesting wasn't a Tobin tax, which is an international system, but rather something like the Chilean currency controls which allowed them to avoid the worst of the Asian Financial Crisis. However, I take your point. Tobin taxes and the Chilean currency controls work on hot currency flows which are short term and based, as I understand it, on speculation regarding currency values. Apparently the profit margins from this type of transaction are pretty small (but if you've got enough money involved...). Making money from interest rate differentials sounds like a completely different kettle of fish.

Thanks and I hope all is well in Melbourne.