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Labour Party Faces Scrutiny Over Stance on Landlord Tax Deductions

The Labour Party is facing internal and external pressure regarding its position on interest deductibility for residential property, a policy it previously decried as a "tax cut for landlords."

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Labour might have moved on from the last Government. Polling suggests voters have moved on too.

But two incidents this week showed the Ardern Government isn’t quite done with Labour.

On Monday, leader Chris Hipkins unexpectedly announced he would leave the interest deductibility rules for residential property unchanged if elected in November.

Labour had been debating what to do about them ever since the present coalition began restoring full deductibility back in 2024. Would the party bring back the ban? Would it settle for a partial restriction?

At first, Labour suggested its answer depended on whether it campaigned on a capital gains tax (CGT). But even after announcing the CGT last year, it said it was still considering restricting interest deductions. That remained its position until Monday, when it put the genie back in the bottle: the current rules would stay.

The decision is painful for Labour because it has spent years calling the restoration of deductions “a tax cut for landlords”. The party built a devastating case for this decision being the original sin of this Government – the first, fatal, cruel decision of the coalition from which all of the others flowed.

It was a potent attack. Why, in strained fiscal times, would a Government give landlords a tax cut? Labour began making the argument while still in Government, when restoring deductions was only National policy. At that point, its own ban was still being phased in at 25 percentage points a year. By the time the coalition scrapped it, it had been only 50% phased in.

The irony is that Labour is incensed about the coalition scrapping a ban that never fully existed.

The rhetoric became a feature of Labour speeches and attack ads. It cut through, even with National voters. Now that dilemma has landed at Labour’s door. As the party appears to be losing votes to the Greens and Opportunity, it must explain to its supporters why a “tax cut for landlords” is suddenly something it can live with.

The problem began in April 2019, when Jacinda Ardern announced she would not adopt her Tax Working Group’s recommendation for a CGT, thanks to NZ First blocking the idea. She ruled out the tax not only for that term, but for as long as she led Labour. Ardern stressed that she believed in the tax; she simply did not want the question hanging over the Government.

Michael Cullen's tax working group recommended a conventional CGT. Photo / Mark Mitchell

It was an understandable position. The CGT had dogged Labour through its nine years in opposition. Ardern was extremely popular following her response to the Christchurch terror attacks, but Labour’s position during its first term was less secure than it now seems in retrospect. For most of that first term, right up until Covid, Labour struggled to establish a convincing and stable lead over National.

Two things changed.

First, Labour became exceedingly popular, winning a greater share of the vote in 2020 than any party had since 1951. Second, the housing market caught fire as a result of irresponsible and lazy monetary policy, a conclusion reiterated in this week’s balanced but damning independent review.

The Government had been warned that monetary easing would have dangerous distributional effects, enriching some people while impoverishing others (credit to Chlöe Swarbrick for prosecuting this in select committee earlier than others).

Before it gave the Reserve Bank the thumbs up to turn on the money printer, the Government was told to consider fiscal measures, including tax, to blunt those effects. Ironically, a later paper by Treasury economists (writing in a personal capacity) reached a counterintuitive conclusion: the housing boom reduced inequality because so much of middle New Zealand’s wealth was tied up in homes, while the wealthiest held more of theirs in businesses whose values did not rise as fast.

Labour did not introduce a CGT. Whether Ardern’s fidelity to her promise showed trustworthiness or political timidity remains one of the most controversial questions hanging over her legacy. After the 2020 election, the Government needed to show it was doing something about housing, just not a CGT.

In March 2021, the Government announced that the bright-line test would be extended from five to 10 years. It also proposed gradually restricting residential property investors’ ability to deduct interest costs from their taxable rental income (Australian-style negative gearing having been banned in 2019). The details of the latter policy were still being worked through and were confirmed in September.

Interest is generally a cost of earning rental income. It is distinct from repaying the principal on a mortgage. Ordinarily, a landlord deducts interest, rates, insurance and other allowable expenses from rent and pays tax on the remainder. Denying an interest deduction can therefore leave a landlord paying tax despite making little, or even no, cash profit.

Why choose such an unusual measure? The 2020-21 paper trail shows officials were asked to devise tax tweaks to slow house price growth but were explicitly reminded that Ardern’s CGT rule-out still stood. This must have been frustrating – the Government had asked a question but taken the best and most logical answer off the table (Treasury, much like the International Monetary Fund and the OECD had repeatedly recommended the Government adopt a CGT).

The Government alighted upon unusual interest deductibility changes not because they were a good idea (they’re not), but because Ardern had taken the good idea off the table. You could detect an element of guilt to the package – Ardern, who had been elected with a mandate to build 100,000 affordable KiwiBuild homes and introduce tax reform, needed to assuage the guilt of presiding over a housing bubble far worse than she could ever have imagined.

Officials hated it. Inland Revenue warned that the change would push up rents, mean fewer new homes and impose massive compliance costs on a quarter of a million taxpayers, dragging on the economy. The Ministry of Housing and Urban Development raised the same concerns. Treasury supported some restriction on deductions, but only if a CGT was definitely off the table.

Even Labour’s current revenue spokeswoman, Deborah Russell, wasn’t a fan of the tax. In a since-deleted 2013 pre-parliamentary blog post, she described a proposed ban as “an arbitrary rule, designed to achieve a non-tax purpose”.

She was more right than she knew. The ban was not meant to solve the underlying problem in the tax system; a CGT would have done that. It was meant to solve a problem in the Labour Party: finding a way to tax property without introducing a CGT.

The years that followed were chaotic for housing. Prices fell, a symptom more of the Reserve Bank hiking rates than the interest deductibility ban. Rents skyrocketed, although this probably had more to do with the economy catching fire than it did with the interest deduction ban.

The same caution applies to claims about what restoring deductions has done for rents more recently.

Labour has now arrived at a defensible position – the position all those officials wanted five years ago. If it introduces a CGT, there is a reasonable case for leaving interest deductions in place. The real tax break for landlords isn’t that they’re allowed to deduct interest (any business can and should be able to do that); it’s that they usually don’t pay tax on their capital gains.

As a brief diversion, it’s worth wondering whether the Government would have made life easier for itself had it left the bright-line test at 10 years back in 2024 – it would be much harder to argue landlords were getting an easy ride had that been left in place.

But Labour made the case against restoring deductions so ruthlessly, many of its own supporters feel betrayed by Hipkins’ decision, fearing it confirms their worst fears of his milquetoast centrism.

Left-wing blogs and podcasts have criticised Hipkins for backing down and queried his argument that reinstating the restrictions would reduce revenue from Labour’s CGT, arguing a ban could be an “and-and” in terms of revenue.

Finance Minister Nicola Willis began reinstating landlord interest deductibility in her 2024 Budget. Photo / BusinessDesk

That criticism misunderstands the original 2021 policy. Interest that could not be deducted from rental income could be deducted when a property was sold, and its gain was taxable under the bright-line test. If Labour brought back the ban in its 2021 form alongside a CGT, Hipkins is right: interest costs deducted against taxable gains would reduce CGT revenue from what is now forecast.

Labour could instead prohibit those deductions altogether (that option was actually considered in 2021), but that would be highly unorthodox and very costly, and would be so heavy-handed it could mean there’d be no capital gains to tax.

The dispute also feeds a broader criticism: Hipkins’ CGT is too narrow. Labour chose a more politically saleable tax over a wealth tax that could have raised far more money. It knew that choice would limit its ability to promise expensive change. Now it has to live with the trade-off.

There is no easy way out. That Treasury paper on house prices and inequality still holds. Using tax to destroy the capital of middle New Zealand creates as many or even more problems than it solves. Though no one in Labour will admit it, the sluggish economy and high street closures have far more to do with the housing crash than the firing of a few thousand public servants.

Nonetheless, that seems to be where Labour’s supporters want it to head.

There’s one potential way to cut through the mess – a change not to Labour’s CGT, but to the type of CGT. Before it decided on banning interest deductions, Labour’s 2020-21 property tax work had officials dust off something called the “deemed rate of return method”, a form of capital gains tax which would be paid every year by investment property owners rather than in a lump sum when the property was sold.

This idea was looked at in detail by the 2018 Michael Cullen tax working group, which ultimately went with the more conventional CGT. Why did Cullen examine this? Well, it had been put on the agenda in 2016 as the main tax policy of the new Opportunities Party.

The problem resembles one that faced the British Conservatives over Europe during the Brexit years. Closer to home, National took its time coming out strongly against Three Waters, a policy many of its MPs considered sound. Turning a flawed policy into the explanation for every grievance can be effective against an opponent.

Eventually, though, your own side expects you to believe it and do something.

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