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Brief Counsel

The Fair Tax for Savers campaign - are savers over-taxed (and if so, why)?

31 July 2014

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The Fair Tax for Savers campaign launched earlier this week is based on the proposition that income from at least two forms of savings is currently over-taxed.   We examine this claim and the proposed solutions and conclude that the campaign:

  • has a valid point regarding interest income, which deserves further consideration, and

  • is really seeking a tax concession on KiwiSaver income, rather than addressing an over-taxation concern.  Its proposal should be debated on that basis.

First proposal – lower KiwiSaver tax rates

The campaign’s first proposal is that rates of tax on KiwiSaver income should be reduced so that the effective rate of tax paid is the same as the marginal rate on other income.  It is not at all clear from the campaign material what this means, or how it would be achieved.  In reality, rather than addressing over-taxation, this is a push for a tax subsidy for KiwiSaver.  In the interests of a high-quality debate, it should be framed that way.

The campaign is obviously correct to say that income from KiwiSaver contributions is currently taxed as it is earned by a KiwiSaver fund.  There is no tax imposed when that income is later distributed to the contributor – usually on their retirement. 

If that income was taxed only when it was paid out, then the amount available to the contributor on retirement would, at least in some cases, be much higher.  The KiwiSaver fund would keep the gross (pre-tax) income and reinvest it for the benefit of the contributor.  The deferral of the tax obligation, over what is often a long period of time, means that the Government’s effective tax take is much lower, and the contributor’s after-tax income commensurately higher.

The campaign claims that this difference in tax outcomes means that under the current tax system, KiwiSaver contributors are being over-taxed, and Kiwsaver Fund tax rates should accordingly be reduced.  Of course, KiwiSaver rates are already, for many if not most contributors, one tax bracket lower than their marginal rate.

Chapman Tripp comments

The over-taxation claim does not stand up to scrutiny.  Furthermore, any attempt to deal with the suggested inequity would create many more inequities than it might be claimed to solve.

In the first place, the campaign has wrongly framed the issue.  The “correct” outcome is not taxation of KiwiSaver income only on withdrawal by the contributor.  That involves a significant deferral of tax for no good reason.  It is equivalent to arguing that corporate income should not be taxed until it is distributed as dividends to shareholders.

There is no reason in tax policy terms why KiwiSaver investors (or more accurately the KiwiSaver fund they invest in) should not pay tax on income earned from their investment as it is earned, just as other investors in the same assets outside a KiwiSaver fund do.

While it is true that some other types of investment enjoy a tax deferral  – in forestry, for example, where the biological income produced by the growth of a forest is not taxed until the trees are sold - this anomaly should not be extended to Kiwisaver, where issues of quantification and liquidity do not arise.

Second, it is not clear how a rate reduction would help KiwiSaver funds that invest in New Zealand shares.  The income earned by those funds is either totally tax exempt (capital gains) or in most cases already tax paid before it reaches the fund (fully imputed dividends).  If the fund were to receive a refund of imputation credits so that the corporate tax rate was adjusted down to some concessional fund rate (as is done in Australia), that would be a significant tax benefit that direct investors in New Zealand shares would not receive.

Third, it is not possible to solve the “issue” properly by simply reducing KiwiSaver tax rates, since the “cost” of imposing tax on income as earned rather than when withdrawn depends on how long a person is in the scheme for.  The only accurate way to achieve the campaign’s objective is to eliminate current tax on KiwiSaver income, and impose tax only on withdrawal.  This would provide such a significant tax benefit to investment through KiwiSaver that New Zealand, like other jurisdictions, would presumably have to introduce “reasonable benefit” rules to restrict the amount that could be invested each year into KiwiSaver.  It would also create pressure for some kind of deferral or reduction of the very large tax cost that would arise on withdrawal.  And of course the reduction in tax would need to be funded by changes elsewhere in the system.

Second proposal – inflation adjusting interest for income tax purposes

The second proposal does address a true case of over-taxation.  It is based on the proposition that debt investors (such as people holding bank deposits, corporate debentures, government stock) are taxed much more heavily than other investors.  That is because a large part of their nominal return is simply to compensate them for the erosion of the value of their investment by inflation.  However, this inflation-compensation component is still subject to tax.

For example, if inflation is 2% per annum, and a person deposits $100,000 for a year at a 2% interest rate, before tax that person is no better off, in real terms, at the end of the year than at the beginning.  However, the income tax system taxes nominal gains not real ones.  Assuming a tax rate of 33%, the person will pay income tax of $660, and after tax is worse off in real terms at the end of the year.  If the interest rate is instead 4%, the person will pay tax of $1,320 and be left with $102,680 after tax.  They are better off, in real terms, by only 0.67%.

The campaign proposes that there would be no tax on the income from the 2% deposit, and only $660 tax on the income from the 4% deposit. 

Chapman Tripp comments

This problem is obviously much more serious at higher than current rates of inflation.  It is less of a problem for banks and other financial intermediaries than it is for private investors.  The former’s interest income is largely offset by interest expense, for which they get a correlative benefit from the current tax system.  

The campaign proposes not taxing investors on this inflation component.  Obviously this would also require denying borrowers a deduction for that component.  There are tax systems in other countries, notably Scandinavian ones, which make an adjustment of this sort.

Legislating a workable rule along these lines would present some challenges.  For example, it would need to take into account the effect of derivative positions which hedge debt assets or liabilities.  The treatment of fixed rate equity would also need to be considered.  There would also be pressure for a similar indexation of long term revenue account assets, and even of depreciable assets for depreciation purposes.

Nevertheless, as the population ages, and if financial investment becomes more of a widespread feature of individual savings, we believe this idea deserves debate and serious consideration by the Government and policy-makers. 

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