The Tax Working Group’s Report, released today, recommends significant changes to the tax system, which would affect most taxpayers and land owners. The fate of those recommendations now lies with the Government and will depend upon the Government’s assessment of the political climate and upon its appetite for political risk. If any changes are to be made in the current term, they are likely to be announced as part of the 2010 Budget.
Chapman Tripp Tax Partner, Casey Plunket, was a member of the Working Group.
Few would argue that there is not a strong case for tax reform. In 2008, out of all OECD countries, New Zealand collected the third highest percentage of its total revenue from personal and corporate income tax - the taxes most damaging to growth. Fiscal projections show a continued increase in this percentage.
Further, the gap between the top personal tax rate and the corporate and trustee rates creates an incentive for some people to structure their affairs so as to pay substantially less tax than others with the same income. And there is significant evidence of tax manipulation in the rental housing market where in the year ended 31 March 2008, net tax deductions of $150 million were claimed on an investment of $200 billion.
These and other facts led the Group to conclude that the current tax system is incoherent, unfair, lacks integrity, discourages work participation and biases investment decisions. How then should the system be improved?
Broad design principles
The Report is clear that:
a broad base low rate strategy is the best for raising revenue at least deadweight cost
New Zealand is overly reliant on personal and corporate income taxes
Structural opportunities for avoiding the top marginal tax rate need to be addressed, either by rate alignment, or reinforcing the current non-aligned system.
Because we had to work within a fiscally neutral framework, our task was to re-allocate the tax burden in ways which are less discouraging of economic growth and will improve the country’s economic performance. We also had to be mindful of the political parameters on the Government.
Alignment or not – the key design choice
The key choice facing the Government is between:
an aligned system, where the top marginal rate, trustee rate and corporate rate are all the same (or within about 3% of each other), or
a non-aligned system, which we currently have, along with most other countries.
Alignment elegantly solves most of the structural anomalies in the current system. However:
of itself, it reduces progressivity by reducing the top personal rate to the level of the corporate rate. The loss of progressivity can be dealt with by reducing rates in the lower brackets, and introducing other progressive taxes (e.g. capital gains tax (CGT))
the loss of revenue from personal taxes needs to be funded, and
maintaining alignment is subject to two challenges:
if other countries, particularly Australia, reduce their corporate rates, that creates a very significant pressure on NZ to do the same. Under an aligned system, that also requires that the top personal and trust rates be reduced, further reducing both progressivity and revenue.
future Governments may feel they have an electoral mandate to increase a relatively low top marginal rate, as the Labour-led Government did in 1999.
Non-alignment allows the Government to maintain a greater degree of progressivity, while encouraging business investment generally and inward foreign investment in particular by lowering the corporate tax rate. However, as the current environment demonstrates, it needs to be buttressed by a number of other measures. With a high top personal rate and a low corporate rate, there is a significant incentive for people to earn income through companies, and to get it out other than through dividends. Two examples can be given of this behaviour, and the measures that are required to address it.
Business owners are incentivised to earn their income through a company, leave it in the company, and ultimately convert it into capital gain by selling the company. This kind of behaviour can be dealt with by way of an excess retention tax and/or a capital gains tax.
Investors are also incentivised to earn their income through companies (or unit trusts), and then to sell or redeem their shares, hopefully for a capital gain. The PIE tax regime has legitimised this treatment. Reversing it would require both raising the top PIE rate to the top personal rate, and also imposing the top marginal rate on income of investment companies and trusts, and other non-PIE investment vehicles.
The Report provides a static costing of $3.1 billion for an aligned income tax system with a top rate of 27%. This could easily be funded by a combination of the base broadening measures considered below. A non-aligned system with 33% top personal and trustee rates and a 30% corporate rate would cost $1.1 billion.
The Report supports alignment. However, if this is not possible it recommends minimising the gap by reducing the current 38% and 33% marginal tax rates, and aligning the top personal, trustee and top PIE rates.
Corporate income tax
The Report does not advocate a reduction in the corporate tax rate for its own sake. It states that the corporate tax rate needs to be competitive with other countries’ rates, particularly Australia’s. The implication is that the current rate is satisfactory (though higher than ideal) unless Australia cuts its rate.
The Report supports retaining imputation, though it recognises that if Australia abandons it, this would need to be reconsidered.
The Report states that increasing GST to 15% would have “merit on efficiency grounds” but that much of the increase would be absorbed by increases in benefits and decreases in the lower individual tax rates, to compensate lower income earners for the increased cost of living.
Base broadening – limited but likely
The Report suggests that three limited base-broadening measures be implemented or considered reasonably quickly. These are:
removing the 20% depreciation loading on new plant and equipment
removing tax depreciation on buildings (or some category thereof) if empirical evidence shows that they do not actually depreciate, and
lowering the thin capitalisation safe harbour threshold to 60%, or reviewing the calculation of the value of New Zealand assets.
Given their more limited nature, these suggestions are likely to be progressed by the Government if it does decide to provide income tax cuts. In aggregate, they could provide $1.8 billion of tax revenue, $1.3 billion of it from denying depreciation on buildings.
Heading the list of more ambitious base broadening measures is CGT. The Report contains little to encourage the Government in this respect. It records that most members of the Group had significant concerns over the practical challenges of implementing a CGT that did not create as many distortions as it solved.
Risk-free return method for taxing residential rental investment
Unsurprisingly, the Report recommends the Government consider changing the basis for taxing residential rental investment. Given its success with the fair dividend rate method for taxing foreign portfolio share investments, and the general sense that the current system does provide a tax loophole for residential rental investment, this is a recommendation the Government should take up. If it were part of a package of measures designed to make the system more fair, and not simply a revenue raiser, it might garner a good level of public support. It might raise as much as $850 million pa.
Land tax is currently somewhat in vogue amongst fiscal economists. Although land is a relatively narrow base, it is held broadly proportionally with income. And it would be a reasonably easy tax to implement, given that it is identical to rates imposed on capital value only (ie excluding improvements such as buildings). Accordingly, the Report supports the introduction of a low-rate land tax. A tax of 0.5% would raise up to $1.6 billion, assuming the land tax is deductible for income tax purposes.
The Report contains various suggestions as to how to alleviate the burden of the tax on those with insufficient cash flow to pay it, or with very significant land holdings (such as farmers and foresters).
For further information, please contact Casey Plunket (contact details to the right)