Brian Fallow on the economy

Brian Fallow is the Herald's Economics Editor

Brian Fallow: Income tax cut tipped as best bet

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Treasury and IRD say drop would boost economic welfare - increasing incentives to work, save and invest.

Finance Minister Bill English. Photo / Sarah Ivey
Finance Minister Bill English. Photo / Sarah Ivey

Finance Minister Bill English has asked officials what tax reforms could materially lift the economy's performance.

The fruits of their cogitations and modelling were made public, with an appropriate lack of fanfare, last week.

Radical they are not.

But they give us an insight into the thinking on tax policy at the Treasury and Inland Revenue.

They conclude that cutting personal income tax would be the most effective in boosting economic welfare.

It would increase incentives both to work and to save and invest.

To the extent that it lifted the country's low level of national savings it would reduce the vulnerability associated with high levels of overseas debt.

And it might raise productivity, which is hobbled by low levels of capital invested per worker.

The report does not discuss any changes to personal tax rates but recommends, in a "you may wish to consider" sort of way, adjusting the thresholds to offset fiscal drag - the process whereby people end up in a higher marginal tax bracket as a result of normal growth in nominal incomes.

"A simple change to current thresholds in 2015, to correct for five years of fiscal drag since the 2010 tax reform, is estimated to cost around $1.5 billion per annum."

OECD data just released indicate New Zealand workers are not heavily taxed by developed country standards, at least in terms of the tax wedge - the difference between what someone's labour costs the employer and the employee's net take-home pay.

The tax wedge for a worker who is single and on the average wage was 16.4 per cent last year, the OECD said, which is the second lowest among its 34 member countries.

And for a couple with two children and one earner, who is on the average wage, the tax burden was just 0.6 per cent, with Working for Families tax credits, compared with 26.1 per cent across the OECD.

One reason New Zealand tax rates are relatively low by this measure is that, with the exception of ACC, we don't fund social security systems like superannuation from payroll taxes, but from the tax base as a whole.

Officials are not keen on a cut to corporate income tax, arguing that might leave the country worse off because it could lose more from giving up tax revenue to non-residents than it gains from improved investment incentives generally.

Because of imputation, a company tax cut would have little impact on investment incentives for residents.

However, they acknowledge that because company tax rates have been falling internationally - albeit not so much since the global financial crisis - it is important for New Zealand's rate not to get too far out of line, lest it encourage multinationals operating here to arrange their finances so that they recognise profits, and pay tax on them, in other jurisdictions.

The officials' report also considers reducing tax on interest income (to what extent they do not specify), for resident individuals only.

This was found to have the biggest effect in boosting savings.

But they worry about causing distortions, like shifting investors' preferences between equity and debt, and about the fiscal risks in creating new opportunities for tax arbitrage.

By favouring debt-financing of companies it could reducing financial stability.

It might require some complex rules, such as a domestic equivalent to the thin capitalisation regime which applies to foreign investors.

And cutting the tax rate on interest income would be regressive, as higher-income households tend to earn more of such income.

Another way of reducing the tax rate on capital income would be to extend the PIE (portfolio investment entity) regime to include investments, both debt and equity, held directly by taxpayers and not just through managed funds.

The Treasury thinks this would raise overall economic efficiency; Inland Revenue doubts it.

The two departments are also at odds on the merits of a capital gains tax.

The Treasury continues to see the lack of such a tax as a glaring and distorting hole in the tax base, but IRD worries about the practical complexities and questions whether a CGT which only applied when gains are realised and which exempted the family home would be more efficient than not having one.

The argument for such a tax, especially on investment properties, is that the absence of one increases the amount it is rational for an investor to pay for a property and thereby bids up prices in those parts of the housing market where investors and would-be owner occupiers compete.

An economic model of tax and housing devised by Wellington economist Andrew Coleman suggests that taxing capital gains on investment properties would reduce the total amount invested in housing and increase the amount invested in interest-bearing assets.

It would reduce the price of housing and increase the affordability of owner-occupied housing, but increase rents.

Overall it would improve economic welfare and reduce the level of foreign borrowing, compared with the status quo.

The officials briefly considered raising the goods and services tax (GST) rate, in the context of funding personal income tax cuts.

But it would reduce the purchasing power of wages, all else being equal, and so perhaps encourage emigration, and it would create a windfall loss on existing savings as their value in terms of future consumption would fall.

They also worry about disadvantaging New Zealand retailers when alternative direct imports are available.

Two other drawbacks, which they do not mention, to increasing the rate of GST is that it would tend to reduce the progressivity, and in that sense the fairness, of the tax system by falling more heavily on those with lower incomes, where there is less scope for offsetting income tax cuts, and it would increase the calls for exemptions, of the kind which the Labour Party has recently, and rightly, abandoned.

- NZ Herald

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