Brian Fallow: Key dumps tax in the too-hard basket

The changes outlined in John Key's speech on Tuesday seem designed to preserve popularity. Photo / Mark Mitchell

The Prime Minister's statement leaves no doubt that his is a profoundly conservative Government and that what it is chiefly interested in conserving is its popularity.

The changes outlined on Tuesday are fine as far as they go, but that is not very far.

What is in prospect is a shift in the tax mix from income to consumption tax and an elimination of the top 38 per cent personal tax rate funded by a routine exercise in tax base maintenance around property investment.

What is entirely missing is a substantial broadening of the tax base needed to fund deep cuts in tax rates, that is, to rates starting with a "2".

On the positive side there is a decent chance that the changes mooted will materially reduce the risk of a repeat of the destructive property bubble of the last decade.

A key driver of the doubling of house prices between 2002 and 2007 was property investors' willingness to pay prices way beyond what was justified by prospective rental yields.

One reason the property boom of the 2000s was a lot bigger than that of the 1990s is that the top personal tax rate had been increased to 39 per cent from 33 per cent, increasing the attractiveness of tax shelters.

So dropping the top rate should have the reverse effect.

Dropping or limiting the depreciation deduction for buildings should help too.

But it is not a big pot of gold. The often-quoted figure that it would be worth $1.3 billion a year is spongy, a maximum figure based on there being no offset if buildings are sold at a loss.

Some buildings do depreciate - industrial ones for instance - and the working group was not proposing that they should be denied a deduction, only that it should not be the default assumption that all buildings depreciate. Maintenance spending, after all, is deductible as well.

If a loss offset is allowed, officials estimated it could reduce the $1.3 billion by something between $300 million and $600 million.

PricewaterhouseCoopers chairman and Tax Working Group member John Shewan puts the case for such a change succinctly: People are willing to invest in property for very low yields and cash losses year after year because they expect capital gain, he says.

"It's very hard to argue that you should have tax-free capital gains but also should be allowed to deduct all expenses, including depreciation, if the asset doesn't depreciate."

Some of the language in the Prime Minister's statement, and other comments he has made, could be construed as leaving the door open for ring-fencing - restricting the ability to use rental property losses to shelter other taxable income like salaries.

This is not an option recommended by the Tax Working Group. And it was give short shrift by officials when they looked at it in 2006 when the search was on to find "mates" for monetary policy and take pressure off interest rates and the dollar.

Ring-fencing would reduce the attractiveness of residential property investment, particularly for highly leveraged investors chasing capital gain, they said.

But it would discriminate in an arbitrary way against a particular form of investment and depart from the sound principle that losses incurred in one activity can be offset against income from other activities in calculating a person's or firm's total income for tax purposes.

And it would be too easy, especially for sophisticated investors, to find ways of burrowing under or pole-vaulting over the fence.

One of the key objectives of tax reform is to reduce the effort expended in structuring people's affairs so as to minimise tax. Ring-fencing would run counter to that.

If a cut to the top personal tax rate and a move against depreciation deductions for buildings mean there is less tax-driven bidding up of house prices by investors then the risk of another property boom would be much diminished.

The collateral damage from the last one is a legacy of debt at the household and international level (because so much of what we borrow has to be imported) and house prices which are unaffordable to many people.

While the boom was running the wealth effect meant that consumption grew faster than incomes, stoking inflation, driving up interest rates and the dollar, and blowing out the trade and current account balances.

The case for a land tax was not primarily about avoiding such imbalances and distortions, however, damaging as they were.

Rather it was a proposed response to a fundamental structural problem with the tax system.

You could call it the "iceberg" problem - the Government's revenue base is like a giant iceberg slowly drifting north.

Nearly 60 per cent of it comes from taxing two things that don't have to be here, labour and capital.

Those are not just friends and relations in the airport departure lounges heading for greener pastures overseas. They are departing chunks of the tax base. The argument is not that lower tax rates will reduce the incentive to emigrate, though at the margin they might.

Rather it is that because so many of us do emigrate, continuing to rely on income tax to the extent we do erodes the Government's ability to continue to fund the level of public services voters have come to expect.

Capital is even more mobile, and competitive downward pressure on company tax rates has been pretty relentless, though whether it will continue is debatable given the fiscal pressure many large economies are now under.

Taxing land, by contrast, has no effect on the supply of land, though introducing such a tax would have a one-off effect on its price.

As John Key put it on Tuesday: "A land tax appeals to economists as an efficient way to raise revenue. However, a land tax is effectively a lump sum tax on people who own land when the tax is introduced, would only fall on people who hold their wealth in one particular form and would create cash flow problems for many landowners, especially those with lower incomes."

The idea is anathema to farmers, Federated Framers president Don Nicholson says. Even though it would be possible to design the tax with a threshold per hectare which would effectively exempt farmland, a threshold could later be lowered.

It has also been an alarming prospect for the retired, especially those who are asset rich but cash poor and unlikely to benefit from associated income tax relief.

That might be addressed by provisions to defer their land tax obligations until they could be met from their estate.

"Some people want the perfect, shiny tax system," Finance Minister Bill English says. "We are dealing with the messy business of reality."

There is no point in making tax changes that will not survive the next election, he says.

Translation: The Government is not going to expend time and political capital making the case for more radical change to the tax system.

And so a "broken" tax system joins superannuation and climate change in the too-hard bin.