Former Economics Editor of the NZ Herald

Brian Fallow: Tax proposal offers savings boost


The Financial Services Council has put up a proposal for tax reform which MPs on both sides of the House should be able to support.

They would do the economy some serious good if they did.

The FSC is proposing a fiscally neutral way of reducing the tax on the earnings of retirement savings in managed funds such as KiwiSaver schemes.

It would mean that the power of compound interest was not hobbled the way it is under the current regime.

It would mean a larger nest egg for savers when they retire.

And it would lessen the debilitating economic distortions which arise from a tax system that treats retirement savings harshly and property investment generously.

Like some sort of fiscal tape worm, changes to the tax treatment of private superannuation introduced by Sir Roger Douglas in the late 1980s cut the returns to saving by way of financial assets.

He stuck us with the internationally eccentric TTE or taxed-taxed-exempt regime, under which savings are made out of after-tax income (where many countries allow a deduction), the income earned on the savings is taxed as it accrues (at the saver's marginal rate until the PIE regime capped it at 28 per cent) and only the final payout is exempt (until it is reinvested in some income-earning asset).

The problem with that middle T is that it frustrates the ability of compound interest to work its magic. Clearly, the bigger the bite the tax man takes every year, the less is left to reinvest and generate earnings.

Assuming a 6 per cent per annum return and no tax, $1000 invested at the age of 17 would have become $16,000 at age 65.

If tax reduced the return to 4.5 per cent per annum, it would be only $8000.

Add the impact of inflation, as tax is imposed on nominal not real returns, and the arithmetic gets even more discouraging.

"The earlier a person starts saving for their retirement in KiwiSaver the higher the real effective tax rate impact becomes, due to, in large part, the taxation of the inflation component of investment returns," says a report the FSC commissioned from a group of senior tax practitioners.

That is downright perverse.

The tax experts also compare the ways the tax system affects returns in KiwiSaver schemes on the one hand and investment properties on the other.

The tax system treats landlords as business taxpayers, entitled to deduct the costs they incur, including interest, while earning a taxable income, rents.

Most escape a capital gains tax when they sell, having in the meantime enjoyed the benefits of leverage in a rising market.

Fund managers not only have to pay tax on the earnings of their members' funds as they accrue, but also escape a capital gains tax only on some asset classes such as New Zealand shares.

The tax experts have calculated the real effective tax rates investors in rental property face, for various degrees of leverage and various tax brackets. Then they worked out what the marginal tax rate for someone in a KiwiSaver fund would have to be to level the playing field.

For the owner of a rental property leveraged to 80 per cent to earn the same return from a KiwiSaver fund for the same investment, the required tax rate would have to be just 1 per cent, not the 28 per cent actually imposed (on savers in the top tax bracket).

For lower levels of gearing the difference is less stark but still substantially in favour of property investment.

The FSC is too realistic to call for KiwiSaver tax rates to be slashed to 1 per cent. Its chief executive, Peter Neilson, is a former Minister of Revenue after all.

Instead it argues that the Government could get a bigger economic bang for its buck by redirecting the existing tax incentives in KiwiSaver, which currently cost $740 million a year, into a lower tax impost on earnings as they accrue - a TtE regime. The first $1042 contributed to a KiwiSaver scheme each year attracts a $521 tax credit.

As tax incentives go, this is badly targeted. Attracted by the guaranteed 50 per cent return a lot of people (who can afford to) enrol their children in KiwiSaver and contribute just enough to earn the maximum $521 tax credit.

The tax experts' report calculates that if the $521 per annum member's tax credit were abolished it would fund a flat KiwiSaver tax rate of 8 per cent. If the one-off $1000 contribution the Government makes upon enrolment were axed as well, it would allow a rate of 6.4 per cent.

If you wanted to keep a progressive tax scale, dropping the member's tax credit would allow those in the bottom tax bracket to pay 4.3 per cent instead of 10.5 per cent, those in the middle bracket 8 per cent instead of 17.5 per cent and those in the top bracket 15 per cent instead of 28 per cent.

And again the rates would be lower still if the $1000 kick-start subsidy were redirected as well.

How can a tax change be revenue-neutral from the tax man's point of view but advantageous from the saver's point of view?

It is because a smaller tax bite taken out of the earnings as they accrue leaves more to be reinvested and earn further income in the future. The tax man is only foregoing some tax on income which would not have occurred anyway.

Then there are the benefits to the wider economy of lessening the relative tax advantage of investing in property.

That advantage has been there for so long that there is an enormous vested interest in the status quo which makes it politically challenging to address from the property side.

So it looks more promising to address it from the retirement savings side - especially if, as the FSC contends, it can be done in a revenue-neutral way.

The distortion in the tax system has left us with a badly unbalanced economy.

The chronic gap between national savings and investment makes us dependent on foreign savers and investors to fund a current account deficit that was $9 billion in the year to June and pushed net foreign liabilities to $151 billion, an internationally conspicuous 71 per cent of GDP.

It means systemically higher interest rates and a higher exchange rate.

And we use the foreign money we import largely to bid up the price of housing to perilous and socially destructive heights.

So what the FSC is offering politicians is a policy which would:

* make it easier for people to accumulate a decent retirement nest egg;
* mitigate the tax drivers of house price inflation;
* reduce our vulnerability to a change of sentiment in offshore financial markets;
* increase the domestic supply of investment capital;
* and take pressure off interest rates and the dollar.

- NZ Herald

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Former Economics Editor of the NZ Herald

Brian Fallow is a former economics editor for the New Zealand Herald. A Southlander happily transplanted to Wellington, he has been a journalist since 1984 and has covered the economy and related areas of public policy for the Herald since 1995. Why the economy? Because it is where we all live and because the forces at work in it can really mess up people's lives if we are not careful.

Read more by Brian Fallow

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