In part two of a series looking at the taxation challenges facing the nation, Professor Craig Elliffe looks at the alternatives available in the reform of the tax system
We are told that this is an odious and unpopular tax. I never knew a tax that was not odious and unpopular with the people who paid it.
- John Sherman, US Senator during Civil War
The Victoria University Tax Working Group - due to report this month - looked at a range of possible reforms including new forms of tax as well as modifying the existing treatment of various items under our current rules.
They sought to assess these under headings of equity, fiscal integrity, efficiency and growth, fiscal revenue, and compliance and administration.
In a simplified form, the proposals for increased revenue raising discussed at the Tax Working Group include:
An increase in GST: New Zealand's GST is recognised as being one of the most efficient and effective taxes in the OECD. In the efficiency stakes it's New Zealand first, daylight second, and Luxembourg third.
The indirect taxes in Australia and the United Kingdom rate well behind New Zealand. The proposal for an increase could be for a rate of 17.5 per cent or 20 per cent, but it is most likely to be to 15 per cent.
Although GST is best viewed as an indirect tax on income from labour, it is also necessary to consider that one consequence of increasing GST is a lump-sum tax on wealth. This is because savings when spent will result in a higher tax cost arising from the consumption.
It is for this reason it is argued the impact of consumption taxes should be measured on a lifetime basis rather than on an annual basis (that is, if you don't pay GST on consumption in any one year and you invest instead, you, or possibly the beneficiaries of your estate, will ultimately spend the savings and in doing so pay GST).
However, on an annual basis, or even on a daily basis (which is where most of us exist), an increase in GST is likely to be regressive. To be a regressive tax means that the proportion of tax paid by low income earners is higher than by high income earners. In tax policy terms this regressive feature is generally viewed as undesirable, no matter how efficient our GST is.
It is proposed that benefit amounts thresholds and abatements can be amended to compensate for the impact of this increase. Papers to the Tax Working Group note that the compensation provided through CPI adjustment may be either too little or too much and certainly likely to be too late.
Introduction of a land tax: A land tax is a tax levied annually on the value of land without reference to the value of buildings. It is therefore very similar to land rates. This leaves the position of local authorities to be resolved.
It is anticipated that significant revenue can be raised with very little compliance cost as local authority rating values currently used would be employed in the assessment process.
Mark Twain once said "buy land, they're not making it any more". This feature of land (that is fixed in supply) means that any purchaser of land after the introduction of the land tax would factor in their increased outgoings with a lower purchase price.
So a land tax is expected to cause an immediate fall in the value of land. Economists calculate this decline in value to be equal to the net present value of the future land tax liabilities. A 1 per cent land tax should result in a 16.7 per cent fall in land value.
If there was an ongoing increase in land rents through the years, then the decline would be greater. Hardest hit would be the retired, young homeowners with little equity in their properties, and large property owners such as farmers, foresters, and Maori landowners.
Introduction of a capital gains tax: The introduction of a capital gains tax would overcome a significant hole in the tax base and it is estimated could raise $3.8 billion.
There are three significant advantages to this. The first is the question of equity. Not taxing capital gains not only offends against the principles of horizontal equity but also creates an "upside-down effect". The benefit from exempting capital gains to a higher salary and wage earner is larger than to a lower wage earner because of the progressive nature of income tax rates.
The second advantage is to protect the integrity of the existing income tax system. The current system relies upon a complex, fact-specific analysis to determine whether a gain is income or capital. The current rules are capable of manipulation, create uncertainty and are hard to administer.
Lastly, it appears the absence of a capital gains tax may have encouraged a disproportionate ownership of capital appreciating assets, notably property. CGT could have a positive investment effect, adding to productivity and growth.
There are, however, a range of problems in the design and effective implementation of the CGT. These include issues relating to "lock-in" (this is the behaviour of a taxpayer to defer the sale in order to defer the tax) and double taxation. The tax is notoriously hard and expensive to administer, making compliance with the tax system harder and more expensive.
Changes to the taxation of residential rental housing: Investment in residential rental housing stock represents $213 billion. This is approximately five times the size of the New Zealand stock exchange.
Despite the size of this investment market in global terms no tax is paid, but in fact, refunds of tax between $150 million and $200 million occur. It is often said that special tax rules exist for property.
This is not correct. It is simply that property is easily understood by investors, is able to be geared and the resultant interest on borrowings is fully deductible against rental income, as is various other expenses including non-cash expenses such as depreciation.
Various ad hoc measures have been considered such as the denial of these interest deductions, depreciation, the ring fencing of losses from rental property against other income and also the tax on profits on sale of rental homes sold within two years.
Risk-free return method (RFRM) on rental housing: Like the ghost of Jacob Marley rattling his chains, the RFRM method of taxation has resurfaced after its failure to launch from the 2001 McLeod tax review.
Instead of taxing the owner of rental housing on gross rents and allowing a deduction for expenses, an imputed income is calculated by applying a risk-free rate to the net equity that the owner holds in the property each year.
The Inland Revenue discussion document bravely suggests that RFRM should apply to owner-occupied housing (that is your family home) as well as to rental investments.
Changes to the thin capitalisation rules: Thin capitalisation is a tax planning technique. Essentially it involves the choice that exists in how to fund a business operation.
If you take a company, it can be either funded by share capital (equity) or loans from shareholders, or finance from a third party such as a bank. Let's call the investors, who were either shareholders or lenders, the stakeholders.
When the company makes a return to the stakeholders it will either be paid as a dividend, after company tax has been paid, or as interest which is tax deductible to the company (a pre-tax return to the stakeholders).
If the lender is a non-resident, then the maximum New Zealand tax would be either a 2 per cent Approved Issuer Levy or non-resident withholding tax (and either a 10 per cent or 15 per cent rate).
The current rules say if a non-resident controls a New Zealand-based entity, then the maximum amount of debt that can be introduced to the entity is no more than 75 per cent of the entity's assets.
The proposal being considered is to reduce this threshold from 75 per cent to 60 per cent.
This change, which predominantly affects overseas investment in New Zealand, is estimated to raise $177 million of revenue. Other proposals were discussed, but the ones listed above are the ones that will receive the most consideration.
The big question now is what is both desirable and politically achievable for the Government in its last two budgets before the next election.
Craig Elliffe is the Professor of Taxation Law and Policy at the University of Auckland, Business School, and a consultant to Chapman Tripp, barristers and solicitors. Any opinion expressed in this article is that of the writer and not the University of Auckland or Chapman Tripp.