In part one, we discussed that the cash deficits faced by the Government reflect a decision to borrow rather than cut spending or raise more revenue.

It was anticipated that an economic upturn would boost Crown revenue but the upturn has been slow to arrive. The "long term" - bringing an ageing population and associated spending commitments - is also nearly here.

It is unlikely that changes to spending, tax, or asset management alone will solve the fiscal problem: likely a combination is required. The only option we cannot consider is doing nothing: Treasury projections show a business-as-usual track is unsustainable in the long term.

Broadening the base

Fran O'Sullivan's Herald column recently suggested 10 ways to beat our snowballing debt.

On the revenue side, options included a 20 per cent GST rate, a high income surtax on incomes over $250,000, increasing excise taxes for alcohol and tobacco, and bringing in a banking profits levy.

While not a full menu, these unpalatable options are of the magnitude likely needed to put us on a sustainable fiscal track. Which to choose, bearing in mind that doing nothing is unsustainable?

O'Sullivan also highlighted that now would be the best time to introduce a capital gains tax (CGT) and/or a land tax, concluding, "It is quite simply a nonsense to continue to run a system which protects the asset-rich". She's not the only one attracted to this option; Treasury and the IRD have agreed to continue considering a capital gains tax.

Why so irresistible?

Whenever we look at improving our tax system it is predictable that capital gains tax will be raised as an option. It has been examined in 1967, 1978, 1982, 1987, 1988, 1989, 2001, and 2009-2010 by the Tax Working Group.

One reason we keep returning to capital gains tax is that the exemption for capital gains is the one, large, glaring exception to New Zealand's typical "broad base, low rate" approach to taxation. Generally we have preferred to eliminate tax breaks for particular types of income in favour of across-the-board cuts to rates.

Another is that the benefits of a capital gains tax are well known, generally uncontested, and extremely attractive. These include:

Fairness

Is there really an adequate answer to the question of why someone should pay no tax on a capital gain of $100,000 but $23,920 on their $100,000 salary? The fundamental issue here is that the burden of tax falls on only some people while others who have derived the same economic income (or gain) escape the tax net. It might be noted that those that escape this burden can usually most afford to bear it.

A strong tax system

Taxpayers currently have an incentive and opportunity to spend time and money on accountants and lawyers to characterise or convert "ordinary" income (that would be taxed under the income tax) into tax-exempt capital gains.

The IRD then has to spend time and money checking whether or not taxpayers' efforts to reap the benefit of the tax exemption for capital gains are permissible "tax planning" or impermissible "avoidance".

The courts have to rule on hard cases, and Parliament has to pass laws (as it often does) outlawing popular but revenue-draining schemes to convert taxable income into exempt capital gains.

A capital gains tax would reduce or eliminate these inefficient incentives. This would help direct investment to where the underlying asset is most productive, rather than on the basis of the tax exemption for capital gains.

Progressivity or rate cuts

Higher income taxpayers generate more of their income in capital gains. The benefit of the exemption is determined by a taxpayer's marginal income tax rate, meaning the benefit is generally greater for a high-income taxpayer than a low-income taxpayer.

This makes capital gains tax attractive to those who favour greater tax burdens for taxpayers who are more able to pay tax. Alternatively, some of the revenues generated by a capital gains tax and not used for reducing deficits could be used to cut income tax rates across the board, or the top rates. Hence the low-rate, broad-base rule of thumb that has guided previous New Zealand tax reform.

Revenue

Capital gains tax delivers tax revenues collected on capital gains. Less obviously, it increases revenues from the ordinary income tax. This is because many taxpayers who would have otherwise tried to convert or characterise taxable income as non-taxable capital gains no longer do so.

The papers provided to the Tax Working Group indicated that a capital gains tax could raise $3.8 billion per year. But in most other countries that have moved to a capital gains tax, the income turned out to be far higher than predicted (almost tenfold over a short period in Australia).

The fiscal pressures discussed earlier in this series are likely to make this aspect of a capital gains tax increasingly attractive.

Why do we keep rejecting it?

Unless we are happy with increased indebtedness to foreign nations, expanding the tax base is necessary.

The elephant in the room for the 2009-2010 Tax Working Group was the prospect of a capital gains tax and/or land tax. For more than 40 years we have debated a capital gains tax and keep throwing a sheet over the elephant.

This is not because the benefits are not recognised. Instead, we have been told that a capital gains tax is unworkable in practice, and that by the time concessions are made to practical and political reality (such as exempting owner-occupied houses) it would be too complex and too inefficient to deliver any real benefits.

The final part of this series will look at those criticisms.