Perhaps the main argument advanced for having a capital gains tax (CGT) is fairness.

Obviously the rich, by definition, have the most capital and almost by definition make the most capital gains. The rich pay more under a CGT and this is seen as fair.

On the other hand, already the highest earning 3 per cent of individuals pay 24 per cent of net income tax and 40 per cent of households pay no income tax taking into account family support.

How far do you push the extent to which the services provided by Government that we all enjoy are funded by a small group of taxpayers?

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When does this become unfair? Depends on your point of view.

Aspects of the design of a CGT can seem more clearly fair or not.

If New Zealand were to tax capital gains at full rates with no account for inflation, then New Zealand would stand out in the world as having a very harsh tax system. That would seem unfair.

If gains were taxed but losses were not able to be deducted, that would seem unfair. Both seem to be suggested by the Government-appointed Tax Working Group.

The group is to report to the Government this month. The Government tasked the group with recommending improvements to the structure, fairness and balance of New Zealand's tax system.

Based on the interim report released in September, when CGT comes in, the entire gain will be taxed at the marginal tax rate of the taxpayer. For individuals, it is likely most gains will be taxed at 33 per cent.

The first question is whether taxing 100 per cent of the gain at the full marginal tax rate is fair.

Australia, Canada, South Africa, the UK and US do not provide such a harsh regime. Most countries either tax only a portion of the gain or tax the full gain, but at a lower rate. That is, most countries provide relief to take into account the effect of inflation, potential double tax or to reduce other unwanted side effects of a comprehensive CGT.

Inflation is a big issue. Consider someone who brought some land for $1 million 10 years ago. Today, after 10 years, they sell the land for $1.2m, under the proposed CGT regime they pay $66,000 in tax being 33 per cent of the gain. If inflation was running at 3 per cent, the inflation-adjusted value of that land should be $1.34m.

Has the taxpayer made a gain of $200,000 or lost $140,000? That is, to buy the equivalent land in today's dollars the taxpayer will need $1.34m. However, they have only $1.134m after they have paid the tax on the $200,000 "gain".

Most countries recognise that taxing the actual gain is not fair, rather the gain that should be taxed is reduced, partly to adjust for inflation.

Another key issue with a capital gains tax is how you treat capital losses.

Deputy Prime Minister Winston Peters has been recorded as saying CGT is not fair if capital losses are not allowed to be offset against ordinary income. Many countries that tax capital gains also ring fence (or defer) capital losses so they can only be offset against subsequent capital gains, not against ordinary income. This results in very unfair outcomes.

Consider a taxpayer who builds up capital or cash savings from employment income.

That employment income has all been taxed. They cease employment and buy a business with their accumulated tax-paid capital. The business loses money and they sell, resulting in a large capital loss. They then recommence employment to rebuild their capital base.

If the capital loss is not allowed to be offset against their ordinary income, when they recommence employment income, they are paying full tax with no recognition of the capital losses. This is the unfair treatment that Mr Peters was presumably referring to.

If there was no ring fencing of the capital losses, they would pay no tax when they recommence employment given the existence of the capital losses.

To address this fairness issue, the proposals in the tax working group's interim report is to have no-loss ring fencing, namely a capital loss can be offset against either capital gains or the ordinary income of the taxpayer. This makes the regime fairer.

This is the right answer. However, if I were the Minister of Finance, I would require capital losses to be ring fenced.

The simple reason is the fiscal risk of having no-loss ring fencing rules.

This is a difficult design issue — have no-loss ring fencing rules, making the CGT fairer, but allow many NZ corporates, multi-national corporates and high net wealth individuals to stop paying tax they currently pay in the years when an investment goes south?
It is not clear whether the group would still support a CGT if the Minister of Finance required losses to be ring fenced.

If they progress a comprehensive CGT, on balance I think they must allow capital losses to be offset against ordinary income (ie no ring fencing) so the regime is fairer. Along with that comes a significant fiscal cost. Luckily, I am not the Minister of Finance.