Does it make sense to impose a capital gains tax on an economy which is capital-shallow and has the hobbled productivity and modest incomes which result?

That is the question the Government needs to ask itself when the Tax Working Group chaired by Sir Michael Cullen delivers its final report in the next few weeks.

Its interim report indicates that it is likely to recommend an extensive expansion of the range of capital income that should be taxed, and at the taxpayer's full marginal rate.


To start with the bleeding obvious, income has to be earned before it can be taxed.

As a nation and as a people, we are not particularly good at that.

On the crucial measure of labour productivity (output per hour worked) New Zealand ranks with Slovakia, Slovenia, Israel and Turkey — not the international peer group to which we normally aspire — and is 20 per cent below the OECD average.

The reasons for this chronic underperformance are manifold and complex, but a crucial one is capital shallowness, or too low a ratio of capital to labour.

This is capital in the economists' sense of a factor of production — essentially the machinery, software and premises firms provide to their workers in order to produce the goods or services they do.

Statistics NZ tells us that since 1996, capital deepening — the rate at which the capital-to-labour ratio improves — has been running at half the pace recorded across the Tasman.

That helps explain why the average Australian produces one-third more per hour worked than the average New Zealander and why so many Kiwis now live there.

Another, broader indicator tells a similar story.

According to the national accounts, gross fixed capital formation (excluding residential building) has been growing pretty much in line with gross domestic product since the turn of the century.

That's not good enough when we started from well behind the international pack for productivity and certainly not a pace you would want to see slacken.

So policymakers need to be wary of changes to the tax system which would make this situation worse by taxing the returns to capital harder than they already are.

And how hard is that? Well, the OECD released new data on corporate taxation this week, which shows New Zealand in the top quartile of OECD countries for both the statutory tax rate and average effective rate.

And we have the highest ratio of corporate tax revenue to GDP of any developed country.
The stock response to this from officials is that the high rate of corporate taxation is mitigated by dividend imputation.

Most countries treat all of a dividend as taxable income. But in New Zealand a dividend comes accompanied by a tax credit for the shareholder's share of company tax paid.

For New Zealand shareholders, the company tax is in effect a withholding tax.

The Tax Working Group does not propose changing that.

But it raises the problem of potential double taxation of retained earnings if capital gains on the sale of shares or business assets become taxable.

If a company retains tax-paid profit in order to grow the business, that should increase the value of its shares. If that increase in value is a taxable capital gain, in effect there is double taxation.

The risk is that this would shift companies' dividend policy in the direction of more distributed and less retained earnings — exactly not what a capital-shallow economy needs.

"It is unclear how much of a problem this will be in practice," says the officials' advice on this.

"Inland Revenue data shows that public companies distribute most of their imputation credits every year, so they are not accumulating large amounts of undistributed taxed income. But private companies are accumulating large amounts of undistributed taxed income, probably because of the additional tax that would be imposed if the income were distributed to shareholders on the 33 per cent income tax rate." So the interim report devotes five pages to possible ways of addressing this problem.

Suffice to say they are the kind of thing that would make tax accountants' eyes light up, and anyone else's eyes roll.

Officials conceded that "Both of these options are likely to be complex, and perhaps even impractical, for widely held companies. Double taxation may therefore represent an important efficiency cost for widely held companies."

There is little international precedent to draw upon in addressing this issue, they say.

Australia — one of the few other countries to have imputation (franking) credits — does not have any rules to address this issue, "although this may reflect the fact that the rate of capital gains tax on Australian shares tends to be relatively low."

By contrast, the Cullen review is expected to recommend that capital gains be taxed at the same rate as other income.

That would be an exceptionally harsh provision, and of a piece with the exceptionally harsh tax treatment of retirement savings vehicles since the late 1980s.

Since Sir Roger Douglas introduced the taxed-taxed-exempt (TTE) regime, we have had a tax system which says to people: "If you want to provide for your old age, don't save money. If you do they will tax you every step of the way.

"Instead, borrow money, use it to bid up the price of housing. Then watch leverage amplify the gains in your equity in what is almost always a rising market, while enjoying tax-free imputed rentals if you are an owner-occupier, or interest deductions if you are a landlord."

We are left with a chronically negative household saving rate. Most years households collectively spend more than their disposable income.

The fiscal costs of scrapping TTE in favour of something more internationally normal are apparently considered prohibitive.

And on the other side of that fundamental imbalance, no Government dares tamper with the tax advantages of owner-occupied housing.

The tax and gearing advantages of investment properties are already being reduced, at least, by the bright line test, ring-fencing of tax losses and by the Reserve Bank's loan-to-value ratio restrictions.

So now we face the risk of tax changes that target the productive sector and will discourage the capital deepening we badly need more of.