COMMENT:

Heard the one about the tourist on the backroads of Ireland, who stopped to ask a local how to get to Ballymacpeake?

"Ah, if I was going to Ballymacpeake, I wouldn't leave from here." Yes, the old ones are the best ones.

However defensible a broader capital gains tax may be as a destination for tax reform — both in theory (real capital gains are income) and on equity grounds — policymakers cannot ignore where we are starting from.

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And that starting point is an economy with a business sector that is capital-shallow and which (at least partly) as a consequence suffers from chronically low productivity and therefore incomes.

Output per hour worked in New Zealand puts us on a par with Slovakia, Slovenia, Israel and Turkey in the OECD league table. Labour productivity is one-third higher across the Tasman, not because Australians are smarter or harder-working but because they have a lot more capital invested per worker.

It is a problem that tax reform should try to reduce, not exacerbate.

The starting point is also a tax system which already taxes capital income harder, and labour income less, than people tend to think.

As economist Andrew Coleman, who divides his time between Otago University and the Treasury, argues in a trenchant critique of our eccentric tax system, New Zealand is unusual in not having social security taxes (unless you count ACC), which are normally imposed to fund the state pension.

On the OECD's latest numbers for the "tax wedge" on wages, when both income tax and social security contributions are included, a New Zealander on the average wage is the second lowest-taxed among the 34 countries listed (Chile is lower).

By contrast, New Zealand ranks in the top quartile of the OECD for both the statutory corporate tax rate and the effective average corporate rate, when they adjust for various tax breaks.

The tax working group says that this ignores an atypical feature of the tax system, dividend imputation, which means that distributed company profits come with a credit for the shareholder's share of company tax paid.

On that basis, it says, the tax rate for domestic shareholders is the sixth lowest in the OECD.

NZ businesses could perform better against the global competition, if they had access to more capital. Photo / File
NZ businesses could perform better against the global competition, if they had access to more capital. Photo / File

But Coleman argues this is misleading. The comparison is only with people in other OECD countries who are on the top marginal rate (usually higher than ours) and who pay income tax on dividend income in the same year it is earned.

In other words, high income earners who don't hold their assets in a retirement savings scheme.

New Zealand is extremely unusual in taxing the income earned by people's retirement savings as it accrues, rather than waiting until they are in a position to spend it.

The taxed-taxed-exempt (TTE) regime introduced by Sir Roger Douglas 30 years ago discourages saving and encourages borrowing to buy housing, and has contributed to exceptionally strong house price inflation and declining rates of home ownership.

The Tax Working Group's recommendations leave this onerous and highly distortionary system intact.

Meanwhile, it has been forbidden by its terms of reference to go near the most tax-advantaged, and therefore most popular, form of wealth accumulation: owner-occupied housing, or at least the family home.

"It is difficult to see how a tax system that provides incentives to over-invest in residential property will not reduce the overall efficiency of the economy," Coleman says.

"It is also difficult to see how a tax system that engineers a transfer from young generations to the land-owning members of older generations by placing upward pressure on property prices will not be regressive."

So our starting point is a household sector with a chronically negative saving rate and a business sector that is capital-shallow.

Imposing a capital gains tax on the returns to capital invested in productive enterprises is hardly going to help those enterprises get more productive.

Coleman points out that the Nordic countries, generally considered progressive, have responded to the detrimental effects of high corporate taxes by deliberately reducing taxes on capital incomes so they are lower than taxes on labour incomes.

"Most other countries have lower taxes on capital incomes than labour income by imposing social security taxes on labour incomes. Either way, New Zealand's attempts to tax labour, business, and other capital incomes (except incomes from owner-occupied housing) at similar rates has little theoretical justification," he says, "and the high taxes that businesses pay as a result may be reducing productivity levels and economic growth rates."

The working group's final report at least nods in the direction of the potential cost of taxing the returns to business investment even harder than they already are, especially for firms whose shareholders are Kiwis: "Most small to medium enterprises, however, cannot readily access international capital markets. Instead they depend on funding from domestic investors to make additional investments. Taxing domestic investors on the gains from their shares would increase the cost of equity capital for these types of companies and could reduce investment," the working group says.

It may be possible to mitigate these costs, it says, by using the extra revenue garnered to fund some productivity-enhancing reforms elsewhere in the tax system. It mentions the loss continuity rules (to support the growth of innovative start-ups), "black hole" expenditure and maybe, fiscal conditions permitting, building depreciation.

It smacks of sugar-coating the pill.

When the working group chairman Sir Michael Cullen was asked what the case is for taxing the returns to business investment harder than they already are, when the business sector is capital-shallow and labour productivity is low, he said that internationally there was no relationship between capital gains tax levels and productivity.

That hardly settles the issue.

But pointing to the long political and legislative process still ahead, he acknowledged that a government might decide to exclude "that active business class". Land-based capital gains were the main problem.