COMMENT:

The recently released Tax Working Group (TWG) report "Future of Tax" should more correctly have been labelled "Taxing our Future".

Tax is an incredibly important component of a well-functioning economy and it is good to review our tax structures periodically.

Unfortunately, rather than being a visionary document as we might have hoped, the TWG have produced a report that is economically naïve and would, in our view, shift more of the tax burden onto aspirational younger people.

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Before looking at some of the problems with the report's recommendations it might be useful to shed some light on NZ's current tax framework.

Let's start by looking at the amount of tax that New Zealanders pay. The best measure of this is the tax to GDP ratio which in NZ sits at 32.0 per cent or just below the OECD average of 34.2 per cent and above countries like Australia and the USA at 27.8 per cent and 27.1 per cent respectively.

Relative to OECD averages the NZ structure is characterised by higher taxes on personal and company income, rates about average on property taxes and contains no separate taxes relating to payroll or social security contributions. So, all in all, our overall tax burden looks about right.

Where it gets very interesting in NZ is when we look at who pays the tax. One measure is the amount of net tax paid, which is the amount of tax paid less transfer payments (like benefits, Working for Families etc).

There are many different ways to slice this but according to Treasury figures the bottom 50 per cent of households, as measured by income, pay no net taxes (that is after transfers and benefits), the top 3 per cent pay about 24 per cent of all net tax paid, and the top 10 per cent pay over 70 per cent of net income taxes.

On top of this, wealthier households often pay twice for the provision of services (for example private healthcare and education), which is not picked up in the tax numbers.

The question of whether or not the wealthy should pay more tax than this is largely a political one. The best way of levying these taxes was the focus of the TWG and the majority (3 members dissented) recommended the introduction of a broad approach to the taxation of capital gains.

NZ is unusual in not having a Capital Gains Tax (CGT). Superficially a broad CGT has great appeal in that it sounds fairer and would help capture "windfall" profits which have occurred largely in the property sector. The devil is of course in the detail and we can simply look overseas at other jurisdictions to see the problems with a CGT:

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• Almost everyone with assets or income would require a tax advisor. This would be great for financial advisors, accountants, lawyers and valuers but would add huge complexity and cost to what is currently one of the world's simplest tax systems.

• All CGT's come with significant loopholes and the very wealthy will spend a great deal of resource to minimise their tax burden. For example the Australian Tax Office reports that in one year alone 48 Australian millionaires who earned a total of $118 million and who paid accountants and lawyers $20.2m were able to legally reduce their taxable income to $0!

• Would be likely to bring in much less additional money than anticipated (due to the point above).

• Would fall heavily on the upper-middle who already pay a lot of net tax (again the very wealthy are very good at structuring their affairs), small businesses and aspirational younger people.

• Would be a real productivity burden – every business decision would need to be weighed up with a CGT lens.

• Assets would become locked up as the tax only applies when an asset is sold, so there is a real disincentive to sell assets. This is bad for the economy.

• It is hard to find a fair treatment for inflation (surely it's only fair to tax the inflation adjusted capital gain?).

• It would result in double or even triple taxation.

• Valuing all taxable assets on a certain date would be extremely difficult and would very likely be "gamed".

• Using the highest marginal tax rate to levy a full nominal CGT would make the proposed scheme one of the harshest in the world.

The theme of "fairness" comes up very frequently (54 times!) in the TWG report but this is a very hard concept to put into place with a complicated tax system. In particular what we are likely to see occur will be a tax on future generations to fund the retirement of baby-boomers, which is probably exactly the opposite of what the government would like to achieve.

Let's look at a few practical examples to demonstrate some issues:

• At Valuation Date (the date at which all assets will need to be valued for the CGT) a wealthy individual who is close to retirement, who owns a business and a number of investment properties will seek a favourable valuation of their assets. Valuation is as much an art as a science, particularly with businesses. This individual has already accumulated her assets and so will pay no tax on her current accumulated wealth. Two years later let's assume this individual sells her business to her young staff at a value 20 per cent less than the favourable valuation received. She will actually receive a tax credit now. The young staff who have acquired the business will have to pay a full CGT based on their purchase price when they in turn retire and sell the business. Likewise with the investment properties. Even if the new investors do not make any gains on the real (after adjusting for inflation) value of the business or properties they will have to pay full CGT on the inflation component.

• A young entrepreneur who, after Valuation Date, builds up a business from nothing to be worth say $100,000 and which, after paying all staff wages and other expenses earns $30,000 before tax or very roughly, to keep the numbers simple, $20,000 after tax. Most people do not understand that every business already has a silent partner, one who takes no risk and puts in no capital but takes a third of any profits every year – the Government. The value of the business when sold is already discounted to reflect the share of the profits that the Government takes each year. Under a CGT, assuming the top marginal rate, the Government will also take another tax, being a third of the sale price, and which also ignores the impact of inflation. The entrepreneur would now have only $67,000 to invest in their next venture or retirement and so may decide not to sell the business, particularly as they can earn more from the $100,000 before CGT than they can from the $67,000 post CGT. This level of taxation may put many people off starting businesses.

• The family home is to be exempt from a CGT so we are likely to see the "mansion" effect occur. This is where instead of investing in additional properties or a business, an investor will put all their investable funds into buying or upgrading the family home to avoid paying CGT.

There are numerous other problems in the proposals including the treatment of lifestyle blocks, farms, NZ shares (very unfavourable and which will drive money out of NZ and into international shares) and Kiwisaver, but it is probably not worth focusing on these issues until we know what the Government position is- this will be disclosed in April.

Politically the issue of a CGT appears to have arisen due largely to the untaxed gains which have occurred in the housing market and related to land.

There are much simpler mechanisms to achieve "fairness" in this area than a broadly based Capital Gains Tax, the burden of which which will largely fall in the years ahead on aspirational young people.

- Paul Glass is the executive chairman of Devon Funds Management.