Sinclair Davidson: Belief NZ is a low-taxing country a myth

Income tax is an emotive issue. Much debate about it is based on beliefs that have little basis in reality.

One such myth is that New Zealand is a low-taxing country. Recently, some commentators have misinterpreted OECD studies of income taxes paid by average production workers in OECD member countries as indicating that New Zealand's overall tax burden is relatively small.

Another myth was typified by a 1998 comment by economist Keith Rankin: "Privileged people are using high taxes paid by low earners to justify further tax concessions for themselves."

My research - released today in a New Zealand Business Roundtable study Personal Income Tax in New Zealand: Who Pays and Is Progressive Taxation Justified? - shows that New Zealand is,in fact, a relatively high-taxing country and that the so-called "rich" pay a disproportionately high share of tax.

Tax comparisons are often ambiguous because of differing definitions of tax and social security contributions. The unweighted ratio of tax to GDP (gross domestic product) for OECD countries as a whole was 36.3 per cent in 2002. Compared with our ratio of 34.9 per cent, it would be easy to conclude that New Zealand is a relatively low-taxing country.

However, using unweighted averages disguises the full extent of a country's tax burden. The OECD consists of 30 economies. Some are large with low tax rates, but many are small with high tax rates. Using unweighted averages means the average tax-to-GDP ratio is biased upwards.

When the average OECD ratio is weighted for population and GDP, a more accurate picture emerges. The average OECD tax take is 31.2 per cent if weighted for GDP while, on a population-based weighting, it is 30.9 per cent. New Zealand's 34.9 per cent appears in a new light.

The difference in tax burdens is even bigger if the comparison is restricted to English-speaking countries. On an unweighted basis, the average tax take of these countries is 31.8 per cent. Based on a GDP weighting, the average falls to 28.3 per cent; on a population basis, the average is 28.7 per cent.

The ratio of government spending to GDP is arguably an even better indicator of the tax burden than the tax ratio. This indicator tells a similar story: for 2004, the OECD puts New Zealand's ratio of general government total outlays (including local government) to GDP at 38.7 per cent, above Australia (36.2 per cent), Ireland (35.8 per cent) and the United States (35.2 per cent). The dynamic countries of the Asia-Pacific region have much lower ratios.

In addition to the overall burden being relatively high, New Zealand's top marginal tax rate cuts in very quickly at an income level of 1.2 times average per capita GDP. This compares unfavourably with nations such as the US at 8.5 times per capita GDP and Singapore at 9.5 times.

The way tax is collected is itself highly skewed. Analysis of Treasury data disproves the perception that the so-called "rich" do not pay their fair share. The tax burden is actually concentrated in households at the top of the income distribution. The top 10 per cent of households pay almost as much in tax as the next decile earns in income.

In 2004-05, the top 2.58 per cent of taxpayers paid 24.07 per cent of personal income tax. These taxpayers pay 9.33 times more in tax than their population share.

In comparison, between 40 and 60 per cent of households receive more in government benefits than they pay in tax. People earning less than $40,000, who make up 79 per cent of the taxpaying population, pay only 33 per cent of all income tax.

It is not surprising that individuals and households with higher income levels pay disproportionately larger amounts of tax because New Zealand operates a progressive taxation system. This means the tax rate rises as income rises.

Many have come to believe that progressive taxation means "fair" taxation. However, the 2001 Tax Review, chaired by Rob McLeod, noted that philosophical arguments can be made for and against progressive and proportional tax systems - and that each can be described as "fair".

The most sophisticated argument for progressive taxation is that it involves equality of sacrifice. The idea is based on the proposition that the "rich" value their last dollar less than the "poor" value theirs. On these grounds, the "rich" can be taxed more than the "poor" to equalise the tax burden. I show in my study that economists - including former defenders of the principle - have savaged this line of reasoning. It is based on false assumptions and is inconsistent with observed behaviour.

Under a progressive tax system, "fairness" tends to be defined according to whatever the current rates are. However, this means any share of tax paid could be considered "fair". A progressive system of taxation is arbitrary and will, therefore, always be politically unstable.

If "fairness" is defined as proportional taxation, it is clear that New Zealand's system is not fair: higher-income individuals and households are paying far more than the proportion of income they earn.

Other ad hoc arguments for progressive taxation are equally unsatisfactory. In a Herald article in January this year, University of Chicago law professor Richard Epstein questioned why a government would bother with the complexity and inefficiency of a progressive tax.

A US tax commission headed by former congressman Jack Kemp put it well: if one taxpayer earns 10 times as much as his neighbour, he should pay 10 times as much in taxes. Not 20 times as much - as he would with multiple and confiscatory tax rates. Not five times as much - as he might with special loopholes. Ten times as much income, ten times as much tax. That's the deal.

A growing number of ex-Soviet Union and former Eastern bloc countries, as well as Hong Kong and Singapore, have adopted flat or almost-flat taxes.

In the popular debate on tax, facts and statistics are often casualties. The empirical evidence is not consistent with the belief that New Zealand is a low-taxing country: this is only true relative to the high-taxing and stagnant economies of Western Europe. The income tax burden is not falling disproportionately on middle-income earners and the poor.

On the basis of myths about taxation, some people continue to argue that New Zealanders can and should pay more in tax. In a democracy, everyone is entitled to their own opinion. They are not, however, entitled to their own facts.

Taxing matters

* Tax comparisons are often ambiguous because of differing definitions of tax and social security contributions.

* The OECD puts NZ's ratio of general government total outlays (including local government) to GDP at 38.7 per cent.

* That's above Australia (36.2 per cent), Ireland (35.8 per cent) and the US (35.2 per cent).

* In addition to the overall burden being relatively high, NZ's top marginal tax rate cuts in very quickly at an income level of 1.2 times average per capita GDP.

* This compares unfavourably with nations such as the US at 8.5 times and Singapore at 9.5 times.

* Sinclair Davidson is an associate professor at RMIT University, Australia.