Brian Fallow: Getting best out of tax goose

You can change the tax laws but the laws of arithmetic, alas, are immutable.

And they ordain, of course, that a dollar of revenue forgone by way of business tax relief is a dollar not available for personal income tax cuts or for Government spending.

This truism is relevant when it comes to appraising Tuesday's long-awaited business tax review because it means vital elements of the calculation are missing.

We don't know how much money will be up for grabs and we don't know how much of it will be earmarked for the submerged part of the iceberg - changes to personal taxation.

It makes little sense to do one without the other but, at the same time, it amplifies the fiscal cost.

It is a review of business taxation, not corporate taxation. Many businesses are not incorporated and belong to sole traders. A lower company tax rate is no use to them.

Where there is a company structure, the corporate tax rate is the final rate only for overseas owners; for New Zealand shareholders the imputation rules mean the final rate of tax is their personal marginal rate.

Then there is the increasing use of trusts to shelter business income.

The wider the gaps between these rates the more incentive and chance there is for arbitrage and tax planning, the more likely decisions will be made for tax rather than fundamental economic reasons and the greater the deadweight costs will be.

Sir Roger Douglas's tax reforms in the 1980s got some things egregiously wrong, notably the taxation of savings. But one thing he got right was to align the company, trustee and top personal rates.

The Labour Government's introduction of a top rate of 39c in the dollar, combined with the effects of fiscal drag from having thresholds that are not adjusted for inflation, has created a kind of trap for itself.

Half of the personal income tax take comes from the 12 per cent of taxpayers with incomes over $60,000 and personal income tax in turn represents nearly half of the Government's total tax revenue.

Consequently any significant tax relief for that group would bite deep into the Government's revenue.

But cutting business taxation without cutting tax for that group of individual taxpayers would rest on the rickety premise that you can separate the taxation of businesses from the taxation of their owners.

You can - but the gains are ephemeral, better than nothing but no substitute for the real thing.

True, every OECD country except Mexico has a top personal tax rate which is higher than its corporate tax rate and New Zealand's 6 percentage points gap is one of the smallest.

But that is because most of them have lower company tax rates than we do and, more importantly, the thresholds for the top personal rates are generally much higher, relative to the average wage.

In New Zealand, the top rate of 39 per cent kicks in at 1.4 times the average wage; the OECD average is 5.4 times.

"At first glance, it might seem that a moderate reduction in the company rate to 30 per cent should not create greater problems for New Zealand than those faced in many other countries," the discussion document says.

"However, other countries also have features in their tax system which help to protect them from exploitation of the difference between tax rates."

Those features to buttress the tax base, Finance Minister Michael Cullen said on Tuesday, were pretty unappealing when you looked at them close up.

So it is unsurprising to learn that officials have briefed Revenue Minister Peter Dunne on a proposal to combine a reduction of the company tax rate to 30 per cent with a corresponding reduction in the top personal rate to 36 per cent and a rise in the trustee rate also to 36 per cent.

Another dilemma the Government faces is that while there is a clear global trend towards lower corporate tax rates and tax burdens, New Zealand is unusually heavily reliant on corporate taxation.

In the fiscal year to June 2006, corporate tax was expected to bring in $9 billion, 19 per cent of total tax revenue and a hefty 5.7 per cent of gross domestic product.

The OECD average is 2.5 per cent of GDP.

Together, the taxation of personal incomes and company profits provides nearly two-thirds of the tax revenue; a high proportion by OECD standards.

In part that reflects a good feature of the New Zealand tax system.

We fund superannuation, health care, unemployment and other welfare benefits out of general taxation, not from social security type taxes.

Such taxes widen the tax wedge on labour, that is the gap between what it costs to employ someone and his or her take-home pay.

It is no coincidence that European countries where that wedge is particularly wide also have high rates on unemployment.

The discussion document rejects out of hand a payroll tax which would have widened the wedge.

This is a good, if unsurprising, call.

Apart from the difficulties of designing such a tax (Australian varieties have various anomalous carve-outs), it never seemed plausible that a Labour Government would introduce a tax on labour to fund lighter taxation of the returns to capital.

But the Government has also dismissed other measures which might have offset the fiscal cost of deeper cuts to the company tax, like an increase in GST or a capital gains tax.

All else being equal, lower rates require a broader base.

The all else in this case is Government spending - and the electorate has been fairly clear it does not want to see a contraction of public services - and the debt target. Cullen and Sir William Birch, deserve credit for reducing, while the demographics are favourable, the amount of public debt, relative to GDP at least, which future taxpayers will have to service.

So the price of significant cuts in company and income tax rates would have to be a significant broadening of the tax base.

The Government last December squandered an opportunity to do that with its decision to scrap the carbon tax. It would have intercepted economic activity across a broad front and been difficult to avoid as it applied to metered, physical quantities.

That leaves a capital gains tax. Most developed countries have one.

The introduction of GST here and in Australia shows that the public will tolerate new taxes if the simultaneous cuts to existing ones are big and broad enough.

What we are left with is a tax system dangerously concentrated in two areas, corporate tax and the taxation of the best-paid eighth of the population.

The fiscal danger is that we are heavily dependent on imported capital and the global trend is to tax it less.

And people who are, or more importantly can realistically aspire to be, in the top tax bracket are also most likely to have skills that are in international demand.

But, in the meantime, the Government's strategy seems to be to settle for ever so slightly smaller golden eggs.