Mary Holm: Tax rules unfair to term depositors

Property investors who deduct the inflation component of their interest payments from their profit are effectively subsidised by government. Photo / NZME

Playing field for tax calculations is far from level — subsidising some but penalising others.

With regard to a recent reply from you, I recall reading a paper by Andrew Coleman, possibly one of the wise people you were referring to, on inflation indexing of interest.

While taxing only the "real" interest - after removing inflation - would lead to a reduction in government revenue, he suggested that property investors be unable to claim the inflation part of their interest payments, which would somewhat level the playing field.

I recommend you contact him directly rather than rely on my garbled recollection. It is an eminently sensible idea.

Dr Andrew Coleman, a senior lecturer at the University of Otago Department of Economics, was indeed one of the people I had in mind. He talked about these issues back in 2010-11 when he and I were members of Treasury's Savings Working Group.

At your suggestion, I asked him to summarise his thoughts, which he has done in the following letter.

Note that when Coleman writes about lenders, he's including everyone with bank term deposits. If that's you, you might not feel like a lender. But you are actually lending your money to the bank for a period - and the bank in turn lends it to, say, a home-buyer. Take note of the way the current system treats you unfairly.

From the horse's mouth

You are correct - most economists argue as a matter of principle that interest income should be adjusted for the effects of inflation before it is taxed.

This is because the inflation component of interest income is not income - it is simply a sum that the borrower pays the lender to compensate them for the erosion of the purchasing power of their initial capital.

Just as firms deduct an allowance for depreciation from their profits before they pay tax, to reflect the way their capital is wearing out, economists argue lenders should only pay tax on the real interest income they earn, which is the difference between the nominal interest rate and the inflation rate.

Under the current tax system, someone lending $100,000 pays $350 to $660 too much tax (depending on their tax rate) when the inflation rate is 2 per cent - quite a large surcharge.

This surcharge only applies to people who lend money (typically older or less sophisticated investors using term deposits), not people who invest in shares or real estate, as the prices of these assets typically increase over time to reflect the inflation rate.

Economists also argue that if someone borrows money to make an investment, commonly rental property, they should not be allowed to deduct the inflation component of their interest payments from their profit before they pay tax. This is because the real value of their debt is shrinking, due to inflation.

If they are allowed to make this deduction, they are effectively receiving a subsidy from the government. The value of the subsidy is complicated to calculate because of depreciation issues. But the subsidy for people who borrow to invest in land - which doesn't depreciate - is probably the largest industrial subsidy left in New Zealand.

For example, if the inflation rate were 2 per cent, a farmer borrowing $2 million is reducing their taxable income by $40,000 per year more than would be allowed under an inflation-neutral system - this saves them around $13,000 tax each year.

Could the government change these rules if it wanted to?

Here economists are divided. Many argue that it would be easy to change the law so that lenders are no longer overtaxed and borrowing investors are not subsidised. They note that the net cost to the government would probably be quite small.

Others say it is quite complex to make adjustments that don't penalise business, because of the way that depreciation allowances would need changing. Maybe, maybe not.

But both probably agree that change is unlikely if the outcry by large borrowers is allowed to drown the calls for reform by the myriad lenders who each lend a small amount.

Now there's a rallying cry if ever I heard one. Term depositors arise!

In the meantime, you might want to consider putting the money you don't plan to spend for 10 or more years into shares or property, rather than leaving it all in interest-paying investments.

But it would be great to see an enlightened government considering these ideas. With inflation currently at unusually low levels, it would be relatively easy to introduce changes now.

Dare to share Loved your response to last week's letter titled "Go on, retire". And I agree with the letter-writer's $25,000 net a year to live on, which means once Super kicks in, only $10,000 a year is needed to supplement it.

I have $870,000 invested in NZX-listed shares, which after the deduction of dividend tax generates $52,000 a year of dividend income.

I am already on NZ Super, so with $52,000 of additional income to meet a need for $10,000, it would need something extreme to affect my financial position.

To obtain income greater than bank interest people need to overcome their financial conservatism and be prepared to invest in shares.

If a large enough buffer between what is coming in and what is required to supplement NZ Super can be achieved, then the vagaries of share price changes should not be of any great concern. In fact, if the buffer is large enough, it is likely the shares will never need to be sold, so the estate will be the only thing affected, and that shouldn't be of any concern to the creator of that estate.

Your letter backs up the previous Q&A.

I wouldn't suggest that most retirees - or anyone else - copy you by investing money they plan to spend within the next 10 years in shares. There's too big a chance that the value will fall over a short period.

But over a decade or more, the value of a share investment will almost certainly grow more than term deposits or bonds. And, as Andrew Coleman says above, shares and property values rise with inflation.

Your situation is a bit different, though. As you point out, you have so much more money than you need that it wouldn't really matter if share prices plunged - as long as you hold a wide range of shares in a variety of industries. You can be confident their values will rise again in due course.

However, if you have invested in just a few shares, there's too much danger that one or two companies will go belly up - and then of course there can be no recovery for those companies.

Once again, this week, we have letters from retired people in very different financial circumstances. Read on.

Costs rise and rise I did find your response in your last column to "Nest eggs compared" somewhat galling. As a retiree living alone aged 72, sole income NZ Superannuation and a very small, diminishing nest egg of $10,000 in KiwiSaver, I am accustomed to living frugally while having a happy, satisfying life, and I own my old, basic home.

My fixed costs have increased far more than the rate of inflation over the past four years. Auckland rates by 50 per cent, house insurance also doubled since the Canterbury earthquake.

And since this Government started preparing my electricity company for privatisation in mid-2012, its charges have risen by more than 33 per cent and continue to increase. Phone charges and all the other costs associated with maintaining the property have also risen substantially during this time.

It is long past time that government by corporate business board policies should have been stopped, and new policies adopted to encourage and ensure a more equitable and healthy future and environment for younger generations and future generations of New Zealanders.

Sorry if my comment to last week's correspondent - "Would it help to try to think about those worse off than yourselves, rather than better off?" - annoyed you. It's a thought I find helpful, but apparently not you - although funnily enough your concern for younger generations suggests perhaps you do think along those lines anyway.

You've certainly been hit hard by price increases. That's tough on a low income. There are, though, several ways you could make things more manageable financially:

Consider applying to Auckland Council for a rates postponement. If eligible, you can put off paying all or part of your rates, usually until you move from the property or die. When your house is sold, the rates are taken out of the proceeds, plus a postponement fee - which takes into account admin costs and the fact that you're paying later. For more on this see tinyurl.com/auckratespostponement

Check on www.powerswitch.org.nz whether you could save money by switching electricity company. This service is run by Consumer NZ.

Peruse the Consumer NZ website, www.consumer.org.nz, for info on how to save on insurance, phone and many other expenses. To get full use of that website, you need to join the organisation. It's well worth the cost.

Next week: A reader's letter describes a way to drastically reduce your cost of living in retirement. In the meantime, though, here's a letter on the costing of dying.

It's your funeral, or not The writer last week wondered how he/she would pay for a funeral. Perhaps you could point out to that person, and others, that it is not required by law, or any agency, to have a funeral.

I have found that a lot of people are unaware of this. All that is required is that the death be registered and the body disposed of according to public health regulations. There would, of course, be a cost involved in this.

However, instead of an expensive funeral in a funeral home with all the attendant costs, one could have a gathering of friends and relatives in a garden, park, home, etc, to pay respects to the deceased for no cost at all.

Thanks for pointing this out. And the Citizens Advice Bureau has some suggestions. Go to www.cab.org.nz and do a search on "funerals". There you'll find "less expensive options for a funeral", including advice on doing it yourself without a funeral director.

Note, too, that the government will give some people up to about $2000 towards funeral expenses. Go to www.workandincome.govt.nz and do a search on "funeral grant".

Pay your debts We regularly read the Weekend Herald and very much agree with the response that you gave the mother in last week's first Q&A.

Both of us thought that she had a cheek to ask you if her daughter could cash in her KiwiSaver without paying off all the debt that she left behind in New Zealand, and it sounds like she has several.

What kind of a life is the daughter going to have if this is how she manages money! She needs to attend a course on setting budgets and keeping to targets.

A really good idea. The daughter now lives in South Africa, but I'm sure there are courses there. Or perhaps her mum could send her a book about it. One way or another, if the daughter changes her ways and her attitude she's in for a better life.

Mary Holm is a freelance journalist, member of the Financial Markets Authority board, seminar presenter and bestselling author on personal finance. Her website is www.maryholm.com. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary's advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to mary@maryholm.com or Money Column, Business Herald, PO Box 32, Auckland. Letters should not exceed 200 words. We won't publish your name. Please provide a (preferably daytime) phone number. Sorry, but Mary cannot answer all questions, correspond directly with readers, or give financial advice.

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