More to Tax Working Group than Capital Gains Tax

Although intertwined with the issue of capital gains, finding a fairer treatment for retirement savings is arguably the most important objective for the TWG, says Terry Baucher


Rather like Dug in Up almost all the commentary around the Tax Working Group’s (TWG) interim reporthas chased the squirrel of capital gains tax (CGT).

Although probably inevitable, the focus on CGT risks overlooking some of the other issues analysed in what is probably the most comprehensive overview of New Zealand’s tax system in nearly thirty years. These other issues would include land tax, GST and retirement savings.

Although a final decision on the optimum approach to taxing capital gains will wait until the TWG’s final report next February, the Government has accepted that the TWG need not carry out further analysis of areas such as wealth tax, land tax, changes to New Zealand’s petroleum and minerals royalty regimes, GST coverage and a financial transactions tax.

I am very surprised that a land tax is completely off the table, particularly after the Victoria University of Wellington Tax Working Group came out strongly in favour of it in 2010. Reading between the lines, the TWG appears to have decided the politics of a land tax are even more difficult than those around a CGT.  Conversely, given the general tenor of the TWG’s comments on the issue of taxing capital, removing the land tax option probably increases the likelihood of either a CGT or taxing capital based on a risk-free rate of return being recommended.

No change for GST

On the other hand it is no surprise that the TWG isn’t recommending changes to the current GST framework.  The arguments for exempting food from GST are pretty comprehensively demolished by the following graph illustrating the average weekly benefit for each income decile resulting from removing GST from food:

In order to achieve this benefit, the TWG estimates an exception for food and drink would reduce the GST take by $2.6 billion. As the group notes, if that amount was instead redistributed, each household would receive $28.85 per week, or practically double the benefit of a GST exemption for the lowest two deciles. As the TWG concluded other measures than an exemption, such as welfare transfers,  would be likely to produce greater benefits for the same cost.

This point is also borne out when considering an alternative measure, an across the board cut in GST from 15% to 13.5% costing $2 billion annually. The result was indentical to that for introducing a GST exception; there were significantly greater benefits to households in the highest income decile.

The TWG then compared a GST rate reduction with two alternative measures: a tax-free threshold of $7,000 and halving the lowest tax rate from 10.5% to 5.25%.

The conclusion was that based on percentage of income, reducing the GST rate to 13.5% would provide greater benefits to households in the lowest income decile when compared with the suggested income tax changes. However, there were fewer benefits for households in deciles 2-9 and households in the highest income decile would be the biggest winners.

The TWG therefore decided against recommending a reduction in GST rates, suggesting instead:

“If the Government wishes to improve incomes for very low-income households, the best means of doing so will be through welfare transfers.

If the Government wishes to improve incomes for certain groups of low to middle income earners, such as full-time workers on the minimum wage, then changes to make personal income taxes more progressive may be a better option.”

As part of its review the TWG looked at whether financial services such as bank fees should be brought within GST and eventually determined “there are no obviously feasible options for doing so.”  Instead, the TWG proposes the Government should monitor international developments.

The TWG also dealt briskly with the idea of a financial transactions tax (or Tobin tax) on tax on the purchase, sale, or transfer of financial instruments. This was proposed by ‘many submitters’ on the basis of improving market stability and discouraging speculative trading. The TWG concluded:

“The revenue potential of a financial transactions tax in New Zealand is likely to be limited, due to the ease with which the tax could be avoided by relocating activity to Australian financial markets…A financial transactions tax is an inefficient tax that is unlikely to raise significant revenue for New Zealand.”

The door isn’t completely shut on a financial transactions tax, with the TWG recommending the ongoing international debate on the issue be monitored.

Changes ahead for KiwiSavers?

In many ways it’s appropriate Sir Michael Cullen is chair of the TWG as his imprint lies directly and indirectly across the current treatment of retirement saving.  Sir Michael was part of the Fourth Labour Government’s radical overhaul of savings in the late 1980s which adopted the present Taxed – Taxed – Exempt’ (TTE) basis for retirement savings. In 2007 as Finance Minister in the Fifth Labour Government he introduced KiwiSaver and the Portfolio Investment Entity (PIE) tax regime.  Both, were, more than a little ironically, measures aimed at redressing some of the issues which emerged in the wake of the adoption of the TTE regime.

The report’s review of KiwiSaver begins with an interesting analysis of the impact of inflation on taxation. The report observes:

“Although inflation is currently low, nominal interest rates are also low; this has made inflation a larger component of the nominal interest rate and therefore increased the real effective tax rate on debt.”

The effect of inflation is illustrated in the following table:

Table 7.2: The future value of $1,000 invested today after 30 years
No tax Tax real income Tax nominal income
17.5% 28% 17.5% 28%
Future value of $1000 in 30 years $4,322 $3,719 $3,396 $3,362 $2,889
Effective tax rate on nominal income N/A 10.5% 16.8% 17.5% 28%
Effective tax rate on real income
(after taking account of inflation)
N/A 17.5% 28% 29.2% 46.7%

The report concludes that the member tax credit offsets the impact of taxing nominal income for KiwiSaver members earning up to approximately $100,000 per annum.  Above that level of income the member tax credit’s effectiveness diminishes.

As the TWG report notes the TTE basis of taxation was, and remains, a significant divergence from the ‘Exempt – Exempt – Taxed’ (EET) basis common in many OECD countries.  However, reverting to EET would be a very expensive move: the report estimates the annual fiscal cost of doing so would be at least $2.5 billion initially.

Even with strict limits on contributions most of the tax benefits of moving to an EET system would flow through to high-income earners.  The TWG, rightly in my view, considers there is “little value in providing incentives to high income-earners, who are likely to be saving adequately in any case.” (Part of the reason for high income-earners being better savers is that they are more likely to be property owners).

This background of inflation and the potentially expensive and regressive risks of saving concessions led the TWG to:

“Focus on options that are targeted towards low- and middle-income earners – which, in turn, will disproportionately benefit women (who are more likely than men to be on lower incomes, due to part-time work or time out of the paid workforce for caring responsibilities).”

The TWG’s two main proposals are therefore:

  1. Remove the Employer Superannuation Contribution Tax (ESCT) on the employer’s matching contribution of 3% of salary to KiwiSaver for members earning up to $48,000 per year; and
  2. Reduce the lower PIE rates for KiwiSaver funds by five percentage points each.

The ESCT proposal would reverse the change introduced in the 2011 Budget and revert the treatment of employer contributions back to what it was when KiwiSaver was established at an estimated annual cost of $180 million. The reduction in PIE rates for KiwiSaver funds would cost a modest $35 million annually.

The TWG also considered the implications for KiwiSaver funds of taxing gains on New Zealand and Australian shares, a matter raised by National MP Paul Goldsmith in Parliament last week. The measure would impose tax of approximately $15 million per annum for those KiwiSaver members with income below $48,000, far outweighed by the proposed changes.

However, the change would cost approximately $45 million per annum for higher income KiwiSaver members.  As a counter to this, the TWG suggests the member tax credit could be increased from its present 50 cents per dollar to 60 cents per dollar at an annual cost of $190 million.

Although intertwined with the issue of capital gains, finding a fairer treatment of retirement savings is arguably the most important objective for the TWG. This is because there are now almost 2.9 million KiwiSaver members, 1.3 million (46%) of whom are under the age of 35.

The sums involved with KiwiSaver are large and growing: in the twelve months to August 2018 employer and employee contributions exceeded $5.4 billion with Member Tax Credits contributing a further $785 million. Employees and employers contributed a record $612 million in August 2018 alone.

The TWG proposals for retirement savings therefore will have a significant impact for a large and growing number of New Zealanders long into the future. The interim TWG proposals are modest but do represent a positive step forward. More than just property owners will be watching and awaiting the TWG’s final recommendations.

Capital Gains Tax? ‘Yeah, nah, definitely, maybe’

Terry Baucher hopes to see the Tax Working Group signal a break from the past, either in the form of a Capital Gains Tax or something else such as a land tax

Does the news that the Tax Working Group’s interim report due very shortly won’t specifically recommend a capital gains tax (CGT) mean it will be the fifth such group in the past 50 years to have considered the issue before concluding “Yeah, nah”?

Not yet. Firstly, this is an interim report which is intended to invite further commentary on the TWG’s initial proposals. This is broadly similar to the process followed by the McLeod Tax Review in 2001. My understanding is that the interim report will analyse in some detail not only the merits or otherwise of a CGT but also how it might work in practice. It will probably be the most comprehensive review of the issues around CGT since the Consultative Document on the Taxation of Income from Capital in 1990.

Although the issue of CGT is dominating attention, the TWG has a very wide brief and its interim report will examine other issues such as the overall design and fairness of the tax system, environmental taxes, the taxation of savings, GST exemptions for particular goods, the taxation of companies and multinationals, the possibility of a land tax and taxpayer rights in dealing with Inland Revenue. The resulting report will be substantial and is probably likely to run to over 200 pages. Yet, for all that the focus will be on the TWG’s proposals around the taxation of capital.

Rather like Banquo’s Ghost the issue of CGT has been an unwelcome guest for every tax review over the past fifty years. During that time the debate over CGT has developed a Groundhog Day quality to it. Every few years a review of New Zealand’s tax system is announced. Some months later, after due deliberation, a report is released which includes passages summarising the pros and cons of a CGT before concluding, somewhat reluctantly, it is not appropriate.

In between each review a major change is introduced widening the scope of income tax to include transactions previously treated as exempt capital gains. These legislative changes essentially undermine the previous review’s reasoning against a CGT. At frequent intervals, international organisations such as the OECD and the IMF will call for a CGT to address imbalances in New Zealand’s economy around housing and saving. The IMF’s recommendation in March 2017 for a CGT was just the latest such instance.

Meantime, as if thumbing their noses at each tax review’s arguments against a CGT, the list of countriesintroducing capital gains tax legislation grows: Canada in 1972, Australia in 1985 and South Africa in 2001.

This rather pusillanimous pattern began with the Ross Committee in 1967 which after declaring “On grounds of equity there is strong justification for taxing realised capital gains,” concluded “we have finally decided against such a recommendation”. The Ross Committee was followed in 1982 by the McCaw Task Force, which opined “The Task Force considers that failure to tax real capital gains is inequitable in principle, and is seen by many to be so.” Ultimately, the McCaw Task Force was “not convinced of the need for a separate capital gains tax, does not propose its introduction, even though capital gains are being made by some which should in principle be taxed.”

The McLeod Tax Review in 2001 detemined “New Zealand should not adopt a general realisation-based capital gains tax. We believe that such a tax would not necessarily make our tax system fairer and more efficient.” It then proceeded to hedge its bets by adding; “Nevertheless, we also remain of the view that the absence of a tax on capital gains does create tensions and problems in specific areas.”

In 2010 it was the turn of the Victoria University of Wellington Tax Working Group. In time-honoured fashion its report concluded:

“The most comprehensive option for base-broadening with respect to the taxation of capital is to introduce a comprehensive capital gains tax (CGT). While some view this as a viable option for base-broadening, most members of the TWG have significant concerns over the practical challenges arising from a comprehensive CGT and the potential distortions and other efficiency implications that may arise from a partial CGT.”

And yet, despite all this previous consideration and rejection, another tax review finds itself confronting the CGT issue anew. There are several key factors as to why this pattern endures but three merit closer review.

Firstly, in the absence of a comprehensive CGT, there is presently no clear legislative framework to deal with the taxation of capital gains in general and the arrival of completely new asset classes such as cryptocurrencies like Bitcoin. This results in confusing uncertainty as some taxpayers report gains as income whilst others treat the gains as tax free. Although issues still arise in other jurisdictions with capital gains regimes, investors know that returns will be taxed either as income or under the relevant CGT regime.

By contrast investors in cryptocurrencies are presently unsure about whether gains are taxable or exempt. This all-or-nothing approach understandably tempts investors to treat gains as tax free sometimes on the most dubious of grounds. Even though the bright-line test relating to sales of residential property has been law now for almost three years, there appears to be widespread non-compliance.

Secondly, as every tax review has acknowledged to varying degrees, the present tax treatment of capital is inequitable and creates unfairness. Differing tax treatment applies to different classes of assets leading to what the 2010 review called ‘incoherence’. The TWG’s brief includes reviewing the overall fairness of the system and in this regard the background issues paper noted that “real property held for more than two years (soon to be five) is undertaxed relative to other investments when there are capital gains”. Since peaking at 73.8 % in 1991 home ownership has fallen steadily to 63.2% in 2016. This means those substantial untaxed capital gains are being derived by fewer people.

Separate from the issue about unfair tax treatment the TWG is also considering the issue of wealth inequality. A background paper on the taxation of capital Income and wealth commented:

“Something that may not have been given enough attention in the discussion until recently has been that wealth ownership has a very skewed distribution, and reducing the tax on capital income may have contributed an increasing level of inequality in many developed countries in recent years.”

This combination of growing wealth inequality and favoured tax treatment for some assets, most notably property, means that the issue of a CGT is unlilkely to fade away even if the TWG decides not to recommend it.  At some point the nettle must be grasped either through a comprehensive CGT or some other tax such as a land tax.

Finally there is plain simple self-interest. Not just of groups such as the NZ Property Investors Federation but of our elected representatives. As Thomas Coughlan pointed out earlier this week currently 113 MPs own 306 properties between them or an average of 2.6 each. At a time of falling home ownership only seven MPs do not own any property meaning property owners are greatly over-represented in Parliament. Even if the TWG does recommend a CGT, getting it into law will require a large number of MPs to decide their self-interest in getting re-elected outweighs their pecuniary self-interest.

We’ll know in a few days whether the present TWG is proposing to break the pattern of fifty years or whether we’ll find ourselves re-hashing the same arguments in 10 years time. I’m hopeful that we will see the TWG signal a change of approach, either in the form of a CGT or some other mechanism such as a land tax. For now it’s a question of wait and see.