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Roger Kerr

Tax Working Group Report Over-Hyped

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Following the tax reforms of the 1980s, New Zealand ’s tax system was widely regarded as one of the least distortionary in the OECD. It remained largely that way through the 1990s (although under National the personal income tax scale was widened rather than flattened with cuts to lower rates not being accompanied by cuts to the top rate, contrary to the efforts of finance minister Bill Birch). The 2001 (McLeod) Tax Review found that the tax system was in good shape.

Now, however, last week’s Tax Working Group report states that the current tax system is “incoherent, unfair, lacks integrity, unduly discourages work participation and biases investment decisions.”

What happened in the course of a decade? The answer can be summed up in two words: Michael Cullen.

The rot began with the first decision to raise the top personal income tax rate from 33% to 39%. This move was unnecessary (the government did not need the extra revenue), it increased economic costs (high marginal tax rates are most damaging to growth), and an apparently simple move increased the complexity of the system (some 50 pages of new tax legislation were needed to implement it).

Subsequent moves by the Clark-Cullen government had similar effects. The Working for Families scheme increased effective marginal tax rates, with the abatement rate of 30% (now 20%) being added to the 33% and 39% personal tax rates. Several new distortionary tax concessions were introduced, ranging from KiwiSaver subsidies to racing industry tax concessions. The Portfolio Investment Entity (PIE) schemes further fragmented the income tax system. And while the cut in company tax to 30% was a positive move, the top personal rates were not reduced at the same time, which increased incentives to shelter personal income in company structures.

Most of Dr Cullen’s moves were contrary to the advice of tax experts at the time. The criticism of them by the TWG is therefore unsurprising.

Having said that, the tenor of the TWG report is over-hyped. The structure of New Zealand ’s tax system still compares favourably with many others. Australia ’s tax arrangements, for example, are disfigured by an even wider range of tax rates, an inefficient capital gains tax, a large tax-free threshold and a GST with distorting exemptions such as food. Some of the TWG comments reflect ‘nirvana’ thinking rather than the realities of real-world tax policy. Certainly the suggestion that we have a “once-in-a-generation opportunity” to redesign the tax system is over the top.

This conclusion is even more apparent when one considers the thrust of the report’s recommendations. Only three were unanimous: the proposals to remove the 20% depreciation loading on new plant and equipment; the removal of tax depreciation on buildings if empirical evidence shows they do not depreciate in value; and changes to the thin capitalisation rules. These are not large changes.

The TWG was split on all the other main options it considered, namely a capital gains tax, the taxation of rental property investment, a land tax and a GST/income tax switch, suggesting at the very least that whether such changes would improve the tax system is debateable.

Some of the analysis underlying the report is also dubious.

For example, the Treasury has rightly pointed to the high economic costs (in the form of damage to growth) of taxing mobile capital income in an era of globalisation. It is therefore curious that the Treasury is one of the strongest advocates of extending taxation of capital gains, which are a form of capital income. Moreover, the Treasury has failed to show that any conceptual arguments for broader tax treatment of capital gains outweigh the practical difficulties.

Another example is the view expressed in several places in the report that a disadvantage (on equity grounds) of moves towards a lower, flatter tax structure is that they reduce progressivity. However, the McLeod Review pointed out that a flatter tax scale does not involve much less redistribution of income than a progressive scale, and that most redistribution of income occurs through government spending.

Moreover, the fundamental arguments for a progressive scale are weak and more inspired by envy than equity, as Buchanan and Hartley show in their book Equity as a Social Goal published by the Business Roundtable.

In terms of analytical quality and depth, the McLeod Review remains the benchmark for tax policy.

Arguably the TWG should have made more of its finding that, with reductions in the lower tax rates and Working for Families, the top 10% of taxpayers now pay 76% of net tax. This is a highly skewed situation; it encourages lobbying for more government spending by large numbers of people who do not face the tax consequences of decisions that would benefit them. There is a strong democratic and constitutional argument for a single rate of income tax that requires most people to pay some amount of tax, however small, to fund any level of spending.

It should also be noted that the options considered by the TWG are not exhaustive. In considering its budget package this year, the government could look at the merits of a low, revenue-neutral carbon tax for implementation if and when trading partners such as Australia and the United States adopt comparable climate change policies. Such a measure would be simpler than the current emissions trading scheme, which in any case may not be viable if no legally binding treaty supersedes the Kyoto Protocol in 2012.

At a broader level, the TWG’s work has a limited bearing on the government’s top priority goal of increasing productivity and economic growth. The 2025 goal of catching up to per capita income levels in Australia is not even mentioned in the report. The group’s terms of reference required its proposals to be fiscally neutral, which meant by definition that it could not make a large contribution to a growth agenda. Reshuffling the deck of cards that makes up the tax system without reducing the overall tax burden is not a game-changing project.

Jean-Pierre de Raad, chief executive of the New Zealand Institute for Economic Research, has made the same point: “Anyone who seriously thinks the TWG recommendations are radical needs a reality check.” He described the report as insightful but ultimately meek and its proposals too limited to do much to close the income gap with Australia .

Nevertheless, the TWG report is a useful exercise for a number of reasons.

First, it has confirmed the merits of the board-base, low-rate tax strategy that New Zealand has pursued since the 1980s.

Second, it supports the government’s medium-term goal of aligning the personal, trustee and company income tax rates at 30%, in line with the thrust of the McLeod report.

Third, it has set aside proposals for tax reforms that are not worth considering. One is the idea of a dual income tax system (with different rates for capital and labour income) which was proposed in the 2025 Taskforce report. Another is the idea of income splitting, which is still being promoted by revenue minister Peter Dunne.

Fourth, it calls for a comprehensive review of welfare policy and how it interacts with the tax system, with an objective being to reduce high effective marginal tax rates.

Fifth, and perhaps most important, it has in effect signalled to the government that not much can be done in practical and political terms through revenue-neutral tax changes to resolve the serious economic and fiscal challenges it is facing.

On the one hand, imposing new or increased taxes will not help close the income gap with Australia .

On the other hand, taxes will have to rise to reduce prospective budget deficits and levels of public debt if spending is not cut.

The unstated but implicit bottom-line message in the TWG report is, ‘It’s the spending, stupid’. Only by focusing on reducing the government spending share in the economy (which is well above that in Australia, let alone the much lower levels in higher income countries such as Hong Kong and Singapore), can New Zealand simultaneously achieve sound public finances, meaningful tax reform and strong economic growth.