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Taxation of Savings and Investment Income

Joint Report: Taxation of Savings and Investment Income

Date:

27 September 2012

Report No:

T2012/2470

PAD 2012/206

Action Sought

 

Action Sought

Deadline

Minister of Finance

(Hon Bill English)

Notecontents of the report

Agreeto recommendations

Referthe report to the Minister for Economic Development

Joint Ministers’ meeting on 16 October 2012

Minister of Revenue

(Hon Peter Dunne)

Notecontents of the report

Agreeto recommendations

Joint Ministers’ meeting on 16 October 2012

Contact for Telephone Discussion (if required)

Name

Position

Telephone

Matthew Gilbert

Senior Analyst, Tax Strategy, Treasury

917 6048 (wk)

 

Matt Benge

Assistant Deputy Commissioner, Policy, Inland Revenue

890 6063 (wk)

 

Executive Summary

This report responds to the Minister of Finance’s question as to whether changing tax settings could lead to a material improvement in economic performance. It provides a high-level assessment of a number of potential reforms to the taxation of savings and investment, based on whether reforms could improve efficiency, incentives to save and invest, and reduce macroeconomic vulnerabilities. These are important in contributing to the ultimate goals of increasing economic performance and improving economic welfare in New Zealand. This has clear links to the Business Growth Agenda: work in this space is urgent, so it is important Ministers consider what tax reforms could offer.

We have complemented existing analysis by using a computable general equilibrium model that has been adapted to reflect the New Zealand economy (the DZ model). Overall we think the model is useful for drawing general observations/insights to use as part of a broader assessment into different tax reforms, but does not offer the level of confidence to rely on quantified results. For capital gains tax only, we have used a simpler general equilibrium model focused on housing and taxation in New Zealand (the Andrew Coleman model). The analyses do not examine practical aspects of designing and implementing reforms in detail, which would need to be considered more fully if such reforms were pursued.

The modelling work has suggested that personal income tax cuts may have greater economic benefit than corporate income tax cuts in New Zealand. This is primarily because most of the benefits of personal tax cuts would accrue to residents, whereas a larger proportion of the benefits of corporate income tax cuts ’leak’ overseas to non-residents given New Zealand’s high level of foreign capital ownership; and that a personal income tax cut would increase incentives for both savings and investment, and labour supply.

It also suggests that reforms which cut corporate income tax may result in a net welfare loss. This is because the country may lose more from giving up tax revenue to non-residents than it gains from improved investment incentives generally (due to imputation, a corporate income tax cut is expected to have little impact on investment incentives for residents, limiting economic welfare gains, but does increase foreign investment). This welfare result may at first be surprising given economic literature suggests cuts to the corporate tax rate tend to be best for economic growth.[1] However such studies tend to focus only on the effects of lower tax rates on GDP rather than on economic welfare, so do not pick up the fact that some of the economic benefits of a tax cut may accrue to non-residents (which is important for New Zealand given our relatively high levels of foreign capital ownership). This will act to reduce economic welfare benefits compared to impacts on GDP. In addition studies often do not account for the general equilibrium effect of the tax cut (which is captured in the DZ model) – so while residents only enjoy some of the benefits of the tax cut, they bear the entire burden of the revenue offset to fund the tax cut, which will further reduce economic welfare.

There are also likely to be dynamic growth benefits from reducing corporate taxes (e.g. higher productivity growth and spillovers from FDI), which are not captured by the model. Personal tax cuts will also likely have wider growth benefits, which are also not captured in the results (e.g., increased investment in human capital and spillovers from this investment), and this is not expected to change the earlier insight that personal tax cuts are more favourable than corporate tax cuts

Overall, we think the welfare result suggests caution in considering a further corporate income tax reduction at this stage – but that it is only one factor. Corporate tax rates have been falling in other countries (although there has been some slowing of the rate of these reductions with the Global Financial Crisis) and it is important to make sure that our company rate is not too far out of line with rate in other countries to minimise the risk of profit-shifting pressures (using transfer pricing). This may lead to an increased case for company rate cuts in the future. It is important that New Zealand remains an open dynamic economy and an attractive destination for FDI, given the benefits foreign investment can bring.

The following table summarises some of the main conclusions from our analysis. The various reforms are modelled at a fiscal cost of $1 billion to aid comparability (with the exception of the Allowance for Corporate Equity), with the cost offset by reduced government transfers.

the Allowance for Corporate Equity, [2]with the cost offset by reduced government transfers.

 Reform/Steady state impacts table

These indicate:

  •  The tax reform option that appears most effective in boosting economic welfare and reducing macroeconomic vulnerability is a personal income tax reduction. This also boosts GDP and increases national savings. The other tax reform which also boosts economic welfare but has a negligible effect on macroeconomic vulnerability is a cut in personal capital income tax restricted to residents (such as reducing tax on interest income). This has the biggest effect in promoting savings.
  • A reduction in corporate income tax offers a more limited increase in national savings compared to other reforms, and also leads to an increase in macro vulnerability. The result that this reform may reduce economic welfare also suggests caution around considering a further corporate income tax reduction at this time.[4] As noted earlier wider factors, such as the competitiveness of our corporate tax rate, may increase the case for a further corporate rate reduction in the future.
  • A dual income tax is likely to increase national savings and GDP, but reduce economic welfare. However, while there are economic gains from a dual income tax, greater gains can be realised from simpler cuts to personal tax rates as shown above. A dual income tax would be complex to implement given current IR systems capability. We therefore do not recommend prioritising further work on a dual income tax in the medium term.
  • The negative fiscal and economic impacts of an Allowance for Corporate Equity (ACE) outweigh the benefits of any additional savings and investment. It would also add significant complexity and would be challenging to implement. For these reasons, we do not recommend pursuing this option.
  • Treasury has reported previously on allocative efficiency issues caused by gaps in the tax base (primarily not taxing capital gains) and the interaction of inflation and the tax system[5]. Treasury continues to see a capital gains tax as the best way of reducing these distortions, although it is cognisant that a fully developed regime must be considered before policy decisions can be made. Inland Revenue acknowledges that this reform is consistent with our BBLR framework but it considers the devil is in the detail - as well as additional complexity, it is not clear that a CGT that applied on realisation and exempted the family home would be more efficient than not having one.
  • Reductions in personal capital income tax, discussed above as one of the most beneficial reforms, may have some second best effects in reducing allocative distortions depending on how they are implemented. Options include:
  • Reducing tax on interest income which was modelled and indicated a strong increase in national savings, similar to a personal tax reduction. The reform is also expected to improve economic welfare (the measure of economic efficiency in the model). However, the reduction in tax on interest income may also cause other distortions, not captured in the model (such as between debt and equity investments), so overall efficiency impacts are unclear. There are also fiscal risks from tax arbitrage opportunities which would have to be managed or addressed with new anti-arbitrage rules, adding to complexity of the tax system.
  • Reforming the PIE regime for example by extending PIE rates to portfolio investments directly held by taxpayers (debt and equity)[6]. This would encourage more domestic savings. On balance, the Treasury consider that overall efficiency would likely be improved; whereas Inland Revenue considers that the opposite may be true. Inland Revenue considers that for coherence reasons it may be preferable to instead remove the cap on PIE tax rates, as was suggested by the Tax Working Group, and use the revenue raised to lower personal tax rates. Both options will be considered as part of further work on PIE reform.
  •  Indexing the tax base for inflation, which would increase after-tax returns to interest income and likely result in a significant increase in savings (although the level of foreign investment will likely fall given only real interest expense would now be deductible, which could reduce macro vulnerabilities). Indexation is also a very complex exercise due to high ongoing compliance costs (especially for SMEs), meaning overall net benefits are unclear, and it would be challenging to implement given current IR systems capability. We do not recommend that it be pursued as a medium-term reform.

Next steps

Tax policy resources will continue to focus primarily on delivering the Government’s tax policy work programme, and supporting IR’s business transformation programme. We are also reporting separately to Ministers on possible packages to consider for Budget 2013, balancing revenue raising and wider economic objectives. Beyond this, we recommend focusing further “investment” work on:

  • Considering reforms to capital income taxes that apply to resident individuals. As noted above this could include reforms to the PIE regime or reducing the tax rate on interest income. Officials will report on these options as part of work on PIE reform on the current tax policy work programme.
  • Considering possible changes to the personal tax structure, including adjusting for fiscal drag. A simple change to current thresholds in 2015, to correct for five years of fiscal drag since the 2010 tax reform, is estimated to cost around $1.5 billion per annum. You may wish to consider such a change beyond Budget 2013 as the impact of fiscal drag increases and the fiscal position improves.

Many of these potential reforms would have a fiscal cost. Given the tight fiscal position in the next few years there may be merit in a ‘package’ approach, as was done in Budget 2010, with tax reductions being offset either by increasing other rates (such as GST) or by base broadening (for instance, Treasury’s advice is this could include a CGT and/or a land tax).
 

Recommended Action

We recommend that you:

a. note the report responds to the Minister of Finance’s question as to whether changing tax settings could lead to a material improvement in economic performance.

Noted                                                             Noted

b. note that, in preparing this report, officials have analysed whether reforms could improve efficiency, incentives to save and invest, and reduce macroeconomic vulnerabilities, which are important in contributing to the ultimate goals of increasing economic performance and improving economic welfare in New Zealand.

Noted                                                             Noted

c. agree/note the recommendations made for each tax reform below: 

Reform

Recommendation

Minister of Finance

Minister of Revenue

Cut in corporate income tax

  • Notesome positive impact on savings and GDP but not macro vulnerability

 

  • Notethe finding that this reform may reduce economic welfare but that other factors may enhance the case for a future cut in the tax rate. 

Noted

 

 

Noted

Noted

 

 

Noted

Cut in all personal income tax rates

  • Note that this reform is likely to offer the biggest gains overall for GDP and welfare, strong gains for savings, and improvements in macro vulnerability
  • Agreethat officials do further work on options to reduce personal tax such as address fiscal drag

Noted

 

 

 

Y  /  N

Noted

 

 

 

Y  /  N

Cut in tax on interest income

  • Notethis reform offers the biggest gains for savings and the capital stock but its impact on economic efficiency is unclear

 

  • Agree that officials consider a reduction in tax on interest income as part of the PIE reform work, currently on the tax policy work programme

Noted

 

 

 

Y / N

Noted

 

 

 

Y / N

PIE reform

  • Note that officials will report later on options related to PIE reform

Noted

Noted

Dual income tax

 

  • Notethis reform is likely to offer some additional savings and investment, and gains to GDP, but these are smaller than gains from cutting personal tax rates, and that a dual income is more complex to implement

 

  • Agreethat officials do not prioritise further work on a dual income tax in the medium term

Noted

 

 

 

Noted

 

Y  /  N

Noted

 

 

 

Noted

 

Y  /  N

Allowance for corporate equity

  • Notethat while there are additional savings and investment, complexity, fiscal cost, and welfare loss are likely to be high

 

  • Agreenot to pursue an allowance for corporate equity as a medium-term tax reform

Noted

 

 

 

Y  /  N

Noted

 

 

 

Y  /  N

Indexation of the tax system

  • Notethat while there are additional savings from indexation, it will increase finance costs for some firms, and will be complex to implement and have high ongoing compliance costs

 

  • Agree not to pursue indexing the tax base for inflation as a medium-term tax reform

Noted

 

 

 

 

Y  /  N

Noted

 

 

 

 

Y  /  N

d. note that officials are not currently doing work on a capital gains tax or a land tax, but that further work could be necessary on these or other options if revenue-raising reforms are needed to offset revenue-negative reforms;

Noted                                                Noted

e. refer a copy of this report to the Minister for Economic Development.

Agree/disagree.  

Matthew Gilbert                                                       Matt Benge

Senior Analyst, Tax Strategy                                     Assistant Deputy Commissioner, Policy

The Treasury                                                             Inland Revenue 

  

Hon Bill English                                                       Hon Peter Dunne

Minister of Finance                                                   Minister of Revenue

Purpose of Report

1. This report provides a high-level assessment of a number of potential tax reforms to the taxation of savings and investment, as agreed in Treasury’s 2011/12 output plan and the Government’s Tax Policy Work Programme. In doing so, the report responds to the Minister of Finance’s question as to whether changing tax settings could lead to a material improvement in economic performance. We would like to discuss the report with you at the joint Ministers’ meeting on 16 October 2012 and get your agreement on medium-term reform priorities.
Background
2. There have been a number of New Zealand tax and other policy reviews that have examined potential reforms around the taxation of savings and investment income. These include the Tax Working Group (2009-10) and the Savings Working Group (2010-11), alongside Australia’s Henry Tax Review and the UK’s Mirrlees Tax Review. Background to these reviews has been provided in Annex 1. In particular the Savings Working Group raised concerns that New Zealand’s low level of national savings increased its vulnerability due to high levels of external debt and low levels of domestic saving. Treasury’s interest in this project has also been motivated by concerns about low productivity growth (underpinned by capital shallowness), which is forecast to continue. These issues have clear links to the Business Growth Agenda: work in this space is urgent, so it is important Ministers consider what tax reforms could offer.

Aims and objective of the work

3. Drawing on these recent reviews, Treasury and Inland Revenue officials have been assessing the merits of a number of major and minor tax reforms to understand their impact from a New Zealand context better, establish whether there is a prima facie case for their implementation, and to identify medium-term reform priorities.

4. In addition to economic welfare, key issues have been how different reforms would affect the:

  • Overall efficiency of the allocation of savings and investment in the economy; and
  • Total level of savings and investment, along with the potential to reduce macroeconomic vulnerabilities in the economy.

5. These are important in contributing to the ultimate goals of increasing economic performance and improving economic welfare in New Zealand. The different issues are motivated by a number of considerations:

  • Efficiency is the standard benchmark for determining how well a tax system contributes to economic performance. It generally tries to assess how little a tax system creates distortions, for example to investment and labour supply decisions;
  • Treasury has expressed concern that there are low levels of national savings in New Zealand. It considers that there may be potential for tax reform (in combination with policies in other areas) to improve savings performance and allocation of investments even if the tax system is not the fundamental cause of the problem; and
  • Concern about the vulnerability posed by New Zealand’s high net external liability position has gained increased importance in the wake of the global financial crisis. All else equal, increases in national savings relative to investment, changes in the mix of external liabilities (from debt to equity) and increasing GDP growth for a given supply of capital reduces vulnerability or mitigates the impact of an increase in net external liabilities. But assessing the impact of policy changes on vulnerability is complex and requires consideration of economic variables such as the current account and gross and net levels of national debt, as well as debt servicing capacity factors such as national savings, exports and offshore investments.

6. This analysis is intended to inform us and Ministers as to whether any tax reforms have the potential to improve economic performance, and therefore whether officials should do any significant further analysis of them. The analysis presented here does not examine practical aspects of designing and implementing reforms in detail, which would need to be considered more fully before forming a final judgement on whether such reforms should be pursued.

7. This work may have little immediate policy implications given that the Government recently completed a major tax reform, but is important going forward given the Government’s strategic priority of building a more productive and competitive economy, and the Business Growth Agenda. It also helps ensure officials are well placed to provide advice on future economic and fiscal challenges (for example, this work will also be used to inform the discussion of tax in the Long Term Fiscal Statement).

Analysis 

8. We have drawn on a number of analyses to inform our assessments. These include:

  • Standard first principles analysis including drawing from analyses we have done for the Tax Working Group and the Savings Working Group;
  • A computable general equilibrium model developed by US academics John Diamond and George Zodrow and modified by Treasury and IR officials (known as the DZ model), which allows us to examine how tax reforms might affect the allocation of capital in New Zealand, and impact key variables such as GDP, economic welfare (the measure of economic efficiency in the model) [7] and the level of savings;
  • A model designed by Andrew Coleman to provide insights into how a capital gains tax could impact investment in housing in New Zealand; and
  • High-level analyses of the likely impacts on equity, tax system integrity (arbitrage potential), complexity, compliance, and administration costs (which is important given IR systems capability for substantial tax reform in the short term). These assessments do not consider detailed design issues for the specific tax reforms.

9. The general equilibrium modelling is a step forward in building our analytical capability, consistent with Inland Revenue and Treasury work on quantifying the effects of tax policy changes and as part of the wider Treasury work on quantifying our key policies. It has been calibrated to include specific factors relevant to New Zealand (e.g. high levels of foreign capital ownership and likely location-specific economic rents) to help us understand how these make the analysis different from standard results. Overall we think the model is useful for drawing general observations/insights that can help as part of a broader assessment into each of the modelled tax reforms, but does not offer the level of precision to use quantified results. The DZ model has its limitations, particularly as it does not pick up dynamic growth impacts or distributional impacts. We have attempted to address these through additional assessment outside of the model to help us reach conclusions.

10. Further discussion and results from the analytical work can be found in Annex 2. No one method of analysis is determinative but considered together they provide guidance as to which tax reforms have the greatest potential economic benefits.

11. Reforms considered in the analytical work include major changes to our current BBLR system (allowance for corporate equity, dual income tax, and the indexation of tax bases). Alongside this we have considered incremental changes to existing tax rates within the BBLR system. This has broadened our understanding of the marginal economic impact of reducing tax rates of different tax bases (corporate income, personal income, and interest income). Reforms are modelled on a fiscally neutral basis with reduction in lump-sum government payments to offset the fiscal cost of the reforms, which isolates the impact of the change being modelled[8]. This is most closely proxied by a reduction in government spending or by introducing a well-designed land tax. If tax cuts are financed by tax increases that are not completely efficient, this will obviously reduce the benefits of the tax reforms noted here.

12. We have also commented on revenue-raising tax reforms we have considered previously (such as land tax and a risk-free return method for taxing housing investments) and have undertaken further analysis of capital gains tax using the Andrew Coleman model.

Findings

13. The analytical work has provided the following high-level insights:

  • Personal income tax cuts may have greater economic benefit than company income tax cuts in New Zealand. This is primarily because:
    • Most of the benefits of personal tax cuts would accrue to residents, whereas some benefit of company income tax cuts would accrue to non-residents given New Zealand’s high level of foreign capital ownership; and
    • A personal income tax cut would increase incentives for both savings and investment by residents, and labour supply.
  • General company income tax cuts may result in a net welfare loss. This is because the country may lose more from a reduction in tax revenue to non-residents than it gains from improved investment incentives generally (company income tax cut is expected to have little impact on investment incentives for residents, because the imputation system claws back the benefit for resident shareholders when income is distributed, but does increase levels of foreign investment). Examples of these are a general company tax cut and an allowance for corporate equity (ACE); and
  • Capital income tax cuts that apply to resident individuals may have some net benefits, although these will have effects that are not able to be captured in the modelling (such as the tax reductions will not apply to all types of capital) and the effects are not as great as for a personal tax rate cut. Examples of these include a reduced tax rate on interest income which we have modelled and an extended PIE regime which has not been modelled.

14. While the modelling work suggests that there may be a net economic welfare loss from corporate income tax cuts that increase foreign direct investment (FDI), this does not mean other policies (such as regulatory changes) which encourage additional FDI may not be desirable. New Zealand currently has a very large stock of FDI and corporate income tax cuts also apply to non-resident owners of the stock of existing FDI. It is giving up revenue on existing FDI which contributes to the net welfare reduction. Further work, such as the work on location-specific rents, may help us get more confidence in understanding how much of the tax reductions are enjoyed by non-resident shareholders. In addition there may be other factors, such as profit-shifting pressures and the question of whether our corporate tax rate is too far out of line with other countries, which affect the decision around future changes to corporate tax settings.

Allocation of capital 

15. The DZ and Coleman models do give some insights into the consequences of how changing the tax settings would change the allocation of capital, and how this affects GDP and economic welfare. In focusing the issue of capital allocation on amounts invested in housing versus other investments, the Coleman model of tax and housing (which is simpler than the DZ model but more informative about the impacts on housing) suggests that taxing housing more heavily (by taxing capital gains, even when the tax is limited to investment housing only) does tend to:

  • reduce the total amount invested in housing;
  • increase the amount invested in interest-bearing assets;
  • reduce the price of housing and increase affordability of owner-occupied housing;
  • increase rents and reduce the affordability of rental housing;
  • increase economic welfare; and
  • reduce the level of foreign borrowing compared to the status quo.

Key conclusions

16. A summary of our assessments is presented in Table 1 at the end of the report (with a more detailed discussion of results in Annex 2). At this stage, the findings from these assessments lead us to the following conclusions on medium-term reform priorities.

Potential medium-term reform priorities

  • Personal income tax reduction – This reform reduces all personal income tax rates and appears strongly beneficial. It provides higher GDP and economic welfare, increased savings (because lower personal rates also reduce the taxation of interest income) and reduced macroeconomic vulnerability. The model does not pick up dynamic growth benefits from reducing personal tax rates, (e.g. higher productivity and entrepreneurship), which will further improve the benefits of this reform. It is also relatively easy to implement given the fairly simple structure of the current tax system and would help with overall coherence of the tax system if the top rate is lowered;
  • Capital income tax reduction accruing to residents – Another area of potential reform is a capital tax reduction targeted towards residents. The reform modelled above which does this is a cut in tax on interest income. In the model this increases GDP, welfare, and has the biggest impact on savings. The increase in economic welfare in the DZ model suggests some gain in economic efficiency. However, there are other effects on economic efficiency which are not captured in the model so the impact on the allocative efficiency of investment is unclear. On one hand, a discounted tax rate on interest may reduce the effective tax rate on interest to be closer to the effective tax rate on housing and other real property investments, where capital gains are not taxed. On the other hand, an arbitrary discount amount could also increase effective tax rate differentials with other investments. Two other reforms which also reduce capital taxes on residents are extended PIE and indexing the tax base for inflation. These are:
    • Reforming the PIE regime for example by extending PIE rates to portfolio investments directly held by taxpayers (debt and equity) – i.e. removing the requirement that the investment be held in a managed fund[9]. This would encourage more domestic savings. Although direct investments would be taxed at the normal rates, Treasury considers this boundary is more sustainable than the current boundary. On balance, Treasury considers that overall efficiency would likely be improved; whereas Inland Revenue considers that the opposite may be true. Inland Revenue considers that for coherence reasons it may be preferable to instead remove the cap on PIE tax rates, as was suggested by the Tax Working Group, and use the revenue raised to lower personal tax rates. Officials will report later on both options these as part of the current tax policy work programme.
    • Indexing the tax base for inflation – Although not specifically modelled, this reform is also a capital tax reduction that is restricted to residents. Inflation adjustments to interest income would be expected to increase savings significantly given it will increase after-tax returns. However by allowing the deduction of only real interest expense the cost of capital borrowed from non-residents may increase, possibly reducing the overall level of investment (although in itself this could improve macro vulnerability). Indexation is also a very complex exercise given the inflation adjustment factor is likely to be imprecise, which will dampen overall benefits, and due to high ongoing compliance costs (especially for SMEs)[10]. Overall net benefits are unclear, and would be challenging to implement given current IR systems capability. We do not recommend it be pursued as a medium-term reform.

17. Many of these potential reforms would have a fiscal cost. Given the tight fiscal position in the next few years, there may be merit in considering a ‘package’ approach, as was done in Budget 2010, with reductions in taxes being offset either by increasing other tax rates or by base broadening. Specific base broadening options considered at the time of Budget 2010[11]include:

  • Capital gains tax (CGT) – Treasury considers a capital gains tax should improve allocative efficiency on a first principles basis. The Andrew Coleman model suggests it would tend to reduce investment in rental housing and increase investment in debt investments (although increase investment in owner-occupied housing if that is exempt from the tax). The Coleman analysis also suggests a reduction in foreign borrowing (due to the impact of the tax lowering the cost of housing) and that effect could allow sustainable economic growth for a longer period before macro imbalances become too great. A capital gains tax has some complexities in operation (although it can help with complexity too given the current unclear capital/revenue boundary may become irrelevant in some cases) and a lot depends on design features which would have to be considered in an overall assessment of the merits of the tax.
  • Land tax – A tax on the value of unimproved land should be efficient on a first principles basis provided there are no exemptions, for example, for owner-occupied housing. It is likely to be fairly simple to implement with low compliance costs. The main downside to a land tax is that it would cause a windfall loss to existing land owners and not to taxpayers who own wealth in a different form. There would also likely be significant pressures for exemptions which, if included, would significantly reduce the efficiency of the tax.

18. Treasury continues to see merit in a general capital gains tax or a land tax as possible revenue-raising reforms, and considers that a capital gains tax offers the best way of improving allocative efficiency by reducing economic distortions caused by gaps in the tax base. Inland Revenue acknowledges that these reform options are consistent with our BBLR framework but it considers that a land tax would impose an unacceptable loss on those who hold wealth in land. Especially for capital gains taxes, all the devil is in the detail. Working through the full details of how best to design a capital gains tax in practice and evaluating whether the pros of the best possible capital gains tax would outweigh the cons would be a very substantial exercise. Inland Revenue’s view remains that the practical disadvantages of a capital gains tax are likely to outweigh its advantages. For example, rollover relief may be required so that taxpayers do not face a disincentive to move to a larger building or larger farm, for example, when it makes economic sense to do so. However, rollover relief may mean that a farmer who sells a farm would face no capital gains tax if he or she purchases another farm, but would be taxed if they bought a different type of business. Inland Revenue is concerned that this can be quite distorting. That the practical disadvantages of a capital gains tax outweigh its advantages was also the on-balance view of the Tax Working Group.

19. In addition another revenue raising option may be to raise the GST rate[12]. This would not change the tax base as currently defined. However, raising GST could increase trends for domestic labour to emigrate (as the value of local wages in terms of consumption would fall) and it could also disadvantage domestic retailers when alternative direct imports are available (although reducing the de minimis below the current $400 in value, and having an efficient way to enforce this may mitigate against this). Raising GST would also cause a windfall loss on existing savings as its value in terms of future consumption would fall.

Reforms not to consider in the medium term

20. Based on overall assessment, officials consider the following tax reforms should not be actively considered as possible medium-term tax reforms. However, they may be revisited at a later stage in response to future economic and fiscal challenges.

  • ACE – The analysis shows there this would attract savings and investment, but any economic benefits are outweighed by the adverse labour supply impacts from meeting the high cost of the reform through higher income taxes (unlike other reforms, the ACE reform is not scalable and is estimated to cost about $9 billion per year given the magnitude of the tax changes). This is shown by the negative GDP and welfare results. It would add significant complexity to the tax system and would be challenging to implement (e.g. given risks around tax avoidance through international arbitrage). We therefore do not recommend this option be taken forward in the medium term.
  • Dual income tax – While the analysis shows a dual income tax would attract some additional savings and investment (which in turn increases GDP), these gains are smaller than for simple rate changes to personal income taxes or interest income tax. It would also not increase economic welfare because the benefits of the additional investment are outweighed by the loss of tax revenue on existing investments. The overall impact on macro vulnerability is unclear but likely to be small. It would also add significant complexity to the tax system and would be challenging to implement given current IR systems capability. Given the complexity of implementing the reform, and that the analysis suggests greater economic gains can be achieved through other rate changes for the same fiscal cost, we do not recommend prioritising further work on a dual income tax in the medium term.
  • Further corporate tax rate reduction – A company tax reduction results in some increase in savings and GDP, although this is lower than for personal tax reductions. This is predominately from increasing foreign investment (as imputation claws back the benefit for residents), which acts to increase macro vulnerability. The analysis also suggests a corporate tax reduction may reduce economic welfare because the welfare loss from giving up tax revenue to non-resident owners exceeds the welfare gain from additional investment and GDP. This suggests caution in considering a further corporate tax rate reduction at this time[13]. There are also likely to be dynamic growth benefits (as a result of higher productivity growth and spillovers from additional FDI) from reducing corporate tax, which are not captured in the modelling results. At the same time there are likely to also be wider benefits from personal tax cuts such as increased investment in human capital and spillovers from this investment which are also not captured so this will not necessarily tilt the balance in favour of company rate cuts ahead of personal tax cuts. But there are other factors, such as the need to make sure that our corporate tax rate is not too far out of line with tax rates in other countries. For example, New Zealand’s corporate tax rate is higher than the OECD average but currently lower than Australia although Australia is currently considering a tax rate reduction. A comparable corporate rate to other countries is important to minimise the risk of profit-shifting pressures (using transfer pricing). These considerations may increase the case for a further reduction in the corporate rate in the future. It is important that New Zealand remains an open dynamic economy and an attractive destination for FDI, given the benefits foreign investment can bring.
  • Comprehensive inflation adjustment of tax bases – For the reasons discussed earlier under capital income tax reduction targeted towards residents, we do not recommend that full inflation adjustment of tax bases be pursued as a medium term tax reform.

Further work

21. Tax policy resources will continue to focus primarily on delivering the Government’s tax policy work programme, in particular high priority projects such as on charities, taxation of intellectual property and supporting IR’s business transformation programme. We are also reporting separately to Ministers on possible packages to consider for Budget 2013, balancing revenue raising and wider economic objectives. Beyond this, we recommend focusing further “investment” work on:

  • Considering reforms to capital income taxes that are restricted to residents. As noted above this could include extending the PIE regime to other forms of capital income, removing the PIE cap to fund personal tax reductions, or reducing the tax rate on interest income. Officials will report on these options as part of work on PIE reform on the current tax policy work programme.
  • Possible changes to the personal tax structure, including adjusting for fiscal drag. A simple change to current thresholds in 2015, to correct for five years of fiscal drag since the 2010 tax reform, is estimated to cost around $1.5 billion per annum. You may wish to consider such a change beyond Budget 2013 as the impact of fiscal drag increases and the fiscal position improves.

22. We are currently undertaking work looking at the extent of location-specific economic rents in New Zealand (important given the finding of gains from corporate income tax reductions accruing to non-residents), which is due to report later this year.

23. While the models are far from being definitive, the development and use of economic modelling work has improved our policy analysis capability and we will continue to invest in the models to improve robustness and capability. This analysis will also help inform Treasury’s discussion of tax options in the long-term fiscal statement.

Table 1: Summary assessments of tax reforms

Summary Assessment Tax Reform table

Annex 1: Background to recent tax reviews

24. In 2009 the Tax Working Group considered a number of alternatives to New Zealand’s broad-base low-rate tax (BBLR) system. These included:

  • A classical company tax system with a low company income tax rate and a high tax rate on residents (as is done in Ireland);
  • A dual income tax (a low tax rate on capital income than on labour income, as is done in Norway);
  • An allowance for corporate equity (ACE) (a deduction allowed for a deemed return on company equity so that a normal return earned by a company is not taxed, but returns in excess of a normal return are taxed); and
  • A combination of a dual income tax and an ACE system.

25. The Tax Working Group did not recommend any of these alternatives, noting they would add complexity and arbitrage opportunities to the tax system.

26. The Tax Working Group also considered less comprehensive base broadening within the BBLR system. This was partly to address perceived under-taxation in real property investments. It considered (but only a minority recommended) a comprehensive capital gains tax,[16] and a majority recommended a risk-free return method of taxing residential investment property and a broad-based land tax. It should be noted that, as part of Budget 2010, the government removed depreciation deductions on rental housing (and other buildings). This will have increased the tax payable by landlords. The aggregate impact of this change on the level of tax paid by landlords has not yet been studied.

27. The Savings Working Group was established to consider matters of private and national savings from a number of perspectives. It did not focus on tax issues primarily but it did examine the tax system from a perspective of improving the efficiency of savings and investment. In its 2010 report, it saw merit in a number of possible changes to the tax system, such as making adjustments for the impact of inflation (either by comprehensively indexing the tax base for inflation or providing a discounted tax rate on interest income to adjust for the inflation component of interest) and reducing the intermediate (10.5% and 17.5%) PIE tax rates and extending PIE tax rates to directly held capital income, such as dividends and interest.

28. In addition, the Mirrlees tax review in the UK concluded there were potential economic benefits to a combined ACE/RRA (rate of return allowance) which would impose no tax on all forms of capital income to the extent they earn a normal return, and tax only capital income in excess of a normal return and labour income. However the review did not consider the practical implementation of this reform, or attempt to clarify how the ‘normal’ rate should be determined.

 

1 Given the high cost of an ACE, part of the fiscal impact is met through increasing remaining income tax rates as well as reducing government transfers.

2 Based on current equity impacts. Assessing equity impacts on a lifetime basis has not been possible given lack of longitudinal data. However, such assessments would tend to dampen the impacts noted above.

3 This may suggest that an increase in the corporate tax rate will be welfare-enhancing for New Zealand.  However such a tax change might not be sustainable given our corporate tax rate is already above the OECD average. It would be a negative signal for business, impacting New Zealand’s ability to attract FDI, and would increase incentives for firms to shift profits overseas, eroding the corporate tax base.

4 Shown by the differences in real effective tax rates for different forms of capital investment  – see Briefing to the Incoming Minister of Finance: Increasing Economic Growth and Resilience (2011), p. 16 (Figure 15).

5 An alternative PIE extension would be to lower PIE rates, as recommended by the Savings Working Group. The type of impacts of such a reform are likely to be similar to the reduction in tax on interest income, modelled above, given it involves reducing the tax rate on specific forms of capital investment.

6 Economic welfare is important to consider as a rise in GDP may not necessarily mean that New Zealanders are better off given some benefits from the tax change and higher GDP may accrue to foreign investors.

7 Reforms (with the exception of ACE) are modelled at a fiscal cost of $1 billion to aid comparability, with the cost offset by reduced government transfers.  See Table 1 for further details.

8 An alternative PIE extension would be to lower PIE rates, as recommended by the Savings Working Group.  The type of impacts of such a reform are likely to be similar to the reduction in tax on interest income, modelled above, given it involves reducing the tax rate on specific forms of capital investment.

9 It may be possible to mitigate compliance costs for smaller taxpayers without sophisticated systems by allowing them to “elect out”, however this also has some complications and may also be challenging for the IR to administer with its current systems limitations.

10 Risk-free return tax on rental property (taxing rental housing on a deemed return basis) is also revenue positive.  However, the need for such a tax may be less now that depreciation for buildings has been removed, and the revenue potential for this tax is minor compared to a capital gains tax and a land tax and is not sufficient to fund a reduction in personal tax rates or capital tax.

11 The DZ model showed that a $1 billion reduction in GST, comparable to the size of the other modelled reforms, had the smallest change in GDP and GNP.  This is not surprising since consumption is generally considered a more efficient tax base than income (so the impact of cutting the rate should be smaller), and New Zealand has a highly efficient GST.

12 The DZ model showed that a $1 billion reduction in GST, comparable to the size of the other modelled reforms, had the smallest change in GDP and GNP.  This is not surprising since consumption is generally considered a more efficient tax base than income (so the impact of cutting the rate should be smaller), and New Zealand has a highly efficient GST.

13 The implication of this result may suggest that an increase in the corporate tax rate will be welfare-enhancing for New Zealand.  However such a tax change might not be sustainable given our corporate tax rate is already above the OECD average.  It would be a negative signal for business, impacting New Zealand’s ability to attract FDI, and that it would increase incentives for firms to shift profits overseas, eroding the corporate tax base.

14 This is based on current equity impacts.  Assessing equity impacts on a lifetime basis has not been possible for the majority of tax reforms given lack of longitudinal data.  However, such assessments would dampen the impacts on equity noted here.

15 Given the high cost of an ACE, part of the fiscal impact is met through increasing remaining income tax rates as well as reducing government transfers.

16 The Tax Working Group was concerned that a capital gains tax may become very complex once real-world design features are incorporated and an exemption for owner-occupied housing may undermine many of its efficiency advantages.