R&D tax changes announced

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Hon Dr Michael Cullen
Minister of Revenue

Media Statement

Budget 2005 to focus on long game

"Budget 2005 will focus on the long game," Finance Minister Michael Cullen told a meeting of the Canterbury Manufacturers' Association in Christchurch today.

"That means creating an environment in which businesses can make investment decisions with increasing assurance. It means long term fiscal and monetary stability, and a programme of careful public investment in those things which underpin a modern, knowledge based economy," Dr Cullen said.

He announced provision in the budget to improve access to tax deductions for R&D expenditure where companies bring in new equity investors after their initial development stage, as commonly happens in the technology sector. [Refer attached fact sheet for more details.]

Dr Cullen said the change built on the new R&D rules introduced by the government in 2001 and was part of a multi-faceted package of business tax cuts provided for in the budget. Measures designed to reduce compliance costs, especially for smaller firms, had already been announced with a further suite of announcements scheduled for budget day.

He said the budget would continue a "conservative fiscal approach." The budget numbers would show the rate of debt reduction flattening out, leaving little room for large new initiatives, including tax cuts, if the government was to stick to its long term debt commitments.

"In fact, the budget will signal an intention to lower the growth trajectory in high spend areas such as health and tertiary education. Spending in both these sectors has expanded considerably in recent years. We need to be satisfied that the taxpayer is getting value for money and that efficiency gains are realised, reducing the need for ongoing, large increases in expenditure," Dr Cullen said.

Contact: Patricia Herbert [press secretary] 04-471-9412 or 021-270-9013. E-mail [email protected]

Attached: Fact sheet on the R&D tax change.

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Hon Dr Michael Cullen
Deputy Prime Minister, Minister of Finance, Minister of Revenue, Leader of the House

Speech Notes

Speech to Canterbury Manufacturers' Association

Holiday Inn on Avon, 356 Oxford Terrace, Christchurch

What I would like to discuss today is the broad economic and fiscal background to this year's budget, so that, come next Thursday, the reason for the detailed choices the government has made will become apparent.

The over-riding theme of this year's budget, as with the past five budgets, is the need to play the long game, to ensure that our economic fundamentals remain strong. That means creating an environment in which businesses can make investment decisions with increasing assurance. It means long-term fiscal and monetary stability, and a programme of careful public investment in those things which underpin a modern, knowledge-based economy. Things like high quality infrastructure, world-class education, and the social services and environmental and cultural values that make New Zealand a place where skilled people want to live and do their best work.

One of the implications of a long-term approach is the need to resist the advocates of 'kick-start' economic policy. New Zealand has fallen prey to this in the past couple of decades: an argument that if we only cut taxes here, slash spending there, de-regulate, sell public assets, privatise education or health, then a cornucopia of riches will be released into our laps.

The reality has never been that simple, although each time the economy enters the rough end of the business cycle these ideas rear their heads again. This is where we are coming to now, as the slowdown in growth that has been confidently predicted in each of the last three years appears to be arriving.

This will be one of the most comprehensively heralded downturns in recent history. Indeed there is something of a tone of relief amongst the commentators who have feared that they have been crying wolf for the last three years.

Nevertheless, to misquote Tolstoy, while happy economies all resemble each other, each unhappy economy is unhappy in its own way. For that reason it is important that we understand the facts as they stand.

The latest figures show that New Zealand’s rate of economic growth slowed further in the final quarter of last year and was even weaker than most commentators expected. Although there were indications of a bounce back in the March 2005 quarter, economic growth has probably peaked in the year to December 2004 and while remaining positive is likely to slow in the second half of 2005.

The slowdown is due primarily to a moderating of domestic demand, which has been at full steam for quite some time. Private consumption increased 0.7 per cent in the December quarter, down from 1.7 per cent in September, while residential investment fell 3.8 per cent and other investment fell 0.8 per cent.

If we look beyond the domestic sector, things start to look more promising:

• The labour market is still extraordinarily strong, with unemployment at 20 year lows.
• The net external sector (that is, exports minus imports) made a positive contribution to growth in December for the first time since March 2003.
• The December quarter saw an 8.5 per cent seasonally adjusted rise in merchandise export volumes, together with a 0.8 per cent lift in the terms of trade. This drove a reduction in the seasonally adjusted goods deficit from $928 million in September to $658 million in December.
• Prices for our commodity exports continue to rise, with the ANZ's World Commodity Price Index up 1 per cent in March, with prices for dairy, beef and lamb at or near record levels.

The current account for the December 2004 quarter showed a seasonally adjusted deficit of $2.5 billion, and in annual terms the current account deficit widened to $9.4 billion, or 6.4 per cent of GDP. The largest component contribution to the quarterly deficit figure was an investment income deficit of $2.35 billion. What that says in part is that we are delivering better returns to overseas investors than our own investors are earning offshore.

Indeed the overall picture is one of a small, fundamentally strong economy that cannot escape forever the weakness in the global economy, in particular as it translates itself into the exchange rate. There will be an eventual return of the kiwi to something closer to its historical post-float average. But for many here, the difficulty is "eventual" may be some time arriving.

Already this exchange rate push has been longer and stronger than the previous two. That has largely been because of prolonged US dollar weakness, a factor over which we have no control or influence. As for the market's irrational exuberance over New Zealand's dollar, there is by definition little rational response the government can make.

So we are entering a period of economic slowdown that looks set to continue for 2005 and into 2006. Instead of barrelling along on the open road at the rate of 4 per cent plus per annum, we have entered a built up area and are reducing speed, heading to around 2.4 per cent by March 2006.

We need to bear in mind that, in economics, provided that the fundamentals remain strong, what goes down must come back up.

So how strong are our economic fundamentals? Stronger than we had realised, as evidenced by our continued solid performance through three years when global conditions started to turn against us. And certainly stronger than they were five years ago by a considerable margin.

We have continued to diversify into a broader range of products, and are shifting the balance away from commodities to high-value niche goods and services.

We are also diversifying our markets, and reaping the rewards of improved market access. The government has made it a priority to continue the momentum in the World Trade Organisation’s multilateral round of negotiations.

We worked hard to ensure the Doha Round was started three years ago. We now have an historic commitment to eliminate export subsidies - the most egregious form of trade distorting support - as well as firm prospects of a substantial improvement in market access for all products. This includes non-agricultural market access which incorporates sectors of major importance to New Zealand, such as forestry and fisheries

We are also putting significant effort into bilateral trade negotiations. We are currently negotiating a free trade agreement with China, where the potential for growth is enormous across the whole of the export sector.

We are making good progress on other fronts, including the ASEAN nations, a bilateral agreement with Mexico, and the "Pacific 3" agreement with Singapore and Chile.

Some major challenges still face us, but we have already made significant progress.

We know we need to upgrade our key infrastructures, and the last five years have seen a turnaround in public investment in this area. In the 1990s New Zealand lost the plot somewhat with respect to maintaining investment in infrastructure. We were perhaps too busy seeking for the perfect regulatory framework for electricity, tinkering with the funding regime for roading and exploring the boundaries of the Resource Management Act to ask the essential questions about whether we were putting enough resources into infrastructure to meet future demand.

In the last five years we have had to play a game of catch up. For example, in the years from 1994 to 2000 net purchase of physical assets by government amounted to an average of $800 million per annum. Over the period 2001 to 2008 we have increased that by over 70 per cent.

Playing catch up is never an easy position to be in, especially because there are many competing interests, difficult issues of sequencing projects and very real constraints on the capacity of the construction industry to deliver. I think we have succeeded reasonably well in allocating new resources in sensible way and in forging the kind of local and regional strategies that give a logic to infrastructure investment, rather than it being simply a matter of ad hoc decisions.

We also know we need to grow the productivity of our workforce, especially in an environment where labour force participation is at an historic high. That is something we have been attacking from a number of angles, including getting better focus in our tertiary education system, increasing our investment in industry training and more proactive immigration policies and practices. We have also been addressing it by reducing the barriers to workforce participation amongst those have young children, but want to maintain a career.

So what are the implications of all this for Budget 2005? Primarily a need to stay the course we have been following. That means a focus on fiscal stability and maintaining prudent levels of debt, and on careful control of government expenditure.

Our record of economic and fiscal management speaks for itself. It has been founded on a conservative approach to government expenditure and debt, and a proactive approach to returning the economy to a higher growth path.

New Zealand will again have a set of government accounts that is envied throughout the world, and that has been achieved by careful management rather than by an excess of taxation. Tax rates on businesses in New Zealand are lower than in Australia, once the total picture of state and commonwealth taxes and payroll levies is taken into account. And they compare very favourably with other developed nations.

What is more we have set the scene for future fiscal stability by making sizeable transfers to the New Zealand Superannuation Fund in order to partially prefund the cost of the state pension at the height of the demographic bulge towards the middle of the century. Few countries are able to boast of that, and it is a factor that will strengthen our creditworthiness and our economic stability going forward.

Budget 2005 will continue a conservative fiscal approach. Indeed, one thing that will become obvious is the absolute necessity for caution in translating fiscal forecasts into fiscal policies. Recent forecasts have shown fiscal surpluses in the outyears which have caused great excitement and sparked ambitions plans for spending or for tax cuts.

What Budget 2005 will show is the rate of debt reduction flattening right out. There is little room for large new initiatives, including tax cuts, if we are to stick to our long-term debt commitments.

My government is under no illusions as to the importance of managing expenditure. I have already indicated that the government is considering pushing out some capital spending to avoid putting excessive pressure on the construction sector.

Budget 2005 will commit far more resources to health and education than National ever did, but it will also signal an intention to lower the growth trajectory in these high expenditure areas over the long term.

For example, for some years we have been orienting our health spending towards early intervention through better primary care, with the aim not only of improving health status, but also of avoiding the need for more intensive and costly treatment. We must ensure that those efficiency gains are realised and banked, and that the benefits of more enlightened health spending accrue not just to patients but to the taxpayer in the form of reduced expenditure pressures.

Another key area of focus is the control of expenditure on tertiary education. This has seen a considerable expansion in recent years, and without a doubt the vast bulk of this expenditure constitutes a valuable investment in building up the skills of our population, both those entering the workforce and older workers seeking to upskill themselves.

We have been particularly proud of our achievements in expanding industry training, modern apprenticeships and trades training. So too, we are proud of the steady increase in the participation rates amongst Maori and Pacific peoples, who have traditionally been under-represented.

However, we have concerns over the quality of some tertiary provision, and its relevance to the skills that are demanded in the workforce. To some extent, a strong labour market has masked this effect, since any level of proven skill has been enough to secure employment of some sort. In time, however, low quality training will be revealed for what it is.

We are particularly concerned about the increase in sub-degree courses, which, the evidence indicates, deliver little return to students in terms of a measurable increase in earnings capacity. Given the tight labour market, we cannot countenance funding courses which give students the impression that they are gaining marketable skills when they are in fact merely treading water, and attracting subsidies and incurring debt in the process.

I have already indicated that Budget 2005 will include a package of tax changes that are targeted in four key areas:

• First, encouraging savings and supporting work-based savings, in particular. This includes proposals to remove current inconsistencies in the taxation of investment income;
• Second, reducing compliance costs for businesses. These include the set of changes I recently announced to Fringe Benefit Tax and aligning GST and provisional tax payment dates.
• Third, ensuring a more productive use of capital, for example, through changes to tax depreciation rules and the tax treatment of R&D expenditure.

The depreciation changes will ensure that depreciation rates better reflect how assets decline in value and reduce compliance costs for businesses. These changes will be the 2nd stage in the depreciation reforms emerging from last year's officials' issues paper. The first stage, included in the taxation bill currently before the select committee, included changes to the depreciation treatment of patents, the special tax depreciation rules and added to the list of depreciable intangible property.

Since April 2001, new R&D tax rules have provided increased certainty over the tax treatment of R&D expenditure and immediate deductibility of R&D costs that are expensed for accounting purposes under FRS13 provided that the general deductibility provisions are met.

Budget 2005 will improve access to tax deductions for R&D expenditure for companies that bring in new equity investors after their initial development stage. Currently, shareholding changes can result in the company losing its R&D deductions. This is particularly a problem for companies in the technology sector where it is common for additional investors to come in after the initial development work has occurred. This change, to be included in the next tax bill, will enable tax deductions to be retained until they can be offset against income resulting from the company's R&D products. This will remove a tax barrier to R&D investment by allowing R&D deductions to be matched with income from that expenditure.

• Fourth, improving New Zealand's access to worldwide capital, skills and labour through reducing tax-related barriers to these flows. Firms need access to capital if they are to develop and grow to the optimal level. In legislation enacted last year the government removed a tax barrier to unlisted New Zealand companies accessing offshore equity finance. This measure provided that offshore tax-exempt investors and foreign funds of funds from countries with which we have double tax agreements are exempt from tax when they sell shares in unlisted New Zealand companies. The change targets offshore institutional investors – such as US pension funds, which provide a significant amount of the world's venture capital.

My colleague, the Hon Pete Hodgson, recently announced further changes aimed at removing tax and regulatory barriers to the flow of foreign venture capital into New Zealand. The government intends to update special partnership law by introducing new rules on limited partnerships, which are to have a separate legal personality. Resulting tax changes will be the subject of a discussion document to be released later this year. Further measures aimed at reducing tax-related barriers to the flow of worldwide capital, skills and labour will be announced in the budget.

Whereas across the board tax cuts are likely to be merely stimulatory and to prompt their own undoing by stoking inflation, the benefits of this tax package are tangible and likely to have a real impact on the drivers of economic growth and social stability.

Over the last five years, the government has moved progressively to improve its capacity to deliver a range of assistance to the business sector. In my first budget funding of $68 million (GST incl) was provided for Trade New Zealand and $36 million (GST incl) for Industry New Zealand. Support for New Zealand Trade and Enterprise in 2005/06 will be more than double that in this year’s budget.

Looking across the OECD, New Zealand's business R&D appears fairly low, but the growth in recent years is encouraging. Business R&D has risen from only 0.3 percent of GDP in 2000 to 0.47 percent in 2004 - that's a 57 per cent increase. It's still short of Australia and just under a third of the OECD average, but is heading in the right direction.

The government is playing its part to stimulate business R&D activity through Technology New Zealand, with grants available to improve technological capability and to undertake R&D itself. Government support for business R&D has almost tripled since 1999, increasing from $14 million in 1999/2000 to $41 million in 2004/05.

Consistency and ease of access is important for the effectiveness of R&D support. The government is in the process of streamlining access to related programmes at New Zealand Trade & Enterprise and the Foundation for Research, Science and Technology. Immediate steps are being taken to improve coordination and delivery of support for SMEs. Within the next 12 months we aim to achieve a common system of access for businesses seeking support for R&D.

This kind of incremental improvement in economic fundamentals is what builds long term sustainable growth. In this sense, the major thrust of Budget 2005 is entirely predictable:

• stable fiscal policy,
• stable monetary policy,
• high-quality investment in what really drives our prosperity,
• minimising the costs of doing business within a business environment that is already amongst the most attractive in the world, and
• delivering high-quality public services that are value for money.

I have yet to see any credible alternative to this, and definitely not one that gives us a better chance of seeing us through the modest economic downturn that lies ahead of us in the next year to eighteen months.

Thank you.

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Factsheet - Removing barriers to R&D investment

Companies that bring in new equity investors will have better access to tax deductions for R&D expenditure under tax changes to come into effect from this year. Technology companies, in particular, often have a long lead-in period in which they incur major expenditure before realising income from it. Under current law, however, they can lose R&D deductions if they bring in extra investors after their initial development stage.

The changes will cater for the growth cycle of technology companies and remove a barrier to R&D investment by allowing R&D deductions to be matched with income from that expenditure.

How will it work?

• Taxpayers will be able to allocate certain R&D tax deductions to income years after the year in which the related expenditure is incurred. Deductions will not be lost if there is a shareholding change between when the expenditure is incurred and when the deduction is recognised by the taxpayer.
• The tax treatment will be optional.
• Those who choose this approach must allocate R&D deductions against income resulting from the R&D expenditure.
• Most of the pre-commercial production expenditure of start-up technology companies, which typically incur significant expenditure for a long period before any income is realised, will qualify.

Where to from here?

The new rules for R&D investment will be included in a taxation bill to be introduced this month. Once enacted, the new rules will apply from the 2005-06 income year.