Chapter 5 - Making the system fairer
As foreshadowed in the discussion document Making Tax Simpler – Towards a new Tax Administration Act, a different approach to penalties may be required. This chapter outlines changes the Government has announced to late payment penalties.
Late payment penalties
The late payment of tax is currently subject to a series of late payment penalties, which are imposed from the first day the tax is overdue and accrue incrementally and indefinitely thereafter. Overdue tax incurs an initial 1% penalty one day after the due date, another one off 4% penalty seven days after, and an incremental penalty of 1% for each month thereafter. Use of money interest (UOMI) is also imposed to compensate the government for not having the money available to them. It is applied one day after the due date and is calculated on a daily basis and does not compound. The longer the tax is outstanding, the more financial penalties are imposed. After two years, the penalties and use of money interest can accumulate to more than 50% of the original tax owed.
Current penalties compound and are imposed over the outstanding tax, with use of money interest imposed over outstanding tax and penalties. With the current use of money interest underpayment rate of 9.21%, the combined penalty and interest rate aggregates to approximately 27% per annum (in the first year). In some years the use of money interest rate has been higher, resulting in a higher effective rate.
The late payment penalty does not effectively encourage all taxpayers to comply. For some taxpayers, late payment penalties can be seen as ineffective if they are imposed on people who did not pay due to an administrative error (as they have underdeveloped business processes), cannot pay (as they do not have the resources) or will not pay (as they have the resources, but choose not to pay). The first group feel Inland Revenue is penalising them for an honest mistake and will grudgingly pay the penalty. The second cannot pay the initial amount and so will not be able to pay the penalty. The third is unlikely to be motivated by a financial penalty and so other tools would be more effective.
In recent years, Inland Revenue has conducted research to learn more about the relationship between penalty and interest rates and compliance behaviour. This research has revealed that the existence of financial penalties is important as they encourage most taxpayers to comply, but high penalty rates may not be essential to encourage all taxpayers to comply. Many surveyed taxpayers commented that it was the existence of possible financial penalties that was the reason they would always file and pay on time. However, beyond the existence of penalties many taxpayers surveyed did not have a complete understanding of the financial consequences of getting into tax debt. When the current late payment penalty rules were explained, over 86% of taxpayers surveyed said that they would be sufficiently encouraged to pay their debt, once the debt had incurred a combined penalty and use of money interest rate of 5.2% (this currently occurs with the debt being outstanding for approximately 8 days).
While late payment penalties encourage on time payment, there is a point when the accumulated penalties and interest overwhelm taxpayers. Taxpayers surveyed suggested that this tipping point is approximately $10,000 of tax debt for small and medium sized businesses. At this point, taxpayers may struggle to see a way forward and become less engaged in resolving their debt. Consequently, imposing more penalties will not encourage repayment. In addition, for many small businesses, the total amount outstanding quickly becomes so big it cannot be repaid using expected future cash flows. At this point, any repayments mostly go to reducing the interest and penalties, with little being left over to pay the outstanding tax itself.
Over the years, the current rules have resulted in a significant amount of unpaid tax, penalties and use of money interest being added to the government tax debt book. The debt book for non-social policy tax debt is currently above $5 billion, with Inland Revenue in recent years being required to write off and impair approximately $800 million to $1 billion of uncollectible debt per annum.
The Government has announced that it will introduce legislation to reform the late payment penalty by no longer imposing the 1% monthly incremental late payment penalty from new GST, income tax and Working for Families Tax Credit (WfFTC) overpayment debt.
The proposed change will benefit approximately 65,000 taxpayers with income tax debt, 67,000 taxpayers with GST debt and 23,000 taxpayers with WfFTC debt. Other tax types may be considered for similar treatment in the future as they transition to START.
New tax debt incurred on or after the application date will incur the initial late payment penalty and use of money interest. This will reduce the effective rate of penalties and interest imposed in the first year, from 27% per annum, to approximately 15% per annum. This combined penalty and interest rate is more in line with established commercial (unsecured) lenders and will lead to less uncollectible debt, which over time will reduce the write-off of uncollectible late payment penalties.
There is a risk that some taxpayers may view the removal of the incremental late payment penalty as a reduction in the ‘cost of borrowing’ from Inland Revenue, and decide that it is financially worthwhile to delay their tax payments. While the effective rate has been reduced, given Inland Revenue’s other recovery and enforcement tools, it is unlikely a reasonable person would consider it prudent to borrow from Inland Revenue, if they could otherwise borrow at a similar rate from a commercial lender. Also, it is important to note that Inland Revenue has a number of non-financial tools available (including the proposed ability to disclose tax debt to credit reporting agencies, discussed in Chapter 6) to address the issue of some taxpayers deciding not to resolve their tax debt.
WfFTC shares the same late payment penalty rules as income tax. Therefore WfFTC recipients face similar issues regarding the fast accumulation of penalties and interest on outstanding WfFTC debt.
The major cause of WfFTC debt is Inland Revenue’s lack of accurate information on families’ household income and circumstances during the year. Approximately 200,000 (half of all) WfFTC recipients choose to receive their entitlement during the year in weekly or fortnightly instalments. However, many of these recipients are paid more than they are entitled to receive during the year. This is because the WfFTC instalments are either based on a default, rudimentary estimate of recipients’ projected end of year entitlement, or rely on the recipient notifying Inland Revenue of changes and asking for their instalments to be changed accordingly. At the end of the tax year when WfFTC recipients’ entitlements are finalised (through square-ups with their income tax returns) these overpayments are treated as a debt. If the debt remains unpaid after the due date, late payment penalties are imposed.
Much of this debt is incurred by low income families, many of whom are the least likely to have the financial ability to repay it. Imposing high late payment penalties is unlikely to further encourage WfFTC recipients to repay their debt. No longer imposing the incremental 1% penalties (leaving just the initial late payment penalties of 1% and 4%) will provide WfFTC recipients a better opportunity to repay any debt that arises.
Inland Revenue intends to address the cause of WfFTC debt as part of the review of social policy in a subsequent discussion document about the administration of social policy. For example, collecting and using better, more real time information about recipients to ensure they receive the correct entitlement should prevent and reduce debt.
The application of this measure will be staggered as tax products begin to be administered by START. This provides the most cost-effective transition option.
However, the staggered approach means that, in the future, some indebted taxpayers will continue to have incremental late payment penalties imposed on them, depending on whether the debt is administered in FIRST or START. This will be the case until all GST, income tax and WfFTC debt is being administered in START.
17 START – Simplified Tax and Revenue Technology – is Inland Revenue’s computer system to replace FIRST. This system is based on the GenTax platform supplied by FAST Enterprises as part of the Business Transformation programme.