Closing Tax loopholes

The Tax Working Group Report: The Good, The Bad and the Predictable

The Tax Working Group Report: The Good, The Bad and the Predictable

The Good

Let’s start with the good stuff, and there is a bit of that, mainly around the environmental tax proposals. The Tax Working Group has acknowledged that the notion of a ‘circular economy’ has informed their recommendations.

The proposed changes to the Emissions Trading Scheme (to reduce carbon emissions) and congestion charging all seem positive. If done well they could help shift us to a sustainable economy by making polluters pay, and rewarding sustainable businesses. However, the devil will be in the detail. For example the revenue from the Waste Levy seems to have been poorly spent in the past, so we have to think carefully before we raise it further.

Congestion charging hasn’t been used yet, but is a much better alternative to petrol taxes to raise the money required for transport projects. By charging for congestion we can ensure that those using infrastructure under pressure pay more, encouraging people to change where and when they drive and help raise money for that infrastructure to be upgraded.

The concept of putting a price (not a tax) on water use and pollution is sound but has been previously ruled out by NZ First. This is bizarre when we are simultaneously talking about how to allocate a scarce resource and looking for funding to clean up our waterways. Surely water bottling companies, irrigators and electricity companies should be paying for the water they use. Similarly, polluters should be paying for the pollution they cause.

The one exception to the generally good environmental tax suggestions is the proposal of a fertiliser tax. This is a blunt tool. The issue of nitrogen is vastly different in different catchments. As the report notes, instruments based on outcomes are a superior approach. 

The Bad

With that comes a lot of bad stuff, particularly around the Capital Gains Tax. Top of that list has to be the impact on business. Apart from inequality and rising house prices, the key problem with our economy is that there is a strong incentive to invest in property speculation rather than productive businesses that create jobs and grow our incomes.

Unfortunately this proposed Capital Gains Tax will apply to business as well as property. The extra tax burden and compliance costs for business means that there is no more incentive to invest in business over housing.

Given these downsides to business, the least damaging option would be to apply this Capital Gains Tax (CGT) only to the treatment of land based assets (including farms). NZ First seems set to rule out including farms, leaving us with a CGT only on investor property. You have to ask if this is worth the bother.

The biggest concern in this scenario would be that it hurts the poor. Modelling suggests that house prices would fall a bit as some landlords sell up to first home buyers. The downside is that the rental market would shrink, and given that rentals have higher occupancy rates than “family homes” we could see rents rise significantly. Such a narrow tax will probably not raise enough revenue to compensate the poor for higher rents, so they would be worse off.

Some other problems from the CGT are likely to include:

  1. Exemptions for the family home, the family farm, rollover relief, reliance on valuations and deductions for improvements make for a complex system that will be costly to administer and provide gainful employment for accountants and lawyers. 
  2. The revenue for government will be unpredictable, and could even turn negative in a downturn.  
  3. Taxing on realisation (sale of the asset) provides an incentive to not sell the asset (business or house) which is bad for the economy. The concerns around cash flow motivating this approach are not consistent with other parts of the tax system (e.g. foreign shares and rates). We will talk more about this in coming blogs.

The Predictable

The Achilles Heel of this review has always been the Terms of Reference with the Labour led Government excluding the family home. Ultimately that will hamstring the effectiveness of any change.

We can see the likely effect of this tax overseas. Australia is second to last ahead of New Zealand in terms of housing affordability. Australia has a CGT excluding the family home. This is not even a second best policy, it is a second to last policy. 

Excluding the family home excludes 3/4 of the value of our housing stock. A 33% tax on 24% of the market is an 8% tax. This may slow the rise in property prices slightly, but certainly not stop it. If anything there will be an increased incentive to invest in owner occupied housing because of its tax free status. This is called the "Mansion Effect", which we have seen in Australia. 

As a result a Capital Gains Tax may slow the increase in inequality (depending on what happens with rents), but certainly won't stop it. Remember that housing - house price and rent rises - is the main driver of increased inequality in the last 20 years.

The Opportunities Party Fair Tax Reform provides an alternative that would reduce income taxes substantially (making 80% of people better off), kill off property speculation and encourage Kiwis to invest in businesses that actually grow our incomes. The key to achieving that is to tax all assets equally – including the family home.

We don’t need to tax capital gain, we need to end it.


Video replay: TOP Tax Talk in Wellington 18 February 2019

If you weren't able to attend the Tax Talk on Monday, 18 February 2019 you can watch it here:

 

To view the companion blog piece with history and background click here


Why Our Tax System Favours Housing

Sources for this piece are the Tax Working Group Report on The Taxation of Capital Income and Wealth and Andrew Coleman’s piece on the Great Income Tax Experiment plus the work behind The Opportunities Party tax policy

To watch the Tax event held on 18 Feb 2019 and which is the result of this research, click here

Most people are worried about the amount of tax that they pay, but that isn’t what we are talking about here. The Opportunities Party doesn’t want to collect more tax overall, we just want to make sure it is collected in a fair and efficient way. Our goal is to use any revenue collected to reduce income taxes

For the economy the amount that one thing gets taxed relative to another is just as important as the overall amount of tax that is collected. If one type of behaviour is taxed less than another, then people will do more of the thing that isn’t taxed. If we want them to do that thing, that might be fine. But if we don’t want them to do that thing, we have a problem.

And that is the case with housing in New Zealand. The current Government is focussed on cracking down on investors and speculators. This may be popular, but doesn’t make much sense economically because the biggest tax break actually lies with the “family home” - otherwise known as owner-occupied housing.

The Government’s own Tax Working Group confirmed this in their report on Taxing Capital Income and Wealth:

See the low bar? The thing that is taxed way lower than everything else? That is the money that people invest in the family home. Many Kiwis struggle to believe this graph when they first see it. So maybe it would help to look at the history behind it.

 

A Brief History of Our Tax System

In the 1980s the Labour Government of the time revolutionised our tax system. The idea was to get rid of any tax incentives and loopholes so that tax rates could be lowered as much as possible. This is the mantra of the “broad-base, low-rate” tax system that is parroted by Treasury and IRD officials to this day.

This meant that almost all investments got taxed twice - once when the money for investment was initially earned as income, and again when that investment created a return. That applied to bank deposits, businesses (including shares) and retirement savings. Even the inflation component of returns is taxed, which is why the effective tax rate on most investments in New Zealand is up around 50%.

The one exception was housing and land. The income used to buy these gets taxed, but the returns from being an owner occupier of housing and land aren’t. Effectively when you live in the house you own, you are landlord and tenant and are paying rent to yourself. In most rental situations the landlord pays tax. But in this case, which is called “imputed rental”, no money changes hands so our tax system ignores it.

Housing and land based businesses such as rental property and farming pay tax on the cash returns they get, but not on the capital gain. In all, property based businesses end up paying about half as much tax as other investments. However we need to remember that capital gain happens because of higher expected returns in the future, all of which ideally should be taxed. So in the long run taxing capital gain is really unnecessary double taxation. The problem with property is that not all those future returns are taxed (the imputed rental problem), which can make a Capital Gains Tax attractive for that asset class.

There was talk of introducing a Capital Gains Tax as part of Labour’s reforms in the 1980s. However Labour imploded, National was voted in, and it was all but forgotten. That would have been the time to bring in a Capital Gains Tax (as long as it included the family home), before all the capital gain happened. But now the horse has well and truly bolted. Imputed rental would still not have been taxed, but at least housing affordability would not be as bad as it is now.

 

What Do Other Countries Do?

The result of this history is that the difference between tax treatment of property and other assets is the greatest in the world. How do other countries deal with this?

A few do something similar to The Opportunities Party proposal - taxing the value of living in the family home the same as you would a bank deposit. Iceland, Luxembourg, the Netherlands, Slovenia and Switzerland all do this. This eliminates the tax differential between the family home and other investments, so people have an incentive to invest in businesses.

The majority of European countries adopt another approach. They drop the ‘broad-base, low-rate’ idea completely. They hike up income taxes and use that money to reduce the taxes on other types of investments. The left of politics makes a big deal of the higher marginal tax rates in Scandinavian countries for example, which seem to have little negative impact on their economic growth. But they ignore the fact that the tax rates on capital - businesses, retirement savings for example - are much much lower than they are in New Zealand.

This approach again helps to reduce the differential between investment in housing and other types of assets, so people still have a strong incentive to invest in businesses. Of course property addicts like to point out that average people don’t have that many opportunities to invest in businesses. In these countries that role is played by retirement savings, which manage people’s portfolios on their behalf. Investments in retirement savings in particular are often untaxed when the income is initially earned.

 

The Impacts of this Experiment

As a result of this tax history, Kiwis have piled into housing. More of our assets are tied up in housing than any other developed country in the world, and house prices are a testament to that.  

House prices have risen faster than any developed country, leaving us with the least affordable housing of any developed country. Rents have followed suit, rising faster than prices or incomes as landlords struggle to maintain some level of return on their investment. As a result, ordinary people have to work more hours to pay for their rent than they did in the 1990s.

Housing is the key driver of growing inequality. Since the mid 1990s inequality has not really grown at all. Workers in general have been getting their fair share of rather mediocre productivity gains. However, when you take housing into account it is a different story. After housing costs inequality is rising.



Rents rising faster than incomes are the key driver of poverty at the bottom end. And higher house prices are the main driver of rising wealth at the top end. Once housing costs are taken into account, the bottom 10% of families are still no better off in real terms than they were in the 1980s.


It isn’t like this is helping our economy. Most of our investment is going into unproductive areas - bidding up the price of already existing housing. Countries don’t get rich together that way, some (namely asset owners) get rich at the expense of others. In New Zealand we have effectively seen a massive transfer of wealth from younger generations to older ones. Our businesses suffer due to lack of investment, which is why our incomes are so low. Meanwhile we all bear the risk of record high foreign debt.


Could Other Factors Be Driving House Prices?

Much has been made of the role of cheap credit and housing supply in the rise of our house prices. It is impossible to completely disentangle tax from these other factors. However over the long run these other factors cannot explain everything.

Firstly cheap credit. This has been available around the world for many years, yet New Zealand has topped house price rises since the Global Financial Crisis. And when incomes are taken into account, we really do stand out.



We topped the latest Demographia survey in terms of unaffordable housing in the developed world. Interesting to note that the two markets just behind us - Australia and the United Kingdom, both have a Capital Gains Tax excluding the family home yet are still well above what experts call “affordable”.

Housing supply is certainly an issue, particularly in Auckland. However many other markets in New Zealand have been unaffordable for some time, without a discernible supply issue. Auckland too was already unaffordable long before the shortage appeared. And again internationally we are not particularly unusual for our planning rules, yet we are a stand out on house prices.

The cost of construction is often raised also. However this is not the key driver of higher house prices - the price of land is. Land banking is the key problem, and this is driven by the differential tax treatment of property. Why develop land when you can make more money sitting on an empty section?



So What Do We Do About It?

If we care about inequality, house prices and the economy, we need to tax property the same as other assets. That extra income could be used to reduce income tax by up to one third. This would be a true broad base low rate system. Returning to the original graph, that would equalise all lines on the chart by lifting the lines on owner occupied housing and rental properties and dropping the others.

1-_Treasury_IRD_estimates_of_marginal_effective_tax_rate_on_real_return_from_various_types_of_saving.jpg

Of course, even if you understand that our tax system favours housing, especially the family home, you might think that is a good thing. Bear in mind however that half of Kiwis don’t live in a house they own. Around 40% of Kiwis own nothing at all to speak of. Aren’t they the people that deserve access to New Zealand’s biggest tax break? Instead, through their income taxes they end up paying a greater burden than many of us. This property loophole is particularly exploited by the rich. One third of the wealthiest people in New Zealand don’t even pay the top rate of income tax. That isn’t the idea of a progressive tax system, and it doesn’t fix the huge distortion that exists.

Nonetheless, if we don’t care about inequality and we want to keep our tax breaks on housing, then we need to at least abandon the broad-base low-rate mantra. We need to drop the tax on other investments to match that on owner occupied housing. This will solve our investment problem and obsession with housing. The downside is that it gives a huge tax break to people with assets - the rich. The question there is where the money comes from to pay for the tax break. Scandinavia achieves that by getting more income tax from higher incomes.

A Capital Gains Tax which excludes the family home achieves neither of these things. It hikes up taxes on rental property, but leaves owner occupied housing untouched. To make matters worse it hikes up taxes on businesses too - taking them over 50% of returns. As mentioned, higher capital values for a business are a sign of higher expected future revenues. Since revenues already get taxed eventually, a Capital Gains Tax effectively brings forward future taxation burden on business. Given the already high rates of business taxes, why would anyone bother to invest in a business then?


How the Tax Working Group Can Make Polluters Pay and Encourage Business Growth.

The economy needs to shift rapidly this century in order to meet our environmental challenges. This is a huge opportunity to do things better, to be clean and clever with our growth and to improve our standard of living at the same time.

We urgently need to nudge businesses in a sustainable direction. But we also need to remember that government doesn’t always (or even often) have the answers. Instead of banning or regulating things as left wing governments tend to do, we need to encourage businesses to innovate and seek out new opportunities to take our economy in a new direction.

The Tax Working Group report (due out next week) is the next opportunity for this Government to take such an approach. What should they be recommending in terms of the environment?

A Price on Water

Looking long term, water is our greatest resource. It is the true backbone of our economy and society, and will only become more so. It provides us with life, energy and agriculture.

First and foremost we must avoid the mistake of favouring commercial water users over the public and customary rights. The access of the public and tangata whenua must be sacrosanct. This hasn’t been the case in the past, such as in Canterbury where nitrates are contaminating people’s water supplies.

Where water is scarce, which is most of the country, commercial water users should pay for their privilege. It is a scandal that water bottlers have got away with paying nothing but the cost of a consent. However the biggest users of water are electricity generators and farmers.

As the demand for water rises, the best way to respond (unless you are a Marxist) is with a price. And the money raised from that price should go to settling Maori rights over freshwater, to improving the quality of that freshwater, and to the local communities that water is being taken from.

Charges on Water Pollution

Charges can also help some forms of water pollution. Nitrogen, mainly from cow pee, is a major problem in many waterways. We need to use charges to make polluting farmers pay, and use that money to reward farmers that are farming in a sustainable fashion. Simple carrot and stick stuff, and so easy to do. Just watch those farming practices change when this is in place.

And yes, the same goes for our urban waterways. Councils should be fined for breaches of water quality and the money used for clean up.

A Decent Price on Carbon

The price of carbon has risen under this Government as they have made relatively minor changes to the Emissions Trading Scheme. The price needs to rise much higher – at least double the current level. We also need to move away from giving away free credits to polluting businesses.

Another big issue is removing the tax incentives that encourage people to use fossil fuels and not plant trees. Here are a couple of examples:

  1. Our tax system currently favours small scale pastoral farming (which benefits from tax free capital gain) rather than forestry.
  2. Our fringe benefit tax favours gas guzzling double cab utes and companies that provide car parks for their employees, but these same tax breaks don’t apply to public transport.

This provides businesses with certainty and incentives to change their practices in the long term. Ultimately businesses and people on the ground will be the ones finding the best way to reduce emissions, not governments.

A higher carbon price is how we will see change in our economy – not by banning oil and gas exploration and running the risk of importing coal in a few years time.

Waste

We are currently working on a Waste Policy but the same approach applies – we should use economic instruments to make polluters pay and provide incentives for them to clean up their act.

This stuff isn’t rocket science. Working with business, rather than against it, is essential to making our economy sustainable and lifting our standard of living at the same time. Sadly this is an anathema to many of the left wing politicians that claim to care about the environment. 

Read more about how TOP policy benefits sustainable business and our Clean Water Policy.


Cracks Beginning To Appear For Kiwibuild.

When the Kiwibuild program was first announced we wrote that there was a chance it may simply crowd out private sector building.  We were not alone in harbouring this doubt as various industry commentators have shared similar views. It appears this, along with other concerns such as the lack of capacity, cost blow outs and affordability problems, have led quietly to a change of scope. The official documentation now states Kiwibuild will “facilitate the delivery” of the planned 100,000 homes, rather than “build”. It may seem minor, and arguing about semantics is never very productive, but it does further expose Labour’s flagship policy to criticism. Analysis from economic modeling firm Infometrics showed that the policy could see as few as 9,200 additional properties added to the dwelling stock over the next four years, representing less than one-third of the program that is penciled in for that period.

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Weak Analyses Plus Political Bias: Failure Inevitable for the Tax Working Group?

The TWG has been set an impossible mission – improve the tax regime, make it more efficient and fair, but don’t recommend any changes to the tax treatment of owner occupied housing. And another – make the tax system fairer but don’t deal with the interface between tax rates and welfare (which is just negative tax after all).

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Winners and Loser: The New Zealand Tax System

Taxation has very much been in the limelight in recent weeks. We have the seen the government chastised for a plan to implement increased taxes on fuel by around 10c per litre over the next few years. There has been the constant spectre of the Tax Working Group hanging over us, and over the weekend, the appointment of Marama Davidson as Co-leader of the Greens gave rise to the discussion of new and higher taxes, including higher income tax, for which she is a supporter.

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Housing affordability - How can we claw our way back?

"It's affordable for now and we don't tend to deal with things until they are well and truly broken,". Economist Shamubeel Eaqub.

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Will Labour’s Increase in the Minimum Wage lift Incomes?

The new government has taken no time extolling its desire for a higher minimum wage. $20 by 2020 is the number they’ve chosen, probably more for marketing purposes than anything evidence based.

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Foreign Buyers – The Villain or the ScapeGoat

Does anyone seriously think that Labour’s first loud policy initiative is anything but window-dressing for the masses, a solution chasing a problem that hasn’t even been evidenced? Sure, Phil Twyford doesn’t like Chinese-sounding names, but that is hardly evidence.

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