Another big tax switch to come?

Bernard Hickey looks through the terms of reference for the new Tax Working Group and sees the potential for a tax switch, where a new land tax helps pay for tax breaks for pensions.

The Tax Working Group set up by Jacinda Ardern and Grant Robertson has a remarkably similar look and feel to the Tax Working Group set up in May 2009 by John Key and Bill English. It may also come up with a tax switch that surprises people, despite having its scope severely limited to come up with the 'right' answer.

The 2009 effort was also created to address a perceived lack of fairness in the tax system that saw taxes more heavily weighted to income from wages and profits, than from capital. Key and English did not stop their Tax Working Group from considering a capital gains tax, but Key virtually ruled one out well before the Group made its final recommendations in January 2010. The following May the then National Government picked the recommendations it liked and had wanted all along and introduced them in the 2010 Budget. They included cuts to both personal and corporate income taxes and an increase in the GST rate. This was all billed as a 'big tax switch' that was both fiscally and distributionally neutral.

It all seemed like a magic solution. An increase in the GST rate from 12.5 percent to 15 percent paid for a cut in the top personal tax rate from 38 percent to 33 percent and a cut in the corporate tax rate to 28 percent from 30 percent. This then aligned the top personal tax rate with the trust rate of 33 percent, removing one of the incentives for higher income earners to shuffle their assets into trusts.

This switch certainly wasn't envisaged during the 2008 election campaign and the switch could have been a different one. The Tax Working Group actually recommended the extra revenue needed for income tax cuts could come from a broad-based and low rate land tax. Key wouldn't agree to that because it could have triggered an immediate one-off drop in land prices of around 15 percent. Instead, he chose the recommendation to go with a GST hike instead, which was something he promised before the election he would not do.

Fast forward seven years and Grant Robertson and Jacinda Ardern also want their Tax Working Group to address a perceived unfairness in the different ways capital and labour are taxed. But they have also circumscribed the target zones for the Tax Working Group. It cannot look at taxing capital gains on the family home or land under the family home. It also cannot look at increasing the GST rate again or suggest anything that could be described as an inheritance tax.

It's clear Robertson and Ardern are nudging the Group towards some form of land tax or capital gains tax that applies beyond the family home. It was just as clear in 2009 that Key and English were nudging their Group towards cuts in personal and company income tax rates and matching up of the top income and trust rates. The GST hike and the 'big tax switch' was the surprising outcome.

This latest Tax Working Group could also generate a surprise outcome, despite its apparent straight-jacket on what it can look at.

The key was in Robertson's comments at the news conference to unveil its terms of reference, and that it would be led by Sir Michael Cullen, his predecessor as the last Labour Finance Minister.

The group could consider the possibility of tax breaks on pensions and savings if it wanted, he said.

The new Government wants to even the playing field between investing in residential property and investing in real businesses that produce goods and services, preferably for export.

There is a way to do that without taxing the capital gains on the family home. The Government could just reduce taxation on investment in other types of assets such as term deposits or managed funds used for pensions.

Currently, regular 'Mum and Dad' investors know that leveraged investments in property are not subject to capital gains, unless they are in rental properties sold within two years of purchase. Given the doubling of house and land prices over the last 12 years and their ability to easily borrow to buy these assets, buying more property has been a no brainer. They know that investing their savings in a term deposit or an investment fund in the stock market would generate earnings that were taxed every year, either through withholding tax on interest or because income from buying and selling shares would be treated as income. They also can't borrow to invest in these assets. It's a simple choice that means households now have over $1 trillion invested in housing, while have just $163 billion in bank deposits and $56 billion in investment funds such as KiwiSaver.

Part of the reason for this almost five-to-one investment in housing over other financial assets is that pensions and other savings do not receive tax breaks in New Zealand. This seems natural to and pleases the tax purists who like simple tax systems with broad bases and low rates where all types of income are treated the same, but New Zealand is unusual in doing this. Up until 1989, New Zealand did provide tax exemptions and breaks for money invested in pension funds.

New Zealand now taxes income that is being put into pension and savings funds two times over. That money is taxed at the point it is earned and before it is put in the fund. It is then taxed while it is in fund and earning money each year. Other countries exempt income from tax if it is being put into a pension fund that is only touched upon retirement. They also don't tax income made by the fund as it is being built up before retirement. But they do tax the money at the other end of the process as it is being withdrawn from the pension scheme.

The end result of this difference is that it makes a lot more sense for New Zealand 'Mum and Dad' investors to put their money into leveraged property where their capital gains are not taxed and the income from the property they live in in the form of imputed rent is also not taxed.

One way to even up the playing field would be for the Tax Working Group to recommend tax exemptions for income being put into retirement funds and tax exemptions on earnings made by those funds as they are being built up. That would be expensive, but they could be paid for through a land tax on high value land that is not the family home, which would include rental property land, farm land and commercial property land. In essence, there would be a switch in the way assets owned by already wealthy people is taxed. Taxes on land and property would rise, but taxes on long term investments in shares and other assets needed for retirement would be reduced. That would encourage more investment in real companies that produce goods and services, potentially for export.

This type of tax switch was suggested earlier this year by academic economist Andrew Coleman as a politically acceptable way to even up the playing field without having to impose a capital gains tax on the family home or farm.

This could be the surprise 'tax switch' that this new Tax Working Group comes up with: a tax cut for pension savings paid for by a tax increase on commercial and residential landlords and farmers. It would fit within the parameters set out by Robertson and achieve a fairer and more even approach to taxing property versus real investments.

Unfortunately, just as the last Tax Working Group was restrained from recommending the simplest and most effective tax change (a land tax including the family home), this one will also have to come up with a clever way of achieving some of what many deem necessary, but is politically impossible.

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