Looking past the capital gains tax obsession

If the reaction so far to the Tax Working Group report is how we debate complex issues, we’re doomed to mediocrity and decline, writes Rod Oram.

So far, our obsession with a capital gains tax is drowning out all the useful insights and recommendations in the Tax Working Group’s final report.

This failure is particularly true in the business sector, which should be the most engaged of all. Many of the recommendations would help it invest more, use people and technology more productively and contribute more to the well-being of the nation.

Yet, since the report came out last week, a senior tax partner in a major accounting firm estimates CGT has consumed 90 percent of the extensive discussions with business people he has had.

Just 9 percent of discussion time has focused on how the report recommends the Government could invest the money raised from CGT. Only 1 percent is spent on anything else, he adds.

This pre-occupation with CGT is evident in the publicly-available reports from many of the major accounting and law firms too, judging by a cursory survey of them.

This intensely narrow focus fails to do justice to the breadth and richness of the report. Worse, many of the strong anti-CGT comments from business leaders show how limited their understanding is.

For example, Kirk Hope, the chief executive of BusinessNZ, wrote

“Taxing capital gain when an asset is sold would create a disincentive for the sale of businesses. Selling a business realises value that allows new businesses to develop, so it would diminish new business development and make the general business environment slower and more static.

“It would tend to lock businesses into their current asset holdings, reducing options for future development. We could expect to see less business development and innovation generally.”

However, the research of the Tax Group tells a different story, illustrated by a chart on page 34 of volume 1, shown below. Inland Revenue data shows the currently untaxed realised gains as a proportion of accounting profit by industrial sector. Those gains were only 8 percent of accounting profits for the manufacturing sector, which constitute a high proportion of BusinessNZ’s membership.

It is hard to imagine how a 28 percent tax on 8 percent of profits would deter business from investing in their future and the country’s.

Moreover, if business cares to consider other issues beyond CGT studied by the Tax Group, they will find a range of useful recommendations. These would encourage them to be the antithesis of the stagnant sector Hope envisages.

These include giving companies greater scope to write off against their tax liabilities their past losses and their black-hole expenditures, which is their spending on projects which did not become new business activity.

The Tax Group also addresses goodwill, which is the difference between the purchase price of a business and the value of its tangible assets. But increasingly companies, not just high tech ones, are valued on intangibles such as their brand, market strength and customer insights and loyalty. Thus, goodwill is a legitimate business investment, but its cost is not tax deductible. If CGT is applied to the selling of businesses, the Tax Group recommends that goodwill should become deductible.

The Tax Group is also recommending depreciation on commercial buildings. A chart on page 76 shows why – the corporate marginal effective tax rates for manufacturing plants in New Zealand is by far the highest in the OECD at 45 percent.

The OECD average is 25 percent, and between 17 and 20 percent in countries we might want to compare ourselves to such as Switzerland, Denmark and Canada. If New Zealand plant owners were allowed to depreciate 2 percent of the value of their plant a year, the effective tax rate would fall to 35 per cent.

Some people obsessed by CGT argue such measures are mere sweeteners detracting from the main issue. But that’s fundamentally wrong on three grounds: CGT is not nearly as damaging to enterprise value and vigour as they claim; the rate for our CGT, if enacted, should be closer to that in our competitor countries than the high rate recommended by the Tax Group; and a range of other recommendations for business will be beneficial.

It is disappointing that Hope, who was the main voice of business on the Tax Group, has come to such negative and narrow conclusions about its work and recommendations. Of the eight members, he was one of three who wrote a minority report arguing for a CGT that only applies to investor-owned residential property and no other asset classes.

His two fellow-dissenters were Robin Oliver, a former deputy commissioner (policy) at Inland Revenue, and Joanne Hodge, a former tax partner at Bell Gully. The trio concentrated on efficiency and practicality of taxation, which are indeed core issues, but their view of taxation was very static.

Their brief minority report did not engage on how the tax system has to help facilitate New Zealand’s response to sweeping global changes in business, technology, society and the environment.

Environmental and ecological outcomes

In contrast, their colleagues in the working group entitled their final report Future of Tax. In many ways the most important part of their work was chapter four on Environmental and Ecological Outcomes. Reading this plus chapter six on business and the executive summary will give you a quick understanding of the report.

Of all developed countries we are the most dependent on our natural capital for earning our living and our reputation. Yet, as the report points out, we rank 30th out of 33 OECD countries for environmental tax revenue as a share of total tax revenue.

"... a capital gains tax is a mangy dog, that will add unacceptably high costs and complexity" (Federated Farmers)

Fair and well-constructed environmental taxes are levied on the damage caused by, for example, polluting rivers, abstracting water or using excessive fertilisers. The more wisely a farmer uses those resources, the lower their tax. Even better, in a well-designed tax much of the revenue raised from polluters is recycled into helping farmers working hard on minimising their negative impact.

This essential principle, articulated by the Tax Working Group, was lost on some farming organisations. For example, a press release from Dairy NZ said: “If an environmental tax was also introduced, it is likely those farmers who are motivated to invest in improving environmental performance will have resource diverted.”

Federated Farmers was particularly strident in its response to the entire tax report: “Federated Farmers has said from the outset that a capital gains tax is a mangy dog, that will add unacceptably high costs and complexity.”

Once again, the chart above sheds light. The primary sector generates 53 percent of its profits from untaxed realised gains, mainly from escalating land values, the highest percentage of any sector.

But farming mainly for capital gains rather than operating profits only pushes the cost of farms up far faster than the price of the commodities many of them produce. For example, the global market-clearing price for whole milk powder has been around US$3,500 a tonne for more than a decade. Yet, the average price per ha of dairy land rose by 97 percent from December 2003 to December 2018, according to the Real Estate Institute’s Dairy Farm Price index. Moreover, the price is very volatile, which creates winners and losers among farmers. With a CGT, farmers would offset capital losses against capital gains. Now they simply have to live with the losses.

Yes, adopting new technology, improving farming practice, diversifying from commodities to value-added products and pushing co-ops and processors to pay more for them can all help. But those only go part way to overcoming high land prices caused by farmers pursuit of untaxed capital gains.

That chart also shows that the property and leasing sector is second to the primary sector, generating 46 percent of its profits from untaxed realised capital gains, with the financial sector third at 38 percent – far ahead of manufacturers at 8 percent.

Much of what we’ve heard about the Tax Working Group’s report so far has come from these sectors. Typically, they are defending their positions by saying any change is unfair, too hard, complicated and costly, while the benefits, if any, would be meagre.

Such a hostile response ensured the previous seven tax reviews in New Zealand over the past 52 years achieved little. This time let’s make sure we finally have constructive debate and change that creates a tax system that helps us rise to our 21st century challenges.

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