Tax Lawyers On Review Panel Feather Own Nest

The Government’s so called fundamental review of the tax system was pretty much a waste of time and money, coming up with only a few suggestions for tinkering with the current regime. This was, I suppose, not too surprising given the panel was stacked with wealthy lawyers who make good money out of exploiting the weaknesses of the present tax system. The panel members with ideas for real reform were ignored.

The only radical idea from the initial issues paper, the home equity tax, was dropped. And in any case it was aimed at the wrong problem. The problem is not that New Zealanders like to put money into owning their own home, but more that they love to invest in rental properties, with tax breaks playing a big part in this love affair. New Zealand’s small-time landlords enjoy telling you how investing in rental properties saves them tax. Typically, they borrow up large so that by the time interest and the over-generous tax depreciation deduction are taken into account they make a loss for tax purposes. This means that more often than not, no tax is paid on the rental income. Then, before the property starts to generate too much taxable income, the property can be sold for a tax free capital gain. Landlords may never pay any tax – ever!

Since landlords usually target cheaper, existing houses, they don’t expand the housing stock but just compete against first home buyers and push up prices. It was this sort of competition that helped raise Auckland house prices to ridiculous heights several years ago. First home buyers and renters were the losers as they struggled to meet huge mortgage repayments and monumental rentals.

While home ownership rates have dropped in recent years (as demonstrated by the decrease in home ownership rates between the 1991 and 1996 Census) the amount of equity invested in housing (giving a poor return to the economy) has increased.

The only way to stop this over investment in rental housing is to tax all the returns from it, including capital gains, on an equivalent basis. Going further and taxing the capital gains generated from the sale of any assets used in an income producing capacity would fix many other distortions created by the current tax system.

However, there are a lot of myths spread about a so called capital gains tax (CGT), especially by the real estate industry. The tax review panel used these tired old excuses too. However, none of the arguments stand up to scrutiny.

One of the more outrageous assertions is that a CGT creates serious distortions by stopping people selling assets. It is like saying that people won’t work if you tax their wages – and of course this would be true if the tax rate was 100 percent but at NZ’s relatively low marginal tax rates it is just not correct. Naturally, lower marginal tax rates are less distortionary and taxing capital gains would assist in raising tax extra revenue to allow a lowering of marginal rates.

There is no inherent reason for a CGT to be complicated either. It does not, for example, have to be indexed for inflation any more than the taxation of interest does. A CGT could actually lessen the complexity of the tax system (particularly if capital gains were just treated like other income) because the current unclear capital/revenue boundary in tax legislation is one of the biggest headaches for NZ taxpayers and tax gathers. Probably hundreds of millions of dollars a year are wasted in administration, compliance and litigation costs dealing with capital/revenue boundary problems. One Crown Entity alone has, in recent years, spent nearly $1 million annually on tax consultants, mostly to deal with capital/revenue issues. There are a few Barristers reputedly making similar annual sums by taking capital/revenue cases, and many tax consultants gain a large portion of their income from helping taxpayers deal with capital/revenue issues.

Many of the capital/revenue disputes arise from the fact that capital/revenue distinctions rely on common law principles going back hundreds of years to when land was the main source of wealth and the annual harvest was the main source of income. The land that produced the crop was capital and it was important that it remained intact to ensure the crop and income stream was sustained. Following this tradition, the earliest income taxes did not tax capital gains. However, such concepts are no longer relevant and in any case are not able to cope with the modern business world and its increasing reliance on intangible assets.

New Zealand’s capital/revenue boundary is made more complicated by the various exceptions in the Income Tax Act. We have the ridiculous situation of the Act purporting to tax any capital gains generated from an asset purchased with the intention of resale. How on earth is the Commissioner of Inland Revenue meant to be able to judge (often years after the fact) the state of mind of a person at the time they purchased a piece of property? The supposed strong winds of tax reform we have had in New Zealand have not dislodged this extremely messy provision, which must be one of the most impractical, troublesome and unenforceable pieces of tax law ever written. Yet the review panel didn’t even mention it!

There is a story told that says that entrepreneurs make their money from capital gains and, therefore, are discouraged by a CGT. However, the reality is that humans tend to be risk adverse and so therefore weigh losses higher than gains when making decisions. The immediate future is also of more concern than the longer term. These factors are important in the debate because many business start-up costs are currently considered capital, and therefore not deductible. A CGT that allowed tax deductions for business start-up costs would therefore give some initial tax relief and make the cost of a business failure lower, with at least a tax loss generated. The later taxing of capital gains generated by successful entrepreneurs would be a lesser concern. A properly designed CGT would, therefore, encourage new businesses and entrepreneurs more than it would discourage them.

If nothing else, the inequity of the non-taxation of capital gains is plain to see. Lower income earners rarely get the opportunity to make a capital gain, while those at the top make sure they do. A Canadian study showed that over 80% of all capital gains were realised by the wealthiest 10% of individuals. On average, capital gains made up 25% of the income of those wealthy individuals. There is no reason to believe that the NZ situation is significantly different. Just witness the $5 million lease inducement paid to a handful of wealthy partners in a large Auckland accounting firm a few years ago. IRD challenged the tax free status of the payment and fought the partners all the way to the Privy Council and lost! No wonder those tax lawyers on the review panel didn’t want any serious reform of the tax system.

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