Paper Opens 'First Principles' Debate On Tax
Paper Opens 'First Principles' Debate On Tax - Cullen
"The Tax Review has delivered a tough-minded
and radical analysis which should spark a 'first principles'
debate on taxation in this country," Finance Minister
Michael Cullen said today.
Dr Cullen was commenting on the launch of the Review's issues paper. The Review will now conduct a second round of consultations before reporting finally to the Government in October this year.
"The Review was asked by the Government to explore a series of questions but was accorded complete independence in how it approached its brief and in the conclusions it formed.
“As I have stated previously, no proposals for significant change will be implemented without first seeking a mandate from the electorate through the 2002 general election,” Dr Cullen said.
"I hope the ideas canvassed by the Review can be debated seriously without reflexive position-taking.
"The Government has never indicated that we would expect to pick up all the Review's recommendations and has always hoped that all political parties will feel free to draw on the final report as a resource.
"Accordingly, I intend to refrain as much as possible from commenting on any of the specific issues the inquiry has raised. We need a broad discussion involving many voices so I would encourage individuals and organisations to make submissions to the Review," Dr Cullen said.
The issues paper and further details about the Tax Review are available on the Review’s website: http://www.taxreview2001.govt.nz.
Review membership and terms of reference.
Chairperson: Robert McLeod, Managing Partner of Arthur Andersen (New Zealand). Members: Srikanta Chatterjee, Professor of Economics at Massey University; Shirley Jones, Chair of the Council of Otago Polytechnic and an accountant specialising in small business; David Patterson, a Partner with the law firm Rudd Watts and Stone; and Ted Sieper, an Australian economist who has advised Governments on both sides of the Tasman.
The
Review's focus was deliberately broad. It was asked the
following questions:
- Can the tax system be fairer in
its role of redistributing income? This includes: whether
the income tax base should be broadened; the extent to which
marginal tax rates should increase with income, wealth and
expenditure; the best mix between different tax bases, such
as income, consumption, financial transactions and
assets.
- How the tax system can be designed to encourage
desirable conduct such as work and saving and to discourage
such undesirable behaviour as the wasteful use of
non-renewable resources.
- How can the level of tax that
is reasonably required by the Government for the provision
of essential social services be achieved reliably in the
medium and long term?
- Do the tax system and tax rates
need to be modified in light of new technology and
international competition?
Executive
Summary
This summary should not be read as replacing
or modifying the full original report.
Introduction
The
structure of the tax system has changed dramatically in the
last 35 years in response to a growing view that in an open
modern society, broad-based low-rate systems are the fairest
and most efficient revenue-raising strategies.
Much of
the impetus for change came from earlier rigorous,
independent reviews. The important reforms were often
controversial at their original launch. Consensus developed
only over time.
This Review, like its predecessors, has
to grapple with inescapable trade-offs among competing
goals. We have tried, as previous reviews did, to let the
evidence speak for itself where it raises inferences that
test inherited conventions.
The report draws on public
submissions. We look forward to testing it rigorously
against further submissions, before presenting final
recommendations.
Tax Bases
Income Tax
New Zealand’s
income tax base is more comprehensive than most other
countries, but falls short of being fully
comprehensive.
Capital gains
The income tax base
already captures a wide range of changes in the value of
assets and liabilities. The issue is whether to tax capital
gains more comprehensively, and if that is considered
desirable, whether to do so by:
• Including more of them
in the income tax base,
• Or introducing a separate
capital gains tax
The argument is theoretically sound
that including capital gains in taxable income as they
accrue makes the system fairer, more efficient, raises more
revenue, permits other rates to be lowered, and stops
conversion of taxable income into non-taxable capital
gains.
But the capital gains taxes used overseas tax
those gains when realised. They are, in fact, a
transactional tax on the disposal of assets. They encourage
people to hold or sell ownership to avoid tax, and tie
assets up unproductively. They require costly and complex
rules that often add to that problem of lock-in.
Because
these are serious problems, our current thinking is that
capital gains should not be taxed comprehensively on a
realisation basis. Options are:
Option I
New Zealand’s
approach for many years has been to include capital gains in
the income tax base as and when specific problems arose that
required such an action.
That approach could be extended
into areas where the absence of capital gains taxation may
currently be creating problems. They include:
•
Inconsistent treatment of different savings vehicles
•
Offshore investment
• Investment in housing
Option
II
Alternatively, fundamental reform could be undertaken
by redefining the tax base for some or all investment income
as:
• The amount the same sum would have earned invested
in a ‘risk-free’ government bond, minus the part of that
return that merely compensated for inflation.
Application
of this Risk Free Return Method (RFRM) would in most cases
be straightforward:
Net asset value at the start of the
year
x
Inflation-adjusted rate of return on a one-year
Government bond
x
The investor’s tax rate.
The
system is capable of application wherever an objective
estimate is available of an asset’s value at the start of
the year. Taxpayers with the same wealth and tax rate at the
start of the year would face identical taxes.
Arguments
about whether sale proceeds are taxable income or capital
gains would be eliminated. Investment choices would no
longer be tax-driven. An annex to the Review report
describes RFRM in more detail.
Owner occupied
housing
People with savings have to make choices about
how they will invest their money. If they put it into shares
or a bank account, they will be taxed on the interest or
dividends which they earn. If, on the other hand, they buy a
house, they can replace those taxable benefits with the
benefit of occupancy—an alternative return that is tax-free.
This tax concession for returns on savings that are
taken in the form of owner occupancy alters the behaviour of
New Zealand savers in favour of home ownership. In this
country, housing accounts for more than 70% of total
household savings, compared with less than 50% of the
average of all OECD countries. Money goes into home
ownership which might otherwise have been invested in assets
that improve economic growth and lift the incomes of all New
Zealanders.
The present concessionary treatment of home
ownership is a tradition that is deeply embedded in the
psyche of all New Zealanders. Quite clearly, any proposal to
change it will be highly controversial.
But the
distortions induced in the behaviour of savers have very
important consequences. It is past time they were more
widely understood and debated by the public.
The OECD
last year recommended that New Zealand should tax both
capital gains and the value of occupancy (imputed rental)
for owner-occupied homes, with deductions for mortgage
interest, depreciation, repairs and maintenance.
Economic
efficiency would, however, suffer if people facing a tax
bill on the sale of their home would be discouraged from
taking up better jobs in other centres. Those who had to
move to find work would be disadvantaged over those who
could find it locally.
Most regimes overseas that tax
income from owner-occupied homes are therefore forced to
make major concessions and exemptions. Where imputed rental
income is taxed, rates are kept at very low levels.
Since interest is deductible, the outcome is often a
greater tax benefit on housing than owner-occupiers enjoy
here.
The Review does not therefore favour a tax on
imputed rental income or capital gains for houses. The
Risk-Free Return Methodology however provides a potential
way of taxing owner-occupied and rental houses.
Property
valuations for rating could be used, net of all debt secured
on the property, so interest would not need to be
deductible. Depreciation and repairs and maintenance could
be built into an expected net rate of return reflecting such
expense, instead of being separately deductible, to achieve
a much simpler approach.
An example is given: David and
Ruth own a $200,000 house with a $100,000 mortgage. His
marginal tax rate is 39%, hers 21%, and the IRD’s risk-free
return is 4%. Taxable ‘income’ from their owner-occupied
house is therefore $4000, split equally between them. His
extra tax is $780 and hers is $420.
The market values of
owner-occupied houses would fall as buyers took account of
the extra tax cost they would face.
The decline would be
less where buyers relied on high mortgages, and more where
they needed low mortgages, ranging from perhaps 2% for a
buyer using 90% borrowed money to 15% for people buying
without mortgage.
The report estimates that, at an
average tax rate of 25%, the tax would generate $750m in
revenue. This should be used to reduce income tax.
The
Review suggests targeted transitional relief with partial or
full tax exemption for some households, or deferral of the
tax until the house was sold.
Wealth taxes
Wealth
acquired by re-investing after-tax income is already taxed.
Inherited wealth, generally accumulated from income subject
to tax, is then used to derive taxable income.
There is
no need for a general wealth tax. Estate duty is not
required to fill any gap in the income tax base. The Review
is not convinced New Zealand could operate an effective
estate duty even if it was desirable. Elderly New Zealanders
would avoid the tax if they redomiciled in Australia, for
example, which has no estate duty.
Cash-flow tax
The
proposal to replace income tax with a cash-flow tax (CFT)
has received widespread academic endorsement. So far no
country has implemented it.
The CFT tax base is simply
cash inflows minus cash outflows. No complicated rules are
needed to deal with timing, valuation or the interface
between a company and investors. It does not distort
investment decisions, improves the return on savings, and
probably induces higher investment.
On the other hand,
several billion dollars of revenue would be lost annually in
the transition from income tax to CFT. The value of some
firms would fall markedly at introduction. Pioneering design
problems would be considerable.
The review does not see a
practicable case for CFT in New Zealand in the foreseeable
future, but recommends a close watch on any developed
country introducing this type of taxation.
Expenditure,
Transactions Taxes
Expenditure and transaction taxes
include GST, excises, customs duty, road user charges, motor
vehicle fees, stamp and cheque duties and energy resource
levies. They comprised 35% of total tax revenue and 11.7% of
GDP in the 2000/01 year.
Goods and Services Tax
GST is
a broad-based, low-rate, fair and efficient tax.
It has
three important exemptions—financial services, rental
accommodation, and housing. Traders in those areas cannot
claim back GST on supplies used in trading. Their GST burden
is believed to be close to what they would pay if GST
applied.
GST is roughly proportional to income for more
than 80% of households. Using multiple rates or exemptions
to remedy concerns about regressivity would create other
costs and anomalies likely to have worse impacts.
The
Review does not propose any significant change.
Gift
Duty
Gift duty raises only $1.6m a year, but involves
significant compliance costs. Its rationale has been eroded
by other tax changes in the past 20 years. Where it does
still in minor degree protect the tax base, other less
expensive options are available. Gift duty should be
abolished.
Welfare issues such as geriatric care can be
managed by bringing into welfare asset tests any assets
transferred over the last half-dozen years. The transfer of
assets otherwise taxable at 39c into trusts taxable at 33c
should be addressed by re-examining the tax scale.
Stamp
and Cheque Duties
Cheque duty is easy to avoid by using
cash, electronic payments, credit cards, debit cards or
direct payment authorisations, which do not carry any such
duty. It raises only $11.5m. It is inefficient and should be
abolished.
Financial Transactions Tax
A financial
transactions tax, levied on withdrawals from financial
institutions, has been promoted as a less regressive
alternative to GST.
The impact of the tax falls not
ultimately on the withdrawal transactions, but on goods or
services purchased with those funds.
But no credits are
allowed on inputs along the production chain. So a cascade
occurs where tax is levied at each stage on the tax which
has already been levied at previous stages. The tax levied
on products of equal value ends up varying greatly,
dependent on the number of stages in the production chain.
Prices of some goods will be artificially inflated,
distorting production and purchasing decisions. In addition,
the amount of tax likely to be raised by any given rate is
very hard to estimate.
Tobin tax
Tobin tax is a
low-rate tax on all foreign exchange transactions aimed at
dampening currency speculation and stabilising exchange
rates.
Long-run exchange rate movements are a vital means
by which New Zealand adjusts to economic changes here and
around the world.
No means exists to identify
transactions aimed primarily at speculation. Every buyer
buys in hope. There is a speculative element in every
transaction.
Buyers anxious to minimise risk hedge
against it via transactions with sellers who are happy to
accept higher levels of risk, but a Tobin tax would reduce
the amount of risk speculators are willing to accept.
It
would therefore limit the ability of exporters and importers
to hedge their own risk by trading it with speculators happy
to manage a higher level of exchange rate risk.
A tax
intended to improve exchange rate stability therefore ends
up exposing importers and exporters to increased exchange
risk.
The tax mix
In general, it is desirable to
spread tax reasonably evenly across a number of bases to
minimise avoidance. Overall revenue flows would tend to be
more stable.
The income tax base is less comprehensive
than the GST base. Income tax offers more scope for base
broadening to raise revenue and reduce incentives to
activities that are less profitable to the nation as a
whole.
Economic decisions are likely to be distorted
less by the GST base than by a comprehensive income tax, and
GST’s compliance costs are also somewhat lower than those of
income tax. The total costs imposed by tax on the economy
would be reduced somewhat if relatively more reliance were
placed on GST.
We therefore think that, if the government
needs to increase taxes in the future, it should turn first
to GST. If it is able to reduce them, it should turn first
to income tax.
Excises and Duties
Excises on tobacco,
alcohol and petrol, and duties on gaming are in marked
contrast to GST, which applies at one rate across the board,
independently of how people choose to spend their money.
They are of particular interest because they raise about
$2.8 billion, and directly challenge the broad-based
low-rate rationale that underpins the rest of the New
Zealand tax system.
Excise tax revenue
Excise receipts
based on the 1999-2000 year—inclusive of excise on local
production, customs duty on imports, the additional GST
induced by the inclusion of those taxes in the price of the
goods, and adjusted for the most recent tobacco tax changes,
implicit regulatory taxes on gaming and road user charges on
petrol—comprise $583m on alcohol, $1063m on tobacco, $507m
on gaming, and $630m on petrol. They total $2783m.
The
total rate of indirect taxation in New Zealand expressed on
a ‘GST-equivalent’ basis is of the order of 16.6%.
Many
of these taxes appear likely to have high deadweight costs
per dollar of additional revenue raised relative to broadly
based forms of taxation. It appears difficult to justify
current levels of excises and duties on ‘efficient taxation’
grounds.
The Review does not believe revenue raising
provides a sustainable rationale for narrowly based indirect
taxes in an environment where GST is available.
Impact on
price paid by consumers
Alcohol excise adds $3.56 to a
dozen cans of beer, $1.70 to a bottle of wine and $17.09 to
a bottle of spirits. Tobacco duty adds about $5.56 to the
price of a packet of cigarettes.
Gaming duties average
15 cents per dollar of gambling expenditure, but they vary
by operator and product. GST-adjusted rates range from 4.4
cents per dollar of consumer spending in casinos, 14c for
lotteries, and 19c for racing and sports, to 22.5c for
non-casino machines.
These figures ignore statutory
monopoly profits and mandatory charitable contributions that
push the total ‘tax’ take to 66% for the Lotteries
Commission and 60% for non-casino gaming machines.
Adverse impact on social equity
Tobacco tax accounts
for 38% of total excise revenue. It is paid by only 25% of
the adult population. A person smoking one packet a day pays
over $2000 a year in GST adjusted tobacco tax.
Although
87% of New Zealanders consume alcohol, 50% of those drinkers
pay 90% of the excise, at an average rate of $400 a year
each. The top 10% of drinkers (260,000 people) pay half the
alcohol excise, at an average $1100 a year
each.
Similarly 86% of us gamble, spending an average
$490 a year each. But more than half of those gamblers spend
less than $240 a year. The top 10.5% of adults who are
regular continuous gamblers spend an average $1800 a year.
At an average tax rate of 40c, those 300,000 New Zealanders
would pay an average $700 each in gaming taxes.
In short,
many New Zealanders of modest means pay as much or more
through taxes on alcohol, tobacco and gaming than they pay
in GST on all of their other spending.
The impact is
disproportionately severe on the minority of individuals and
their families who experience drinking or gambling problems.
To the extent that alcohol and gaming abuse is a symptom of
a deeper problem, this large transfer of funds away from
such families must worsen the problems it was intended to
counter.
Tobacco tax, in particular, falls dramatically
more heavily on disadvantaged people. Smoking prevalence is
37% among the most deprived New Zealanders, falling to only
16% for the least deprived.
Smoking prevalence among
Maori is about twice that of the general population. Among
sole parents with dependent children, a notably low-income
group, it is also very high at 42%. No feasible change in
other forms of taxation can address these large vertical and
horizontal inequities.
Because excises fare so poorly on
normal criteria of fairness and efficiency in raising
revenue, such taxes require a strong alternative
justification.
Public spending externalities
Some
submissions sought ‘regular and substantial increases in
tobacco excise’ to modify lifestyles in pursuit of improved
health outcomes to meet health system targets.
Where
smokers and drinkers incur additional medical expenses paid
for by the individuals themselves, those costs will be
factored into their decisions about smoking and drinking.
That will not be true where public health care is provided
free.
We are not convinced that those concerns provide a
robust basis for tax policy. It is not easy to justify
singling out smokers and drinkers. The same public health
rationale applies to other lifestyle choices that impose
extra costs on the health system.
Road transport
externalities
We have reviewed recent estimates of
generalised environmental road transport externalities, and
regard these as too speculative to provide a rational basis
for the 21c/litre general revenue excise on petrol, or to
suggest that diesel should be brought into the excise
regime.
Gaming taxation
The Government is undertaking
a comprehensive ‘first principles’ review of the gaming
sector. This review is managed in the Department of Internal
Affairs.
Submissions to the Gaming Review on the tax
treatment of gaming have been forwarded to us for
consideration. Chapter 2 contains our initial observations
on some aspects on this topic.
Eco-Taxes
The Review
considers that an eco-tax is appropriate only when the
following three conditions are broadly
satisfied:
The environmental damage of each unit
of emissions is the same across the geographic area to which
the tax applies;
The volume of emissions is
measurable; and
The marginal net damage of
emissions is measurable.
At a national level, we
consider only greenhouse gases satisfy these conditions.
Prospects for a broader range of eco-charges may,
however, be more promising at a local level. For example,
each tonne of organic waste going to a landfill can be
presumed to have much the same impact as any other
tonne.
Carbon Tax
We note that under the Kyoto
Protocol New Zealand’s gross emissions in the first
commitment period from 2008 are expected to exceed by about
nine percent the levels required under the Kyoto Protocol.
However, accounting for forests planted after 1990,
which are recognised as carbon sinks under the Kyoto
Protocol, New Zealand’s net emissions in 2010 will be less
than 75% of targeted levels.
A carbon charge satisfies
the conditions for effective eco-taxation at a national
level.
New Zealand has an unusual greenhouse gas emission
profile, heavily weighted towards methane (48.5%) and
nitrous oxide (15.9%) relative to carbon dioxide (35%).
The Review has not seen with any analysis of the impacts
of methane taxes and we have been unable to find any
explanation for why ruminant methane should be excluded from
a New Zealand carbon tax regime.
We seek further
consultation on the feasibility of this form of taxation, on
its efficiency in providing incentives for greenhouse gas
emissions abatement in New Zealand and on the risks under
Kyoto of excluding ruminant stock numbers from a carbon
charge.
We would not favour the introduction of a carbon
charge prior to ratification of the Kyoto Protocol by New
Zealand, because of our inability to take meaningful
unilateral action to affect global climate change.
Following ratification, imposition of a charge prior to
the first commitment period may be desirable but only after
international carbon markets begin to give clearer
indications of the likely price of carbon (emissions
abatement).
It would be desirable for meaningful debate
over the feasible, fair and efficient coverage of a national
carbon charge, consistent with the government's Kyoto
commitments, to begin immediately.
Tax Rates
Personal
Tax Rates
Personal income tax is used to generate revenue
for government, and reduce income inequality. The number of
personal rates has been reduced from 33 ranging from 15-60%
in 1967 to four now, ranging from 15-39%. At the same time
the tax base has been broadened. The top rate has halved but
proportion of tax collected from the top bracket remains
roughly the same.
There is a wide gap between our present
21% middle rate and the top rates of 33% and 39%. This
creates a large incentive for higher income people to split
income with a lower tax-rate partner.
Family trusts,
with minors as beneficiaries, are one common means. Measures
implemented so far to block the gap are only partly
successful. The top personal rate is now 6 percentage points
higher than the company rate, creating incentives for
individuals with income above $60,000 to earn it through
companies.
Preventive measures so far miss some
companies, and may unfairly penalise others.
The new rate
structure has led to a growing number of business decisions
based on tax avoidance, not efficiency. The ability of many
individuals to avoid the new top rate undermines the
credibility of the tax system.
Effects on
Inequality
In New Zealand, most redistribution occurs
through government spending. The distribution of taxpayers
does not permit large amounts of redistribution through
additional rate scale progression.
Only 200,000 taxpayers
earn more than $60,000, compared with 1.65 million on less
than $30,000. It takes eight dollars in tax from each person
in the high group to provide one dollar for each person in
the low-income group.
The top income group does almost
the entire nation’s saving. The country is not well served
if they reduce their saving, focus more effort on avoidance,
raise their fees to recoup extra tax, or emigrate.
People
sometimes suggest helping low-income earners by not taxing
income below $9500. That would give people on $20,000 a gain
of $17.31 weekly, but the other rates would have to move to
26%, 39% and 49% to fund that tax threshold.
The real
driver of redistribution is that both the proportional and
progressive systems collect more tax at the top, and
governments spend it with a bias towards low-income groups.
If an increase in progressivity is desired, it is best
achieved through an increase in targeted spending, not an
increase in the progressivity of tax rates.
Implications
for tax scale design
The tax scale has limited ability to
help low-income earners through progressivity, and in doing
so creates expensive inefficiencies.
The Review
considers that a proportional scale offers substantial
benefits over a progressive one in terms of efficiency,
administration costs and avoidance.
However, a
proportional scale would result in income losses to
low-income earners. Also, many New Zealanders value the
progressivity delivered through the tax system.
The
Review’s analysis points towards a two-rate scale that
retains some progressivity while reducing its cost, and
simultaneously, minimises the loss that low-income earners
would suffer if the system moved to a simple proportionate
scale.
The following table gives examples of two-rate
combinations which, based on a rate step at $29,500 and a
corporate rate aligned with the top personal rate shown in
the table, are approximately revenue neutral as compared
with the present four-rate system:
Low Rate High
Rate
17% 34%
18% 33%
19% 32%
20% 31%
Taxable
Unit
Tax in New Zealand is based on individual income,
while the benefit system operates on a basis of household
income. Some suggest using household income for both systems
to overcome anomalies created by a progressive rate
structure.
Currently, for example, a household with two
$25,000 incomes pays $9,360 in tax, while a household with
one earner on $50,000 and a non-working partner pays
$11,370. Why not let that earner split the income with the
spouse for tax purposes?
That would create as many
anomalies as it solves. Traditional ‘empty-nest families’
with a single earner on a high income would make quite large
gains, for example, while sole working parents with
dependent children made none. Concerns focused on households
are addressed best through decisions on spending, not
tax.
Taxation and the Benefit System
The welfare
system targets cash payments (income) to beneficiaries. As
they move into work and their income rises, they pay tax and
they also lose part of their benefit.
Their effective
marginal tax rate comprises both payments, and may reach
high percentages. High marginal rates affect people’s
decisions. They may, for example, decide the residual gain
is not enough to warrant working full-time.
Family
support abatement for example pushes effective marginal tax
rates for a one-child family to rates between 39% and 51% at
incomes from $20,000-32,000. At the same time, the problem
should not be exaggerated. As they gain experience, are
promoted and change jobs, their income in many cases rises,
the benefit abates fully, and they move back on to normal
tax rates. This is the price of targeted
assistance.
Targeting Vs Universality
Universal
benefits are payments made at the same rate to everyone,
regardless of income. They do not change effective marginal
tax rates as income rises. But they are so costly that only
limited assistance is provided to low-income groups, while
an equal gain is passed to middle and high-income
people.
Increased Targeting
More targeting means more
people facing high effective marginal tax rates as they try
to move out of benefit dependency. Less targeting means a
lower level of assistance to needy people. There are no
perfect answers.
Universal Basic Income
Some
submissions recommend paying a universal basic income to
every New Zealander, based on age and residence.
Unfortunately such a payment, set at $17,000, around the
level of the highest present benefit, would require raising
the tax rate to 67.5% on every taxpayer, and tolerating
major inefficiencies.
With a universal basic income of
$10,000 per person, a family of four would have an income of
$40,000 without working. If they did work, they would face a
tax rate of 41%.
Universality usually has little impact
on the underlying objective of policy. Paying benefits to
middle and upper income families does not reduce child or
family poverty.
Conclusion
There is no way to
eliminate high marginal tax rates without making
beneficiaries better off than working people, or incurring
large costs by paying benefits to middle and upper income
people. It may be possible to make significant gains,
however, if the benefit system, with its many different
rates, benefits, abatements and eligibility rules can be
simplified.
Collapsing the present 15% and 21% rates into
one rate in the 17-22% range would also provide some
reduction in marginal tax rates for most beneficiaries and
low-income earners.
Corporate Tax Rate
For domestic
shareholders, company tax acts as a withholding tax on their
company income, like PAYE on wages and salaries. Through the
imputation system, it is taxed ultimately at the personal
rate of the shareholder. Company tax also discourages people
from sheltering labour income in companies to avoid personal
income tax. For non-resident shareholders, it is a final tax
on company income as it accrues.
The statutory rate is
not a complete guide to the impact of company tax because
taxable income is not fully aligned with economic income.
However, the evidence is that the effective tax rates
imposed on investment in New Zealand are lower and less
disparate than in most other countries. It also suggests our
effective marginal rates are broadly consistent across most
types of business asset.
Impact on domestic
shareholders
For domestic shareholders, the focus should
be on aligning the company rate with the top personal tax
rate to reinforce its withholding tax role, and to remove
any opportunity to shelter any income in
companies.
Impact on avoidance
Other countries do not
always take this approach. Some are relatively tolerant of
individuals sheltering income in entities. Some have given
up on enforcing the boundary, and accepted split rates.
Others use distortionary efforts to block tax base leakage.
New Zealand should not follow any of those
examples.
Impact on foreign investment
Company tax on
non-resident shareholders is one of the factors affecting
our ability to attract foreign investment. The rate
appropriate to domestic investors is not necessarily the
same as the rate appropriate to non-resident investors.
Impact on competitiveness
While many factors affect
our ability to attract foreign capital, the statutory
company tax rate is a headline indicator of receptiveness to
international capital flows.
Conclusions
Setting the
company rate is complex, because the tax plays different
roles. In general, it should be aligned with the top
personal rate, if that rate is not out of step with
international norms.
Taxable Entities
Where entities
are interposed between individuals and their income, rules
are needed to deal with transactions between the entity and
the beneficial owner. Companies, partnerships and trusts are
the most common entities.
The existence of such entities
can create opportunities and incentives for people to ‘shop
around’ among entities. Outcomes include search costs,
sub-optimal entity choice, and leakage from the tax base.
The goal of policy is to minimise those and compliance
costs.
The number of different entity-specific regimes
should be as low as possible. Core rules applied to all such
entities should be as wide as possible. Boundaries between
such regimes should be clean.
Different forms of
substitutable investment should be treated as uniformly as
possible. Marginal rates at individual and entity level
should be aligned where possible.
Do existing rules
measure up?
New Zealand has different entity-specific
regimes for qualifying companies, controlled foreign
companies, foreign investment funds, co-operatives, producer
boards, Maori authorities, unit trusts, group investment
funds, life insurance companies, superannuation funds and
close companies.
The substance of all those varying
rules falls into three main groupings:
Partnerships, ignored entirely for most tax purposes. Income
is attributable directly to partners.
Companies,
taxed on their income with imputation credits to
shareholders. The income they derive is taxed, overall, at
the correct rate for the individual.
Trusts,
where distributions of current-year income are treated as if
directly derived by the beneficiary (not the trustee), but
income retained by the trustee is subject to final tax in
the hands of the trustee.
The Review suggests reducing
the number of entity-specific regimes to a minimum by mixing
and matching to bring all entities within these three
groups.
We also distinguish between widely held entities
(many owners with an arm’s-length relationship) and closely
held entities (a few closely related owners).
Widely
held entities & their owners
Default rules for
widely-held entities
In substance, the owners of widely
held entities are simply providers of finance. The
management team is a distinct and separate group. The
company tax regime is an appropriate set of default rules,
modified as necessary to accommodate unique features of
other business forms.
Under that regime, dividends are
not tax deductible, but double taxation is prevented by the
attachment of imputation credits. All dividends, however
funded, are taxable.
At present, other widely held
entities are treated differently. Distributions from
current-year income are, in effect, deductible while
distributions from retained income are exempt.
In
examining how to integrate widely held entities into a
single tax regime, the Review examines three alternatives to
imputation. It concludes that imputation should be the
default approach, despite design challenges in areas such as
discretionary trusts.
Pass through of
preferences
Shareholders receive returns in two
forms—dividends and capital appreciation. If it were not for
tax differences, they would be indifferent to the source of
the dividend.
The Review endorses the view of the 1990
Valabh Committee that dividends, like interest on debt,
should be taxed whether or not it derives from a source that
is tax-free within the company.
Current trust and
partnership rules do however allow the flow-through of
entity-level preferences other than losses to beneficiaries.
This would prove costly if trusts could be substituted
for companies. Widely held trusts compete with widely held
entities taxed as companies, including unit trusts and life
insurance funds.
The same general rules should, in
principle, apply to both. Current rules already treat trusts
as companies where the rights and entitlements of
contributors are sufficiently well defined.
The Review,
after examining the issues involved, concludes that
imputation without pass-through can—with modifications if
necessary—be applied to widely held discretionary trusts,
much as it is applied currently to unit trusts.
Widely
held partnerships also tend to have relatively clearly
defined property rights based on contract. Under an
imputation regime, a widely held partnership would be
defined as a widely-held company, pay tax on all partnership
income, and distributions would carry imputation
credits.
The Review wishes to explore these options
further, and invites submissions on the application of the
company regime to widely held partnerships and
trusts.
Taxation of closely-held entities
A closely
held entity regime has to recognise the close economic
connection between the owner, entity and its underlying
assets. It should minimise the extent to which taxpayer
choices are influenced by differences in tax treatment among
entities.
The Review envisages that closely held
companies would be subject to the qualifying company regime,
closely held partnerships would be subject to the present
partnership rules, and closely held trusts would come under
the present trusts regime.
Wide/close held entity
boundaries
The key priorities in defining the boundary
between widely and closely held entities are to:
Reduce the ability of widely-held entities to seek tax
advantages by recharacterising themselves as closely held;
and
Ensure the rules avoid undue
complexity.
Charities
These recent Government Tax and
Charities discussion document proposes a number of changes,
and also defines three options for amending the definition
of ‘charitable purpose’:
The status quo
safeguarded by registration and a possible government
veto
The same safeguards plus a new definition
based on guidelines and applied by an independent
body
A narrowing of the definition to the relief
of poverty, which is included for discussion purposes
only.
The Review will follow with interest the outcome of
this document and its proposals.
International
Tax
Introduction
Taxation of inbound investment
(income earned in New Zealand by non-residents) and outbound
investment (income earned offshore by New Zealanders) have
been controversial policy areas for 15 years. They are
complex.
They impact on mobile corporates and high-worth
individuals who are very responsive to tax, so the stakes
are high.
Globalisation is challenging the ability of
governments to tax such income, but the time has not yet
come for New Zealand to move away from taxing income from
capital.
Theoretical Framework
The three income tax
bases involved are: residents’ New Zealand income, and their
offshore income; and non-residents’ New Zealand income. The
offshore income of non-residents is generally beyond our
reach.
Which bases should be taxed, how, and by how much,
to achieve outcomes that are ‘best for New Zealand’? The
Review begins by analysing simplified economic models, to
arrive at insights not otherwise available.
Theory:
Taxing of non-residents
New Zealand depends on capital
inflows for its development. It helps performance by
introducing new technology, management, expertise and access
to world markets. Direct foreign investment totalled $63.8
billion at 31 March 2000.
Tariffs on imported capital,
like tariffs on imported goods, raise revenue at a high
price, and make New Zealand a less attractive place for
non-residents to invest.
They have plenty of other
options. They will bring funds here only if their return
after New Zealand tax at least equals their return
elsewhere. They require international levels of post-tax
interest and yield.
If our tax on them is high, it
merely boosts the interest rate or yield they require to
come here. So the tax burden does not fall on them. It
passes to New Zealanders through higher costs of capital,
less investment and depressed share prices. On that basis,
it is best for New Zealand not to tax them at all. But there
are two important qualifications to that conclusion:
1.
Economic rents
First, foreign direct investment by
multinationals to earn income that is specific to New
Zealand may give them access to economic ‘rents’ or economic
rents.
In that case, the tax may not deter them, and may
not damage New Zealand. Reducing it may merely raise their
after-tax profit without enhancing this country’s national
welfare.
2. Foreign tax credits
Many countries reduce
the tax liabilities of their residents in their home country
by the amount of any tax paid elsewhere. In that case, tax
in New Zealand, if it is not higher than their rate at home,
affects where tax is paid, but does not change the amount
they pay.
In theory, those non-residents should be taxed
by New Zealand up to the level of the foreign tax credits
available to them in their own country.
Practical
difficulties arise because the tax credit schemes vary by
rate, timing and the restrictions placed on them,
complicating the question of optimal design.
Theory: NZ
residents’ offshore income
The system presently used to
tax income earned by New Zealanders offshore is a compromise
that does not arise from the strict application of any
policy framework. The Review has therefore thought carefully
about policy framework design.
Taxes paid to the New
Zealand government contribute to national wellbeing. Taxes
paid to foreign governments do not. It will be in the
national interest for New Zealanders to invest offshore only
when the return after foreign tax is higher than the pre-tax
return of a similar investment in this country.
Residence
principle
The idea that New Zealanders should be taxed at
the same rate on the income they earn, here and abroad,
subject only to a deduction of foreign taxes, is known as
the residence principle.
On that principle,
non-residents would not be taxed on the income they derive
here. Most economists think a pure residence basis gives the
best outcome for New Zealand. World welfare is, by contrast,
maximised when investors choose the best investment
available globally, regardless of tax.
New Zealand’s
obligations under double tax agreements reflect that world
welfare view. New Zealand is therefore constrained in its
ability to adopt the pure residence approach.
The
‘see-saw’ model
The right level, in theory, for tax rates
on offshore investment, approximates the following
equation:
Average net NZ rate on NZer’s foreign sourced
income
=
Tax rate on New Zealand sourced
income
minus
Net effective NZ tax rate on income
sourced by non-residents from NZ.
This implies that when
either of these two rates is high, the other rate should be
low. In line with that ‘see-saw’ principle, New Zealand will
gain by:
Allowing a deduction, not a credit, for
foreign taxes paid by New Zealanders earning offshore
income.
Imposing uniform tax rate on all
offshore income as it accrues, regardless of source.
(Differences in treatment will distort residents’ offshore
investment decisions.)
Taxing New Zealanders’
offshore income at a lower rate than domestic income, to the
extent that the cost of capital to New Zealand is raised by
taxes on non-residents earning New Zealand sourced
income.
Where tax on non-resident income earned in New
Zealand raises their required pre-tax return in New Zealand,
the burden of that tax is not carried by the non-resident.
It passes to New Zealanders in the form of higher interest
rates, higher costs of capital, lower levels of investment
and lower national welfare.
Reducing the present level of
New Zealand tax on non-residents’ New Zealand income will,
as a general principle, help to increase investment and
improve economic growth.
Finally, tax policies, trends
and rates elsewhere impact on our inbound investment. New
Zealand should keep the tax rates of other countries in mind
when setting its own rates.
Non-resident income earned in
NZ
The sensitivity of inbound investment to New Zealand
tax varies.
Debt finance, portfolio investment and
direct foreign investment in goods and services intended for
export are highly sensitive because substitutable
investments are available in other jurisdictions.
Direct
foreign investment targeting the local market is less
sensitive because the non-resident cannot be a player in the
market without investing here. Moreover, some of that
investment is likely to be made in order to earn economic
rents by exploiting the market.
Current rules compared
with framework
At present, New Zealand imposes somewhat
disparate effective tax rates on non-resident investors.
Equity is currently taxed significantly higher than
debt, distorting their relative costs to New Zealand firms.
The Review concludes that it would be highly desirable
to narrow the gap by reducing effective tax rates on
investment in equity instruments for both direct and
portfolio foreign investment.
Options for non-resident
regime
Direct Investment
The review does not recommend
any across-the-board reduction in company tax rates
significantly below the top personal marginal rate. It is
costly, and not well targeted to a reduced burden on
non-resident investors. It sees advantage in:
Somewhat reducing the effective rate on foreign direct
investment
And reducing the effective rate on
equity to narrow the present debt/equity gap.
The Review
seeks submissions on the size of the reduction. It would
like New Zealand’s regime to ‘stand out from the
crowd’.
The Review outlines options to pursue those
objectives:
1. A reduction in company tax rate for
non-residents.
An Annex to the report outlines and seeks
submissions on a proposal to impose 33% on companies which
are entirely New Zealand owned, 15% on companies entirely
owned by non-residents, and set intermediate rates for mixed
ownerships.
A 1% change in the non-resident rate reduces
government revenue by $45-50m. The fiscal cost is estimated
at $380m for a 25% rate rising to $855m for a 15%
rate.
2. If it proves that significant economic rents
exist, the reduction could apply only to foreign equity
investment in new productive activities, or for example new
productive activity in export industries, or new productive
activities in selected industries or regional development
zones.
The review notes that limiting the concession to
new activities alone may have unintended consequences.
Interest
The Review advises against any material
increase in tax rates on interest paid to non-residents, but
sees possible merit in a small AIL increase to 3% (2% after
tax).
Portfolio Equity
Two options targeting separate
effective tax rate components warrant further consideration,
with a case for implementing both of them:
1. A choice
for companies paying ‘supplementary dividends’ between
Non-resident withholding tax (NWRT) and an approved issuer
levy (AIL) at the level applied to debt.
2. An increase
in the present Foreign Investor Tax Credit (FITC).
Taxing
NZers’ offshore income
New Zealand’s current
international regime does not satisfactorily reflect the
insights either of economic theory or the business
community. The current compromise in the taxation of New
Zealanders’ offshore income is unsound. It needs
change.
Key design issues
Key design issues include
the timing of income inclusion, the availability of foreign
tax credits, and the taxation of capital gains in offshore
equity investments in non-grey-list countries.
Approach
of Review to design
Our double-tax treaties require us to
allow tax credits. Differences in the approach of other
jurisdictions to tax credits mean that foreign investors do
not face a single uniform ‘net’ rate of New Zealand tax on
New Zealand sourced income. The Review is considering two
possible approaches:
Allow tax credits across
the board for tax-treaty and non-tax treaty
countries.
Or use the ‘Risk-free return method’
outlined in the Report to introduce a fundamentally
different approach to taxing equity investments. Evaluation
of this option will require careful consideration of the
incentives likely to be created by this option, and the
likely reaction of treaty partners.
Repeal of grey
list
The present grey-list framework creates incentives
for New Zealanders to invest in high-tax grey-list
countries. This does not maximise national welfare. The
Review recommends repealing the grey list, providing repeal
occurred as part of a satisfactorily revised regime for
offshore investment.
Policy options for offshore
investment
The review outlines two broad options to
consider the context of grey-list repeal:
1. A modified
CFC approach with an active/passive distinction for taxing
foreign direct investment by New Zealand residents outside a
designated list of low tax/tax haven countries.
2. An
RFRM approach, involving either foreign investments only, or
both foreign and domestic investments.
The RFRM approach
would increase the relative New Zealand tax burden of grey
list investments compared with foreign investments
elsewhere, and create some helpful movement of investment
flows towards lower tax countries.
The analysis of the
costs and benefits of these options is set out in the full
report.
Australian and triangular issues
The Review
awaits the outcome of bilateral talks between the Australia
and New Zealand governments. When they are completed, the
Review will consider whether any unilateral steps would be
desirable.
Foreign trust rules
The review has not yet
considered the foreign trust rules.
Attracting high net
worth immigrants
In general, residents are taxed on their
worldwide income, but non-residents are taxed only on their
New Zealand sourced income. The prospect of facing New
Zealand tax on their world income may deter individuals of
high skill and net worth from taking up residence in New
Zealand.
Because that does not enhance national well
being, the Review is considering a domicile rule similar to
the United Kingdom’s, where residents not domiciled in New
Zealand would be exempt, perhaps for 6-8 years, from FIF and
CFC rules.
Capping an individual’s maximum tax liability
at $1 million a year could also be considered as a means to
reduce the perceived disadvantage of New Zealand tax
residence.
The issue of capping the amount of income tax
paid by any individual arose in discussions with submitters.
An amount of $1m was raised as a possibility. It is the
amount of income tax that would be paid by a person earning
$2.6m a year. Under this idea, people earning $2.6m a year
or more would simply pay $1m in income tax.
The proposal
was directed at countering the increasing mobility of
high-income individuals and encouraging such people from
overseas to make New Zealand their economic base. It would
have fiscal costs if applied to any existing New Zealanders,
offset to the extent that residents in this category were
encouraged to stay instead of leaving, and people overseas
were attracted.
The proposal would also have to be judged
against accepted notions of vertical equality. The Review
has reached no conclusion but welcomes additional
submissions on this issue.
Conclusion
The most
appropriate direction for reforming tax of non-residents may
be to refine the current regimes so that New Zealand taxes
them only where the economic incidence of the tax is not
shifted to New Zealanders.
Successive governments have
found it difficult to develop an appropriate sustainable
framework for taxing the foreign sourced income of
residents.
The Review sees merit in trying to design a
suite of regimes with a core based on ‘risk-free rate of
return’ methodology, and will further examine the
feasibility of this course.
Savings
‘Saving’ refers to
all additions to a person’s net worth, including financial
assets, housing and small businesses. Tax is just one of a
large number of factors that impinge on their motivation to
save, ability to save, and the form in which they
save.
Policy since 1988 has been to treat income from
savings identically to other forms of income. We have a TTE
regimesavings are funded from taxed income, the
income earned by the savings is taxed, but withdrawals of
savings are tax-free.
Aggregate savings by households,
business and government are currently estimated at 2% of
GDP. A ‘true’ measure would include e.g. investments in
education and consumer durables, and would probably be more
than 20% of GDP.
The more we save as a nation, the better
off the nation will be in the future. But the average rate
of return on our savings is equally important. Our
lacklustre economic growth in the last 20-30 years owes more
to poor returns than low investment. It is very important to
ensure that the tax system does not induce investment in
poorer performing assets.
If a savings problem does exist
here, it is because national savings, not private savings,
are too low. The Review is not convinced that tax
concessions would benefit national saving, and therefore
favours retaining the present TTE regime.
However,
people’s choices on how they will save are very sensitive to
tax considerations. Concessions on housing, for example,
encourage widespread investment in housing, which has lower
financial returns than returns on financial assets.
Using
the Risk-Free Return Method of taxing some forms of capital
could benefit savers by reducing the impact of inflation on
tax. It offers a more neutral treatment of different forms
of saving, and promotes investment in the highest yielding
uses.
If that approach is not possible, no tax
concessions should apply to savings, but disparities in the
tax treatment of returns on saving could be addressed. They
include:
• Owner-occupied housing
• The
non-deductibility of mortgage interest, which encourages
paying off the mortgage ahead of other forms of saving.
•
Disparities in the treatment of closely substitutable
savings vehicles, e.g. unit trusts and superannuation
funds.
If, despite our conclusions, governments want to
introduce savings concessions, the present regime can be
rearranged in a variety of says, but it is difficult to
design ‘good’ savings incentives. The transition to new
concessions may also involve considerable fiscal costs for
uncertain gains.
One of the less costly approaches would
be to apply a reduced rate to earnings on savingsthe
middle T in TTEto create what might be called a TtE
regime. The Review surveys the design difficulties involved
in policing the boundaries of the concession, and outlines
options for doing so.