Roger Kerr: Is There a Case for a Payroll Tax?
10 March 2006.
Is There a Case for a Payroll Tax?
Recent media reports suggest the government may be considering a payroll tax as an option in its review of business taxation. It might be used to raise some or all of the revenue lost from a possible cut in the rate of company tax.
In response to a request from the minister of finance, the Treasury advised (on certain assumptions) that a cut in the company rate from 33% to 20% could be paid for by a payroll tax of 5.4%.
What is a payroll tax? Unlike an income tax which is a tax on labour income (wages, salaries, fringe benefits etc) and capital income (such as interest, dividends, rents and sometimes changes in the value of assets), a payroll tax is a tax on wages alone.
Although not intuitively obvious, it is equivalent (at least in simple terms) to a tax on consumption (such as GST). This is because most people spend most of what they earn in wages (or from investments based on savings from wage income) over their lifetimes.
A payroll tax could be imposed on either employers or employees, but generally speaking the ultimate cost would be borne by employees. If employers pay in the first instance, there will be an offsetting effect on wages or employment over time.
Only where labour is internationally mobile might firms be forced to increase gross wages (and maintain after-tax pay) to compensate for a payroll tax. In this case fewer such people would be employed over time as firms would make adjustments to maintain a normal return on investment.
Exporting and import competing businesses would be unable to reflect higher wage costs in their prices. They would also respond by reducing their demand for labour.
A payroll tax was introduced by the Muldoon government in the 1970s but was controversial and quickly abandoned. A number of Australian state governments have payroll taxes but a reason for this is that they need a separate revenue base (just like local government needs rates).
The comprehensive McLeod review of the New Zealand tax system in 2001 did not see merit in a payroll tax. Its main recommendation was to adopt a lower and flatter income tax structure.
Why do tax experts not favour a payroll tax at central government level? A key reason is the major practical problems that arise from the self-employed (a growing category) and investors in closely held companies being able to characterise labour income as income from capital if it bears a lower rate of tax. Also much the same economic outcomes could be achieved in New Zealand's case, with far lower administration and compliance costs, by increasing GST.
Certainly there would be gains from reducing the rate of company tax. Such a move would reduce the cost of capital, encourage additional investment and stimulate economic growth.
However, the gains would be limited unless there were parallel reductions in personal tax rates and, preferably, an alignment of the top personal rate and the company rate, as the McLeod review recommended. For a good number of businesses (such as many small businesses and farmers), the personal rate is the most relevant one for investment decisions. If the company tax rate were set well below the higher personal tax rates the current incentives to engage in tax planning and the costs and complexities of the tax system would be greatly increased.
However, a payroll tax is not needed to fund meaningful reductions in company and personal tax rates. These could be funded from the government's existing provision for new spending or revenue reductions; savings in base spending; a lower operating balance; and the revenue benefits of the impetus to the economy of a lower tax structure. The idea that a cut in wages is needed to fund a reduction in company tax would be hard to defend.
The argument that a payroll tax would force firms to economise on labour in a tight labour market and invest more in capital equipment, so raising labour productivity, is unpersuasive. We do not need a payroll tax to make that happen, and New Zealand still needs to create more jobs. Unemployment remains relatively high among young people and Maori; significant numbers of potential workers remain on benefits; and others, such as part-time or older workers, have difficulty obtaining full-time jobs.
A payroll tax/company tax reduction package would do little for economic growth and would be no substitute for a more credible growth strategy. There is no logic in the proposition that a move in the direction of Australia's company tax rate necessitates the adoption of other features of the Australian tax system.
Most business organisations, analysts and tax experts would see a reduction in wasteful government spending (and thus a lower overall tax burden), combined with a lower and flatter tax structure, as being a better approach.
Roger Kerr is the executive director of the New Zealand Business Roundtable.