Cullen's Speech To Accountants
Auckland Public Practice Special Interest Group (Institute of Chartered Accountants) 5.30pm, 6 March 2000 Ellerslie Convention Centre Auckland
Hon Dr Michael Cullen Treasurer Minister of Finance Minister of Revenue
Speech to the Public Practice Special Interest Group
You have asked me to talk about the Government’s proposed economic, tax and commercial goals. I am going to try and do that in the context of talking about the interface between the government and yourselves as people who offer accountancy services to public agencies.
I can come at this question from a number of angles, but I do have to be careful not to move beyond my area of competence and responsibility and intrude into the territory of my colleagues, particularly the Minister of State Services.
Let me start with a comment on the goals of this Government. These were laid out in the Speech from the Throne. They do reflect a government with a different philosophical approach. I do not think that I am misrepresenting the previous government when I say that it tended to see economic and social goals as distinct. It had a very clear idea of the so-called economic fundamentals that guided it. Then, if those economic fundamentals produced financial surpluses in the public accounts, it could make what was akin to a dividend distribution: either in the form of tax cuts, or service increases, or a mix of a dollar of tax cuts per dollar of social spending.
This government takes a much more integrated approach. We have goals of fostering national identity, restoring trust in government, closing social and economic gaps and nurturing the environment. But we see these as an integral part of an economic programme that provides opportunities and adapts to change.
What does this mean for general fiscal policy? Firstly, it means that we are not hell bent on lowering taxes. There are a number of reasons for this. One is that it is very clear now that some of the tax cuts of the mid 1990s were ill advised. They tended to exaggerate economic upswings and cause overheating, contributing ultimately to an excessive contraction and an unhelpful level of volatility in economic output.
They also tended to reduce national savings at a time when a poor record on national savings was contributing to the deterioration in the external accounts.
I want to make it clear that the government has no net foreign debt. However, tax cuts stimulate private consumption, and tend to increase the gap between spending and earning foreign currency.
A growing deficit in the current account of the balance of payments could only be met by selling assets to foreigners or by borrowing from them. In both cases, net external indebtedness rose.
This has two effects. One is a treadmill effect. As interest payments on rising private foreign debt increase, so the deficit itself is larger than it would otherwise have been.
The second is the transfer effect. We tend to measure our economic performance in terms of gross domestic product. GDP is the total value of goods and services produced within our borders. The problem is that as more and more of the factors of production used within those borders are provided by foreign owners, more and more of the domestic product accrues to foreign nationals. They own the railway system, the banks and so on, and have to be paid for the contribution each makes to domestic product.
A persistent current account deficit is usually accompanied by a transfer of a rising share of GDP to foreign suppliers of capital. What is left is GNP ? gross national product. It is that share of total production available for nationals to consume. At the end of the day it is only GNP, not GDP that is available to source the consumption and well being of New Zealanders.
I am not against foreign investment. Foreign investment can make a vital contribution to an acceleration of the rate of growth of GDP, and hence of GNP. There is a win-win scenario out there.
But when foreign investment takes the form of acquisition of existing assets as an indirect type of quid pro quo for excessive consumption, then there is another dynamic operating.
Bryan Philpott of Victoria University calculates that the amount of GDP accruing to foreigners has grown ? in inflation adjusted terms ? from $1.6 billion in 1984 to $7.4 billion in 1999. The result is that about $3,000 per person of working age per year is transferred to foreign owners of productive capacity.
This must make major inroads into income levels and the well being of New Zealanders.
I am not into conspiracy theories or into blame. The pros and cons of the investment flows are complex. Some of the sale of assets has allowed governments to write off their own foreign debts, so the net effect is not so dramatic. And from a purely selfish point of view, as Minister of Revenue I tax GDP not GNP.
The point is to look forward, and any sensible forward looking government responds by putting a lot of emphasis on fostering the growth and diversification of the outward looking parts of the commercial world. That is going to be a big part of the economic policy programme of this government.
Let me just digress a little and share a few thoughts with you about some of the recent political interventions and campaigns of sections of the business lobby fraternity.
There is a basic conundrum. For some time, monetary conditions have been quite loose: interest rates and the exchange rate have been low at the same time. There was some improvement in cash flows into the export sector, but we did not see the export response that might have been expected. Many manufacturers are now operating close to capacity but there is an apparent reticence to invest in an expansion of that capacity.
The knee jerk political response is to blame it on government initiatives: ACC and the Employment Contracts Act in particular. I reject these explanations. There is no evidence that the new ACC regime is going to be more expensive that the one it replaces. And there is no evidence that the ECA had major economic impacts, one way or the other. It was more about power in the workplace, fairness at work issues and the distribution of income. I am not going to expand on these observations but am happy to defend them.
It seems to me that the problem with the export sector is twofold. One is that existing capacity is too narrow. Too many exporters went offshore during the 1990s. They relocated to environments where macroeconomic conditions were kinder and industry supports were more extensive. There are some spectacular exceptions ? like boat building, electronics and such like ? but in general we were left with manufacturing capacity built around resource extraction. That meant a muted response from the looser monetary conditions.
The second problem is more complicated. It may be that in the new global economy, it is not domestic but world wide manufacturing capacity that is relevant. The effect of the Asian economic crisis was to leave a large amount of surplus manufacturing capacity in Asia, exporting from behind soft currencies. This global capacity overhang is restricting the pricing discretion of manufacturers and squeezing their margins. These conditions, rather than particular government policies, could explain investment reticence.
It means that if we want to improve export performance, it is not good enough to rely on everyone doing a little more of what they do now.
It does mean deepening the processing that takes place in the resource-based industries and it means new greenfields initiatives. These considerations open up questions about what the real barriers are and of how best to lower them. The mix includes skills formation, research and development, technology transfer, business supports, export market development support, credit insurance, venture capital, adequacy of infrastructure and so on.
I have had to sketch out these wider issues of responses to core structural problems in the economy in order to give you a feel for the government?s economic and commercial goals. It doesn?t get much closer to your interests as public practice accountants.
To focus in a bit closer let me turn to tax.
Tax has a major role to play in creating the kind of society we want to live in. We need the tax system to raise the revenue necessary to fund essential services like schools, hospitals, social services, defence, and the police. To do this most effectively, the tax system needs to work well - it needs to be efficient, coherent, rational, and easy to comply with.
It also needs to have integrity ?and, just as importantly, to be seen by the public to have integrity. If that integrity is perceived to decline, voluntary compliance will decline accordingly.
We will protect the tax revenue base by a variety of means. They include closing legal loopholes as they emerge, reducing opportunities for tax avoidance, and constantly updating and improving the law. We will also continue the work that is being done to make it easier for people to comply with the law -- by measures such as simplifying the tax system and reducing compliance costs.
Although there will be some continuity between the tax policy of this Government and that of the previous era, there will also be major changes. We believe, for example, that the tax system should be used to distribute income more fairly. That is the reason for the forthcoming increase in the top personal tax rate. The tax rise will affect only a small percentage of the workforce -- the high-income earners, those who can most afford to contribute something more towards the country's well being. The income from this increase will be redistributed to areas such as restoring the level of the pension.
We have ideals but we are also sensibly pragmatic. We know that there will always be some loss of revenue through tax avoidance. Tax avoidance has been around for as long as tax, regardless of what the top personal tax rate is. We do not seek perfection. What we will vigorously seek to do, however, is to limit the loss of revenue through avoidance. But we do not intend to go overboard legislatively. Instead, when possible we will use the general anti-avoidance rules in the Income Tax Act, and introduce specific rules to deal with specific problems.
We want our tax policy to be workable. That is why we have put so much effort into consulting with professional groups, like yours, about measures to support the increase in the top personal tax rate. We wanted to find the most workable way to prevent high-income people avoiding the effects of the increase by substituting a portion of their salaries for employer contributions into superannuation funds which can be drawn on at any time. Thanks to that consultation, our proposals have developed to the point that I'll be taking them to Cabinet for sign-off next week. Once approved, they will be included in a bill to be introduced into Parliament later this month.
We are also looking at other ways that high-income people may try to avoid the tax increase. One is by diverting income through companies, trusts or partnerships. In the simplest form of the scheme, employees incorporate themselves, in an attempt to have that part of their income, which should be taxed at 39% instead, taxed at the company rate of 33%. I know that such schemes are being promoted - and I consider it both unethical and foolish.
Although at least some of these arrangements must be at risk of running up against the anti-avoidance rules, I believe it is better to introduce rules that are explicitly targeted at the diversion of income from personal services. Legislation along these lines is expected in a bill to be introduced in May.
I'm also advised there is a plethora of tax schemes that aim to enable high-income people to shelter income. Key features of these schemes include limited recourse funding, the depreciation of so-called "fixed life" intangible property, and partnerships in loss attributing qualifying companies. Through these schemes, individuals can obtain tax deductions that are significantly larger than the money they invested.
I understand that Inland Revenue is auditing a number of these schemes and may well apply the anti-avoidance rules to them. Work done by Inland Revenue suggests that a large amount of money is involved. For the 1998-99 income year, schemes of this nature are believed to have resulted in at least $55 million of tax that has not yet been paid. I emphasise that this is tax avoidance that has been taking place when the top personal tax rate was 33%, and is not the result of the increase to a 39% rate. Again, the Government will be considering targeted anti-avoidance rules in this area.
We are countering tax avoidance to help fund our social programme. And because Inland Revenue collects about 80 percent of all Government revenue, which makes it by far the major income stream for the Government, it is extremely important that we build public trust in it. For this reason, the Government is giving serious consideration to the recommendations of the Finance and Expenditure Committee and of the Committee of Experts on Compliance, which reported over a year ago. It is not something that we will put on the back burner.
I am now going to open up a topic on which a lot more discussion and debate is needed.
As things stand, there are four types of government agency. There is a small band of organisations that are Offices of Parliament. Then there are 43 government departments ? what is left of the old public service. Privatisation has reduced the number of State Owned Enterprises to 18, but there are big variations in size in the SOE sector. Finally, we have the vast array of Crown entities.
The issue is how the government runs or presides over the running of these organisations. I suppose that is pretty central to your core business.
The restructuring of the state sector had major advantages, but it would be silly to say that it was perfect. It is also true that organisations that stop adapting die. We are not so much revisting the past but trying to identify where the next plateau may lie, and how to get there.
I mentioned that a restoration of trust in government was an explicit goal of this government. That does not only mean restoring trust in Parliament and the political system. It also means restoring trust and confidence in the delivery agencies: something that has taken a battering in recent times.
Some of that requires initiatives from the Prime Minister, some from the Minister of State Services.
As Minister of Finance, I have made it clear that I see a value for money project as something that I will return to time and time again during the next three years.
The contracting regime in the public service has had its advantages. They are mainly advantages of transparency and financial discipline. However, they have not been costless. One of the costs may well have been duplicated provision of service when there were economies to be had from shared services. I have initiated work on shared services, but accept that it is likely to be a slow process.
The second cost is associated with layers of compliance. The contracting model has implicit in it processes of forming and monitoring contracts. It also involves contracting in varying services. The danger is that in ensuring contract compliance, compliance cost can get out of hand. They can protect the contracting parties rather than produce value for money.
I know that giving advice on forming the contract, letting the contract and monitoring the contract has been a lucrative source of fees for legal and accounting firms. It gives comfort to the officials who have to meet various reporting standards. I want to be assured that the government gets value from the costs of checking and double-checking in this contracting process.
I could not possible canvass the range of governance issues associated with all of the Crown Entities, so I will leave this topic for another time.
I want to end with a brief discussion of SOEs.
The previous government had a general policy of hold for sale. Under those circumstances, there were some degrees of tolerance about how the SOEs were capitalised and managed. Overcapitalised SOEs would sell for more, undercapitalised ones for less, and it would all come out in the wash. Any ambiguities in Statements of Corporate Intent would soon be reconciled by new owners clarifying the strategic orientation of the enterprise.
We have shifted to a hold in perpetuity stance. This does raise a number of matters that will require our attention. Capital adequacy is an obvious one. Investment policy is another. Normally, I would expect SOEs to meet their capital requirements within their balance sheets. They can borrow on commercial terms but should not over-gear operations. However this will impact on Crown gross debt, and I have a responsibility under the Fiscal Responsibility Act to manage that.
As a macroeconomic regulator I need to be concerned about the sequencing of investment and its timing in relation to the business cycle.
Owning an SOE is only justified if there is some indirect public interest purpose associated with the enterprise. Specifying this in the statement of corporate intent without compromising the commercial orientation of the organisation or intruding into the commercial judgement of the Board is something that we are going to have to work our way through.
I have tried to share with you my vision of the big economic picture and to bring you up to date with the details of tax policy. I would like to thank you for the opportunity to speak to you this evening and I look forward to working with you over the coming years.