How Does New Zealand's Tax System Stack Up?
How Does New Zealand's Tax System Stack Up?
Dr Don Brash National Finance Spokesperson
An address to the Institute of Chartered Accountants of New Zealand 2002 Tax Conference Christchurch 12 October 2002
New Zealand is fortunate that, by most measures, our tax system is relatively "clean", a judgement shared by both the recent Tax Review chaired by my fellow panellist, Rob McLeod, and by successive OECD reports on the New Zealand economy. We have a broad base for the calculation of income tax, with few opportunities for the more egregious rorts of yesteryear. And we have a broad base for GST, with financial services and residential rent being the main exclusions.
Because of that, we probably have fewer distortions in our tax system, and have rather lower compliance costs, than in many other countries.
I was privileged to chair several of the consultative committees which recommended many of the changes to the tax system which produced this favourable result in the second half of the eighties, though of course I am the first to admit that most of the credit belongs to the Labour Government in which Roger Douglas and David Caygill were Ministers of Finance.
Today, I want to focus my comments towards two issues. First, I want to discuss the issue of taxation and economic growth. Secondly, I want to discuss the issue of progressivity - how progressive is the current tax scale?
Taxation and economic growth
There is no doubt in my mind that, if we want to encourage faster economic growth in New Zealand - and that must surely be the primary objective of any New Zealand Government under current circumstances - we need to find ways both of reducing the total tax burden and of reducing the effective marginal tax rates applying to those most likely to invest and take entrepreneurial risks.
No measure of the tax burden is perfect. But the best measure is probably the ratio of general government total outlays to GDP. Government spending must generally be funded from taxes. At the present time, the OECD estimates that New Zealand's general government outlays, which include outlays of both central and local governments, are equal to about 40 per cent of GDP.
That puts the tax burden in New Zealand around the middle of the OECD rankings. And since OECD countries are among the most highly taxed in the world, being around the middle of the OECD rankings in terms of total tax burden puts New Zealand among those countries that are relatively highly taxed. Within the OECD group, the tax burden in Ireland, the United States and Australia is much lower than in New Zealand, while the tax burden in the dynamic countries of Asia is generally about half that in New Zealand, at about 20 per cent of GDP.
I know of no country (with the possible exception of Luxembourg, which is a special case) that has achieved sustained growth in per capita income of 4 per cent or more - the kind of growth which will be needed if we are to raise New Zealand's living standards back to at least the average of those in other developed countries within a reasonable period - with total government spending at New Zealand's level of around 40 per cent of GDP.
What about effective marginal tax rates? The Labour Government appears to believe that these are irrelevant, that effective marginal tax rates can be increased without any negative effect on incentives to work and invest, and without any effect therefore on economic growth. How else can an increase in the marginal tax rate to 39 per cent for those on incomes above $60,000 (less than US$30,000) be explained?
The reality is that taxes have a pervasive effect on the behaviour of individuals and firms. If human behaviour were unaffected by effective marginal tax rates, the rate of income tax could be set at 100 per cent without any loss of economic efficiency. In that event, the government would be able to fund many worthwhile projects at no economic cost and community well-being could be increased.
However, commonsense, experience and economic analysis all confirm that taxes do affect the choices that people make.
Indeed, the efficacy of many government policies, such as excise tax on beer, wine and spirits, tax concessions for research and development, tax concessions for movies made in New Zealand, exemption from income tax for the crews of internationally-mobile super yachts, and so on rests on the proposition that taxes do influence the behaviour of people. If taxes did not affect people's behaviour, what justification would there be for such policies?
Recall also that the government is required to apply its extensive coercive powers to collect taxes. There would be less need for them if the behaviour of people and firms were unaffected by taxes, because tax avoidance and evasion would not occur. Economists talk of the deadweight costs of taxation. These deadweight costs are a drag on overall community well-being. Many studies of deadweight costs have been undertaken. They find that the deadweight costs of taxation are generally quite high, and as tax rates rise, the costs imposed on the community rise more than proportionately. Thus, while all taxes involve deadweight costs, high effective marginal tax rates are particularly bad for the community.
A study by Diewert and Lawrence a few years ago found that the deadweight costs associated with raising the last dollar of revenue from the taxation of labour income in New Zealand were over 18 per cent. In other words, it costs around $1.18 in total costs to raise the last dollar of tax on labour income. Similarly, the deadweight costs of raising the last dollar of revenue from the taxation of consumption spending were estimated to be around 14 per cent.
Based on these arguments, I am left in no doubt that lower government expenditure relative to GDP, and lower marginal taxes, would help to improve New Zealand's economic performance.
The progressivity of the income tax scale
But I readily acknowledge that most New Zealanders are not wildly enthusiastic about what they see as tax reductions for those on high incomes. They are not content with people who earn ten times as much as those on the average wage paying ten times as much tax as those earning the average wage; they want proportionately more tax paid by those on high incomes. In other words, they want a progressive tax system, and they fear that any moves to reduce the effective marginal tax rates of those earning above $60,000 would make the tax system less progressive.
Well, it is fair to acknowledge that any reduction in the top tax rate would make the income tax system less progressive than it now is, and for that reason would not seem to be a vote winner. Indeed, if my primary interest was in winning votes, I would not even contemplate such a move. But important though winning votes is for any politician, I nevertheless believe that we should be contemplating that because reducing the top tax rate would be of benefit to all New Zealanders through the faster growth which that would make possible.
Moreover, the tax system, taken together with the system of family tax allowances, is already quite steeply progressive, and some reduction in that progressivity would still leave it quite progressive.
It is interesting, for example, to compare the income tax paid by a breadwinner with a dependent spouse and two children under the age of 13 earning $25,000 per annum with the income tax paid by a breadwinner in the same family circumstances earning $100,000 per annum.
How much should the person earning $100,000 pay in income tax relative to the person who earns $25,000? The same amount, on the grounds that both families use the same government-provided services? Four times as much, on the grounds that the person earning $100,000 earns four times as much as the person earning $25,000? Or nearly 100 times as much, as is the case currently, after taking the Low Income Rebate, Family Support, the Child Tax Credit, and the ACC levy into account?
The big issue remains whether reducing the top marginal tax rate would increase New Zealand's potential growth rate. I don't have much doubt that it would. It is interesting to note that Singapore announced a few months ago that, to reinvigorate growth in that country, the corporate tax rate and the top personal tax rate would both be dropped to 20 per cent over the next three years.
Of course reducing tax rates would involve some loss of revenue, at least initially. By my estimation, reducing both the company tax rate and the top personal tax rate to 30 per cent (so that everybody earning over $38,000 would pay less tax) would cost about $1.6 billion in revenue - an amount somewhat less than the operating surplus forecast for the current financial year, and that without assuming that those reductions in tax rates would stimulate any additional activity. In other words, those tax rates could be reduced without cutting anything from currently planned government spending on health, education, or social welfare. (It is also perhaps worth noting that, between 1996 and 1998, the last National-led Government reduced the marginal tax rate applying to somebody earning $35,000 from 33 per cent to 21.5 per cent.)
As an aside, I strongly advocate a harmonisation of the corporate rate and the top personal rate. Having the company tax rate equal to the top personal tax rate served New Zealand well between 1988 and 2000. This Government's decision to increase the top personal tax rate from 33 per cent to 39 per cent in 2000, thus opening up a significant margin between the company tax rate and the top personal tax rate, was a backward step in terms of tax design, and has been responsible for a substantial increase in the compliance costs paid by the business community - and indeed by many private individuals as they have attempted to shelter their income from the higher tax rate.
Over all, the New Zealand tax system stacks up reasonably well, but that is not to say that it is by any means perfect. There is much to be done if New Zealand is going to achieve a higher sustainable rate of economic growth. I have no doubt that some judicious changes in the tax system could make a useful contribution to that goal.