Michael Cullen Address to KPMG Tax Seminar
Michael Cullen Address to KPMG Tax Seminar
Sky City Auckland Convention Centre, 88 Federal St, Auckland
One of the more puzzling phenomena in public policy debate is the tendency for a small and vocal rump to argue for obfuscation and against clarity. For an example of this one needs look no further than the curious resurgence of what one can only call Muldoonist tax and fiscal policy.
You will recall that in the mid 1980s we operated a cash-based fiscal management system, in which there was no clarity about future commitments and liabilities. The government of the day practised a distorted version of Keynesianism which took a lax, if not downright friendly, attitude towards fiscal deficits and burgeoning public debt.
Meanwhile, our tax system was almost as Byzantine as those developed over the century in Europe or in the federations of Australian and American states.
Two decades of hard work has turned that situation around. We have a set of government accounts that is envied around the world not just because of the strong long term fiscal position they demonstrate, but also because they provide a complete and accurate picture of the current and future financial position of the government, inviting the government of the day to demonstrate how future risks will be met.
And we have a tax system that is envied for its transparency, fairness and relative simplicity. That system is one of the factors that has placed New Zealand high on OECD comparative studies of competitiveness. One needs only to look across the Tasman or to the EU to realise that New Zealanders and New Zealand businesses have a comparatively low overall tax burden and suffer less tax-related confusion and uncertainty.
Yet there are still those amongst us who hanker after the days when governments happily engaged in short term fiscal stimulus and pretended that there would be no consequences in terms of increasing debt or destabilising government finances in future years. And there are those who argue that, if we only threw away our tax system and adopted the Australian one, skilled individuals and businesses would flock across the Tasman in response.
This is a great disappointment for all of those politicians, business leaders and officials who have worked hard bringing us to where we are today. They are like Charlton Heston’s Moses in Cecil B. de Mille’s Ten Commandments, who descends from Mount Sinai with a legislative and tax code so simple it could be written on two tablets of stone, only to find that in his absence the people have fallen victim to charlatans, melted all their jewellery into a golden calf and collapsed into drunkenness and debauchery.
So much for the future promised land. Jam today, and crumbs for our children.
This morning I want to re-affirm two essential priorities that should drive decisions about tax:
First, that a strong long term fiscal position is both an important goal of tax policy and also the best environment in which to make sensible changes to tax policy. Fiscal weakness leads inevitably to the need for quick, dirty and hazardous changes in tax, if not now, then in years to come.
Second, where any headroom exists that allows changes in taxation precedence must be given to changes that foster productivity growth. That is not to rule out tax changes that leave individuals with more in their pockets to spend; but it is to say that this should only be done on the platform of a strong fiscal outlook and a tax system oriented towards investment and growth.
It is within this context that I want to go through the key tax policy announcements in last month’s budget.
I want to start by talking briefly about the fiscal outlook, and answer the question: how strong is it, in fact? Then I want to go through the elements of the investment tax package and the business tax package, before touching finally on the issue of indexation of thresholds.
First, the fiscal outlook, which I would characterise as strong enough to meet the challenges ahead, but only just. Those challenges include:
A slowdown in the economy from annual GDP growth of around 4 per cent per annum to growth of around 2 ½ per cent in the next two years;
A looming demographic shift, whose impact is starting to come on to the radar screen of international credit rating agencies; and
A need to compensate for the under-investment in infrastructure that occurred during the 1990s.
The fiscal surpluses are strong in the immediate term, but will soon start to come under pressure. The cash surplus for the current year is forecast to be $2.4 billion. This reduces to a cash surplus of $30 million for 2005/06 but changes to an average cash deficit for the following three years of about $1.9 billion a year.
Looked at in operating balance terms, this translates into an OBERAC of $7.4 billion or 4.9 per cent of GDP this year, $6.7 billion or 4.3 per cent of GDP next year, and an average of $4.8 billion or 2.9 per cent of GDP in the following three years.
This sounds large in nominal terms, but the key indicator of fiscal strength is gross sovereign-issued debt, and how that tracks through the medium to long term. That indicator has fallen from 35 per cent of GDP in June 1999 to an estimated 22.6 per cent at the end of June this year. Alongside this, the accumulated assets in the New Zealand Superannuation Fund will stand at around $6.5 billion.
The fact is the forecast surpluses are just sufficient to fund the contributions to the New Zealand Superannuation Fund and other capital needs without a trend increase in the gross debt to GDP ratio.
The forecasts show a flattening of the debt track just above 20 per cent of GDP, with the net debt track likewise somewhat flat around 7 per cent of GDP. Moreover, this assumes that the growth in expenditure during both the forecast and projection periods will be significantly less than it has been in both Budget 2004 and Budget 2005.
In other words, the situation is encouraging but finely balanced. This was affirmed last week by the OECD Economic Outlook on the New Zealand economy, which stated that “any additional fiscal stimulus beyond that already planned could put the projected soft landing at risk and would need to be offset by higher interest rates in order to bring the economy back onto a sustainable growth path.”
We must not fool ourselves into thinking there is more room to move when it is not the case. In an economy operating at full capacity, cutting tax or raising expenditure beyond what is already planned, or even signalling an intention to do so, will flow immediately into higher mortgage rates for homeowners and higher interest rates for businesses.
Within that constraint, what the budget contained was, I would argue, a balanced set of investments in future stability and future productivity. We continue to put additional resources into infrastructure, into education and training, and into the range of initiatives under the Growth and Innovation Framework which cover scientific research, technology and support for export industries.
The tax changes in the budget fit into the same set of strategies. The business tax package has a number of key elements.
The first of these is a more neutral set of tax depreciation rules so that businesses have incentives to invest in assets that provide the best commercial returns.
Tax depreciation rates will be changed to reflect better how assets decline in value. Current rates are likely to penalise investment in short-lived plant and equipment, which can create tax biases that distort the structure of capital investment away from the best investment opportunities. To deal with these biases, depreciation rates for short-lived plant and equipment will increase and depreciation rates on buildings will reduce.
The method for calculating tax depreciation rates has been revised. From the 2005/06 income year tax depreciation rates will be worked out in one of two ways. For buildings the straight-line basis will be applied over their economic lives to determine their depreciation rate, and a diminishing value equivalent of this straight line rate will also be available. For plant and equipment the double declining balance method will apply. This means, for example, an asset with a ten year economic life can be written off at a rate of 20 per cent diminishing value. For equipment such as laptop computers the changes will result in a 25 per cent increase in the allowable annual depreciation deduction, from 48 per cent to 60 per cent a year.
The new depreciation rules will apply to plant and equipment purchased on or after 1 April 2005 and to buildings purchased from Budget day, 19 May 2005.
Also taking effect from budget day, the low-value asset threshold will rise from $200 to $500. This will reduce some of the compliance costs to business from having to maintain fixed asset registers,. This change should reduce the number of assets that a business must annually account for and will reduce the number of tax adjustments that it must make when the asset is sold.
Budget 2005 also contains a number of tax measures to improve New Zealand businesses’ access to worldwide labour, skills, and capital.
The first of these is a temporary tax exemption of five years on foreign income for people who come to work here, whether they are foreigners or New Zealanders who have been non-resident for tax purposes for ten years. This will reduce tax costs related to international recruitment to New Zealand. People who are not in employment will receive the same exemption for three years.
Tax on offshore income is an important issue for highly skilled people who are in demand internationally and for the businesses that recruit them from overseas. The new exemption will thus remove a tax barrier to New Zealand gaining the skilled people it needs.
Updated tax rules for securities lending will make New Zealand more attractive for international investment. Existing rules have acted as a barrier to the development of a securities lending market here. Qualifying transactions will now be treated on their economic substance rather than legal form.
Budget 2005 will also give companies that bring in new equity investors better access to tax deductions for R&D expenditure. This will cater for the growth cycle of technology companies by allowing R&D deductions to be matched with income from that expenditure. Proposals are also being developed to change the tax treatment of employee share options. The aim is to remove some of the obstacles created by the tax system to businesses which offer share options to their employees. A paper setting out proposals will be released for public consultation later this year.
Alongside the Budget initiatives were the major changes announced earlier in the month with respect to tax simplification and reforms to Fringe Benefit Tax. The simplification proposals involve the alignment of payment dates for provisional tax and GST, allowing businesses to elect to base provisional tax payments on GST turnover, and a subsidy to payroll agents for meeting PAYE–related compliance costs imposed on small employers.
With respect to Fringe Benefit Tax, the valuation rate for motor vehicles will be cut. Taxpayers will also be able to elect to calculate motor vehicle FBT on a vehicle’s tax book value as an alternative to using the cost price. At the same time, the thresholds applying to unclassified fringe benefits will be raised. In the case of an employer the rise will be from $450 a quarter to $15,000 a year.
Added to this, the private use of employer owned or leased business tools will be exempted from FBT where provided primarily for business purposes and where they cost less than $5,000 each.
Alongside of the package of changes to business tax, the Budget featured a set of changes to the taxation of investments. These complement the major new policy initiative of the Budget: the KiwiSaver scheme, aimed at increasing the number of New Zealanders regularly contributing to work-based superannuation schemes.
If we are encouraging people to save more, we need to improve on the current tax regime for investments, which is very complex and can lead to perverse incentives. It overtaxes those on the lower statutory rate of tax, tends to advantage certain forms of offshore investment, and distinguishes between various destinations for that investment.
The changes in the budget are designed to remove disincentives to save and invest, remove elements of overtaxation, and lead to an outcome where investment is guided more by the returns on the investment than by the tax opportunities presented.
The package has two elements: domestic investment and offshore investment.
With respect to the taxation of domestic investment two major changes will be legislated for. Under the first, New Zealand-based collective investment vehicles will no longer be required to be taxed as entities. Rather they will be able to elect to have the income earned by a fund regularly attributed to the individuals investing in it and taxed at their marginal statutory rates.
As with the current regime for taxation on interest-bearing accounts, the investor will advise the fund of their marginal rate. When income is earned, it will be credited to the account of the individual and the fund will withhold tax from it at that marginal rate. This will be a final withholding tax so no tax return will be required. Equivalence to the tax regime on interest and direct investment of shares will be achieved. And, as it is a final withholding tax, the investment income will have no impact on family assistance, child support or student loan repayments.
For those collective investment vehicles which elect into the new rules the overtaxation on those earning under $38,000 a year is removed.
At this stage the new rules are not compulsory, recognising that some collective investment vehicles would find it hard to adopt the look-through rules. However, as the new elective rules bed in this issue will be kept under review.
Under the new elective rules some taxpayers on the 39 cent marginal rate could pay more, depending on how their financial affairs are arranged. But for many this will be more than offset by the second change to the taxation rules on New Zealand domestic investment.
This involves the removal of the taxation on the gains made on the sale of domestic shares by collective investment vehicles.
Reform of the taxation of offshore investment is more difficult. Under current rules, offshore share investment is taxed differently depending on the country in which the investment is made. If direct investment is in what is called a “grey list” country, it is excluded from the foreign investment fund rules. If it is not, then foreign investment fund rules which tax accrued capital gains apply.
Consideration was given for some time to the use of a version of the risk-free rate of return method. This is conceptually simple but quickly becomes complex in application, particularly for individual investors where investments are made at different points in a year. It also suffers from a fundamental perception problem with respect to tax being applied even where losses had been incurred.
Instead, it is proposed to issue a discussion document within the next few weeks proposing to apply an income calculation method based on actual changes in value for investment funds, companies and individual investors. Under this proposal, the grey list will be abolished for portfolio share investment. Collective investment vehicles will be taxed on the basis of the change in their accrued value. This would make for clearer rules, but in practical terms the results should be similar to the law as it currently applies for funds that are in the business of actively trading shares.
For individual and other investors it is even more difficult to find an approach that is reasonable without favouring direct offshore investment over investing in a fund. The approach being proposed is that individual and other investors will also be taxed on the change in value of their overseas shares, but with an annual cap so that tax is spread over a number of years to better reflect cash flow. The discussion document will propose a threshold so that those with small holdings of foreign shares continue to be taxed just on dividends received.
This will lead to accusations of extending the capital gains tax regime at present implicit in taxation on non-grey list investment. It is clear, however, that any reform of the current regime that does not penalise investment into New Zealand shares will lead to some such outcome.
The choice then is between a complex regime which tends to favour investment going offshore or a simpler regime which is more favourable to investment in New Zealand.
It is proposed that the new tax rules on investment come into force on 1 April 2007.
A brief word finally on the decision to move the three main personal tax thresholds to match inflation. Because tax threshold changes need to be announced well in advance of implementation there would be a very significant lag between the last available CPI figure and the commencement of changes on the subsequent 1 April. For that reason, we decided to adjust each three years by using the mid-point of the Reserve Bank’s Policy Targets Agreement inflation band. This equates to a 6.12 per cent movement in the thresholds every three years. This means that at the time of the first triennial adjustment, 1 April 2008, the $9,500 threshold will move to $10,081, the $38,000 threshold to $40,324 and the $60,000 threshold to $63,672.
This is actually a significant change, tying thresholds to real rather than nominal values. Its impact will be to make the tax system fairer over time, and reduce the bracket creep that has been a small but significant irritant to a large number of tax payers.
Taken together, all the tax cuts I have announced today will cost $229 million in 2005/06, $319 million in 2006/07, $535 million in 2007/08, and $776 million in 2008/09, or about $1.86 billion over the forecast period. Additionally, in delaying provisional tax payment dates in 2007/08 to 2008/09 there is a delay of $760 million in tax revenues.
These revenue losses will be partially offset by about $720 million of net carbon charge revenue which will start to flow from 1 April 2007.
For those who threaten to throw a tantrum if they don’t get tax cuts by lunchtime, this is clearly too little and too late. Those with a wider view can see that it is incremental changes, carefully designed and competently implemented, that make the difference. Seen in this light, the Budget continues to make progress towards a future that is characterised by a high-skill, high-value economy, quality health and education, and the environmental and cultural values that make New Zealand distinctive.
As for my government, we are in this for the long haul, and are not about to jeopardise that steady progress.