The OECD, in its June 2013 economic survey of New Zealand, has again highlighted the lack of a comprehensive capital gains tax as a weakness in our tax policy framework.
According to the OECD, the widening of disposal income inequality in New Zealand since the 1980s has been exacerbated by the rejection of a capital gains tax by successive governments. This is because the redistributive power of tax is reduced when high income earners can enjoy untaxed capital gains.
The OECD also concluded the tax free treatment of capital gains reinforces a bias towards speculative housing investments and undermines housing affordability.
Its tax reform prescription was predictably hailed by the Labour Party (which supports capital gains tax), and hosed down by the Minister of Finance, who pointed to the 2001 McLeod Review and the 2009 Tax Working Group reports that did not recommend a capital gains tax.
Policy experts are not necessarily opposed to a capital gains tax from a theoretical perspective but, rather, due to the practical realities of designing and implementing it in an efficient manner.
Common features of the capital gains tax regimes implemented overseas in some 30 OECD countries are:
- the family home is excluded;
- gains are taxed on a realisation basis; and
- Capital losses are claimable only against capital gains and not ordinary income.
These features have adverse consequences on the economic efficiency of a capital gains tax. For example:
- the “mansion effect”, where people are incentivised to invest in bigger and grander family homes to take advantage of the tax preferred nature of this asset category compared to other capital assets;
- Deferring tax until gains are realised leads to a “lock-in” effect at a cost of assets not being transferred to their best economic use;
- Discouraging risk taking if capital losses can’t be offset against ordinary taxable income.
Capital gains taxes are usually imposed at a lower rate than income tax. There are a variety of reasons, including a reduction in the lock-in effect and discouraging risk-taking. And capital gains tax on the vendor of an income-producing asset effectively adds another layer of tax on future income streams that will also be taxed in the hands of the purchaser when earned as income. However, the lower tax rate creates an incentive for income to be recharacterised as capital gain.
Once the design issues are decided on, implementing the tax is the next challenge. Should it apply to assets acquired on, or after, a specific date? Should it apply only to gains and losses from a specific date? The theory probably supports the latter option but the challenge of valuing all capital assets subject to the regime and the potential for manipulation make this problematic in practice.
In his defence of the status quo, Finance Minister Bill English pointed out that scrapping (from the 2012 financial year) of tax depreciation on “investment” buildings with a useful life of more than 50 years is expected to raise $3 billion over four years. He calculates that is more than a capital gains tax proposal that excludes family homes.
Treasury has estimated a capital gains tax might raise the equivalent of 1% of GDP (a bit more than $2 billion) although this will depend on the particular regime implemented.
Our total tax revenue as a percentage of GDP is on average in the vicinity of 29% so a capital gains tax might generate something in the order of another 3.4% of New Zealand’s total tax revenues.
While New Zealand does not have a comprehensive capital gains tax, we have several specific provisions that tax gains of a capital or quasi- capital nature.
Land, personal property (eg, shares), financial arrangements and patents are examples of asset categories that may be subject to tax on sale.
The government has in recent years given the Inland Revenue Department dedicated funding to pursue speculative activity in the residential housing market. This “property compliance programme” had funding of $16.7 million from 1 July 2010 to 31 December 2012. The total discrepancies found amounted to $110.4 million - a return of 6.6:1. Further funding of $26.6 million has been announced for the next four years and the expected revenue is $180 million (at an estimated return on investment of 6.77:1).
The OECD believes recurrent taxes on immovable property (real estate) are the least harmful taxes to economic efficiency and long term growth. This is because the supply of land is fixed and a tax on the landowner can’t be averted. So such a tax is likely to have the least impact on the incentive to work and be thrifty which is the so-called “deadweight loss” from imposing taxes.
Treasury estimates a 0.7% land tax on the unimproved value of all land could raise the same amount of tax as a capital gains tax (approximately $2 billion).
The OECD recommends property tax should be imposed according to the marginal tax rate of the property owner to ameliorate the regressive impact (ie, taking a larger proportion from less well off people).
The biggest problem with this type of tax is a likely decline in the value of land and a consequential one-time loss for all landowners because the tax effect becomes built into the price of the asset (the same feature is equally true for a tax concession relating to an activity involving land use).
Compared with a comprehensive land tax, the impact of a capital gains tax on land values would be blunted if family homes are excluded. However, New Zealand has previously had a land tax that did not apply to residential property and there were various other exemptions. Political pressure for exemptions would undoubtedly arise again if such a tax was mooted.
Property taxes may be efficient but the history of the world demonstrates people have an almost pathological hatred of such taxes unless they are being imposed on somebody else. For that reason it seems highly likely that economic theory will be trumped by political expediency.
That takes us back to capital gains tax with an exclusion for the family home as the most likely future tax reform candidate. Probably the best that can be said is it would promote a degree of fairness and likely raise some money over time for the government - and tax advisers.
David Haywood is a tax partner at EY.