When I went looking for the interim report of the Tax Working Group, I found that various other papers had been released. These include background papers prepared by the Treasury and IRD secretariat looking at various possible options for reducing other taxes if, for example, new capital taxes were to provide more government revenue.
Among them was a short and rather unconvincing paper on productivity. It was notable for highlighting how difficult it was to give any concrete meaning to the aspiration repeatedly expressed by the Minister of Finance, and included in the terms of reference, of “promoting the right balance between the productive and speculative economies”. And it was also notable for the aversion of officials to lowering the company tax rate (or the effective tax rate shareholders pay on company income), even though they accept that our business income tax rates are now high by international standards, and that business investment (including FDI) is low by international standards. This chart is from the paper. In general, what is taxed heavily you get less of.
But this time I was more interested in another of the background papers, this one on the possibility of inflation indexing the tax system. Even with 2 per cent inflation, failing to take explicit account of inflation in the tax system introduces some material distortions and inefficiencies. Many of the costs of inflation arise from the interaction with the tax system, and these distortions may be greater in New Zealand than in many other countries because of the way we tax retirement income savings (the TTE system introduced, as a great revenue grab at the time, in the late 1980s).
In the days of high inflation there was some momentum towards doing something about indexation. It had, for example, been a cause championed by former Reserve Bank Governor Ray White. And in the late 1980s, the then government got as far as publishing a detailed consultative document. But then inflation fell sharply (and maximum marginal tax rates were cut) and the issue died. We don’t even have the income tax thresholds indexed for inflation, allowing Ministers of Finance ever few years to present as a tax cut an increase in revenue that should never have occurred in the first place.
In the early days of inflation targeting there might even have been a case for letting the issue die. The inflation target was centred on 1 per cent annual CPI increases, and that target was premised on a view that the CPI had an annual upward bias of perhaps as much as 0.75 per cent per annum). But since then, the extent of any biases in the CPI have been reduced, and the inflation target has twice been increased. The inflation target now involves aiming for “true” inflation” of at least 1.5 per cent per annum.
The distortions are most obvious as regard interest receipts and payments. Take a short-term term deposit rate of around 3 per cent at present. Someone on the maximum marginal tax rate (33%) will be taxed so that the after-tax return is only 2 per cent. But if, as the Reserve Bank tells us, inflation expectations are 2 per cent, that means no real after-tax return. Compensation for inflation isn’t income and it shouldn’t be taxed as such. Only the real component of the interest rate (1 per cent) should be taxed. The same distortion arises on the other side, for those able to deduct interest expenses in calculating taxable income: in the presence of inflation, this tax treatment subsidises business borrowing. The amounts involved are not small. As economist Andrew Coleman notes in his (as ever) stimulating TWG submission
Even at low inflation rates, these distortions are substantial. In 2017, for instance, residential landlords borrowed $70 billion. Even if the inflation rate is as low as 1 percent, this means residential landlords can deduct $700 million of real principal repayments from their taxable income, a subsidy worth over $200 million per year. New Zealand households lend in excess of $150 billion. When the inflation rate is 1 percent, lenders are expected to pay tax on $1.5 billion more than they ought. Many people who invest in interest-earning securities are elderly, risk averse, or unsophisticated investors. For some reason the New Zealand Government believes these investors should pay more tax than any other class of investors in New Zealand. It is a strange country that taxes the simplest, most easily understood, and the most easily purchased financial security at the highest rates. It suggests the Government has little interest in equity, its protestations notwithstanding.
There are other distortions too, notably around trading stock valuations and asset valuations on which true economic depreciation would be calculated.
As reflected in the paper released this week, officials are very wary about doing anything about fixing these distortions (and they fairly note that “no OECD country currently comprehensively inflation indexes their tax system”), and they devote many pages to outlining the practical challenges they believe would be involved, and the new distortions they believe would arise from partial approaches to indexation.
I have some sympathy with the stance taken by officials on the specific challenges to doing comprehensive indexation, especially in a way that does not bias transactions through favoured institutional vehicles. But it is a particularly bloodless document that seems to reflect no sense of the injustice involved in taxing so heavily relatively unsophisticated savers (while subsidising business borrowers, especially those financing very long-lived assets).
This seems like a case where some joined-up whole-of-government policy advice would be desirable. There would be no systematic distortions arising from the interaction between inflation and the tax system if there was no systematic or expected inflation. Systematic inflation isn’t a natural or inevitable feature of an economic system – in some ways it is about as odd as changing the length of a metre by 2 per cent a year, or the weight of a gram by 2 per cent a year. In the UK, for example, (and with lots of annual variation) the price level in 1914 was about the same as it had been in 1860). And the most compelling reason these days for targeting a positive inflation rate is the effective lower bound on nominal interest rates, itself created by policymakers and legislators. Take some serious steps to remove that lower bound and (a) we’d be much better positioned whenever the next serious economic downturn happens, and (b) we could, almost at a stroke, eliminate the distortions – and rank injustices – that arise from the interaction between continuing, actively targeted, positive inflation, and a tax system that takes no account of this systematic targeted depreciation in the value of money.
It wouldn’t be hard, but our ministers, officials (Treasury and IRD), and central bankers currently seem utterly indifferent to the issue.