Dipping into the HYEFU

Just a few things caught my eye flicking through yesterday’s HYEFU summary tables – if you don’t count points like the fact that The Treasury projects we will have had five successive years of operating deficits (in a period of a high terms of trade and an overheated economy), and that net debt as a per cent of GDP (even excluding NZSF) is still increasing, notwithstanding the big inflation surprise the government has benefited (materially) from.

This chart captures one of the things that surprised me. It shows export volumes and real GDP, actual and Treasury projections. Exports dipped sharply over the Covid period (closed borders and all that), but even by the year to June 2027 Treasury does not expect export volumes to have returned either to the pre-Covid trend, or to the relationship with real GDP growth that had prevailed over the pre-Covid decade.

The Reserve Bank does not forecast as far ahead as the Treasury but has quarterly projections for these two variables out to the end of 2025. Here is a chart of their most recent projections

It is a quite dramatically different story.

The issue is here is not so much who is right – given the vagaries of medium-term macro forecasting there is a fair chance that none of those four lines will end up closely resembling reality – as that the government’s principal macroeconomic advisers (The Treasury) have such a gloomy view on the outward orientation of the New Zealand economy. One of the hallmarks of successful economies, and especially small ones, tends to be a growing number of firms footing it successfully in the world market. Earnings from abroad, after all, underpin over time our ability to consume what the rest of the world has to offer. Quite why The Treasury is that pessimistic isn’t clear from their documents – one could guess at various possibilities in aspects of government economic policy – but it does tend to stand rather at odds with the puffery and empty rhetoric the PM and Minister of Trade are given to.

Then there was this

On Treasury forecasts the CPI in 2025 will have been 13.3 per cent higher than if the Reserve Bank had simply done its core job and delivered inflation on average at 2 per cent per annum (the Reserve Bank’s own projections are very similar). It is a staggering policy failure – especially when you recall that the Governor used to insist that public inflation expectations were securely anchored at around 2 per cent. It is an entirely arbitrary redistribution of wealth that no one voted one, few seem to comment on, and no one seems to be held to account for, even though avoiding such arbitrary redistributions (benefiting the indebted at the expense of depositors and bondholders) was a core element of the Reserve Bank’s job. We don’t – and probably shouldn’t – run price level targets, but let’s not lose sight of what policy failures of this order actually mean to individuals.

And the third line that caught my eye was this

A good question for the National Party might be to ask how much of this 3.5 percentage point increase in tax/GDP they intend to reverse, and how, or would any new National government simply be content to leave little changed what Labour has bequeathed them?

As longer-term context (slightly different measure to get back to the 70s) the only similarly large increases in tax/GDP seem to have been under the 1972-75 and 1984-90 Labour governments.

Profits

A couple of weeks ago I wrote a post here, prompted by a paper by the former Bank of England Deputy Governor Sir Paul Tucker. Tucker’s paper was written in the context of the huge losses central banks in many countries, including his own UK, have run up through their large scale asset purchase programmes, especially those undertaken in 2020 and 2021 when bond yields (actual and implied forwards) were already incredibly low. While central banks continue to hold the bonds, the losses are seen every year now as the funding costs on those bond positions (the interest paid on the resulting settlement cash balances) swamp the low earnings yields on the bonds themselves. Bond positions purchased at yields perhaps around 1 per cent are financed with floating rate debt now paying (in New Zealand) 3.5 per cent (a rate generally expected to rise quite a bit further).

Tucker explored the idea that central banks might in future choose not to fully remunerate all settlement cash balances (while still applying the policy rate at the margin), and that if they did not then politicians might in future be reluctant to authorise future LSAPs and associated taxpayer indemnities (this seemed like a bonus to me, but Tucker is a bit more open to the potential of QE generally than I am (for New Zealand). With $60 billion or so of settlement cash injections still in the system (although with other offsets, total settlement cash balances are less than that), there is a lot of money potentially at stake.

My post was pretty sceptical of the idea – it seemed like arbitrary “taxation” by an entity with no mandate and little accountability – and in a Herald article at about the same time I was pleased to see several former colleagues also expressing considerable scepticism. In the wake of my post I had a bit of an email exchange with Tucker and while that didn’t change my mind it did help clarify the importance of reaching a view on whether the LSAP additions to settlement cash balances had resulted in something akin to a windfall boost to bank profits or not. Here is Tucker

Now, reaching a definitive view on a matter like this isn’t easy. Formalised models might even help, although I’m a bit sceptical even they could ever offer anything very definitive, and – in arbitrary taxation at least as much as criminal justice – we might reasonably expect something close to a “beyond reasonable doubt” test to be applied (especially when no one compelled the state to ever do LSAPs at all). You could think of a hypothetical world in which such a windfall might appear to rise – central banks buy the bonds from pension or hedge funds who simply deposit the proceeds with banks and happily (or resignedly) just accept zero interest on the resulting deposits – but it doesn’t seem very plausible. Perhaps there are other hypotheticals, but it still seems a stretch (and we aren’t in the world decades ago where, for example, banks were forbidden from paying interest on transactions balances).

I don’t have the resources or data for the sort of in-depth analysis that might be required if governments and central banks were to be seriously considering the Tucker option. But what do the high-level indicators we do have show? This, inevitably, bleeds into the recent (and annual or semi-annual) ritual in which the political left and the popular media bemoan the profitability of the banking system more generally.

The first increase in the OCR was in October 2021. Until then, settlement balances had been earning 0.25 per cent per annum, so that even if banks had somehow been paying nothing on the counterpart deposits, the amounts involved would have been too small to have shown up in the aggregate data (0.25 per cent per annum on $60 billion is about $150m per annum). But we have aggregate data now up to and including this year’s June quarter.

I’m including some long-term charts here (from the Reserve Bank website data, going as far back as their data go), as background to some comments on bank profitability too.

There is return on assets

return on equity

and the net interest margin (shown on the same chart as the average interest rate earned on interest-earning assets)

It is early days – the much higher OCRs for the September and December quarters may shed more light in some months’ time – but at present there isn’t anything much pointing to windfall earnings, whether directly from the Tucker effect or from the LSAP or other Covid interventions. Returns dipped during the 2020 deep (if brief) downturn, and then seem to have returned to about pre-Covid average levels. If the net interest margin has risen a bit, in the June quarter it was at about the average level for the previous 15 years.

On the other hand, supporters of the Tucker story could point to this chart. It is interesting that interest-bearing liabilities have dropped to a record (over this 30 year period anyway) low but (a) perhaps it is less surprising given that, at least to June, the absolute level of interest rates remained very low (and well below the prolonged period 20 years earlier when the interest-bearing share of total liabilities was also unusually low) and (b) as yet, there is no sign of this reflected in unusually high bank returns (see earlier charts).

Time will tell, but to this point there is no smoking gun, in New Zealand anyway. Tucker does note that (at least in the UK context) windfall returns could be paid away in management bonuses, so that they wouldn’t show up in after-tax profit figures, but (a) that seems more like a UK issues (big bonuses in the City etc) and (b) you would expect to see it showing up in bank disclosures (eg CEO salaries etc) and I’m not aware of any sign it (yet) has.

More generally, what to make of the bank profits story? On a cyclical basis there were reasons one might have expected the last year to have been the best for some time: the economy was extremely overheated, unemployment was extremely low, and although house prices have been falling more recently they only peaked in November last year, having risen to an extraordinary extent over the previous 15 months or so. Banks tend to make lots of money in circumstances like that (and, on the other hand, to do poorly in deep recessions). Perhaps reflecting the abnormal and uncertain state of the Covid world over 2021/22, in fact none of those charts above suggest anything exceptional about bank profitability (at times, really high reported bank profits can themselves be a worrying financial stability indicator – lots of poor quality loans with high upfront fees and/or dodgy accounting can produce very flattering short-term numbers, all while storing up big future losses. Cyclically, the year ahead looks a lot less favourable for banks (as the ANZ CEO noted they are now writing a tiny fraction of the number of new mortgages they were doing at peak) and a recession (with all the attendant reduction in demand for products, reduction in servicing capacity, and outright losses) is generally agreed to be looming.

What about overall average rates of return? When they left aren’t making cyclical complaints, this tends to be where they focus. And of course the return on equity is better than you are going to get on a bank deposit, but it is also a great deal riskier.

One obstacle to analysing the issue in a specifically New Zealand context is that hardly any New Zealand banks are listed on the stock exchange as such, so we don’t have a good read on the value the market puts on them. But the big-4 banks are the dominant players in Australia too, housing lending makes up almost two-thirds of credit in Australia, and Australia has similarly absurd house price to income ratios in its largest cities. Historically, rates of return have also looked quite high

(One might also add that in recent decades the New Zealand and Australian banking systems have been amongst the most stable anywhere).

Then again, the market seems less impressed with the Australian banks than the New Zealand political left are. Price to book value ratios don’t look particularly impressive – for long-established “licence to print money” entities – and of the four big Australian banking groups, in three cases the first time the current share price was reached was well over a decade ago.

We (and Australia) have big banks. When regulation renders house prices absurdly expensive, you need entities that will facilitate very large amounts of debt. Big banks require lots of capital, and on lots of capital lots of money can and should be made. But if the left is so convinced there is money for jam on offer there is a readily accessible market response: buy more shares with their own savings.

Instead, from the party that wants to make us all poorer, force people to live in expensive townhouses, and do all they can to discourage cars and planes (oh, and free speech too), yesterday we got a proposal that there should be an “excess profits tax”. The Green Party’s discussion document is here. I guess it is mostly just political spin to try to keep up the radical left vote, but it really was an astonishingly threadbare document.

For precedent, we are reminded on a couple of occasions that there were excess profits taxes in World Wars One and Two. And since we actually conscripting people – and ordering them into the military or directed service – and restricting all manner of other economic activity probably few people had much problem with that (the idea of “conscripting capital” was (understandably) big on the left in New Zealand. But while the left may like to claim we are now in some “moral equivalent of war”, in fact we are running a market economy in which firms and individuals are free to come and go, invest or not, as they choose. We are also told about windfall taxes on energy companies in Europe at present, but again these are rather more equivalent to an actual wartime situation (very high returns to lower cost renewables producers for example are arising out of the foreign policy choices of governments around the Russian/Ukraine situation).

But nothing in the Greens’ document establishes a serious case for New Zealand now (eg for better or worse we aren’t tied into the global LNG supply chain)

And then there are the basics. This appears early on.

I followed the footnote to be sure I was using the same sources. From the Annual Enterprise Survey

So you can see the $103.3 billion. But you might also note the sharp fall in this measure of profits the previous year (Covid disruption and all that), and the smaller fall the year prior to that. Actual profits before tax on this measure were about 5 per cent high in the 2021 years than in the 2018 years.

And nominal GDP? Well, it was up 17 per cent over roughly the same period (calendar 2021 over calendar 2018).

Then we get charts like this.

I have no idea where any of the lines comes from but note (a) the orange line, which claims to be taken from the AES, has a latest observation LOWER than the one a couple of years earlier, and (b) while the Greens claim that “the graph below demonstrates that profits are already exceeding prepandemic levels; and are several times higher in real terms than in the 1990s” they fail to point out that real GDP is a lot higher than it was in the 1990s too.

How do those ratios look? From the national accounts we have a breakdown between compensation of employees on the one hand and returns to business (including labour income for self-employed operations). Wage and profit shares have ebbed and flowed but nothing about the last few years looks very unusual.

The same data are now available on a quarterly basis, but only since 2016 (and inevitably the more recent observations are subject ot revisions). This time I’ve just shown the two series as cumulative growth rates since 2016

Labour costs and non-labour components of the income measure of GDP have risen over the full period by almost exactly the same percentage (seasonally adjusting through the Covid lockdowns is a real challenge so I wouldn’t pay much attention to those particular quarters).

We are left wondering where all these excess returns the Greens are on about really are. If they mean house prices rising in 2020 and 2021, well of course I can quite understand (and we know they like the idea of a capital gains tax) but……house prices are now falling quite a lot, and excess profits taxes aren’t usually aimed at Mum and Dad (indeed the rest of the document is all about th rapacious capitalists).

One could go on, but I won’t. The Greens seem keener on planning to spend the proceeds of their tax than provide firm analytical underpinnings to it, and of course while feeding the narrative that somehow there is money for jam being left on the table, there seemed to be no mention of countervailing reductions in business taxation if/when there is a deep recession or windfall losses (and in the nature of windfalls, losses are as likely as gains). But why would anyone really be surprised?

The document has this line: “The Green Party considers that record profits during a time of economic hardship for many New Zealanders are immoral and unsustainable”. Except that whether one uses their AES measure, or national accounts measures there isn’t anything very remarkable about profits in recent years – except of course that there is lots of inflation, but even then as that final chart shows returns to labour in total have been growing at about the same rate of returns to providers of other resources.

Taxes

A conversation about the similarities and differences between taxes and social security contributions – my son is studying economics – prompted me to head off to the OECD website and get the data on total taxes and social security contributions as a share of GDP.

Here is what I found for 2021 (the OECD didn’t have this level of data for its Latin American members, and I omitted Ireland and Luxembourg, as their GDP numbers aren’t a suitable basis for these purposes).

That is the snapshot for the most recent year, 2021, and here is how New Zealand has compared to Australia and to the OECD median (countries in the first chart) for the period back to 1995 when the data are comprehensive.

To be honest, I was a little surprised. I guess time passes and impressions need updating from time to time: the story I had been walking around with (probably formed a decade ago) was that New Zealand tax revenue as a share of GDP fluctuated around the OECD median. It used to but, whether under National or Labour-led governments, it hasn’t done so for some time now. It isn’t that taxes are trending down in New Zealand – as a share of GDP in 2021 they were about the same as in the first couple of years of the Clark government but (a) the contrast with huge surge in tax revenue in the 00s is striking, and b) the OECD median has been edging up.

Of course, Australia is an important comparator, given the number of New Zealanders who look at making – and often do make – the move to Australia, and there is not much consistent sign of a change in the relationship between the two countries’ tax/GDP shares. And the Anglo countries have tended to be lower taxers than continental Europeans, and of the five Anglo countries we were the median taxer in 2021. Whatever one thinks of the US, Australia is hardly some unliveable hellhole (certainly the New Zealanders who move there don’t think so), although neither is it some star productivity growth performer.

Opposition parties seem to be making a fair amount of noise about tax as we begin to head towards next year’s election. And in many respects I sympathise: I find it hard to think of a single one of the tax increases put in place in recent years that I thought there was a good economic case for, and the fiscal drag that results from not indexing income tax thresholds is just bad policy at any time. We tax business too heavily, whether under National or Labour.

But…..you have to identify the things you don’t want governments spending money on, and that is where our main Opposition party seems to struggle.

The picture is, if anything, a little more stark if we shift from taxes and social security contributions to total current revenue. Natural resources owned by the state are part of the picture here (see Norway in this chart vs the first one above)

On this measure, we are even more firmly to the left of the chart.

(Incidentally, there is a line – that I probably thought had merit – that we don’t need quite such high taxes because our public debt is low. But the OECD database had net interest data, and we turned out to have been the median country last year. (Low central government debt, but persistently high relative interest rates I guess)

All this data has been taken from the OECD. There is some IMF data, and for a wider range of advanced countries. I don’t put a great deal of trust in the IMF numbers (too often I find NZ numbers that look odd), but they do capture places like Singapore and Taiwan.

But here is the IMF’s total general government revenue data, for 2021

On this measure and this group of countries we are somewhat further from the left. And if (like me) you aren’t overly interested in underperforming Mexico, Chile, and Colombia, note nonetheless the really low revenue/GDP numbers for Taiwan and Singapore. One can have a highly productive economy (both countries now have materially higher GDP per capita than New Zealand) with a materially low overall share of government revenue and/or taxes.

I focused on taxes in this post because (a) that is where the political debate seems to be, and (b) because in 2021 government spending was much more thrown about by Covid one-offs than tax revenue was. In the longer-run, it is the level of spending that determines how high taxes eventually will need to be. Over the recent decades New Zealand governments have had a good record of returning to balance or surplus whenever shocks push the budget into deficit (which means we are one of a minority of OECD countries like that, and very unlike say the US and UK where deficits have been normalised). But note that – with an overheated economy, and thus cyclically high revenue – we are not projected to be at balance or in surplus this year.

(And to anticipate questions as to what I would cut were I granted a magic wand, here are the first five that come to mind: Kiwisaver subsidies, fees-free first year tertiary education, R&D subsidies, the accommodation supplement (having freed up peripheral land and collapsed house/land prices), and NZS (raise the eligibility age to 68 in the next five years not the next 25). But realistically I do not expect New Zealand wil operate with a lower tax or revenue to GDP share than it has now.)

We deserve better

A few weeks ago there was the debacle of the government introducing one afternoon a bill that would have imposed GST on investment management fees, ministers defending that bill the next morning, but then by lunchtime the policy was gone.

The proposed law change seemed on the face of it perfectly sensible in principle. I even read the Regulatory Impact Statement that was published with the bill, and most of the reasoning and argumentation made sense there too.

But it contained this little section

Perhaps unsurprisingly, those big numbers got a fair amount of media and political attention. As an example, here was an RNZ story

I was a bit curious about this “modelling”, which was not published at the time the bill was introduced. It wasn’t described in the RIS, the numbers weren’t put in any sort of context, they were just baldly stated. Quite probably ministers don’t read RISs, but perhaps you might think that the political advisers in their offices would (looking for fishhooks and headlines if nothing else). And you might have hoped that officials (Treasury/IRD) might have done a bit more than drop big numbers into the RIS – numbers that might reasonably be seen as creating problems for a sensible rational tax reform – rather than just stick the numbers out there waiting for the first curious journalist or Opposition MP to find them.

My suspicion was that something very simple, and potentially quite misleading, had been done. After all, one wouldn’t normally look to the FMA to undertake any serious modelling (it is a regulatory implementation agency). So I lodged a request for the modelling, and got a reply back this afternoon.

It is a helpful reply. They have set out their assumptions clearly, and even offered that I could talk to the responsible senior manager if I wanted to discuss matters further.

And it was pretty much as I had expected. They had assumed (probably reasonably enough [UPDATE; but see below]) that all of any GST burden would be passed on to customers/investors, and thus that overall returns would be a bit lower. But then they simply assumed that all the additional tax went to the government, which sat on it, and neither the government nor the savers made any subsequent changes in behaviour……..over the subsequent 50 years. And thus, mechanically, future managed fund balances would be lower than otherwise (about 4.5 per cent lower)

It might be a reasonable approximate assumption for a first year effect. Just possibly it might even be valid for the KiwiSaver component, since KiwiSaver contributions are largely salary-linked. But it makes no sense over a 50 year horizon, across all managed funds (let alone all private savings) and especially as the only macro-like number to appear in the entire document.

Over a 50 year view surely it would be reasonable to assume that one modest tax change makes no difference to the fiscal outlook, and thus that what is raised with this tax won’t be raised by some other tax. Household income won’t really be changed, and since most of the evidence tends to be that household savings rates in aggregate aren’t very sensitive to rates of return (partly because there are conflicting effects – low rates of return on their own might discourage saving, but on the other hand people with a target level of accumulated savings in mind for retirement will need to save a bit more when returns are lower than they had previously assumed) neither will the overall rate of household saving. There is more sensitivity (to return) on the particular instrument people choose to put their savings in, so that if returns on investment management products are a little lower than otherwise, people might prefer, at the margin, to hold a bit more of some other assets. But what of it? Supporting investment management firms’ businesses is no part of a sensible government’s set of goals.

Surely the best assessment would have been that over anything like a 50 year view, a small tax change like this, affecting returns on one form of savings product, simply would not be expected to make any material difference to accumulated household wealth in 2070, with perhaps some slight change in the composition of household asset portfolios: a little less Kiwisaver, not much change in other investment management products, and a little more in other instruments.

The FMA were at pains to point out that they “had limited time to feedback to IRD as part of IRD’s policy consultation”, although it isn’t clear whether IRD/Treasury requested these numbers or the FMA took it upon themselves to do it. And thus in a way I don’t much blame the FMA. They tend to be enthusiasts for and champions of KiwiSaver, and simply do not have a whole-economy remit or set of expertise.

What disconcerts me is that neither IRD nor Treasury (the latter especially) seem to have been bothered by FMA’s numbers, and neither seems to have made any effort to provide any context or interpretation. There wasn’t any obvious reason why those FMA numbers had to be in the RIS, but if they had put them in with a rider “On the (unlikely) assumption that governments simply accumulate the additional tax revenue for 50 years and neither they nor households make any other changes in behaviour, then FMA ‘modelling’ suggests……”, it might have done materially less damage, through highlighting the sheer implausibility of the assumptions over a 50 year horizon.

Of course, you might also have hoped that ministers and their political staff would have noticed that something seemed odd.

What was proposed still seems as though it would have been a sensible tax change. Perhaps it will even happen one day. Perhaps it would have been derailed anyway, even if those FMA numbers – unqualified – had never made it into the document. But neither ministers nor officials really seem to have helped themselves.

UPDATE

A reader got in touch and suggested I might have been too generous in accepting the FMA view that all the GST would have been passed on to customers. With that reader’s permission, here are his comments

“Having owned a fund manager as part of a wider business, the GST exemption was a pain.  We could not recover GST on certain inputs and so therefore had to charge more – about 7.5% more because of this.  Plus we had an extra employee in the finance area that we could have got rid of.  It is not obvious to me that the fees would have gone up for this reason at all, except that the industry would probably have used it as an excuse to raise fees as it means that at some future point they could cut them and get a pat on the back from the FMA.”

Cutting the cake not baking a bigger one

There has been a series of Tuesday events (“Tax on Tuesday”) held at Victoria Univerisity recently, jointly promoted by Tax Justice Aotearoa, the PSA, and the university’s own Institute for Governance and Policy Studies.  I wrote about one of the earlier events here.

The final event was held this week, marketed as “Where’s the party at?”   Political parties that is.   In an event moderated by the Herald’s Hamish Rutherford, speakers from four political parties (NZ First declined the invitation) each spoke about some aspect of tax policy for 8-10 minutes, with plenty of time for questions.   It wasn’t a hugely well-attended event, but it is pretty safe to assume that the overwhelming bulk of the audience was on the left of the political spectrum, and I guess the speakers recognised that in what they chose to say.

First up was ACT’s David Seymour.  He started well, talking about twin challenges for New Zealand around (lack of) competitiveness/productivity and about (insufficient) social mobility and the spectre of entrenched disadvantage.  He was bold enough to note that there is a large group, mostly Maori, who  – rightly and reasonably –  feel that the last 30 years has not done much for them, in economic terms.  I was still with him when he argued that the way to fix the housing market was at source –  around the RMA and associated land use restrictions –  not by trying to fiddle the tax system.

But his centrepiece was an attempt to make the case for a flat rate of income tax (I think set at 17.5 per cent), scrapping our current progressive system.   He attempted to support this with the suggestion that all the rest of our tax system was flat, but I couldn’t quite see the relevance of his point, since (a) personal income tax is almost half of government revenue, and (b) we’ve chosen to achieve the desired progressivity through the income tax rather than, say, the consumption tax.    Attempting to engage his (left wing) audience he attempted to argue that we should think of “fairness” as involving the same rate of tax on every dollar of income (with a half-hearted suggestion that a poll tax could be considered even fairer, but probably wouldn’t fly politically).  Progressivity, he argued, simply doesn’t fit with New Zealand’s culture and values as an “aspirational society” and sends the wrong message, wrong values.  It wasn’t a  description of New Zealand I could recognise, at least any time in the last 100 or more years.

Anyway, Seymour then proceeded to undermine his own argument by addressing the question of “but what about the low income people whose marginal and average tax rates would then rise?”  Consistent with his logic, I’d have thought he should have just said “well, tough –  this is what fairness is, all paying the same rate on every dollar” (while perhaps making the fair point that many people on the lowest marginal tax rates aren’t there for long).  Instead he suggested two possible responses.  The first was to use the tax/transfer system to offer a credit to these people to leave them no worse off (ie progressivity, at least at the bottom, by another name) or…..and this is where I had to check I was hearing correctly…..the minimum wage could be increased further (noting that employers could “afford it” because their own tax rates would be lowered).  In a country with one of the highest ratios of minimum wages to median wages, the MP for the libertarian party appeared to be seriously proposing increasing that impost further……

The Greens finance spokesman (and Associate Minister of Finance) James Shaw –  the calm and relatively sensible face of the Green Party – was up next.  I’d never ever vote for them –  the party that, among other things, whips its members to vote for abortion –  but there was something refreshing in hearing a serving minister frankly state (in answer to a later question) that he really didn’t think taxpayer money should be spent on subsidies for the America’s Cup.  Perhaps he could next offer some thoughts on (New Zealand) film subsidies to makers of propaganda films vetted and controlled by the Chinese Communist Party?   He also spoke highly of a recent NZ Initiative report.

Anyway, on tax, Shaw was clear about where his priors were (and, of course, most of the audience weren’t minded to object).  He is keen on Northern Europe and Scandinavia.  He characterises those countries are starting by identifying what they want to achieve (desired outcomes) and then work from there to an appropriate tax system.    In all cases, that means much higher tax/GDP (and, of course, spending/GDP) ratios than in New Zealand.   From his perspective, he’d be keen on more environmental taxes and –  the Elizabeth Warren side in him coming out – on taxing wealth relatively more.

Perhaps somewhat at odds with the environmental point, he made the interesting argument –  with which I’d sympathise –  that we should hypothecate (ring fence, not into general government revenue) revenue from Pigovian taxes, lest government forget why the taxes were imposed (to deter the behaviour) and become reliant on the revenue (eg tobacco taxes).   That sounds fine –  and he went on to note, in the same vein, that his ideal carbon price in 2050 would be zero (carbon emissions would have been successfully eliminated or out-competed) – but it would leave the pot of general revenue not looking any much larger than it is today.   Despite his evident preference for a much larger government, he didn’t dwell on where the credible sources of much higher long-term revenue were in the Green Party’s view of the world.

Deborah Russell, chair of the Finance and Expenditure Committee, and a former tax academic and official, represented the Labour Party.   As she noted, she came along –  rather than the Minister of Finance or Minister of Revenue –  because people would pay less attention to her.  As she noted, Labour doesn’t have much to say because –  having junked a capital gains tax –  they are in “pretty intense” debate as to what their tax policy next year should be.

Russell –  who people seem to regard quite highly –  was an odd mix of the conventional and aspirational.   She ran a very similar line to Shaw in suggesting that we should first identify what we want to spend money on –  while noting that Labour hadn’t done those conversations that well – and only then identify how best to pluck the goose.  Since she went on to answer a question about inequality later, claiming that she wanted New Zealand to be “the most equal” country in the world, wanted “real radical equality” and supported more support for children, including a return to a universal family benefit, it seemed pretty clear that she too wanted a bigger government and thus materially more tax.

But at the same time she was talking about broad agreement on the “broad base low rate” mantra that has (mis)guided New Zealand tax policy for decades –  even though the high tax countries (eg Scandanavia) she seems to admire don’t have BBLR because they can’t (they recognise a need not to overburden business investment).   And she noted that when her Labour people talk about taxing the rich she often reminds them to think harder about “who are the rich?” and how many (few) there might be to pluck.   The Stuff article on this event played up talk that Labour is looking at campaigning on a higher maximum marginal tax rate, although it is hard to imagine there is really much money in such a proposal (and while it is one thing to campaign for higher taxes from Opposition at the end of a tired old’s government’s term –  as in 1999 –  it might be another thing now, campaigning for re-election, with Budget surpluses).

National’s Paul Goldsmith –  who has actually written a fascinating history of New Zealand tax policy –  spoke last.  He was pretty underwhelming on this occasion, perhaps concluding his audience wasn’t likely to be sympathetic anyway. He repeated the BBLR mantra, talked briefly of National’s (sensible) policy of indexing income tax thresholds, and repeated the promise of no new taxes in the first term of a National government.  He sounded quite pessimistic about fiscal prospects –  talking about the risk any new government could inherit material deficits –  which would act as a constraint on any desire National might have to do something more about lowering taxes.  As for growth/productivity/competitivess, all we heard was the short-term stuff about current low business confidence etc.

Question time followed.  James Shaw was challenged on his line, from earlier in the year, that the government wouldn’t deserve to be re-elected if it didn’t introduce a Capital Gains Tax. To his credit I guess, he looked abashed, mumbled a bit, and didn’t really pretend to have an adequate answer.

Herald columnist Brian Fallow asked about low household savings and low business investment/ “capital shallowness” (including the alleged ”overinvestment in housing” and asked what parties were proposing to do.  Here, my view of Russell started heading downhill.   There isn’t a low savings rate, she claimed, just the wrong measures of savings, and as for business investment, why 1 per cent interest rates might bring about desired change –  as if rates aren’t low for a reason –  and repeated that (deeply flawed) Adrian Orr line that interest rates are now just returning to more normal long-term historical levels.   Goldsmith and Shaw at least both suggested that any housing issues were housing market problems and need to be fixed at source.  But not one of the three of them (Seymour had to leave early) even mentioned the company tax rate (or cognate issues).     All three –  Russell and Shaw more than Goldsmith – actually seemed keen on taxing multinationals more heavily.  None showed any sign of engaging with the literature that much of the burden of capital taxation falls on wage earners.

The chair of the Tax Justice Aotearoa group noted that on OECD measures New Zealand is around the middle of the pack on inequality and asked the speakers whether they were happy with that, and if not which country they would aspire to be like.  I’ve already mentioned Russell’s response, although shouldn’t omit her suggestion that as a result we need to look a lot more seriously at what we don’t tax: wealth.  The CGT had been rejected but she argued we need to relook at options that tax wealth.

Paul Goldsmith responded that he wanted to emphasise equality of opportunity, while noting that the state –  rightly in his view –  does lots of redistribution as it is.  James Shaw, while rejecting the idea of a single country to aspire to, was quite open about aligning more with the Nordics –  in his view they had the best outcomes and were the best run.  By contrast we had “emaciated social support over several decades”, and he went on to note that we couldn’t, in his view, have equality of opportunity without much more government spending (“investment”).

It was interesting to hear both Shaw and Russell suggest that there should be more focus on desired outcomes, which should then lead us to design a tax system that would raise the (more) money.    Arguments on that sort of point are part of what politics is about.  But it was also interesting to hear both of them talk about how politicians end up disguising revenue increases in various not-very-transparent guises (levies etc) and how hard it is to make the case for higher taxes (although as Paul Goldsmith noted, one of the striking things of the CGT debate was the way Robertson/Ardern simply didn’t engage in making the case).  Perhaps the left really can make the case for much more spending, much more tax, but their own words suggest they have something of an uphill battle.

As for me, I probably came away still disinclined to vote at all next year.

But, for what it is worth, two final points.  First, it is easy to admire the Nordics.   But they’ve built really strong economic foundations, which we simply no longer have.  Here are the latest OECD real GDP per hour worked numbers

Denmark 65.4
Finland 55.3
Iceland 56.9
Norway 80.5
Sweden 61.9
New Zealand 37.3

And not one of the speakers showed any real emphasis on getting the conditions right for markedly lifting productivity (not even Seymour, despite the opening reference).    Parties just don’t seem to take the failing seriously, and continued failure to do so will increasingly constrain both public and private consumption/service options.

And, as for wealth taxes, I happened to see this table in a Cato Institute piece the other day.

wealth.png

You might end up favouring a wealth tax for some principled purpose, or just as an “envy tax”, but it isn’t likely to be the sort of option that is going to dramatically transform the size of government, in New Zealand or anywhere else.

NZ’s company tax rate: enforcement and investment

Last week I wrote briefly about a short presentation, at a Victoria University event, by tax blogger (and former Treasury/IRD official, former adviser to the Tax Working Group) Andrea Black on what should be done with the company tax rate.  Andrea argued that it should be raised, both to collect more tax from the “rich” and to reduce the evident opportunities for avoiding or deferring tax that differential rates for company, personal, and trust income creates.

Since what I wrote about that was buried in the middle of a long post, I reproduce the relevant section here

I wasn’t really persuaded.  With dividend imputation, the company tax rate in New Zealand bears much more heavily on foreign investors (none of whom needs to be here) than it does on domestic shareholders.  In a country with low rates of business investment and now relatively low rates of foreign investment, it seems cavalier to be calling for increases in company tax rates which the global trend is clearly downwards (at 33 per cent the company tax rate would be the second highest in the OECD).   In defence of her position, Andrea invoked some old IRD analysis that company tax cuts haven’t made much difference to investment –    IRD has a strong institutional bias towards a simple tax system and little real focus on productivity, economic performance or anything of the sort – while noting that “if you did care about foreign investors” –  there were various technical tweaks (I didn’t catch them, but perhaps thin capital rules?) that could be adjusted to compensate them at least in part.

As if to forestall a question, Andrea alluded to this chart I’ve used several times –  a version of which appeared in the TWG’s own background document last year.

corp tax 2017

Prima facie, it didn’t look as though – by international standards – we were undertaxing business income.

Now, of course, there are some well-recognised caveats to this data.  First, it doesn’t take account of dividend imputation in New Zealand (and Australia, but not elsewhere), and the TWG suggested there were some issues around consistency of treatment of government-owned businesses.  On the other hand, in many countries lots of shares are owned by long-term savings vehicles with much less onerous tax provisions than their peers in New Zealand would have, and our tax system (mercifully) has fewer deductions and “holes” in it.     In yesterday’s presentation Andrea suggested that in many other countries various classes of business income that would be incorporated –  and thus captured in the chart – here wouldn’t be treated the same way in other countries.

All that said, if anyone is seriously suggesting that the chart of OECD data is substantially misleading about the New Zealand position –  say that in truth we might be in the lower half of the chart on an apples-for-apples comparison, the onus is probably on them to demonstrate that more specifically.    The OECD data itself suggests we have taxed businesses quite heavily going back 50 years, to (for example) well before imputation was ever on the scene (chart in this post).  Perhaps it is just coincidence – and I’m certainly not suggesting it is the only factor –  that business investment as a share of GDP has been low by OECD standards throughout almost all that period.

In a comment on my post, Andrea clarified that it was changes to the thin-capitalisation rules she had in mind to mitigate adverse effects on foreign investors.

I’m sympathetic to the idea that New Zealand shareholders shouldn’t be able to shelter income in companies in a way that means that some forms of flow capital income are taxed more lightly than others.  For small closely-held companies, for example, I can see a certain logic to a mandatory distribution of profits (which could then be simultaneously reinvested).

When I heard Andrea’s brief presentation last week, I hadn’t seen her initial post on the issue.   It is worth reading and she presents what looks like persuasive indications that there is more of an issue here than (for example) some people who commented on my post or got in touch privately might have suggested.   For example

Except that overdrawn current account balances – loans from the company to the shareholders- have been similarly growing too. Now sitting at about $25 billion.

And yes this all started from about 2010. And what happened in 2010? Why dear readers the company tax rate was cut to 28% while the trust rate remained at 33%.

Last night Andrea put out a further post on the issue, prompted (it appeared) by my post last week.    It is also worth reading, repeating some of the earlier material but also extending her argument.   For example, in dealing with the foreign investment issues she now suggests another possible response

If the focus was New Zealanders owning closely held New Zealand businesses, an adjustment could be made either by increasing the thin capitalisation debt percentage or making a portion – most likely 5/33 – of the imputation credit refundable on distribution.

I’ll leave you to read Andrea’s case. On its own terms, it makes a fair amount of sense on her terms (and she is much more expert on tax detail than I am) but I want to focus on the issue through a different lens.

Thus, take for example the line –  which apparently originates with IRD –  that we’ve had no more foreign investment since the company tax rate was cut.   Well, here is a chart of New Zealand company tax rate relative to the median OECD country’s company tax rate (OECD data that take account of sub-national taxes as well).

coy tax oecd

The story of the century, around company tax, is that the gap has been widening between our company tax and those in other advanced countries (with the two local cuts just temporarily closing the gap a bit). At the start of the century, our company tax rate was around the median for the OECD countries, and in 2019 it is just over 4 percentage points higher.  (One could add that the global environment for business investment seems to have been pretty poor over the last decade, not least in New Zealand.)

At present, our company tax rate –  the one that counts for foreign investors –  is just above the upper quartile.

coy tax 2

Andrea’s proposal would give us the highest company tax rate in the OECD.   One could adopt the clever wheezes she suggests to limit any adverse effect on foreign investors of raising the rate but (a) our statutory rate is already (now) at the upper end of the scale, and (b) our company tax regime is generally regarded as fewer holes and deduction possibilities etc than many of those in other countries.

And it isn’t as if business investment has been present in abundance in New Zealand.   This chart is from an OECD review of New Zealand from a few years ago.bus I oecd 2011.png

Focus on that bottom right panel.  The only time business investment as a share of GDP was above that for the median OECD country for a few years was during Think Big – the spectacular government-led misallocation of capital.  And recall that for at least the last 25 years, our population growth has been well above that of the median OECD country, so that all else equal one might have expected more of current GDP to be devoted to investment.

I’ve seen –  but can’t now find –  the OECD data for these graphs back to the 1960s and the picture is similar,  What about the more recent period?

“Business investment” is calculated as a residual. Take gross fixed capital formation and subtract investment spending on new housing and general government investment spending.  When I use OECD data for cross-country tables, I usually take care to check their New Zealand data against what is on the SNZ website.  In this case, GDP, GFCF, and dwellings investment are all identical in the two places, but the general government investment numbers are somewhat different.  So in this chart, comparing business investment as a share of GDP for New Zealand with that for the median OECD country, I’ve shown the New Zealand numbers estimated both ways (ie using OECD and SNZ gen govt investment data).

bus I NZ

Whichever line you use, business investment in New Zealand (per cent of GDP) has been materially below that of the median OECD country in most/all years, despite having had population/employment growth far faster than that of the median OECD country.

I am not, repeat not, suggesting that our company tax rate –  or the broader tax regime for capital income –  is the only factor, or even necesssarily the most important factor, in our weak business investment (and terrible productivity growth) record.   Simply that if any government were ever seriously concerned about those failures –  and wouldn’t that be a novelty –  raising the company tax rate looks as though it would be a step in the wrong direction.     If anything, in my view we should be taxing capital income less heavily.  No business has to invest – and no foreign investor has to invest here –  and if you want more of something it isn’t usually a good place to start to tax it more heavily.

And to end on a note that seems to me to –  at least on paper – better balance fairness and efficiency/opportunity, here is my final paragraph about that seminar last week at which Andrea spoke.

I remain tantalised by the idea of a progressive consumption tax. In the abstract, it gets around all the debates on capital gains taxes, realisations (or not), company taxes, gift or inheritance taxes or whatever, and has the appealing the feature of taxing people on what they consume not on what they produce.  Of course, no country runs such a system –  which does have formidable practical issues.   And if one wants to align company and personal rates – which has some appeal (although the Nordic model questions that), better to lower the personal income tax rates by 5 percentage points (max rate to 28 per cent) and add a Social Security Tax of 5 percentage points on labour income up to a certain threshold.  New Zealand and Australia are, as I understand it, the only OECD countries not to adopt some such model (we do it on a very small scale with ACC).

 

“We don’t tax businesses highly” and other misrepresentations

As we wait to learn where the government has setttled on the idea of a capital gains tax, Radio New Zealand had an interview this morning in which their presenter Guyon Espiner talked to a business lobby group opponent (John Milford of the Wellington Chamber of Commerce) of a capital gains tax.   I’m someone who is, at best, sceptical of the merits (and potential revenue gains) of a CGT, but it wasn’t the most effective case made against such a tax.

But what really prompted me to pay attention was when Milford argued that business was already quite highly taxed.  The interviewer responded along the lines of “oh, come on, the company tax rate of 28 per cent isn’t high at all”, and Milford simply let it pass and moved off to a claim that regulatory burdens and other costs were high.

We should not lose sight of the fact that we have one of the highest statutory company tax rates of any OECD country.  Here are the OECD’s own numbers for 2019 (incorporating all levels of government –  some countries, including the US, have state level company taxes as well as national ones).

corporate tax 2019

As almost everyone knows, headline corporate tax rates can mask a multitude of exemptions and deductions.  So here is the data on the tax collected on the “income, profits, and capital gains” of corporates, expressed as a share of GDP.  Data on actual tax collections takes time to compile, so these data are for 2017.

corp tax 2017

In this particular year, we took the second highest share of GDP in corporate tax revenue.      That rank bobs around a bit from year to year (in the year the Tax Working Group used in their discussion document, we ranked number 1) and it appears to matter a bit whether countries collect taxes from central government entities or not (we do), but no one seriously questions that however one looks at things, New Zealand is one of the handful of countries collecting the highest tax (share of GDP) from corporates.

The picture is further complicated by the fact that New Zealand (and Australia, but almost no one else) runs a dividend imputation scheme, such that for domestic resident shareholders (only), corporate tax is really a withholding tax, and tax paid at the corporate level is credited against the shareholder’s personal tax liability. In most other countries there is a double taxation issue (profits and dividends are taxed with no offsetting credits), and partly as a result dividend payout rates tend to be lower.  (This, incidentally, is one reason why there is a stronger case for a CGT in other countries than there is in New Zealand or Australia.)

Incidentally, here is how corporate tax revenue (same measure as in the previous chart) in New Zealand compares with that of the median OECD country over 50+ years.

corp tax hist

If anything, the gap appears to have been widening over the last 25 years or so.

It is worth remembering here that New Zealand is not, by OECD, standards a highly taxed country.  Over that entire 50 year period we’ve been around the median OECD country for total tax revenue as a share of GDP (currently just a bit below).   We also have relatively low levels of capital in our production processes (recall low rates of business investment, relative to population growth, over many decades), and yet we raise among the largest share of GDP from companies of any OECD country.

We also get quite a lot of revenue from taxes on good and services (mostly GST here).

G&S tax

We are also a bit above the median OECD country in the share of GDP taken in property taxes (mostly local authority rates, levied on property).

And, by contrast, the area where New Zealand collects hardly any tax revenue at all, as a share of GDP.

soc security taxes.png

I can’t highlight the New Zealand bar.  There isn’t one.  On this definition, we collect nothing (on other definitions one might include ACC levies, but their equivalent is presumably also excluded in the calculations for other countries).

Most advanced countries fund a significant chunk of their welfare systems (unemployment, disability, age pension) with explicit social security taxes, typically levied only on labour earnings (although some are directly paid by employees, and some directly by employers).  Of course, as the chart indicates there is a wide range in practices, but we (and Australia) are at one extreme, and partly in consequence we are the two OECD countries taking the largest share of total tax revenue in corporate taxes.

Does all this have much bearing on the case for a CGT?  Personally, I don’t think so.   A decent CGT –  that didn’t tax pure inflation and allowed proper loss-offsetting –  would be expected to raise very little revenue over time.   If there is an argument for a CGT it is mostly in some conception of “fairness”, which needs to be weighed up against problems such as lock-in, and of the consequent biasing of asset holdings towards big institutional entities and away from individuals.

But don’t try to use as an argument for a CGT that business activity in New Zealand is lightly taxed.  It isn’t.  In absolute terms, business tax revenue as a share of GDP is currently well above the average for the last 50 years.  In international comparative terms, we tax business activity more heavily than almost OECD country –  and perhaps it isn’t entirely coincidental that we sometimes anguish about why we don’t have more business activity.

I listened to more of Morning Report than usual this morning (kneading hot cross bun dough as I did) and had the misfortune to hear Business New Zealand chief executive commenting on government proposals to crackdown on the “exploitation” of migrant workers.  I haven’t looked into the details, so have no view on the substantive merits of the specific proposals (sympathetic as I am to the cause generally).  But people shouldn’t be able to advance their cause with straight-out lies.  Kirk Hope claimed that what the government was proposing was quite inappropriate in part because we currently have “record low” unemployment.   Perhaps his memory is short, but Business NZ used to have an economist who could have briefed him.  In the absence of that person, here are the data

U historical

Perhaps you might want to discount the first 20 years (although it was a real phenonenon), but current unemployment rates haven’t even reached the lows we managed for several years prior to the last recession.   And these days older workers (aged over 65) are a much larger share of the labour force, and naturally tend to have a materially lower unemployment rate (in other words, what might have been unsustainably low 15 years ago, is probably rather more sustainable now).

Reading the TWG report

You might idly dream –  or hope, increasingly desperately, for your own sake (younger readers), or for your children or grandchildren – that one day real house prices might be sustainably lower again. There is no good or defensible reason why they shouldn’t be.  It is just that our political “leaders” choose to keep on doing nothing real about it.  From time to time some of our politicians talk a good talk about fixing this national disgrace –  once upon a time the current Minister of Housing was foremost among them (embraced even by the libertarians at the New Zealand Initiative) –  but then do nothing, or attempt to distract us with interventions that have little or nothing to do with the real problem.

The Tax Working Group’s report, out last week, assumes this state of affairs goes on indefinitely.   Why do I say that?   Because in the revenue projections they include in the report (and on which they construct a case for permanent income tax cuts):

  • the bulk of the revenue is from gains in urban property prices (land and buildings), and
  • they assume that property prices rise (indefinitely) at 3 per cent per annum, only 2 per cent of which is general consumer price inflation.

Since actual physical buildings experience real depreciation, and since over the long term construction costs are unlikely to rise at a rate much different than general CPI inflation, the implicit assumptions seems to be that urban land prices will rise even faster.   (It has never been clear to me how anyone thinks they can safely forecast real asset prices, let alone plan responsible tax policy on such forecasts, but set that to one side just for the moment.)

So most of the revenue would arise from general consumer price inflation –  which simply shouldn’t be taxed (since no one is better off as a result; there is no addition to purchasing power) – and the rest apparently from assuming that the rigged (by central and local government) housing market continues to get even more out of line.   If we are going to have a capital gains tax on urban property, perhaps the government could at least consider using any proceeds to compensate the generation put in an ever-more-impossible position by their own policy choices/failures?   Alternatively, if the government (Mr Twyford) really is still serious about fixing the housing market –  and he claims to be so – they need to recognise that there will be little or no revenue from a capital gains tax for a very long time.  In principle, the ability to deduct capital losses from other taxable income would actually make it a net drain on the public finances were anything serious ever to be done about fixing the housing market (investors, but not owner-occupiers, would be partly compensated for their losses, upending most people’s sense of fairness).

There is a choice:

  • reasonable amounts of revenue, much of it plundered by taxing inflation compensation, if the rigged housing market is allowed to continue, while doing nothing to compensate the actual losers from that (governmentally) distorted housing market,
  • or little or no revenue (perhaps even net fiscal costs) if a government ever gets serious and fixes the housing and urban land market.

Reading the entire report yesterday, and even going back to read the interim report, I was struck by how thin and weak the economic analysis in the document was.  As someone noted to me yesterday, it had a strong feel of something in which the working group started with a conclusion and went pretty much straight to how to write rules, without thinking about the underlying economics.   I noted a year ago how little any concerns around productivity (lack of it) figured when the Tax Working Group set out their plans.  And they delivered –  there was very little about those considerations in their reports.  Not even a recognition that, for all the talk about reallocating investment, if anything probably too few real resources have gone into housebuilding over the years not too many (given the growth of the population).

There was lots of focus on raising more revenue, and little on the low rates of business investment we already have, or on the way in which we tax much of capital income more onerously than almost any other OECD country.   The idea of fixing inflation distortions directly didn’t get much space either.  The current system bears very heavily –  and quite unjustly – on people holding savings in the form of bank deposits, and it also gives away money, totally unnecessarily (and without economic justification) to business borrowers. Allow deductions of interest expenses only for the real component of any interest rate –  it wouldn’t be that hard to do –  and you’d both improve efficiency and get more money out of leveraged property investors (and in ways that didn’t rely on a continued rigged market).

The economic analysis around the proposed capital gains tax itself was also weak –  I’d say “surprisingly weak”, but there was an agenda going into this review, so I can really only say “disappointingly weak”.   I know I saw no mention of the idea that most real capital gains (and losses) are windfalls (since markets tend to price assets efficiently on the information available at the time) –  and that, in the case of windfalls, a capital gains tax is pure double taxation.   I don’t think I saw a single mention anywhere of the fact that, if these recommendations are adopted, New Zealand will have probably the very highest rate of capital gains tax in the world.   The discussion of the lock-in problems around capital gains taxes was threadbare –  it was noted, but there was no sustained analysis, no careful discussion of various published studies on the effect, and nothing linking back to the fact that if our CGT rate is the highest in the OECD, our lock-in problems are likely to be more significant.    There was little or no serious analysis of the potential impact on entrepreneurship and innovation –  and certainly nothing that put that issue in the context of an economy with low rates of business investment.

There was also nothing at all about the incentives a realisations-based CGT creates for assets to be held not by those best able to utilise them, but by those least likely to have to face a CGT charge and those best-placed to utilise any losses: capital gains taxes  (like ring-fencing, like the PIE regime) will create more of an incentive for more assets to be held by institutions, foundations etc, rather than directly by individual investors, not because those institutions are better managers or owners, but because they are less likely to have to crystallise a CGT liability.  Tax policy for the big end of town.

And, of course, there was nothing about the systematic asymmetry built into the system, in which gains are fully taxed (when realised) but many losses may never be able to be fully utilised.   Take two separate businesses each valued at $100 million on the day the CGT is implemented, both owned by individuals who are 55.  Over the following decade, one business does well and when the owner comes to retire he sells it for two hundred million dollars. He is liable for CGT on that gain. The other business does poorly and when the owner comes to retire, there is little or no value left in the business.    In principle, he can offset that capital loss against other income, but at 65 it is very unlikely that over the remainder of his life he will anywhere near enough income to fully utilise those losses (and even if he does, there is a further –  perhaps lengthy –  time delay).   In fact, the TWG proposes that some losses could only be used to offset other losses in that same sort of activity (not against, say, labour income).  Since the nature of a market economy is that some businesses do well and others don’t, mine isn’t at all an implausible scenario.  There might be a decent case (in equity, although not in efficiency) for taxing windfalls etc if the treatment of losses was fully symmetric –  the government then would be a pure equity stakeholder in all businesses –  but that isn’t what is proposed.

And finally, I was also struck by how threadbare was the discussion around the New Zealand Superannuation Fund.   That organisation appeared twice in the report.  The first was this bid.

35. The New Zealand Superannuation Fund (NZSF) has suggested the use of a limited tax incentive to spur investment into Government-approved, nationally significant public infrastructure projects that would benefit from unique international expertise.
36. NZSF suggested that investors pay a concessionary rate of 14% (i.e. half of the
current company rate of 28%) on profits made in New Zealand from qualifying projects. Qualifying investors would need to have a demonstrated capability to deliver world-class infrastructure projects; they would also need to bring expertise that is not ordinarily available in New Zealand and commit that expertise to the delivery of the infrastructure.
37. NZSF’s suggestion has merit. The Group recommends that the Government consider the development of a carefully designed regime to encourage investment into large, nationally significant infrastructure projects that both serve the national interest and require unique international project expertise to succeed.

I wrote about this bid when NZSF first published their submission.  I wrote then that

I’m all in favour of lower company (and capital income) taxes more generally.  Standard economic analysis supports that sort of policy, and all of us would be expected to benefit from adopting such a policy approach.  But that isn’t what is proposed by NZSF; it is just a lobbying effort to skew capital towards particular sectors they happen to favour.  It is a pretty reprehensible bid to degrade the quality of our tax system.  There is no economic analysis advanced in support of their proposal –  so little it almost defies belief –  no sense of considerations of economic efficiency, just the success of lobbying efforts in a few other countries (including two struggling middle income countries not known for the efficiency of capital allocation or quality of governance, and the United States –  which not only has plenty of poor infrastructure, but a corporate tax code  riddled with exemptions and distortions).

Same goes for the Tax Working Group’s treatment of the issue.  We deserve better.

The second substantive issue in which NZSF is mentioned is around the tax liability of NZSF itself.

56. During its discussions on retirement savings, the Group noted the oddity that the NZSF must pay tax to the New Zealand Government. The NZSF reports that it paid $1.2 billion in tax, or 9% of New Zealand’s corporate tax take, in the 2016-17
tax year.

That is a good thing. It helps to ensure that the NZSF –  operating at arms-length from the government of the day –  faces the same incentives as any other New Zealand investor.   Were it not so the ownership structure of various assets could look quite different, since NZSF would be in a position to pay more than other potential investors for any particular asset, not because they would be better owners, but just because they were tax-favoured.

There does appear to be a small substantive issue, relating to NZSF’s activities overseas

It is more difficult to argue that the NZSF should benefit from sovereign immunity when it is subject to tax in its home jurisdiction. The NZSF reported paying approximately $14 million in tax to foreign governments in the 2016-17 tax year (New Zealand Superannuation Fund, 2017). This is a cost to the NZSF that does not benefit New Zealand.
59. Tax-exempt status would better recognise the fact that the NZSF is an instrument of the Government of New Zealand and make it easier for the NZSF to apply for tax exemptions in foreign countries where they are available. Not all governments recognise the principle of sovereign immunity, so the NZSF may still have to pay tax in some jurisdictions, even if it becomes tax-exempt in New Zealand. Nevertheless, the NZSF will benefit from lower compliance costs in New Zealand and some reduction in foreign taxes.

That $14 million is a real cost to New Zealanders, but as the TWG themselves recognise even exempting NZSF from all New Zealand taxes would probably not reduce that number to zero.

But what is really striking is that there is no discussion –  not a word –  about the risks that exempting NZSF from taxes might pose to the efficient allocation of capital in New Zealand.  Instead we get shonky arguments like this

Tax-exempt status would also reduce the amount of contributions that need to be made by the Government over time in terms of the funding formula in the New Zealand Superannuation and Retirement Income Act 2001.

Well, yes, but so what?   Reduced contributions aren’t a real saving in this context, just a substitute for reduced tax revenue from the NZSF.

Ah, but “the NZSF will benefit from lower compliance costs in New Zealand”.   No doubt that is true, but NZSF with its $37 billion of your money is considerably better placed to cope with the inevitable compliance costs of the tax system than most of the rest of us, including most of the rest of the business operations that would become subject to the TWG’s capital gains tax.   Hard to believe that they could really run that line with a straight face.

Capital gains taxes: some thoughts

It is a day for repeating some material from old posts. I haven’t yet read any more than a few news reports on the Tax Working Group’s report.  But I have debated capital gains taxes for years.   This was a post on the topic from 2017.  Here was the gist of my comments.   My bottom-line is that capital gains taxes aren’t the worst thing in the world, but mostly are a distraction from what should be the real issues.

Anyway, here are some of the points I make:

  • in a well-functioning efficient market, there are typically no real (ie inflation adjusted) expected capital gains.    An individual participant might expect an asset price to rise for some reason, but that participant will be balanced by others expecting it to fall.  If it were not so then, typically, the price would already have adjusted.  In well-functioning markets, there aren’t free lunches.    It also means that, on average, capital losses will be pretty common too, and thus a tax system that treated capital gains and losses symmetrically wouldn’t raise much money on average over time.   A CGT is no magic money tree.   And there is no strong efficiency argument for taxing windfalls.
  • if you thought, for some reason, that people were inefficiently reluctant to take risk, there might be some argument for a properly symmetrical CGT.  In such a system, the government would take, say, a third of your gains, but would also remit a third of your losses (the overall risks being pooled by the state).    The variance of an individual’s private after-tax returns would be reduced, and they might be more willing to take risk.   But, in fact, no CGT system I’m aware of is properly symmetrical –  there are typically tough restrictions on claiming refunds in respect of capital losses (one might only be able to do so by offsetting them against future gains).  There are some reasonable base-protection arguments for these restrictions, but they undermine the case for a CGT itself.
  • All real world CGTs are based on realised gains (and losses to an extent).   That makes it not a pure CGT, but in significant part a turnover tax –  if you never trade, you never pay (“never” isn’t literal, but tax deferred for decades discounts to a very small present value).    And that creates lock-in problems, where people are very reluctant to sell, even if their circumstances change or if a new potential owner could make much more of the asset, for fear of crystallising a CGT liability.  In other words, introducing a CGT introduces a new inefficiency to asset markets, making it less likely that over time assets will be owned by the parties best able to utilise them.
  • Basing a CGT on realised gains will also, over time, bias the ownership of assets subject to CGT to those most able to avoid realising the gains.  A long-lived pension fund, or even a very wealthy family, will typically be better able to  count on not having to sell than, say, an individual starting out with one or two rental properties, or some other small business, where changed circumstances (eg a recesssion or a divorce) might compel early liquidation.  Large funds are also typically better able to take advantage of loss-offsetting provisions.  The democratisation of finance and asset holding it certainly isn’t.
  • CGTs in many countries exclude “the family home” altogether.  In other countries, they provide “rollover relief”, enabling any tax liability to be deferred.  Most advocates of a CGT here seem to favour the exclusion of the family home, even though unleveraged owners of family homes already have the most favourable tax treatment in our system.  Again, a CGT applied to investment properties but not owner-occupied ones would simply trade one (possible) distortion for another.
  • In practice, most of the arguments made for a CGT in New Zealand have to do with the housing market.   But, on the one hand, all major (and minor?) parties claim that they have the fix for the housing market (various combinations of RMA reform, infrastructure reforms, changes to immigration, restrictions on foreign ownership, state building programmes or whatever).  If they are right, there is no reason to expect significant systematic real capital gains in houses.  If anything, real house prices should be falling –  a long way, for a long time.    Of course, prices in some localities might still rise at some point, if unexpected new opportunities appear.  But “unexpected” is the operative word.   Enthusiasm for a CGT, at least at a political level, seems to involve a concession that the parties don’t believe, or aren’t really serious about their housing reform policies.
  • Oh, and no one I’m aware of anywhere argues that a realisation-based CGT applied to (a minority of) housing has made any very material difference to the level of house prices, or indeed to cycles in house prices.
  • In general, capital gains taxes amount to double-taxation.    Think of a business or a farm.  If the owner makes a success of the business, or product selling prices improve, expected profits will increase.  If and when those profits are achieved, they would, in the normal course of affairs, be subject to income tax.  The value of the business is the discounted value of the expected future profits.  It will rise when the expected profits rise.  Tax that gain and you will be taxing twice the same increase in profits –  only with a CGT you tax it before it has even happened.   Of course, at least in principle, there is a double deduction for losses, but as noted above utilising losses (whether of income, or capital) is a lot more difficult.    If you think that New Zealand has had less business investment than might, in some sense, have been desirable,  you might want to be cautious about applauding a new tax that would fall heavily on those who took business risks and succeeded.
  • Perhaps double taxation of expected business profits doesn’t bother you.  But trying reasoning by analogy with wages.   If the market value of your particular skills has gone up, your wages would be expected to rise.  When they do you will pay taxes on those higher wages.  But by the logic of a CGT, we should capitalise the value of your expected future labour income and tax your on both that “capital gain” and on the later actual earnings.  Fortunately, we abolished slavery long ago, but in principle the two cases aren’t much different: if there is a case for a CGT on the value of a business, it isn’t obvious why one shouldn’t have one on the value of a person’s human capital.
  • (I should note here, for the purists, that there are other concepts of double-taxation often referred to in tax literature, none of which invalidate the point I’m making here.)
  • Real world CGTs also tend to complicate fiscal management?  Why?   Because CGT revenue tends to peak when asset markets and the economy are doing well, and when other government revenue sources are performing well.  CGT revenue doesn’t increase a little as the economy improves and asset markets increase, it increases multiplicatively.  And then dries up almost completely.  Think of a simple example in which real asset prices had been increasing at 1 per cent per annum, and then some shock boost asset prices by 10 per cent.  CGT revenue might easily rise by 100 per cent in that year (setting aside issues around the timing of realisations).  And then in a period of falling asset prices there will be almost no CGT revenue at all.   Strongly pro-cyclical revenue sources create serious fiscal management problems, because in the good times they create a pot of money that invites politicians to (compete to) spend it.  If asset booms run for several years, politicians start to treat the revenue gains as permanent, and increase spending accordingly. And if/when asset markets correct –  often associated with recession and downturns in other revenue sources-  the drying up of CGT revenue increases the pressure on the budget in already tough times.     It is easy to talk about ringfencing such revenue (mentally, if not legally) but such devices rarely seem to work.

None of this means that I think there is no case for changes in elements of our tax system as they affect housing.  The ability for business borrowers to deduct the full amount of nominal interest, even though a significant portion of that interest is simply compensation for inflation (rather than a real cost), is a systematic bias.  It doesn’t really benefit new buyers of investment properties (the benefit is, in principle, already priced into the market) but it is a systematic distortion for which there is no good economic justification   Inflation-indexing key elements of our tax system is highly desirable –  at least if we can’t prudently lower the medium-term inflation target –  and might be a good topic for a tax working group.  In the process, it would also ease the tax burden on people reliant on fixed interest earnings (much of which is also just inflation compensation, not a real income).

Of course, at the same time it would be desirable to look again at a couple of systematic distortions that work against owners of investment properties.  Houses are normal goods and (physically) depreciate.  And yet depreciation is no longer deductible.  Perhaps there was a half-defensible case for that when prices were rising seemingly inexorably –  but even then most of the increase was in land value, not in value of the structures on the land –  but there is no justification if land reform and (eg) new state building is going to fix the housing market.    Similarly, when the PIE system was introduced a decade or so ago, it gave systematic tax advantages to entities with 20 or more unrelated investors.  Most New Zealand rental properties historically haven’t been held in such entities.  There is no good economic justification for this distinction, which in practice both puts residential investment at a relative tax disadvantage as a saving option, and creates a bias towards institutional vehicles for holding such assets.  Institutional vehicles have their own fundamental advantages –  greater opportunities for diversification and liquidity –  but it isn’t obvious why the tax system should be skewing people towards such vehicles rather than self–managed options.  As noted above, any CGT will only reinforce that bias.  Funds managers, and associated lawyers and accountants, would welcome that. It isn’t obvious why New Zealand savers should do so.

And in all this in a country where we systematically over-tax capital income already.  I commend to readers a comment on yesterday’s tax post by Andrew Coleman, of Otago University (and formerly Treasury).  As Andrew noted:

Somehow, New Zealand’s policy advising community decided it would restrict most of its attention to the ways income tax could be perfected rather than question whether income taxes (which are particularly distortionary when applied to capital incomes) should be replaced by other taxes. It is almost as if we have the Stockholm Tax Syndrome – fallen in love with a system that abuses us.

A broad-based capital gains tax would just reinforce that problem.

2019 again. I hope the TWG report has dealt substantively with these sorts of points.  But I’m not optimistic.

 

Inflation and the tax system

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.

corp income tax

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.