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.

Regressivity, petrol taxes, and ministerial PR

Someone around home mentioned this morning that there was a confused article on the Herald website about the progressivity (or otherwise) of the fuel tax increase.   I didn’t pay much attention until I read the paper over lunch, when I was a bit staggered by what I found.

This was the centrepiece chart

fuel tax

The line of argument from opponents has been that the fuel tax increase will fall more heavily on low income people.   But according to the Herald’s journalist, channelling Phil Twyford.

 in a startling revelation, the ministers claim that the wealthier a household is, the more it is likely to pay for petrol. They say the wealthiest 10 per cent of households will pay $7.71 per week more for petrol. Those with the lowest incomes will pay $3.64 a week more.

I still don’t understand what the journalist finds startling.  It is hardly surprising that higher income households spend more on petrol than lower income households do.  They spend more on most things.

But he goes on to claim

This is a complete reversal of the most common complaint about fuel taxes, which is that they are “regressive”. That means, the critics say, they affect poor people more than wealthy people.

The suggestion that these data are some sort of “complete reversal” of the claim the tax is regressive is itself just nonsense.  One would need to look at the impact of the fuel tax increase as a proportion of income.  And households in the top decile earn about ten times as much as households in the bottom decline, according to the same Household Expenditure Survey.

So I went and got the income by decline data for the June 2017 year from the Household Expenditure Survey.  The income data is presented in range form, so for each decile I used the average of the high and low incomes for that decile.  And then I took the Auckland fuel tax increases numbers in the right hand column of the table above, and calculated them as a annual percentage of annual household income by decline.  (The income numbers are for 2017, and the fuel tax increases phase in to 2020, so the absolute percentages will be different –  incomes will have risen – but what won’t change materially is that high income households earn a lot more than low income ones.)

fuel tax by decile

On the numbers the Herald themselves used, apparently supplied by the Ministry of Transport, the  direct burden of the fuel tax increase will fall much more heavily on low income people than on those further up the income scale.   The extremely high number for the lowest decile masks how significant these effects are even for other groups: the second and third deciles of household income will see an increase twice as large, as a percentage of income, as those in the 9th decile.

I’m driving to Auckland later this afternoon for a wedding, and planning to get out again on Sunday without having paid the increased Auckland fuel levy.

So much company tax, so little investment

Almost 10 years ago I stumbled on this chart in the background papers to Australia’s tax system review.

Chart 5.11: Corporate tax revenue as a proportion of GDP — OECD 2005

Aus company tax as % of GDP 2008

I was intrigued, and somewhat troubled by it.   New Zealand collected company tax revenue that, as a share of GDP was the second highest of all OECD countries.   And yet New Zealand:

  • didn’t have an unusually large total amount of tax as a share of GDP, and
  • had had quite low rates of business investment –  as a per cent of GDP –  for decades, and
  • as compared to Australia, just a couple of places to the left, New Zealand’s overall production structure was much less capital intensive (mines took a lot of investment).

And, of course, our overall productivity performance lagged well behind.

Partly prompted by the chart, and partly by a move to Treasury at about the same time, I got more interested in the taxation of capital income.   After all, when you tax something heavily you tend to get less of it, and most everyone thought that higher rates of business investment would be a part of any successful lift in our economic performance.  That interest culminated in an enthusiasm for seriously considering a Nordic tax system, in which capital income is deliberately taxed at a lower rate than labour income.  It goes against the prevailing New Zealand orthodoxy –  broad-base, low rate (BBLR) –  but even the 2025 Taskforce got interested in the option.

Flicking through the background document for our own new Tax Working Group the other day I came across this chart (which I haven’t seen get any media attention).

company tax revenue

It is a bit harder to read, but just focus for now on the blue bars.   On this OECD data New Zealand now has company tax revenues that are the highest percentage of GDP of any OECD country.   A footnote suggests that if one nets out the tax the government pays to itself (on businesses it owns), New Zealand drops to only fourth highest but (a) the top 5 blue bars are pretty similar anyway, and (b) it isn’t clear who they have dropped out (if it is just NZSF tax that is one thing, but most government-owned businesses would still exist, and pay tax, if in private ownership).

So for all the talk about base erosion and profit-shifting, and talk of possible new taxes on the sales (not profits) of internet companies, we continue to collect a remarkably large amount of company tax (per cent of GDP).  Indeed, given that our total tax to GDP ratio is in the middle of the OECD pack, we also have one of the very largest shares of total tax revenue accounted for by company taxes.

The Tax Working Group appears to think this is a good thing, observing that it

“suggests that New Zealand’s broad-base low-rate system lives up to its names”

There is some discussion of the trend in other countries towards lowering company tax rates, but nothing I could see on the economics of taxing business/capital income.  It is as if the goose is simply there to be plucked.

There are, of course, some caveats.   Our (now uncommon) dividend imputation system means that for domestic firms owned by New Zealanders, profits are taxed only once.  By contrast, in most countries dividends are taxed again, additional to the tax paid at the company level.    But, of course, in most of those countries, dividend payout ratios are much lower than those in New Zealand, and tax deferred is (in present value terms) tax materially reduced.

And, perhaps more importantly, the imputation system doesn’t apply to foreign investment here at all.   Foreign investment would probably be a significant element in any step-change in our overall economic performance.  And our company tax rates really matters when firms are thinking about whether or not to invest here at all.  And our company tax rates are high, our company tax take is high –  and our rates of business investment are low.  Tax isn’t likely to be the only factor, or probably even the most important –  see my other discussions about real interest and exchange rates – but it might be worth the TWG thinking harder as to whether there is not some connection.

Otherwise, as in so many other areas, we seem set to carry on with the same old approaches and policies and yet vaguely hope that the results will eventually be different.

 

Taxes, housing, and economic underperformance

Two local articles on possible tax system/housing connections caught my eye this morning.  One I had quite a lot of sympathy with (and I’ll come back to it), but the other not so much.

On Newsroom, Bernard Hickey has a piece lamenting what he describes in his headline as “Our economically cancerous addiction”.    The phrase isn’t used in the body of the article, but there is this reference: “our national obsession with property investment”.   Bernard argues that the tax treatment of housing “explains much of our [economic]underperformance as a country over the past quarter century”, linking the tax treatment of housing to such indicators (favourites of mine) as low rates of business investment and lagging productivity growth.

Centrepiece of his argument is this chart from the Tax Working Group’s (TWG) discussion document released last week.

TWG chart

Note that, although the label does not say so, this is an attempt to represent the tax rate on real (inflation-adjusted) returns.

It is a variant of one of Treasury’s favourite charts, that they’ve been reproducing in various places for at least a decade.   The TWG themselves don’t seem to make a great deal of it –  partly because, as they note, their terms of reference preclude them from looking at the tax-treatment of owner-occupied housing.  They correctly note –  although don’t use the words –  the gross injustice of taxing the full value of interest income when a large chunk of interest earnings these days is just compensation for inflation, not a gain in purchasing power at all.   And, importantly, the owner-occupied numbers relate only to the equity in houses, but most people get into the housing market by taking on a very large amount of debt.  Since interest on debt to purchase an owner-occupied house isn’t tax-deductible –  matching the fact that the implicit rental income from living in the house isn’t taxed –  any ‘distortion’ at point of entering the market is much less than implied here.

Bear in mind too that very few countries tax owner-occupied housing as many economists would prefer. In some (notably the US) there is even provision to deduct interest on the mortgage for your owner-occupied house.   You –  or Bernard, or the TOP Party –  might dislike that treatment, but it is pretty widespread (and thus likely to reflect some embedded wisdom).  And, as a reminder, owner-occupation rates have been dropping quite substantially over the last few decades –  quite likely a bit further when the latest census results come out.  Perhaps a different tax system would lead more old people –  with lots of equity in a larger house – to downsize and relocate, but it isn’t really clear why that would be a socially desirable outcome, when maintaining ties to, and involvement in, a local community is often something people value,  and which is good for their physical and mental health.

So, let’s set the owner-occupied bit of the chart aside.  It is simply implausible that the tax treatment of owner-occupied houses –  being broadly similar to that elsewhere –  explains anything much about our economic underperformance.  And, as Bernard notes, it isn’t even as if, in any identifiable sense, we’ve devoted too many real resources to housebuilding (given the population growth).

So what about the tax treatment of rental properties?   Across the whole country, and across time, any distortion arises largely from the failure to inflation-index the tax system.  Even in a well-functioning land market, the median property is likely to maintain its real value over time (ie rising at around CPI inflation).  In principle, that gain shouldn’t be taxed –  but it is certainly unjust, and inefficient, to tax the equivalent component of the interest return on a term deposit.     Interest is deductible on rental property mortgages, but (because of inflation) too much is deductible –  ideally only the real interest rate component should be.  On the other hand, in one of the previous government’s ad hoc policy changes, depreciation is not deductible any longer, even though buildings (though not the land) do depreciate.

But, here’s the thing.  In a tolerably well-functioning market, tax changes that benefit one sort of asset over others get capitalised into the price of assets pretty quickly.  We saw that last year, for example, in the US stock market as corporate tax cuts loomed.

And the broad outline of the current tax treatment of rental properties isn’t exactly new.  We’ve never had a full capital gains tax.  We’ve never inflation-adjusted the amount of interest expense that can be deducted.  And if anything the policy changes in the last couple of decades have probaby reduced the extent to which rental properties might have been tax-favoured:

  • we’ve markedly reduced New Zealand’s average inflation rate,
  • we tightened depreciation rules and then eliminated depreciation deductions altogether,
  • the PIE regime – introduced a decade or so ago –  had the effect of favouring institutional investments over individual investor held assets (as many rental properties are),
  • the two year “brightline test” was introduced, a version of a capital gains tax (with no ability to offset losses),
  • and that test is now being extend to five years.

If anything, tax policy changes have reduced the relative attractiveness of investment properties (and one could add the new discriminatory LVR controls as well, for debt-financed holders).  All else equal, the price potential investors will have been willing to pay will have been reduced, relative to other bidders.

And yet, according to Bernard Hickey

It largely explains why we are such poor savers and have run current account deficits that built up our net foreign debt to over 55 percent of GDP. That constant drive to suck in funds from overseas to pump them into property values has helped make our currency structurally higher than it needed to be.

I don’t buy it (even if there are bits of the argument that might sound a bit similar to reasoning I use).

A capital gains tax is the thing aspired to in many circles, including the Labour Party.   Bernard appears to support that push, noting in his article that we have (economically) fallen behind

other countries such as Australia, Britain and the United States (which all have capital gains taxes).

There might be a “fairness” argument for a capital gains tax, but there isn’t much of an efficiency one (changes in real asset prices will mostly reflect “news” –  stuff that isn’t readily (if at all) forecastable).   And there isn’t any obvious sign that the housing markets of Australia and Britain –  or the coasts of the US –  are working any better than New Zealand’s, despite the presence of a capital gains tax in each of those countries.   If the housing market outcomes are very similar, despite differences in tax policies, and yet the housing channel is how this huge adverse effect on productivity etc is supposed to have arisen, it is almost logically impossible for our tax treatment of houses to explain to any material extent the differences in longer-term economic performance.

And, as a reminder, borrowing to buy a house –  even at ridiculous levels of prices –  does not add to the net indebtedness of the country (the NIIP figures).  Each buyer (and borrower) is matched by a seller.  The buyer might take on a new large mortgage, but the seller has to do something with the proceeds.  They might pay down a mortgage, or they might have the proceeds put in a term deposit.    House price inflation –  and the things that give rise to it –  only result in a larger negative NIIP position if there is an associated increase in domestic spending.  The classic argument –  which the Reserve Bank used to make much of –  was about “wealth effects”: people feel wealthier as a result of higher house prices and spend more.

But here is a chart I’ve shown previously

net savings to nni jan 18

National savings rates have been flat (and quite low by international standards) for decades.  They’ve shown no consistent sign of decreasing as house/land prices rose and –  for what its worth –  have been a bit higher in the last few years, as house prices were moving towards record levels.

What I found really surprising about the Hickey article was the absence of any mention of land use regulation.  If policymakers didn’t make land artificially scarce, it would be considerably cheaper (even if there are still some tax effects at the margin).   And while there was a great deal of focus on tax policy, there was also nothing about immigration policy, which collides directly with the artificially scarce supply of land.

I’ve also shown this chart before

res I % of GDP

These are averages for each OECD country (one country per dot).  New Zealand is the red-dot –  very close to the line.  In other words, over that 20 year period we built (or renovated/extended) about as much housing as a typical OECD country given our population growth.    But, as I noted in the earlier post on this chart

The slope has the direction you’d expect – faster population growth has meant a larger share of current GDP devoted to housebuilding – and New Zealand’s experience, given our population growth, is about average. But note how relatively flat the slope is. On average, a country with zero population growth devoted about 4.2 per cent of GDP to housebuilding over this period, and one averaging 1.5 per cent population growth per annum would have devoted about 6 per cent GDP to housebuilding. But building a typical house costs a lot more than a year’s average GDP (for the 2.7 people in an average dwelling). In well-functioning house and urban land markets you’d expect a more steeply upward-sloping line – and less upward pressure on house/land prices.

And, since Hickey is –  rightly – focused on weak average rates of business investment here is another chart from the same earlier post.

Bus I % of GDP

Again, New Zealand is the red dot, close to the line.   Over the last 20 years, rapid population growth –  such as New Zealand has had –  has been associated with lower business investment as a share of GDP.  You’d hope, at bare minimum, for the opposite relationship, just to keep business capital per worker up with the increase in the number of workers.

This issue, on my telling, isn’t the price of houses –  dreadful as that is –  but the pressure the rapid policy-fuelled growth of the population has put on available real resources (not including bank credit).  Resources used building or renovating houses can’t be used for other stuff.

And one last chart on this theme.

productive cap stock

The blue line shows the annual per capita growth rate in the real capital stock, excluding residential dwellings (it is annual data, so the last observation is for the year to March 2017), but as my post the other day illustrated even in the most recent national accounts data, business investment has been quite weak.   I’ve added the orange line to account for land and other natural resources that aren’t included in the official SNZ capital stock numbers.  We aren’t getting any more natural resources –  land, sea, oil and gas or whatever –  (although of course sometimes things are discovered that we didn’t know had been there).  The orange line is just a proxy for real natural resources per capita –  as the population grows there is less per capita every year, even if everything is renewable, as many of New Zealand’s natural resources are (and thus the line is simply the inverted population growth rate).

In New Zealand’s case at least, rapid population growth (largely policy driven over time) seems to have been –  and still to be – undermining business investment and growth in (per capita) productive capacity.   Land use regulation largely explains house and urban land price trends.  And it seems unlikely that any differential features of New Zealand’s tax system explain much about either outcome.

The other new article that caught my eye this morning was one by Otago University (and Productivity Commission) economist, Andrew Coleman.    He highlights, as he has in previous working papers, how unusual New Zealand’s tax treatment of retirement savings is, by OECD country standards.  Contributions to pension funds are paid from after-tax income, earnings of the funds are taxed, and then withdrawals are tax-free.   In many other countries, such assets are more often accumulated from pre-tax income, fund earnings are largely exempt from tax, and tax is levied at the point of withdrawal.   The difference is huge, and bears very heavily on holding savings in a pension fund.

As Coleman notes, our system was once much more mainstream, until the reforms in the late 80s (the change at the time was motivated partly by a flawed broad-base low rate argument, and partly –  as some involved will now acknowledge –  by the attractions of an upfront revenue grab.

The case for our current practice is weak.  There is a good economics argument for taxing primarily at the point of spending, and not for –  in effect –  double-taxing saved income (at point of earning, and again the interest earned by deferring spending).  And I would favour a change to our tax treatment of savings (I’m less convinced of the case for singling out pension fund vehicles). I hope the TWG will pick up the issue.

That said, I’m not really persuaded that the change in the tax treatment of savings 30 years ago is a significant part of the overall house price story.  The effect works in the right direction –  and thus sensible first-best tax policy changes might have not-undesirable effects on house prices.  But the bulk of the growth in real house (and land) prices –  here and in other similar countries –  still looks to be due to increasingly binding land use restrictions (exacerbated in many places by rapid population growth) rather than by the idiosyncracies of the tax system.

“Productivity” missing in action

There was going to be a post yesterday, on the Reserve Bank’s newly-published estimates of the natural rate of unemployment, the NAIRU etc.   But then, walking down the stairs at home, I went over on my right foot and, so it turns out, broke a bone.   And so now I sit encased in plaster for a couple of weeks, not able to do much of what stay-at-home parents do.  But I can still type and the NAIRU post might appear later in the day.

In the meantime, this morning the Tax Working Group released its Submissions Background Paper.  I’m sure there is plenty of interesting material in it, and in due course I’ll read it, and probably write about it (especially the capital gains tax sections).  But, out of curiousity, I electronically searched the document.   First, I searched for “productivity”    There were two footnotes referring to Productivity Commission documents, and one quote from the terms of reference for the Tax Working Group; one of the government’s objectives for the tax system is

·             A system that promotes the long-term sustainability and productivity of the economy

And that was it.

So I tried “productive”.  That produced four results, but

  • one was in the appendix reproducing the Terms of Reference,
  • one was in an appendix of questions for submittters”,
  • one was a question posed at the start of a chapter, and
  • the final one simply described the question the government had asked them to think about.

In other words, no analysis, no description at all.   The (short) Terms of Reference were weak on this score –  the clear focus was “fairness” –  but the TWG’s own much-longer document was even worse.    And just in case some serious analysis or discussion was lurking under terms like “the tradables sector” or a concern about growing “exports” I searched under various forms of those words, and there were no references at all.  Not one.

The yawning productivity gap isn’t the only problem or issue New Zealand faces, and it shouldn’t be the only consideration in the design of the tax system.   But when it is totally absent from the discussion document framing the Tax Working Group’s work, it simply further reinforces that perception (which I’ve writtten about here and here) that there is little reason to think the government is serious about grappling with the decades of relative decline.  I doubt that anything in the tax system is overly important in explaining that relative decline –  although a heavy tax burden on returns to business investment (especially FDI) won’t be helping –  but it seems extraordinary that the issue isn’t even touched on in the working group’s background document.

 

Scattered thoughts on tax and fiscal policy

It has been a quite remarkable rookie error by the Labour Party that allowed the mere possibility of specific tax increases to become such a major part of the election campaign, in a climate where the government’s debt is very low, and where official forecasts show surpluses projected for years to come.   If government finances were showing large deficits, and there was a desperate need to close them, that political pressure might have been unavoidable.  Closing big deficits involves governments taking money off people who currently have it –  by whatever mix of spending cuts or tax increases – and doing so in large amounts.   But the PREFU had growing surpluses, and Labour’s fiscal plan had almost identical surpluses for the next few years –  without relying on any further tax changes that might have flowed from the recommendations of the proposed Tax Working Group.

These are the surplus projections

labour surplus

Of course, Treasury GDP forecasts can’t always be counted on – and it is seven years now since the last recession – but there is quite a large buffer in those numbers even if the economic outlook changes.  But the other side of politics wasn’t disputing the (Treasury) GDP assumptions.  And it seems to have been lost sight of that in a growing economy, with low and stable debt levels, modest deficits (on average) are the steady-state outcome (consistent with low stable debt).     That might involve decent surpluses in boom years, and perhaps quite big deficits in recession years (as the automatic stabilisers work on both sides) –  but again the Treasury numbers, which both sides are basing their numbers on, say that at present we are in the middle (estimated output gap around zero, unemployment still a bit above a NAIRU, and on the other hand the terms of trade above average).

I guess it was always the sort of risk Labour faced in changing their leader so close to the election (things move fast and something –  who knew what specifically –  was almost bound to not work out well), but it was all so easily avoidable.  They could have:

  • stuck with the Andrew Little policy (now reverted to) of no changes flowing out of the TWG process to come into effect before the 2020 election,
  • they could have reverted to the 2014 policy (a specific detailed capital gains tax proposal, perhaps including revenue estimates), or
  • they could have committed to any package of TWG-inspired changes implemented before the next election being at least revenue neutral (if not revenue negative).   This latter sort of commitment would have been easy to make precisely because of the large surpluses in the projections both sides are using (see chart above).

After weeks of contention and uncertainty –  some reasonable, some just fear-mongering – they’ve finally adopted the first option.

But you have to wonder what the proposed Tax Working Group will be left to do?  In practice, it looks as though it might most usefully be described as a capital gains tax advisory group –  to advise on the practical options and details on how to make a capital gains tax work, as well perhaps as to review the evidence and arguments for (and against) such an extension to our tax system (my reflections on the CGT option are here).

They’ve ruled out increases in personal or company tax rates, they’ve ruled out GST increases, and they’ve ruled out a land tax affecting the land under “the family home” (which is most of the value of land in New Zealand).    They apparently haven’t ruled out revenue-neutral packages that involve a reduction in income tax rates, but this looks like a pretty empty suggestion.  Why?

The first reason is that they claim that their suite of policies are going to solve the housing crisis.   I’m a bit sceptical about their claims (and those of the government), but if they are right, how much revenue do they suppose there is likely to be from a capital gains tax anytime in (say) the next 20 years?  Treasury once produced some rather large revenue estimates, but (from memory) they involved some sort of muted extrapolation of the experience of the previous 20 years.       Both sides of politics seem to think they can stabilise nominal house prices, and then let income growth and inflation reduce real prices and price to income ratios.   If so, there are no systematic capital gains on housing  –  and idiosyncratic ones (particular cities or specific locations that do well) won’t add to much revenue at all.    Of course, it might be different if the housing measures fail, but Grant Robertson yesterday seemed pretty adamant.

“What we are signalling is, the Labour Party’s policy is that our focus is on fixing the housing crisis. That is our focus.

A capital gains tax might (or might not) be a sensible addition to the tax system, but it shouldn’t raise much money.

What else is there?  I’m sure tax experts have various small things they’d like the working group to look at, but it is hard to believe there is anything that could raise much revenue.    For some, a land tax looked promising –  my own scepticism is here.  But Labour has now ruled out a tax on the land under “the family home”, which effectively nullifies any possibility of a sensible, credible, and enduring land tax.

It is one thing to rule the family home out of a capital gains tax net.  Even for most of those left liable for capital gains tax (CGT), the effective liability can be deferred for many years (reducing the present value) simply by not realising the gain (not selling the asset).  That is even more true with the sort of institutional holders than many seem keen to encourage into the rental market.  And, of course, there is only a liability if prices actually go up.    Those are among the reasons why the overseas literature tends to find little evidence that a CGT would make much useful difference to the housing market.

A land tax would be different.  It is a liability year in, year out.  Owner-occupiers (and associated trusts etc) wouldn’t pay it, but everyone else would.  It would be a huge change in the effective cost of (say) providing rental services.

New Zealand real interest rates are the highest in the advanced world.   A very long-term real government bond rate is around 2.5 per cent at present (the real OCR is currently zero or slightly negative).  So suppose a government imposed a 1 per cent per annum land tax on land not under owner-occupied dwellings.     Relative to a risk-free rate of, at most, 2.5 per cent that would be a huge impost (40 per cent of the implied safe earnings of the asset –  the appropriate benchmark since the tax itself isn’t risk-dependent.)   It would dramatically lower how much any bidder who wasn’t planning to live on the land could afford to pay for the land –  by perhaps as much as 40 per cent.

That might sound quite appealing.   Rental property owners (actual and potential) drop out of the market and land (and house+land) prices plummet.    But wait.   Wasn’t the political promise that they weren’t trying to cut existing house prices?    And what about the people who –  because of youth, or desire for mobility –  don’t want to own a house and positively prefer, for time being at least, to rent.    And what about farmers?  Lifestyle blocks (presumably exempt from the land tax) instantly become much more affordable than farming (which presumably does face the tax).    To what social or economic end?

Attempt to impose such a land tax and my prediction would be (a) that it would never pass, since it would represent such a heavy impost on a large number of people (and yet on not enough to raise enough revenue to allow meaningful income tax cuts to offset the effect), and (b) if it did pass, exemptions and carve-outs would quite quickly reduce it to the sort of land tax we actually had in New Zealand only 30 years ago –  which only affected city commercial property.

Now perhaps there is a limited middle ground.  There is a plausible case that can be made for use of land value rating by local councils rather than the capital value rating system that most councils now use.  I’m not aware that we have good studies suggesting better (empirical) outcomes in places that still use land value rating, but the theory is good.  The problem, of course, is that by ruling out a land tax on the family home, Labour would appear to have ruled out (say) using legislation to encourage or compel councils to rely more heavily on land value rating.   Perhaps that might leave undeveloped land within existing urban areas as potentially subject to land value rating?  There might be some merit in that, but the potential seems quite limited.

So, as I say, it looks as though the proposed tax working group should really just be a CGT advisory group.

And that would be a shame because, whatever you think of the merits of a CGT, it isn’t the only issue that would have been worth addressing in a proper review of the design of our tax system.  For 30 years now –  since what was a fairly cynical revenue grab (recognised at the time by those involved) in 1988/89 –  our tax system has systematically penalised returns to savings  (both relative to how we treated those returns previously, and relative to how other countries typically treat such returns).    The prevailing mantra –  broad base low rate –  which holds the commanding heights in Wellington sounds good, until one stops to think about it.     We have modest rates of national savings, and consistently low rates of business investment –  and our productivity languishes –  and yet the relevant elites continue to think it makes sense to tax capital income as heavily as labour income.  It doesn’t, whether in theory or in practice.   They don’t, for example, in social democratic Scandinavia.  They don’t –  when it comes to returns to financial savings –  almost anywhere else in the advanced world.    We should be looking carefully at options like a Nordic system, a progressive consumption tax, at inflation-indexing the tax treatment of interest, and at whether interest should be taxed (or deductible) at all.

Plenty of people are worrying about the potentially radical nature of some aspects of a possible new left-wing government.  I come from the market-oriented right on matters economic, but I worry that in these areas they won’t be radical enough –  won’t even be willing to open up the serious issues that might be contributing to our sustained economic underperformance.  And frankly, when the debt levels are as low as they now, and sustained surpluses appear to be in prospect, if ever there is a time to look at more serious structural reforms it is now.   It is a great deal easier to do tax reform when any changes can be revenue-negative (actually the approach taken by the current government in 2010 –  see table of static estimates here) or (depending on your orientation) used to increase public spending.  But it looks as though another opportunity is going to be let go by.    That would be a shame.

(Having mentioned the 2010 package in passing, I am a little surprised that the increase in the effective rate of business taxation in that package doesn’t get more attention.     It often passes unnoticed because the headline company tax rate was reduced, but as the published Treasury assessment at the time put it

While the tax package lowers the company tax rate, changes to thin capitalisation rules and depreciation allowances mean that, on average, firms will pay more tax as the reduction in the company tax rate does not fully offset the impact of higher taxable income owing to the base-broadening measures. As a result combined company and dividend tax revenues are estimated to be about 3-4% higher than in the absence of the package. In the case where all investment is financed by equity, this could increase the user cost of capital by about 0.6%.
Using the New Zealand Treasury Model (NZTM) we estimate that the increase in the user cost of capital leads to the private business capital stock reducing by 0.45% compared to what would have been the case in the absence of the package.

Not obviously a desirable outcome for an economy that had, for decades, had low levels of business investment.)

And finally, a chart showing in just what good shape New Zealand public finances are relative to those in the rest of the advanced world.   New Zealand government debt has increased relative to GDP under the term of the current government (mostly some mix of a recession and earthquakes), but government debt as a share of GDP has increased in most other countries too.   Here is the gap between New Zealand and the median OECD country, using the OECD’s series of general government net financial liabilities.   Our net financial liabilities last year were around 5 per cent of GDP on this measure  (seven OECD countries have less net debt, or have net assets).  The median OECD country has net financial liabilities of 40 per cent of GDP.  But here is the gap, going back to 1993 when the data commence for New Zealand.

gen govt net liabs nz less oecd median

It is quite a striking chart –  and took me a little by surprise frankly.   If you didn’t know when the two changes of government had occurred, there would be no hint in this chart.  For almost 25 years now we’ve kept on lowering our net debt relative to that of other OECD countries, through good times (for them and us) and for tougher times, under National governments and Labour ones.  There just isn’t any obvious break in the series.  And as we have a lot fewer off-balance sheet liabilities (eg public service pension commitments) the actual position is even more favourable than suggested here.

I’m not a big fan of increasing government debt as a share of GDP –  and low as current interest rates are (a) productivity growth is lower still, and (b) our interest rates are still the highest around.  But you do have to wonder quite what analysis backs up the drive for still lower rates of government debt to GDP, absolutely and relative to the rest of the advanced world.   And persisting with the “big New Zealand” strategy of rapid population growth makes the emphasis on very low levels of government debt even more difficult to make much rational sense of.

Capital gains tax: quite a few reasons for scepticism

Going through some old papers to refresh my memory on capital gains tax (CGT) debates, I found reference to a note I’d written back in 2011 headed “A Capital Gains Tax for New Zealand: Ten reasons to be sceptical”.  Unfortunately, I couldn’t find the note itself, so you won’t get all 10 reasons today.    But here are some of the reasons why I’m sceptical of the sort of real world CGTs that could follow from this year’s election.  Mostly, repeated calls for CGTs – whether from political parties, or from bodies like the IMF and OECD –  seem to be about some misplaced rhetorical sense of “fairness” or are cover for a failure to confront and deal directly with the real problems in the regulation of the housing and urban land markets.

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.

I see that there are more than 10 bullet points in the list above.  I’m not sure it covers all the issues I raised in my paper a few years ago, but it is enough to be going on with.

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.