The Tax Working Group suggests two ways of taxing income from capital. Some argue the proposals don’t go far enough, while others say they risk chasing away capital. Thomas Coughlan reports.

“Income may be an easy word to say, but it has many different meanings,” the Tax Working Group says. But income is set to get another meaning — income earned from capital gains. 

The group’s interim report on the tax system has proposed two forms of taxes on capital. Neither is a broad-based capital gains tax as proposed by Labour at the 2011 and 2014 elections, and which is still the preferred option of the Green Party. 

The stakes are high. Labour is likely to take one of the two proposals to the 2020 election.

While the report argues taxes on capital will add much-needed fairness to the tax code, some argue they could drive investment away from New Zealand businesses. 

Finally, a tax on capital

The two proposals aim to address an inequality in the tax system, which sees people who earn income through wages and salary taxed at a higher rate than those who earn income from capital gains.

The Government wants to see “horizontal equity” – meaning people who earn the same amount of income should pay similar rates of tax, regardless of where or how the income was earned. 

The report notes that “the lack of a general tax on realised capital gain is likely to be one of the biggest reasons for horizontal inequalities in the tax system”.

This also plays into an overall inequality in the tax system, which sees poorer people taxed a higher proportion of their income than the wealthy. The report notes overseas evidence shows capital gains income tends to be concentrated in the hands of the wealthy. 

The current regime also sees massive investment flowing into the property market, where it is taxed less, instead of into the sharemarket, where it is badly needed. 

What about rents and property prices?

Controversially, the group did not think a tax on capital would have much effect on the housing market.

This goes against the received wisdom of both National and Labour. National introduced the bright-line test (for taxing capital gains on investment property that was bought then quickly sold again) and Labour extended it. In doing so, they both wanted to dampen housing speculation and cool the market.

But the group said today that “tax has not played a large role in the current state of the New Zealand housing market and will be unlikely to play a large role in fixing it”.

It also said that any impacts from capital taxes on the housing market were “unlikely to be large”.

“Rents will rise over time, and house prices will be lower relative to the status quo,” it said. 

And it might divert income from the New Zealand sharemarket

A tax on capital would also apply to income from shares.

A recent report from the productivity commission identified a lack of capital depth as a key constraint on New Zealand firms making investments to enhance productivity. 

The working group’s report makes the same point and notes that current tax settings see investment flow to the property market. 

“A greater pool of domestic savings could deepen domestic capital markets and enhance the ability of local firms to secure capital to grow,” it said. 

A new, more balanced regime might see greater investment in businesses as property lost its tax favourability.

But Deloitte Tax Partner Patrick McCalman said that continued discrepancies between the ways investments were taxed in New Zealand, particularly the difference in taxation between foreign and domestic shares means that investment would not necessary deepen the capital pool of New Zealand businesses. 

Foreign shares are currently taxed at a risk-free rate of return (or RFRM) rate of 5 percent, while domestic shares are taxed on dividends. Applying a tax to the capital gain of New Zealand shares, as well as taxing dividends would likely incentivise investors to shift their interests offshore, where they would be taxed less. 

How the two options would work
The schemes proposed by the group both consider money earned from capital as income. Rather than creating a new, distinct tax like a standalone capital gains tax, money earned on capital will be taxed as income.

They differ on the point at which they tax that income. The first option would tax the income at the point at which the asset was sold.

The second proposal is for a RFRM tax. This would mean taxing income earned on capital before it was realised, in the form of an annual charge raised on the equity person has in a home, for instance.

Ironically, an RFRM rate was recommended to Cullen by another working group in 2001, but he rejected the recommendation. 

So which one? 

Although the group reserves the right to recommend neither proposal, comments from Cullen implied that would be unlikely. 

“I doubt that we will do that but it’s possible,” he said, before adding “possible does not mean likely”.

Green Party leader James Shaw said he remained committed to his party’s policy of a broad-based capital gains tax. 

Opposition finance spokesperson Amy Adams said the proposals were a tax on small businesses and farms. 

She said the proposed taxes on capital income would add unnecessary complexity to the tax system. 

“They become expensive, they become low, they create massive inefficiencies in where our capital goes,” she said.

But Finance Minister Grant Robertson is likely to go to the 2020 election with whichever capital tax is eventually recommended by the group. It releases its final report in February.

On Thursday Robertson gave a strong indication he would like to see some form of capital gains tax included in the group’s final report.

In a letter to the group, co-authored with Revenue Minister Stuart Nash, Robertson asked it to examine “whether a tax on raised gains, or the risk-free rate of return method of taxation (or a mix of both) is the best method for extending a potential income tax on specific assets”. 

Or both…

McCalman told Newsroom he believed the most likely option would be a mix of the two.

“I think they’ll go for a combination of both,” he said.

He said a combination of both would mean mitigating some of the negative effects of each tax.

An issue with RFRM is the tax is levied at a point when the person holding the asset might not have any cash with which to pay it, unlike the first proposal, which taxes at the point of sale.

McCalman said he could see the RFRM applied to rental properties and shares, but not to more illiquid assets.

Terry Baucher, director of Baucher Consulting said the report showed that something was going to change in the way New Zealand taxed capital.

He said the effects on the housing market of capital taxes could be limited as the exemption for the family home could still encourage owners to over-invest in their home.

Other considerations 

It appears likely some form of income tax cut will be recommended, or a change to the income tax thresholds. 

“Reduction of the lower rates and/or thresholds would be the most progressive means of assisting low-and middle-income earners through the tax system,” Cullen said. 

Cullen recommitted to the group’s recommendations being fiscally neutral, meaning any tax gains somewhere in the system would be offset by cuts elsewhere. An income tax cut alongside taxing income from capital gains could make the tax system more progressive without increasing income tax levels, which the group is prohibited from doing by its terms of reference. 

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