Government still eyeing savings tax break, but complexities and poor IRD computer systems stand in the way

By Alex Tarrant

The government is still considering a form of tax break for term deposits as it works through the complexities of an idea proposed by its Savings Working Group that would see the tax on interest earned indexed for inflation.

This would mean withholding tax on earnings from term deposits would be much lower because they would be discounted for inflation. For example, the current average 1 year term deposit rate for a bank was 5.1% (see interactive chart here) in June 2010 while the CPI inflation rate in the year to June 2011 was 5.3%, meaning term deposit income would be tax free at current inflation rates. New Zealand households and companies had NZ$102.1 billion in bank deposit accounts  at the end of June 2011 and they paid NZ$1.98 billion in tax on the interest received in the year to June 2010.

Although a decision one way or the other could be some time away, interest.co.nz understands the government is still looking at the idea after indicating before this year's budget that it was too complex to be included in Budget 2011, given the workload following the Canterbury earthquakes.

And on top of the complexities, it is understood one of the biggest roadblocks to a timely implementation of such a policy, or in fact any new tax policy, is the dire state of the Inland Revenue Department's computer systems.

Years of underinvestment have meant the IRD's 1990s IT systems have been operating at capacity since the implementation of policies such as Working for Families and are in need of an investment in the order of hundreds of millions of dollars to handle further changes - something the government may have to seriously consider over coming budgets.

Indexation

Earlier this year the Savings Working Group recommended the government look at ways to incentivise certain savings vehicles, due to high marginal tax rates for vehicles such as term deposits versus lower rates for housing investment, something that had contributed to what the Group said was over-investment of household savings in property.

The recommendation to index taxes on savings for inflation had been earlier raised by one of the Group's members, Andrew Coleman, on interest.co.nz. Coleman and the Savings Working Group argued that while inflation ate away at the nominal returns of an investment like a term deposit, the full nominal interest earned on that deposit was taxed, meaning the investor was effectively paying tax on income they did not earn in real terms. 

The Group argued only the real return from the deposit should be taxed.

Renewed hope

Before the Budget, Finance Mininster Bill English said the complexities involved with such a policy meant it had not been considered in Budget 2011. Likewise, Opposition finance spokesman David Cunliffe did not express an interest in such a policy either, saying it would benefit only those who could already afford to save.

Finance Minister Bill English on Saturday morning told media at the National Party's annual conference in Wellington that the government was still considering small changes to the tax system, mainly taxes on savings vehicles.

IRD systems in need of hundreds of millions - could be a problem for Labour's CGT

Interest.co.nz understands one of the biggest obstacles to overcome in order for the savings tax break policy to be properly implemented would be the IRDs 1990s IT system which is at capacity due to policies such as Working for Families.

And if the policy were to be given the go ahead, without some serious investment in those IT systems, other policies and current programmes may have to be put on the backburner in order for IRD to be able to handle any changes.

See earlier piece: Alex Tarrant asks whether IRD could even implement changes if the govt embarked on widespread tax reform?

Upgrades in the order of hundreds of millions of dollars would be in order for the IRD to be able to handle more of a shake-up in New Zealand's tax system, something which could count against the Labour Party's policy to introduce a more comprehensive capital gains tax if it was in power after the November 26 general election.

The recommendation

Here's what the Savings Working Group recommended on the issue of inflation indexation of interest:

Recommends that at a minimum, interest income and expenses be indexed at a notified standard rate for tax purposes that reflects the rate of inflation (e.g., 2% per annum), and that asset cost bases for depreciation and, potentially, trading stock opening balances are also indexed.