Andrew Coleman explains why we have been handicapping ourselves out of capital investment for high-paying jobs, and he is hoping the new Secretary of the Treasury can move to fix that bad policy

Andrew Coleman explains why we have been handicapping ourselves out of capital investment for high-paying jobs, and he is hoping the new Secretary of the Treasury can move to fix that bad policy

About fifteen years ago, the new Secretary of the Treasury, Dr Caralee McLeish, was part of a World Bank team that put together a dataset measuring the regulations and taxes that small businesses face in different countries. In conjunction with Price Waterhouse, this group (including an extremely famous Harvard economist) worked out the taxes paid by a standardised 20-person business in its first two years of operation, as well as the taxes its employees pay. 

The authors then used this data to ascertain if there was a consistent relationship between the taxes and regulations that businesses in each country face and the amount of investment taking place in each country.

There was: the countries with lower tax rates and less onerous regulations tended to have more investment and more foreign investment. The data were considered so useful that the exercise is now repeated annually. One of the original papers by this group of authors, “The effect of corporate taxes on investment and entrepreneurship” (published in 2010has been cited more than 750 times. 

New Zealand has low levels of capital for a country of its income level and quite high corporate taxes. 

‘Quite high’ is actually an understatement: in 2004 (that year the data used in the 2010 paper were collected) New Zealand was third highest in the OECD (if social security tax payments made on behalf of workers are excluded), and in 2016 it was the highest. At the same time taxes paid by average workers were the second or third lowest in the OECD, slightly higher than Chile but lower than just about everywhere else. 

The basic reason why New Zealand has relatively high taxes on capital incomes and relatively low taxes on labour incomes is that New Zealand has much smaller social security taxes than almost all other OECD countries, and does not have a compulsory contributory superannuation system. Social Security taxes are only levied on labour income, not capital income, and this forces a wedge between the average tax rates on these two forms of income. On average, OECD countries raise about 9 percent of GDP in these social security taxes. New Zealand raises about 2 percent of GDP, from ACC contributions. 

I have discussed the potential consequences of this in more detail here. There are at least three theoretical reasons to think that social security taxes – or a compulsory saving scheme – may be a good idea. 

  1. First, social security taxes should create fewer disincentives than other taxes, for in most countries the more money a person pays in taxes the larger the pension they receive. (This does not have to be the case, however: Ireland has a social security tax system, but pension entitlement depends on time in the country not the amount a person has paid in taxes.) 
  2. Secondly, a compulsory saving scheme may reduce long run wealth inequality. 
  3. And thirdly, social security taxes are a very easy way of letting the tax rates on labour incomes and capital incomes diverge.

The argument that there is no good reason for the tax rates on capital and labour income to be the same was formalised by the Nobel Prize winning economists James Mirrlees and Peter Diamond in the early 1970s (in two articles: on the non-taxation of intermediate goods and on an optimal linear income tax). There has been almost universal acceptance of the basic principle by tax economists ever since (see the discussion in Chapter 6 here or here). 

They argued an optimal tax system should result in a trade-off between redistributive equity objectives and production-enhancing efficiency objectives. Since capital incomes are unevenly distributed, the former motive suggests higher taxes on capital incomes. Since capital is supplied more elastically than labour (meaning the supply of labour does not change much when taxes change, but the supply of capital can change a lot or can be directed to sectors with low tax rates), this provides a reason for low taxes on capital incomes. 

This trade-off suggests labour income taxes could be higher or lower than capital income taxes, depending on both preferences for redistribution and the technical responsiveness of labour and capital to tax rates. 

Most countries have decided that tax rates on capital incomes should be lower than tax rates on labour incomes. These countries include Norway, Sweden, Finland and Denmark, – countries famous for their low income inequality and redistributive policies – which have invented the Nordic tax system (the Nordic model). 

The Nordic model has the same initial basic tax rate for capital and labour incomes, but labour incomes are subject to steeply rising marginal tax rates whereas capital incomes are not. The reason: the Scandinavian countries do not want to jeopardise the high levels of capital investment that help generate high incomes in their countries, fearing that high taxes on capital incomes would generate capital flight. 

Furthermore, wages are likely to decline if capital stocks decline in response to taxes, so that the burden of capital income taxation partially falls on workers as lower wages. (This is a widely accepted result, and there is recent empirical evidence from Germany and the United States supporting this idea.) The appropriate tax on capital incomes is not zero, as some theorists have argued, but there are few who argue it should be higher than the tax on labour incomes either. 

So why has New Zealand adopted a tax system that is significantly different from those in most OECD countries? Do these differences create incentives that lead to a low capital, low productivity economy? I suspect that they do, and it is a conversation – with evidence – that New Zealand needs to have.

At least two possibilities, and the assumptions that they require, come to mind.

The first is that there may be fundamental technical reasons why it is efficient for New Zealand to have low taxes on labour incomes and high taxes on capital incomes. The responsiveness of labour to tax rates could be much higher in New Zealand than in other countries, or the responsiveness of capital to tax could be much lower. This could mean it is not optimal to have higher taxes on labour incomes than capital incomes.

Secondly, it could be that New Zealand has a higher preference for income redistribution than other countries, so New Zealanders are prepared to have inefficiently high taxes on capital incomes because of equity considerations. (There is not much evidence that this is true, as our tax system is not particularly redistributive – New Zealand has a low top marginal tax rate, for example).

Either way, it would be useful to understand why New Zealand’s tax system looks so different from those in the rest of the world. We can hope the new Secretary is just the person to ensure the analysis takes place.

Andrew Coleman is a lecturer in the Department of Economics at the University of Otago, where he teaches public finance. This article was first published here and is reposted with permission. He adds "I would like to thank the editorial team of the "The Visible Hand in Economics" blog for allowing me to post on their site."

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But how does our imputation system affect this? For locals (and Aussies) that ensures capital income is taxed at the same rate as our labour income, no?

I believe ICTs could work in favour of productive investments only if a shareholder pays themselves and then reinvests the tax credited to them back into the business as growth capital.

Seems convoluted but workable.

Thanks for the comments. The imputation credit story was designed in the 1980s to ensure that business income was not taxed twice and therefore not taxed at higher rates than labour income. At the time the IRD and government policy makers thought it was important that labour and capital income were taxed at the same rate. However, as the article indicates, this need not be the case: the only theory supporting the case is that it is easy to do (to stop small businesses arbitrarily redefining some of their income as labour income and some as capital income) and all other theory suggests it is best to have capital and labour income at different rates. This is what most other countries do. As a result, NZ has high taxes on capital income. Standard economic theory suggests this is a disincentive to the creation of capital intensive businesses, although there is a not a lot of NZ evidence on this point. (There is interenational evidence supporting this idea - and NZ does have low capital-to-income ratios.)
One of the disappointing things about the Tax Working Group is that they didn't discuss this issue - it was assumed that labour and capital income should be taxed at the same rate, an assumption that is not supported by either academic literature or international practice. It would be possible to have imputation credits and lower taxes on capital income than labour income

Thanks Andrew. So "other OECD countries" is the relevant reference point for "NZ taxes capital at a high rate". I originally thought that the labour income tax rate was the reference point you were using for the statement. Re-reading your article, I can see why I came away with that impression, for example:

“This could mean it is not optimal to have higher taxes on labour incomes than capital incomes.”

“… there are few who argue it should be higher than the tax on labour incomes either.”

For NZ/Oz investors at least, capital is not taxed at a higher rate than labour. I understand you are making the case that capital rates should be much lower than labour, but statements such as those above had me scratching my head!

Anyway, I appreciate your response and the well-reasoned article. One thing I'd question is whether we are capital-starved in NZ. Seems like there is sufficient supply of capital into NZ for listed firms, but there is a lack of capital for start-ups. (This opinion is based on the NZ fund managers and entrepreneurs I speak to...) Not sure fiddling with tax rates will change that...

Yields are down below 5% which means there's tonnes of capital investment. The issue is there's not enough consumers with disposable income to buy the productivity of that capital investment. It's a problem of inequality. The solution is Georgism.

Worse when those low-income consumers are forced to buy overvalued properties just to keep a roof over their family’s heads.

That quickly drops the risk appetite of the consumer to put any savings into a growth venture for the 15 plus years they service that huge debt pile.

Not surprising that NZ has been struggling with stubbornly low productivity. A great way to make the problem worse would be to tax capital based on the imputed (imaginary) income that it could/should be earning instead of the actual income it is generating. Like the geniuses at TOP want to. Not sure what Coleman’s position on this is.

Good talk by Coleman on this here

I'm not a huge supporter of taxing imaginary income. But I don't work as a tax lawyer or a tax accountant (or at the IRD) either and have no idea of the scale of the problem it is trying to address, which is tax avoidance. The point seems to be similar to the minimum tax regime in the US; if a person has a large number of assets and or a large amount of consumption, but declares very low income, it is at least possible that they are redefining income in a manner that avoids tax. An imputed regime is to ensure that there is a back-up system to prevent people from getting away with this. The downside is that in order to catch this class of people and get them to pay more tax, you also catch people with assets who actually made very little income. In the big picture, it depends on whether a person believes the scale of tax avoidance is sufficient that it is worth the unfortunate side effect of taxing people on imputed income that they really didn't earn. I normally support "presumed innocent until found guilty" but there are circumstances where guilt is hard to prove and a large number of people engage in "guilty" behaviour that it is sensible to design rules in the opposite manner.

Personally, I prefer a system of progressive consumption taxes. But NZ scrapped the main way other countries implement progressive consumption taxes in the 1980s, and as a result we have a tax system that emphasises income taxes and all the well known problems these entail.

Andrew can you explain this statement; "NZ scrapped the main way other countries implement progressive consumption taxes in the 1980s"? I remember the introduction of GST as a consumption tax, but i also understood there was NO consumption tax before it?

Unsure of the merits of comparing a low top tax rate with the rest of the world without considering what sort of lifestyle it will buy you. 45 cents on $180K+ AUD seems like a better deal than $70K+ NZD @ 33 cents, but Aussie also take 32.5 cents from $37,001 to $87,000 AUD. Plus you can also add in that there are plenty of people out there who are in the top tax bracket for earnings but still qualify for social assistance like WFFTC. There's a lot more going on here than just "Our highest rate is lower than everyone else's highest rate".

... the countries with lower tax rates and less onerous regulations tended to have more investment and more foreign investment.
Does Foreign Direct Investment Generate Economic Growth? A New Empirical Approach Applied to Spain

FDI is funded locally using money of the receiver country that is in reality, created by domestic banks. Since banks create money out of nothing (Werner 2016), and foreign currency-denominated funds mostly do not physically enter the receiver country, it is neither possible nor necessary to boost economic growth with foreign-denominated money. FDI competes with private domestic investment for funds, crowding out domestic investment (an extension of the substitution of foreign direct and indirect investment shown previously by Werner 1994). This fatally damages the theoretical case for beneficial FDI.

Moreover, Australia's lenders have the world's highest exposure to residential real estate - 63.3%
One trick pony bank economics needs to desist from destabilising our growth prospects while seeking to maximise returns by gravitating to low RWA capital requirement real estate lending, which contributes little to GDP.

The situation is made worse given two thirds of Australian/New Zealand households don't have a mortgage, but are excluded from seeking bank credit to develop GDP qualifying enterprises by those that do.

It's past time to cast these building societies aside in favour of commercial banking businesses dedicated to building an economy capable of supporting the whole country not just a property flipping minority.

Here's someone who a grasp of the problem.

If the banks are not prepared to lend to businesses themselves, bring in regulation that requires a certain level of loan portfolio that has to be business loans. Owning and running a bank is a privilege, not a right. What other business is allowed to be as illiquid as a bank, where presently they only need to hold 10% of accounts payable while calling up 100% of their accounts receivable any time?

Speaking of tax....

In the five years Shields ran the trades, his personal income from the deals amounted to about $20m. He told the court: "I often ask myself whether if I had my time again I would do things differently. Knowing what I now know, the answer is obvious.

Of course, it's obvious Martin! You'd have made sure you weren't in court or the headlines for a start...

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