In most countries the loopholes in the income tax regime are somewhat imperfectly addressed by the use of wealth taxes, stamp duty, land transfer taxes, and estate duties. None of these alternatives close the loophole efficiently and instead give rise to their own inequities, distortions and inefficiencies.
It is important that all forms of income be taxed in the same way, most notably because it improves economic efficiency – both allocative (where we allocate our investments) and productive (ensuring those investments are used efficiently). An efficient economy is one wherein consumers and investors make the same choices whether they consider the benefits in before-or after-tax terms. If those relative benefits differ because the way that taxes are imposed, then there is a loss of allocative efficiency. If businesses (including farming) make different investment and production decisions because it reduces their tax bill, then people will invest in ways that aren’t ideal for the economy. In other words, the tax regime inhibits productive efficiency.
In our 2011 book, “The Big Kahuna: Turning Tax and Welfare in New Zealand on its head”, Susan Guthrie and myself posited the Comprehensive Capital Income Tax (CCIT) as an overdue reform for the New Zealand income tax regime. We pointed out that until it was introduced our economy would suffer from over-investment in low returning capital assets – and by implication under-investment in high-returning capital assets. The argument was that the current income tax regime fails to tax the full return from investment in some asset-types and as a consequence investors compete to buy those types of assets. This is not because of the pre-tax return being created by the productive use of the asset, but rather because the favourable tax treatment makes these asset types attractive to hoard. The demand for asset types that reap at least some return that lies outside the gambit of the income tax regime becomes excessive as investors clamber to take advantage of the tax break. This results in a pricing of the asset that far outweighs its ability to produce competitive risk-adjusted income.
The CCIT is designed to remove that tax distortion – albeit only partially. It does that by subjecting to the normal income tax rates, a deemed minimum rate of return on the value of all major assets. So let’s say the cyclically-adjusted, risk free rate in the economy (often taken as the long term average of the government bond rate) is 5%. Then under a CCIT-augmented income tax regime, all assets would have to return at least 5% for taxation purposes.
Consider the consequences. It means for instance that owner-occupied dwellings would be deemed to furnish their owners a 5% return, and that return would be taxable. Such a step would remove the anomaly that exists today between the choice an investor has to put their money in the bank and earn interest and pay tax on that interest before they can spend it; versus purchasing a house with that cash and enjoying year after year the rental services that asset provides – tax free. This is a huge distortion in our economy and continues to drive the house price to income ratio up and up, placing that asset type beyond the reach of more and more people. Such an outcome is a nonsense result and totally unnecessary. As Europe’s most successful economy Germany attests, there is no need for the house price to income ratio to rise at all, if you tax the effective return to housing fully.
How the CCIT applies to business & farming
Now turn to business. Why do some businesses persist year after year without even making the risk free rate of return on the assets deployed?
Of course any half decent business test by the IRD would determine that they’re not businesses at all – but rather lifestyle choices. And why? Because the owners are able to effectively reap an income from the “business” in a tax efficient (read, “avoiding”) manner. Your friendly corner dairy or workman with a van could well be this type of “pretend” business. The impact of the CCIT on such an activity would compel the business owner to declare at least a 5% return for the purposes of income tax. If the taxable profit from the business is already above 5% of the assets deployed, then the CCIT would have no effect.
So finally we come to farming. It’s just a business like any other so under the CCIT regime it would be subject to a minimum taxable income of 5% of assets deployed, each and every year. If a farm already exceeds that on average, then the CCIT has no impact. If it doesn’t average that then the tax impost on the farm owner would rise.
Now of course farm income is volatile and the concept above is a year-by-year deemed income. That implies that for businesses with a volatile annual income there would need to be a smoothing regime in place for the CCIT liability. This is not of course an option to escape the tax, but merely to smooth the cashflow effects. One would expect use of money interest to apply and there to be a limit to how long tax could be deferred. Remember a business that doesn’t make the risk free return over time isn’t a business at all, so the assets are being either deployed lazily – or as one would expect as more likely – being deployed in order to reap benefits that lie beyond the gambit of the income tax regime (anyone heard of capital gains?).
On a final note the CCIT regime we advocate is a little different to the current income and expenditure regime. Rather than apply the 5% deemed income to the full value of the asset and make interest deductible, because the CCIT only applies to non-financial assets (interest and dividends are already subject to tax), the approach for assessment of the CCIT liability is to apply the 5% deemed income to the value of the productive asset less the liabilities secured against that asset.
Remember the objective here. It is to ensure that all forms of income are subject to income tax to some degree. A CCIT would be a huge improvement on the distortive, inefficient and inequitable income tax regime we currently have. In the household sector alone we estimate that there are $750bn of assets (net of financial liabilities) held that deliver untaxed benefits to their owners. On the principle that not an additional dollar of taxation is to be raised from deploying a CCIT, expansion of the tax base by the 5% of income deemed to come from those assets could provide a 20-25% cut in overall income tax rates.
It would also free up an enormous amount of capital currently sunk into housing and other unproductive assets to be invested in productive assets. We simply can’t get rich as a nation by selling houses and land to each other; we need to sell stuff to the world.
Gareth Morgan is a New Zealand economist and commentator on public policy who in previous lives has been in business as an economic consultant, funds manager, and professional company director. This content was first published here and is used with permission.