By Gareth Morgan*
Under TOP’s income tax reform package, all capital must declare a taxable income of (say) at least 5% of the value of the capital.
An obvious line of enquiry is what will this do to the extent and allocation of investment in New Zealand, in particular whether capital would flood overseas.
To address this we go back to why removing this tax loophole is so important.
The reason is that by enabling some forms of income from capital to be tax-exempt, an advantage is created for investment in the areas where the exemption applies, and that is to the disadvantage of all other avenues for investment. Such a bias will see the allocation of capital different to that which would prevail in a tax-neutral environment. Investors will respond to the tax signal rather than the economic signal if it materially alters their after-tax return.
Such a situation has prevailed in New Zealand ever since the deregulation of 1984 when all forms of taxation on the non-cash income to capital were removed. Prior to that time there were somewhat imperfect attempts to tax that income through approaches such as estate duty, inheritance taxes and stamp duty, and gift duty for instance.
But the most efficient way to ensure all income to capital is taxed is via a pay-as-you go tax on annual income, not to roll it up and attempt to tax either on a transaction (or realized) basis or at an owner’s end-of-life basis. Both of those compromises generate all manner of anomalies between economic and post-tax returns and as a consequence sub-optimal allocation of capital, and costs to income and employment. We can see the downside of those anomalies with the Labour and Greens proposals to outlaw negative gearing and create a capital gains tax (excluding the family home).
The pay-as-you-go approach requires the income to capital to be estimated each year – or as a proxy, the market value of the capital to be estimated each year and a deemed rate of return applied to that value. Clearly debt would not be included, and any income attributable to that capital and already declared would need to be netted from any minimum taxable income assessed.
The idea of ensuring all income is taxed is hardly radical, but of course in an environment where that has not been the case, it is. As a consequence we can expect a change in savings, investment and asset prices as we adjust to an environment where economic benefit is being harmonized with private post-tax incentives.
This leads us to whether the change will lead to an avalanche of capital outflow.
There is always a lower tax jurisdiction available – tax havens for example. The fact all capital hasn’t already flowed to them demonstrates that investors are concerned by more than tax rates when they invest in places apart from tax havens. That is self-evident.
Other things equal, it is reasonable to posit that a rise in tax on the owners of capital will lead to less, rather than more or same, levels of investment. Unless of course the tax proceeds are applied to areas of society that make the investment environment more attractive. That offset would be important in adjudging the overall effect.
And that’s the case with the socio-economic conditions The Opportunities Party (TOP) is contemplating with its package of reforms. The whole point is to make post-tax returns of productive investment greater than those available currently from investments that enjoy tax-exemption on their returns. We expect investors to switch their investment from one to the other. In addition the proceeds from closing the tax loophole are being applied to boosting the post-tax incomes of individuals, including low-income people who typically spend a higher percentage of their income – domestic demand will be boosted.
Most importantly, savers still require to accumulate funds for retirement and with the absence now of a ‘free rider’ return from simply accumulating funds in property assets that are no longer tax-favoured, they will seek alternatives. As the New Zealand business community is on record consistently saying, the greatest constraint on their expansion is access to finance. Well here it is.
The economic growth dividend that removal of the tax-favoured bias in the income tax regime will generate is strong. The reform is being implemented primarily to spur investment and economic growth. It’s all about having a more productive allocation of capital.
So we would posit that these benefits would easily outweigh the impact from ending low yielding investments that would no longer find it profitable to arbitrage our tax system. Those investments will be penalized for sure, but investments that are already reaping more than the risk-free rate and paying tax on that income will be unaffected by the changes. So for them the outlook is even more positive – thanks to more income in the pocket for their customers. Further, all investors will benefit from the cut in their own tax rates which is how the expansion of the tax base is being spent.
In summary, TOP’s taxation reform provides a substantial positive boost to the business sector in four ways;
- Households will get more income which will fuel their demand (80% of taxpayers benefit) for our firms’ products;
- Access to finance will be easier for businesses because savers will seek to invest less in speculative assets and more in income-generating assets;
- The competition for funds from low yield productive assets will diminish given the increase in tax on them; and
- The cut in overall tax rates will benefit shareholders.
Gareth Morgan is a businessman, economist, investment manager, motor cycle adventurer, public commentator and philanthropist. He has recently founded The Opportunities Party which is contesting this year's general election. The TOP tax reform policy is here.