Is a capital gains tax ever possible?
Earlier this week Gareth Vaughan asked me whether a New Zealand political party could ever sell the idea of a capital gains tax (CGT) to the public and if so, how? Always up for a challenge, I believe the answer is yes.
Firstly, a quick definition: we’re discussing a realisation-based CGT, i.e. the gains are determined when an asset is sold or otherwise disposed of. This is the “standard” CGT in use around the world. All assets would be revalued prior to implementation so any gains which have arisen prior to the start of a CGT would never be taxed.
To begin with, it’s vitally important to recognise the scale of the challenge. As Bernard Hickey pointed out, Jacinda Arden’s “Captain’s Call” was effectively a $520 billion gamble.
Viewed like this, Labour’s initial approach was a bit like Custer’s charge into the Little Big Horn, a bold cavalry raid relying on shock and awe to overwhelm the enemy before it can organise. Like Custer, Labour underestimated the scale of the opposition but unlike the hapless 7th Cavalry, managed to extract itself and is still in with a chance even if a bit battered by the experience. Jacinda Ardern and Grant Robertson will now appreciate that introducing a CGT will not be a swiftly won skirmish but full on trench warfare.
Into the breach
The arguments in favour of a CGT can be summarised as follows:
- Raising taxes is not politically impossible;
- We already tax a large number of capital gains;
- Broadening the base of taxation to include capital gains is consistent with current policy settings;
- Broadening the base would produce a fairer tax system and should enable tax rates to be lowered;
- CGT would simplify the tax system; and
- It could help address New Zealand’s poor productivity record.
Let the difficulties argue for themselves
In 1943, facing opposition to his proposal for floating harbours to be used in the D-Day landings, Winston Churchill growled “Don’t argue the matter. The difficulties will argue for themselves.”
What’s remarkable about the CGT debate is that proponents of a CGT regularly fall into the trap of arguing the difficulties. Even when the Labour Party ran on introducing a CGT in 2011 and 2014 it started from a circumscribed position of exempting the family home.
Opponents therefore didn’t even have to address the question of whether it was fair that someone owning a multimillion-dollar property and receiving non means-tested New Zealand Superannuation (hello Winston!), shouldn’t be taxed on any capital gains from the sale of their property.
Taking so much off the table without question just puts those advocating change on the defensive. Better to follow Nelson’s last signal at Trafalgar and “engage the enemy more closely”. It’s going to be trench warfare so don’t surrender ground willingly.
The base line for a CGT should be to put everything, including the family home, up for debate. If a CGT was introduced my preference would be to give a generous exemption for the family home, maybe $250,000 per person as is the case in the United States. Remember gains arising prior to commencement will NOT be taxed.
“But the politics”
Recent history shows that parties can raise taxes and still win elections. In the last thirty years three New Zealand governments have either introduced or raised taxes and all were subsequently re-elected. David Lange’s Labour Government introduced GST, a completely new tax, in 1986. Helen Clark campaigned and won in 1999 with a promise to increase the top rate of income tax to 39%. Finally, in 2010, John Key’s National Government raised the rate of GST to 15%. All three governments were comfortably re-elected after their tax increases. Raising taxes or introducing a new tax is therefore not politically impossible.
There is no CGT in New Zealand, there are no sheep on our farms
New Zealand remains virtually unique among the OECD’s 35 nations in not having a CGT that is generally applicable regardless of intent. The principle behind taxing capital gains is not revolutionary. As Inland Revenue advised then Minister of Revenue Todd McClay in February 2014:
“Increases in asset values, just like regular income, increase a person’s net wealth and ability to consume. A capital gain is income…
“There is no obvious reason why a person who derives $100,000 in interest income should be taxed differently to a person who derives $100,000 in capital gains.”
In fact, we already tax a LOT of capital transactions. There are presently over thirty provisions within the Income Tax Act which tax capital gains. These rules were described as “an incoherent mix of taxation based on accruals, realisation, and imputed return” in a paper prepared by Leonard Burman and David White for the 2010 Tax Working Group (“the TWG”).
Capital gains already taxable include the financial arrangements and foreign investment regimes, foreign superannuation scheme transfers and certain property transactions including the “bright-line” test introduced in 2015.
Against this backdrop the CGT argument really should be framed as “why aren’t we taxing X or Y?”
What’s in it for me? Broadening the base
Following the example of the introduction of GST in 1986 and its 20% rate increase in 2010, any CGT introduced should be promoted as a revenue-neutral measure and accompanied by compensatory income tax and/or GST reductions. Such a step would be entirely consistent with the “broad base, low rate” approach to tax policy both Labour and National have supported for the past 30 years.
This is also the view of Treasury which in a September 2012 report stated;
“Treasury continues to see merit in a general capital gains tax or a land tax as possible revenue-raising reforms, and considers that a capital gains tax offers the best way of improving allocative efficiency by reducing economic distortions caused by gaps in the tax base.”
The debate on CGT has tended to paint its application as a loss for those affected. The better question is what is the opportunity cost of NOT taxing capital gains?
Inland Revenue advised the TWG in 2010 that a comprehensive CGT including the family home could raise $9 billion annually. That was more than the projected $8.3 billion corporate income tax take for the June 2010 year, or just under 25% of the combined GST and individual income tax take of $36.1 billion. If the family home was excluded, the projected CGT revenue was $4.5 billion, still a substantial sum. Excluding the family home would come at a cost which should be made clear.
Based on the available evidence (and unlike Australia, Canada, the UK and the US, Inland Revenue doesn’t release very detailed tax statistics), the evidence is that capital is under taxed especially relative to salary and wages. Furthermore, non-taxation of capital tends to favour the wealthy.
A joint Treasury/Inland Revenue report prepared for the TWG in 2009 examined the composition of taxpayers paying tax on capital gains in Australia and the United States.
In Australia, 1,148,440 taxpayers reported taxable gains for the year ended 30th June 2007. And 48.4% of all gains for the year was returned by the 90,202 taxpayers (7.8%) with taxable income in excess of $150,000. There were similar findings for US taxpayers.
The report concluded “If New Zealand is similar, this would suggest that omitting to tax capital gains is likely to favour the rich.”
A subsidy from the general taxpayer to property owners
A further issue arises not just in the potentially higher income tax rates for taxpayers in general but also through the ability for negatively geared investors to offset their losses against other income. This offset often results in substantial tax refunds. For example, according to information supplied to me by Inland Revenue, the rental losses reported by the top three income deciles for the year ended 31st March 2016 totalled $339 million (about 60% of the total losses for the year). At 33% that represents about $112 million in tax. This is effectively a subsidy from the general taxpayer to property owners.
This leads on to the question whether it is fair that someone who may have enjoyed perhaps hundreds of thousands of dollars of tax refunds through negative gearing, also gets the capital gains on their investments tax free? This is perhaps one of the biggest anomalies of the present system.
According to Statistics New Zealand, the number of New Zealanders living in their own home has fallen from a peak of 73.8% in the March 1991 quarter to 63.2% in the December 2016 quarter.
Statistics New Zealand now estimates 33% of New Zealanders, over 1.5 million people, live in rental property. Increasingly, it seems the benefits of residential property are going to fewer people. Does the present tax treatment of property effectively result in an unseen subsidy in the form of higher taxes paid by non-property owners? The trade-off proposed is that the revenue from a more comprehensive CGT could be used to lower income and/or GST rates for everyone. This is not being debated at the moment.
Complicated compared with what?
The Burman and White paper for the TWG acknowledged that a CGT would be "relatively challenging to administer" but then asked the question "compared to what?” Anyone arguing a CGT would be more complex than the financial arrangements and foreign investment fund regimes clearly hasn’t spent much time navigating these minefields of complexity. CGT should enable both regimes to be consigned to somewhere near the bottom of the Kermadec Trench.
For many transactions, a realisation-based CGT would be conceptually clearer than the current law and therefore more comprehensible to the layperson. This is particularly true of land transactions, where tax advice is often little more than a variation of ‘It depends’. The introduction of the ‘bright-line test’ in 2015 highlighted how unsustainable the existing approach to taxing land transactions based on intent at the time of purchase had become.
Critically, a CGT would also be more enforceable, as intent would no longer need to be determined. It would also be fairer: given the subjectivity of measuring ‘intent’, taxpayers in identical circumstances could currently finish up with differing tax bills. (What may be acceptable proof of intent to one Inland Revenue auditor may be insufficient for another.)
What productivity growth?
In any case how are the present rules really working out for us? Ex-Reserve Bank economist Michael Reddell pointed out this week that New Zealand’s productivity has gone nowhere in the past five years, part of a near 70-year relative decline.
What part has the present tax rules played in that decline? The Burman and White paper for the TWG raised this issue, arguing:
“That is why geniuses who might otherwise do productive work have been drawn to financial engineering or into fields that can earn income in the form of capital gains rather than income. With such huge tax incentives, the investments that produce capital gains do not even have to be particularly productive. Thus, many resources invested in such underperforming assets may be wasted.
Eliminating that waste would be good for productivity. It would also bolster support for the income tax. A tax system riddled with loopholes, where billionaires can pay lower average tax rates than their secretaries, invites disrespect and undermines voluntary compliance.”
Apart from having a CGT, something else Australia, Canada, the UK and the US all have in common is superior productivity to New Zealand. This lends weight to Burman and White’s argument that the lack of a CGT may have resulted in lower productivity here. Maybe those opposed to CGT should answer that question when defending the present treatment. (And Bill English, simply saying it’s not true about no productivity growth in the past five years doesn’t count).
If not a capital gains tax, what?
What might also emerge from a debate could be that CGT isn’t the answer, but maybe the alternative suggested by The Opportunities Party of a deemed rate of return on all productive assets would be worth pursuing.
Ponder this: a one percent levy on the $1.38 trillion net financial wealth currently held by households would yield $13.8 billion a year. To put that in context the Government expects to collect an estimated $20.6 billion in GST, and $34.3 billion in income tax from individuals in the year to 30 June 2018. A levy should provide a substantial amount for redistribution to cushion the cashflow impact of an asset tax.
A fairer, more comprehensible and productive tax system
Whether it’s through a CGT or an asset tax, taxing capital more comprehensively would achieve the goal of a broad-base, low rate tax system. It should be sold on this basis and introduced alongside a potentially quite substantial reduction/re-alignment of income tax and GST.
CGT is not without complexities but it would be far more comprehensible than the present “incoherent mix”. Eliminating the bias towards tax-free gains would mean a fairer tax system as Burman and White pointed out. It should also free up capital to be deployed more productively raising productivity and wages. That’s a lot of positives for those proposing change to deploy.
Any party wanting a fairer, more productive New Zealand, and as far as I can tell, that’s all of them, needs to address the issue of the taxation of capital. Because whatever we’re doing now isn’t working.
*Terry Baucher is an Auckland-based tax specialist and head of Baucher Consulting. You can contact him here »
(Parts of this article are reproduced with permission from Chapter Five of Tax and Fairness, a book by Terry Baucher and Deborah Russell).