Ryan Greenaway-McGrevy on the Top Ten resolved and unresolved issues on the Tax Working Group’s proposed capital gains tax

Today's Top 10 is a guest post from Ryan Greenaway-McGrevy, a Senior Lecturer in Economics and the Director of the Centre for Applied Research in Economics at the University of Auckland. 

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See all previous Top 10s here.

The tax working group released its interim report in September. No prizes for those of you that predicted that they’d recommend a capital gains tax on everything but the family home; the parameters around the mission were made rather clear by the Labour-led government.

There was a small chance that the group would come back with a recommendation of some kind of a tax on wealth – such as a land tax, as recommended by the previous tax working group. This time around the experts have eschewed a broad-based wealth tax, a land tax, and an inheritance tax. Although, I will argue below that one of the versions of the capital gains tax being considered resembles a wealth tax on certain assets.

Section six of the report discusses their conclusions on a capital tax to date.

1. Will taxation be based on ‘realised gains’ or on a ‘deemed return’ basis?

The interim report has narrowed-down the options to two very different approaches to taxing capital.

Under realised gains you are taxed based on the different between the sales and purchase price of the asset (perhaps less any improvement expenses incurred – see below). This method corresponds to how most of us understand how a capital gains tax works.

The deemed returns (or risk-free rate of return method of taxation) taxes the asset holder on the assumption that the asset earns a constant return. This could be 4% per year, for example.

The two approaches are very different and have potentially have vastly different implications for revenue stability, wealth and income distribution. See paragraphs 37-42, section 6 of the report, for further details on the two methods.

Although the group eschewed a broad-based wealth tax, the deemed returns approach is very much like a wealth tax, as it would be payable whether the asset was disposed of or not, and it is based on the value of the asset.

In what follows it will frequently be important to recognise the distinction between these two methods, since many of the issues only apply to one of the methods.

2. What kinds of assets would be subject to the “deemed returns” capital tax?

A tax on wealth is difficult to implement, since many forms of wealth can be hidden with the help of a creative accountant and a few overseas bank accounts. For these and other reasons, the working group dismissed a broad-based wealth tax (paragraphs 104-108).

Yet this begs the question: How is the deemed return method any easier to implement? If the tax rate is based on a deemed return of 4%, it is necessary to have an up-to-date estimate of the value of the owner’s interest in the asset.

That is easy for some assets, but harder for others.

These and other difficulties lead the working group to indicate that only portfolio investments and residential real estate would be considered for deemed return taxation. Rural, commercial and industrial land would be subject to the current income taxation. Equity interests in businesses that are not publicly listed would also, presumably, continue to be taxed based on the income generated.

The differences in the tax regimes applied to different land-use types (residential, commercial, industrial and rural) may require some form of harmonisation across different local government, and it is unclear how residential housing built on commercial land would be treated.

One last and very important point: Under the risk-free rate of return approach, the income from the asset (e.g. dividends or rents) would not be subject to taxation. But neither would the cost of improvements and repairs of real estate be deductible. See paragraph 79.

3. What is the tax rate?

It looks as though realised capital gains would be taxed at the same rate as other forms of income. Paragraph 72 states:

As this approach does not impose a new type of tax but significantly expands the capital/revenue boundary, taxation would generally be calculated and collected in the same way as currently applies for disposals of revenue account property — i.e. taxation would apply at ordinary income tax rates to nominal gains and losses (emphasis added).

To my reading, it is not completely clear what the tax rate would be for the deemed return or risk free return method, but it seems likely that the marginal tax rate would also be applied.

4. What are the expected effects of the capital gains taxes on economic mobility?

The working group is up-front about its goals and concerns in tweaking the tax system, with ‘Fairness’, ‘Distributional Impact’, and ‘Revenue Stability’ as stated priorities (see paragraph 47, section 5).

Yet no attention is paid to economic mobility – the extent to which people and families can improve their lot through hard work and savvy investment.

Working hard, saving and investing is how a person born of humble means climbs the income ladder. We already have a tax on interest and dividends; throwing in a tax on realised capital gains would make it that little bit harder for them to get ahead. It inhibits economic mobility.

A tax on wealth – as prescribed on some assets under the deemed return basis – is far better in this regard. It would be progressive. But rather than tax people as they try to make their way up the ladder, it would only tax them when they reach the top.

5. What is the distributional impact of the home exemption on renters?

As expected, the family home will be exempt from capital gains (paragraph 55, section 6).

This puts yet another disadvantage on tenants. Owner-occupiers are already gifted tax-free income when they put their savings into their house. Renters, on the other hand, have to pay income tax on their savings – and now they will also be hit with tax on any capital gains on their savings.

The working group claims that fairness and distributional impacts are an overarching concern – but it is difficult to see how the home exemption can be either fair or progressive.

Low income families have always found it difficult to get on the property ladder, and it is only getting worse. Like it or not, there will be more and more middle income families renting in this country as sky-high house prices in the big cities like Auckland put home ownership out of their reach.

The home exemption further exacerbates the gap between the haves and the have-nots, but it also exacerbates the gap between the young and old, making it that much harder for young families to build their lives in this country. About one in five people born in NZ live overseas – one of the highest rates of emigration in the OECD.

6. What are the economic and financial impacts of home exemption?

Needless to say, the home exemption also further skews incentives towards investment in the family home.

Imagine a couple in their mid-40s thinking about where to invest their savings. Option one is the stock market. Option two is a purchasing a rental. Option three is to trade up to a larger, more luxurious home that will then be sold once they reach retirement.

The first two investments will attract income and capital gains taxes. The third will not. When the couple plans to downsize for retirement, they recoup all of their investment via an untaxed capital gain (unless the bottom falls out of the property market).

This tax distortion could mean even less kiwi money invested in the kinds productive capital that sustain and generate jobs – and correspondingly more business profits flowing to foreign owners.

And what of financial fragility? The old maxim ‘don’t put your eggs in one basket’ comes to mind. More of us should be diversifying our investments and putting our savings overseas.

7. Why won’t capital gains be indexed to inflation?

Inflation is one way that the taxman can get away with taking a little more than what you think. What matters is not your nominal income, but its purchasing power, and inflation erodes that purchasing power. Even if your wages keep up with prices, you will be pushed into higher marginal income tax brackets, thereby reducing the purchasing power of your pay after tax. The Taxpayer’s Union calls this “bracket creep”.

The prospect of a capital gains tax not indexed to inflation is yet another way that the taxman can quietly take a little more. Indexing the capital gains to inflation would be an honest move. But apparently any CGT will not be indexed to inflation because other forms of income are not indexed either. But all of the tax system is up for review – not just taxation of capital. Surely now is the time to raise the issue?

8. How will improvements be treated?

For those DIYers who put their sweat and cash into doing-up all those properties listed under “Handyman’s delight” or “Renovate or detonate”, the prospect of a tax on realised capital gains could represent a big hit on all that effort.

Thankfully, the working group recognises that these improvements do not represent capital gains. Paragraph 54, section 6 states that:

Taxpayers would be entitled to deduct their acquisition and improvement costs (to the extent that those costs have not already been depreciated) from the sale proceeds received on disposal, so only the net gain (or loss) would be taxable.

9. How will realised capital losses be treated under a realised capital gains tax?

Some forms of capital losses will offset other income. However, of some asset classes, capital losses will only offset against future capital gains. Paragraph 68, section 6 states:

As a general rule it is proposed that capital losses would be able to be utilised against ordinary income. However, for base integrity reasons, in some cases capital losses would be ring fenced (only able to be carried forward against future capital gains from similar asset classes).

10. Where is the economic analysis of the impact of these taxes?

Beyond a simple analysis of the impact on government revenues, there is not a lot in terms of what the effects of these different taxes may be on the economy and households. The previous tax working group recommended a land tax, but also provides some work to show that a 1% land tax would reduce land values by approximately 25%. What impact would a 2% ‘deemed return’ capital tax have on house prices? It remains to be seen whether the group will take an evidence-based approach to their final recommendation in their full report.   

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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20 Comments

Seeing the Herald header story about the family moving 4 times in a year, you would have thought an economist would have explained to the Housing minister the risks of bashing providers of rental stock .

Or worse still openly discouraging the use of private Capital to provide houses for rent when clearly the Government could never house everyone in the country .

There will always be landlords in the market; always have been. They are a crucial part of any society.

What will attract the next generation of landlords? Entry price.
I assume you're a landlord, so what would you do if the prices of residential property halved? Sell what you already own, or buy more?
The answer boils down to "Productivity". If it makes financial sense to buy a property for $X (half today's prices) and get a net yield of, say, 7%, MORE investors would enter the market until the net yield falls below what they will accept. Arguably, that market is at the 'acceptance' stage now; as all know variables are built into today capital and rental prices. What the market doesn't know is "What changes ( this article) might there be?" and I, for one, can't see any that are beneficial for the future of landlording beyond what we have today.

So what attracts 'the next lot'? As I suggest - Entry Price.

I agree with the comment there will always be Landlords, however, what we've seen over 3 decades is everyone and their dog entering this market (and that's not restricted to NZ, the same is true in the UK and AU), there are simply too many.

As long as we keep importing people there will always be demand for rentals, and demand for Landlords. Why should a young Kiwi family be able to buy a house, where did this entitlement mentality come from?

If everyone fortunate enough to have equity in their house (thanks to their birth year) goes out and buys a rental, then plenty of young Kiwi families won't need to go out and buy a house themselves. Then the Landlords can gloat about how they're providing a service to these families due to houses being expensive to buy. Also, think of all the Trades People the Landlords employ it's great for the economy.

@bw , I am not a residential property landlord , and dont EVER intend to become one , but do have a share in a trust that owns a small commercial property , which is part of my future retirement plan .

I also hold listed shares in 3 Property Co's on the NZX , which from a yield point of view is 100% better than owning a rental home and 500% better from a hassle factor point of view

@bw. Productivity will be the answer once we rid ourselves of speculation. We all know that yield has taken a back seat to capital gains brought on by credit expansion/easy money. For productivity/yield to become key again we will have to have some sort of change in our monetary system and a reset of some sort.

If the system doesn't change then we're still in the same place, we will still speculate and chase capital gains. A drop in values will temporarily change the dynamic but as soon as the prices start rising again, the specuvestors will come again in my opinion.

Several comments come to mind;
Re Economic mobility, considering who the chair of the TWG is, I would suggest he doesn't want it to happen. The left wingers, of which he is a staunch one, seems through his commentary and actions to believe that people should be kept in their place, thus economic mobility would definitely not be a permitted outcome.

In #5 the author shows his limited thought capacity, shallow thinking and bias. "This puts yet another disadvantage on tenants. Owner-occupiers are already gifted tax-free income when they put their savings into their house. Renters, on the other hand, have to pay income tax on their savings – and now they will also be hit with tax on any capital gains on their savings." Owner occupier homes are definitely not tax free, Owners pay rates on them, plus maintenance, plus insurance.

The real disadvantage to renters is the failure of Government to regulate the property investment market. A CGT on the family home would not achieve one jot of difference, other than possibly forcing some people out of their own homes into the rental market to be fleeced by parasitic landlords. Renters need to be taught to understand the consequences of their choices. i have seen many articles from economists discussing the relative advantages and disadvantages between buying and renting a home. Very few of them put much weight in a high demand market, greedy landlords and a lack of regulation of the rental and property investment markets.

A fair proportion of renters chose to rent so they could "live" now, while a few chose to buy and forewent "living" which was largely the message behind those economists articles. Guess what? Having a choice means accepting the consequences of that choice. Some of the recent renters are there because they had no choice, and parasitic landlords are locking them into a lifecycle of poverty, unless they are fortunate enough to be in a well paying job. The consequences of the failures of a series of Governments. Tax the increase in value of the family home will not change this at all! Bemoaning the unfairness of it all is more about a child crying that they want a choice but are not prepared to accept responsibility for the consequences of that choice.

So under the deemed gain proposal , my 90 year-old mother's only income generating asset ( a small single tenant commercial building in a Provincial town ) would see its "deemed gain" taxed ?

WTF ?

How on earth will she ever be able to pay the tax

What if the "deemed value'' was to fall........ does she receive a capital loss receipt from IRD ?

She would be forced to sell the asset just to pay the tax

The whole thing is simply ridiculous

I assume your mother has it for the income not the capital gain? Did you not see the bit that the deemed rate of return is INSTEAD of taxing the income on the property? If the property is generating healthy income then your mother will likely pay LESS tax under this proposal. It will hit all those cashflow negative property “investors” hard, but I’m OK with that. Personally I think it’s a great idea but unlikely to ever happen because it’s hard for people to understand.

Re # 3 above , the tax rate is quite problematic .

If my normal annual income is $120k, and I sell my commercial building and the gain is $500k, which is distributed to me , then the $500k will be taxed at the maximum marginal rate for individuals .............

Let me just tell you right now , to avoid crystalizing the tax debt , I will never dispose of the asset out of the trust , it will be owned by my family in perpetuity .

I will simply borrow against the income stream of the asset if I ever need more money ( which BTW is unlikely)

Its nonsense that we who have forgone consumption to acquire assets for our sunset years , should be treated differently to someone who has swanned through life saving nothing , smoking , drinking or gambling their money away and who are often a burden on the rest of us .

Its nonsense that we who have forgone consumption to acquire assets for our sunset years , should be treated differently to someone who has swanned through life saving nothing , smoking , drinking or gambling their money away and who are often a burden on the rest of us .

It's nonsense that those who work for an income should be taxed at the high rate while those who gain unearned income from the growth of society around them should not pay any tax on that income.

agree 100%

But is the person receiving that unearned income? How do you spend equity without taking out a loan and being charged for doing this? A loan is not income.

The specific case Boatman raised: "...and I sell my commercial building and the gain is $500k"

Re "a loan is not income", at least we're well ahead of the MSD on that point.

I interpreted the rest of his comment to be talking about the Deemed Return taxation.

When they sell it, yes taxed on the Real gain. Meanwhile if they live in it they are enjoying an un-taxed benefit which strictly speaking should also be taxed. Ergo if its put in a trust then tax should be paid on the benefit(s).

Interesting that a loan is not income, however there is a clear benefit. So maybe the principle the loan is taken out owes CGT on. I mean as there is a clear benefit tax is due.

That is rubbish, its really simple if you have made a gain you should pay tax on it. Meanwhile you accuse others of being wasters, an insult frankly on [hard] workers.

Boaty, would a bank allow you to borrow against the income stream, or would they require some form of lein over the property title? That then would be capitalising on a change in the value of the property.

In which countries has a CGT been a roaring success? A tax on deemed rich pricks needs to demonstrate it is going to achieve something other than increased complexity and investment risk aversion.

"If you work a certain amount of time, you are legally entitled to the pay that you were offered when you took the job. Capital gains involve risk. They are not guaranteed. You can invest your money and lose it all. Moreover, the year when you receive capital gains may not be the same as the years when they were earned.

...The biggest losers from politicians who jack up tax rates are likely to be people who are looking for jobs that will not be there, because investments will not be there to create the jobs."
https://www.creators.com/read/thomas-sowell/10/12/capital-gains-taxes

"The previous tax working group recommended a land tax, but also provides some work to show that a 1% land tax would reduce land values by approximately 25%"

The government shot itself in the foot by limiting the scope of the TWG.

The Government should stop TWG now and direct them to a land tax with no exemption for family homes. Its simple, efficient, & inescapable, and necessary to drive the efficient use of land (re land banking, inefficient low density land use increasing carbon through more travel etc)

Land in NZ is extremely overpriced due to the poor implementation of the RMA, (eg millions of land zoning rules rather than effects based) & the unwillingness of successive governments to issue national standards (the RMA per se is fine).

Land values are the single current biggest distortion in the NZ economy. A 25% drop would help realign them.

Any effects on the poor can be dealt with other taxation and benefit adjustments.