Andrew Coleman probes whether New Zealand’s productivity performance has been adversely affected by the way capital income is taxed

By Andrew Coleman*

This is the introduction from a paper entitled Taxing capital income in New Zealand: an international perspective. It is available here in full.

For several decades, New Zealand has had an economy characterised by high labour participation rates but low capital intensity, low productivity levels, and low per capita incomes. A programme of reforms in the 1980s and 1990s raised income growth rates and arrested the decline of incomes relative to other OECD countries. However, the increase in productivity growth rates has not been large enough to enable New Zealand to catch up with other countries.

Some of the 1980s and 1990s reforms involved significant changes to the tax system. Many of these reforms were aimed at reducing the ways taxes can alter the economic choices that people and firms make. Top marginal income-tax rates were reduced, a value-added tax (GST) was introduced, a system of imputation credits for dividend income was implemented, and the taxation of retirement savings was reformed. As a result of these reforms, New Zealand has a tax system that differs in many ways from the tax systems of other OECD countries. While many of the tax reforms have been successful, and have been lauded internationally, some tax distortions remain and some may have been exacerbated.

By world standards, New Zealand has relatively low taxes on labour incomes (see the discussion in Section 2). Economic logic suggests low taxes on labour incomes should promote or at least not discourage labour participation and encourage people to undertake rewarding activities. Consistent with this logic, New Zealand has the fifth highest labour participation rate in the OECD, and particularly high participation rates for people aged over 55. Taxes may not be a particularly important determinant of participation rates, however. There is reasonable consensus among tax experts that income taxes have only modest effects on the labour participation decisions of prime-age males, although there is less consensus on the extent that taxes affect the participation decisions of women with children (Slemrod and Bakija 2017). New Zealand’ labour force participation rate is high, but it is not dissimilar to several countries with high taxes on labour incomes such as Iceland, Sweden, Denmark, the Netherlands and Norway.

In contrast to the low taxes on labour incomes, New Zealand collects relatively large amounts of tax from capital incomes (also see the discussion in section 2). There is growing although not yet conclusive international evidence that high taxes on corporate income reduce economic growth rates by reducing the speed at which firms make productivity-enhancing investments to catch up with the leading firms in their sectors (Lee and Gordon 2005; Arnold et al 2011; Gemmell et al 2018). Moreover, New Zealand’s taxes on capital income are unevenly applied, as some forms of capital income are taxed at much lower rates than other forms. The uneven way capital incomes are taxed may be reducing investment in sectors subject to high tax rates and encouraging investment in sectors subject to low tax rates. To the extent this is happening, it is liable to reduce economic efficiency and the overall productivity of the economy.

Even though the ways capital-income taxes affect investment patterns and productivity levels are imperfectly understood, most countries are concerned that poorly designed capital income taxes may impose large economic costs because they divert investment flows towards sectors that are lightly taxed or towards foreign jurisdictions (Mankiw et al 2009). Since the 1980s most countries including New Zealand have reduced taxes on capital income. Indeed, many countries including all of the Nordic countries have chosen to tax capital incomes at lower rates than labour incomes out of concern that high taxes on capital incomes impose economic costs that do not justify the revenues they raise.

The structure of taxes may also affect productivity levels by changing where people choose to live. Globally, a rising fraction of people choose to live in regions of a country that have relatively low productivity levels but offer desirable natural facilities rather than regions that have high productivity levels (Graves 1980; Chen and Rosenthal 2008; Partridge 2010). High taxes on consumption and income may reduce productivity by deterring internal migration flows to the most productive cities and by encouraging migration to less productive cities with favourable but untaxed amenities (Albouy 2009). Because it alters location decisions, this mechanism is similar to the effect that restrictive development regulations may have on aggregate productivity (Hsieh and Moretti 2015; Schleicher 2017).

In recent years the OECD has argued that the tax reforms with the greatest scope to enhance productivity growth concern the way capital incomes, particularly property incomes, are taxed (Johansson et al 2008; Brys et al 2016). For this reason, this paper primarily concerns the taxation of capital income and asks whether New Zealand’s productivity performance may have been adversely affected by the way capital income is taxed.

Three issues are addressed:

1. Does the tax system reduce productivity levels by encouraging investment in low productivity sectors?

2. Does the tax system reduce productivity growth rates by discouraging investment in the most productive and dynamic firms within sectors?

3. Does the tax system reduce productivity levels by deterring investment in high productivity regions?

These questions are addressed sequentially. First, the paper examines the extent that New Zealand imposes different effective tax rates on different forms of capital income, and how this may encourage over-investment in lightly taxed sectors or asset classes. Much of this analysis concerns residential property taxation as this sector is extremely large and has particularly low tax rates. Secondly, the paper reviews the recent literature examining the way taxes on businesses may reduce the growth rate of more productive and dynamic firms. A key issue that arises when examining this question is whether the dynamic effects of business taxes on productivity growth may justify taxing capital incomes at lower rates than labour incomes. In contrast to the position adopted by the Tax Working Group, this paper argues that standard economic analysis provides no reason to tax capital and labour incomes at the same rates and several reasons not to tax these incomes at the same rates. Indeed, consistent with this theoretical position most OECD countries tax capital incomes at lower rates than labour incomes. Thirdly, the paper briefly considers how income and consumption taxes may encourage migration to low-productivity regions with desirable natural amenities.

A major reason that this paper focuses on the taxation of capital income is that New Zealand has a capital-shallow economy and levels of labour productivity which are low by OECD standards. It is possible but by no means proven that New Zealand’s unusual tax system may be affecting investment and saving patterns in ways which are detrimental to productivity growth. There has been little research undertaken about the way that New Zealand’s tax system affects productivity growth rates and levels, which is surprising since New Zealand’s tax system is now quite different to those in many OECD countries. Indeed, in writing this paper it was striking how little agreement there is even over such basic issues such as whether New Zealand has high or low taxes on capital income, an issue that is inadequately addressed in the Tax Working Group Interim Report. Whatever the outcome of the Tax Working Group recommendations, it is to be hoped that considerably more research is undertaken about the ways New Zealand’s tax regime may be affecting its productivity outcomes. Currently little is understood about the incidence, productivity and distributional consequences of several aspects of the New Zealand tax system. Nor does there appear to be a work programme aimed at resolving several areas of uncertainty. It will be difficult to design a tax system that will enhance New Zealand’s society in the future unless there is a greater understanding of the ways New Zealand’s unusual tax system affects economic decision-making and aggregate economic outcomes.


*Andrew Coleman is a senior lecturer in the economics department at the University of Otago. He's also principal advisor & economics lecturer at Treasury.

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36 Comments

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Aha, do I spy an economist fumbling about in the right area? Surely, not, and yet...

The obsession with the distorting effects of the tax system, important though it is, is really a second order effect. Yet fumbling around in the area leads to wondering why the productive export oriented or import substituting SME is not very profitable. There lies the rabbit hole. Low profitability and high tax rates mean the SME cannot expand rapidly. He can keep turning the wheel over the years, but eventually it takes its toll on a chap. It ain't easy. So eventually he sells up.

So where does the rabbit hole lead? Excess capital inflows to low productivity areas (eg Auckland houses, casinos, motels and hotels) causes the exchange rate to rise just enough to snuff out the profitability of the hard working SME. Yet government types and their economist lick spittles all thing a current account deficit is a Very Clever Thing and it is what the big boys do. Sigh.

If you want a higher income economy you need to do more productive stuff than house building and selling residency permits and tourism. These are useful for providing jobs nearly anyone can do, but that's about it. Ireland attract people like Google by offering them low company tax rates, the benefit from well paid jobs fills the government coffers and raises incomes. Speaking English helps. Well paid export oriented jobs in the regions suggest mining, but that is verboten. NZ is seen in the mining industry as less investable than nearly everywhere else on earth, including very dangerous places like DRC. Historically it helped build the country's infrastructure of course and yes it is destructive, but perhaps we are frightened of ghosts here.

There is a hierarchy of skills in a country or region, each better paying industry poaches the more skilled from the next layer down. Tourism is a good base layer, but where is the skills hierarchy?

We however, rely on SNAFU thinking. Inflation in the prices of existing assets is the blindingly obvious effect of excess capital inflow. Read Michael Pettis for more.

Well said! Especially the intro ..." an economist fumbling about in the right area".
I was waiting for a conclusion, but there isn't one, except' we need to do more work on the subject'.
Sigh, indeed!
(NB: 90% of readers of this blog know what the answer is, even if it doesn't suit them. But, hey, they use what they are given, and in that light, good luck to them. But one day, it's all going to go wrong.)

"I was waiting for a conclusion, but there isn't one!"

This is the introduction from a paper entitled Taxing capital income in New Zealand: an international perspective. It is available here in full.

(Thx. That's where I was off to next. Just commenting on what was published here)

Okay. So the conclusion appears to be that 'whilst we recognise that things have to change, or not, any change will be difficult, and some sectors of the economy will object to whatever is done or find a way around the rules.

Maybe I missed 'the answer' but from what that tells me, nothing is going to change. It's all too hard.

You are pretty spot on.

Tax reform is not a new topic in New Zealand and over the past 20 years there have been notable attempts by economists to highlight the issues and design more appropriate taxation approaches.

However, these are simply infeasible on the basis of both, as you say, the "too hard basket" (typical public sector crap) and political undesirability.

All those attempts at reform have simply added more layers of complexity. Have we asked the right questions in the first place? Who wrote the original tax laws? For whose benefit? It matters because the answer to the first will answer the second and probably still applies now. What is the purpose of taxation? Can taxation be used for other purposes effectively?

Forcing a system onto people without their voluntary buy in was always going to create future problems.

So we are now seeing an inferred ‘distribution’ from the ‘hit the rich tax’. Not bad politics but let’s redlect for a moment on the two groups who are going to lose most from this unfolding ‘war’ on the better off. Because asset prices (property) are at historic peaks and, moreover, at ludicrous multiples of Kiwi income how will Cullen et al generate the future price increases to trigger the CGT liability? They can only do so by two expedients - aggressive monetary debasement and mass-immigration. Debasement will hammer the poor, and the young trying to save up to buy a home. Meanwhile the rich will be able juxtaposition the situation via offshore investments and other monetary vehicles that benefit from a debased currency. The mass-immigration also needed will, of course, further pressure availability of housing etc for the poor whilst depressing labour costs (to the benefit of the rich and the capital indices).

If Cullen et al really wanted to help the poor they would do two things. Firstly they would examine what mechanisms might be brought to bear to ensure that $NZ better retains its purchasing power over time. We could, for example, consider some sort of roll for gold within our monetary structure - currently along with a few other absolute ‘basket cases’ we have the rare distinction of being a country with no gold-reserves whatsoever! Secondly, if the ‘Left’ really cared about the poor it would proscribe mass-immigration because of its wage-depressant and resource pressurising characteristics. Yet no, they have just signed up to the UNs Migration Compact! The economic ‘darling’ of the Left - John Maynard Keynes - in quoting Lenin explained the way the deployment of currency debasement arbitrarily enriches some but impoverishes others. To make CGT work requires the propelling of asset prices to yet more absurd levels and that means a massive devaluation of $NZ will need to be engineered - otherwise Cullen’s pot will be empty

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Thanks bw. I added a few more random thoughts. Basically, the government advisors, for whatever reason, don't really understand the importance of capital flows. When looking at the current account deficit they see that we earn less from the rest of the world than we spend, but think we therefore need more exports. My argument is that capital flows are the driver most of the time.

So, encouraging capital inflow by flogging Auckland to foreigners isn't "investment", it is capital mis-allocation. So is bidding up the price of existing housing stock by borrowing more money from the ever helpful Aussie banks. Investment means creating or maintaining productive assets that pay for themselves by the increase in productivity they enable.

NZ use to advertise in China that come and buy property in NZ and pay no Tax.

Will this be changed.

Anyone earning even $1 is taxed and people earning in hundred of thousands go free with loopholes. Is it fair ?

What specific loophole do you think we should close?

It's a good post.
However I'm pretty sure your post is just a copy and paste comment from any economist asked about the nature and direction of productivity in New Zealand.

Ironic that 'your' ideas aren't too different to the people you chastise.

Sorry Nymad, I probably put you off by mentioning the dreaded M word. I just couldn't help it. I just wonder where people think the money comes from in a developed society. It has to come from somewhere, or else we stagnate and go backwards.

Investing in productive assets vs. non productive assets is the key argument. I do not understand why the Government is not focused on this as shifting towards productive assets will only mean a larger tax take and ability to spend more.

"...New Zealand's productivity..."

ROTLMAO!

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'striking how little agreement there is even over such basic issues such as whether New Zealand has high or low taxes on capital income, an issue that is inadequately addressed in the Tax Working Group Interim Report'

So there is little research, which means Cullen is being driven not by data and facts but socialist ideology.

One look at their interim report would confirm that to definitely be the case.
You'd find more quantitative analysis in a 1st year gender studies essay on lesbian dance theory than was presented in that report.

Yes! And no thought as to the real returns, I.e, avg return on residential is roughly 3% after inflation over the last 40 years.

Does anyone actually understand why property goes up in NZ? Hint, it’s not the Chinese, and it’s not immigration.

Com'on, do tell us what makes property go up in NZ

Mark Twain - Buy property - they have stopped making it.

Demand and supply - no more nor less.

JB,

Mark Twain said ‘Buy land,they’ve stopped making it’,which is very different from buying property,as I think you would agree. Just drive to Pokeno-there’s no more land there,but lots of new properties.

Hmm, so socialist ideology is a problem and capitalist ideology isn't. Can you open your mind enough to see that both ideologies are a problem? It's funny though, communism probably existed before all, it's called community. Socialism/capitalism, two sides of the same coin much like political left vs right and yet it's all the same bullshit.

Take off the blinkers. See how we're all manipulated into the divide and conquer regime.

Hmm, so socialist ideology is a problem and capitalist ideology isn't.

Yes. Are you at all familiar with the 20th century? Capitalism has consistently out-performed socialism.

Most OECD countries are much too highly taxed, and this has a lot to do with how slowly the economies grow.

I only wish Singapore was large enough that it had small towns and affordable houses.

Could you live on a boat?

There's one issue here: The 'rate of return' on capital gains was distorted by offsetting rental losses against taxes. If you cannot do this anymore, this significantly changes your cashflow equation and your actual rate of return. You won't be able to do this anymore soon, so why don't we see what the adjusted value of the assets are once this change comes into effect. Or is the aim of the game just to tax as many things as possible in as many ways?

Oh dear. Careful there, walls have ears and all that:
Or is the aim of the game just to tax as many things as possible in as many ways?

No doubt tax loss offset supported by WWF propping up in rent side has grossly distorted NZ property, and been a massive focus for some. Like winter, change is coming...

"If it moves, tax it. If you live in it tax it. If you eat it, tax it. If you drive it, tax it."
It will be interesting to see Cullen's final report & whether or not he's got the balls to address the productivity issue. I'm thinking this may be a bridge too far for an aging 20th Century socialist like him, but would be happy to be proved wrong.

Imagine how much less it would cost to the Government to pay for roads and other infrastructure if they cut back on taxes a bit?

I hope someone has calculated the tax loss to NZ when all the wealthy people living here up sticks and move to Singapore like all the rich Australians and Americans did. I am willing to bet that the amount collected in CGT will be less than the amount of capital that is moved offshore. And since the Govt will only deploy that tax revenue on more unproductive welfare handouts, rather than investing in new businesses that provide jobs, that lost capital and its compounding effect will be gone for good.
https://www.smh.com.au/business/singapore-lures-the-super-rich-20120801-...

People that want that sort of lifestyle have already left NZ. $1.4 for a 48sqm apartment. Go for it!

If you want high density apartment equitorial living go for it.

So all the rich people are going to throw a tantrum and teach everyone a lesson for being mean to them by leaving the country? Are you talking about the rich people with money sitting idle in bank accounts or the rich people that own companies and stuff?

"You know what, screw you guys I'm leaving. Oh, and I'm taking my 2 supermarkets and 3 rental properties with me too!".

Perhaps, they already have. Who do you think owns the banks and brewers and supermarkets?

Capitalism, like socialism, is a wonderful theoretical construct.

Perhaps someone somewhere should give them a whirl. . .

Capitalism, like socialism, is a wonderful theoretical construct.

Perhaps someone somewhere sometime should give them a whirl. . .