Labour's second best, politically palatable capital gains tax stance; Why not actually do what the IMF and OECD recommend?

Alex Tarrant looks at Labour's tax policy

The Labour Party's response to the government's housing affordability release included the expected reference to the need for a capital gains tax.

For our benefit, finance spokesman David Parker even included comments made by the IMF and OECD on New Zealand's tax settings (with the important bits in bold), and the support they gave to the need for a capital gains tax here.

So does Labour's policy actually follow what these two economic agencies recommend, or does the party need to take a step further with its policy if it wants to claim their support?

At the moment, if you asked the OECD, Labour's policy may be a second best option with exemptions to appease the public. And if you asked the IMF, they'd probably say it's not using the revenue raised from its CGT for the right reasons.

But Labour reckons it's policy is along the right lines - considerably so, compared to the status quo. But given recent comments by leader David Shearer, has the party taken a backwards step? Read what Parker thinks a bit further down.

What they said

The IMF had recommended "continuing efforts to broaden the tax base by looking at capital gains tax settings and introducing a land tax to fund growth-enhancing tax rate reductions.”

ie. Tax one type of income (capital gains) more, so that company taxes or other tax rates, like on wages, can be reduced - a tax switch.

Now the Labour Party did contest the 2011 election with a promise to cut income taxes, by making the first NZ$5,000 of income earned tax free. On the mark with that recommendation, right?

Well, leader David Shearer has implied the party will scrap that policy.

Meanwhile, the company tax rate would have stayed the same, and a new top tax rate would have been introduced to pay for GST off fresh fruit and vegetables. 

While the GST off fruit and veg policy is expected to be scrapped too (the IMF supports broad-based consumption taxes, so wouldn't have liked the policy anyway), it's still not clear whether Labour will stick with its new top tax rate stance.

No other tax rate changes were mooted as being allowed for due to the introduction of Labour's capital gains tax.

Neither did Labour consider a land tax as a further way of base-broadening as proposed by the IMF. So I reckon Labour's a wee way off before it can claim tax policy mateyness with the IMF. Its election policy actually had a few more ticks, but by doing away with the tax-free band, any capital gains tax revenues currently aren't being put towards other rate reductions.

Second best

Meanwhile, here's what the OECD had to say about how it would like NZ tax setting to change:

"Introducing a comprehensive realisation-based tax on capital gains would further reduce the bias towards housing investment relative to other assets.  Excluding primary residences from taxation would diminish the effectiveness of such a tax, but partial exemption or rollover relief could act as a “second best” solution so as to facilitate public acceptance."

A "second best” solution so as to facilitate public acceptance.

OK, so that's better than nothing, but the OECD is basically saying that in terms of tax policy, Labour's suggestion is a bit economically silly. To be fair to Labour, the OECD implies the status quo is even more silly.

Yet despite it's support for a comprehensive capital gains tax, the OECD even suggested what the government should do if it wasn't going to move on that front:

"The government has so far refrained from introducing a capital gains tax.  In such circumstances, it should consider other alternatives including reducing the taxation of alternative savings to level the investment playing field and further limiting the extent to which property investment losses can be deducted for tax purposes. Such measures should be accompanied by higher property or land taxes that could be designed to achieve the same objectives as a tax on imputed rent."

To Labour's credit, it did announce a policy to ring-fence property losses so they could only be written off against future property income, but not against other earnings. Now that's something the OECD would like to see happen. A tick there.

If you're not going to tax capital gains properly, then both the OECD and IMF reckon adjusting tax on savings for inflation, an idea mooted by the Savings Working Group in 2010.

This is a hard one for Labour to support, because it's effectively a tax break for those who can afford to have term deposits. The biggest gains would go to the wealthy. But on the other hand, if you implemented the flip-side of the recommendation, people (like property investors) would only be able to write off the real portion of interest costs against their other income.

So will Labour get closer to the OECD and IMF recommendations?

That's not likely, and we're not really going to find out about the party's thinking on tax until much closer to the next election.

Finance spokesman David Parker told interest.co.nz the party knew about the criticism on excluding the family home from a capital gains tax.

“All of the economic purists say that the family home ought to be included in a capital gains tax. But virtually no country does it, because it’s politically untenable, and we’re of the same view," Parker said.

“So no, we’re not saying that we would extend it to the family home," he said.

I asked Parker whether the party had considered doing away with the 'capital gains' label, and treating everything just as income, net of inflation, as economist Norman Gemmell reckons should happen.

Labour did consider that, Parker said.

"We decided in the end that we didn’t want to tax the inflationary component of the increase, because it’s not real income," he said.

“You can do that in two ways: You can either say 50% of it, which is a proxy for inflation, is taxed, and it’s all taxed at the marginal tax rate as if it were income; Or you can say all of the gain will be taxed at a lower rate. It’s a similar answer.

“In the end we went with saying all of it will be taxed, but at a lower rate,” he said. Labour's policy was for a flat 15% tax rate on all capital gains, regardless of inflation.

Parker also defended against the suggestion that the CGT revenue was not being put towards reductions in other tax rates like the IMF wanted to see.

“We had the NZ$,5000 tax-free zone. That was effectively being funding out of mainly capital gains tax revenue," he said.

While Shearer had implied Labour will do away with the band, the party would “for some time” not reveal its tax policy for the next election.

“At the last election we said that by far and away most of the CGT revenue was being used to reduce other taxes. It was a combination of funding some of the KiwiSaver tax costs, and the GST off fresh fruit and vegetables, and the NZ$5,000 tax-free zone," Parker said.

“So it wasn’t being spent on consumption.”

Revenue needed

However, Labour also needed the revenue from its new top tax rate to fund its policies.

Meanwhile, Labour had not moved any further on where it stood with regard to the proposal to adjust tax on interest earning for inflation.

“There are two sides to that. You can say that savings are over-taxed relative to capital, or you could say that interest is overly deductible compared with real costs," Parker said.

“It’s the other side of savings being arguably over-taxed. That’s arguable, I can see the logic in that. The flip-side of that is you’re giving too much deduction for interest," he said.

"If you were going to adopt that approach and say you ought to be taxing only the real component of interest earnings, you ought only to be getting a tax deduction for the real component of interest payments."

Would Labour consider this further though?

“That’s not under active consideration from us," Parker said.

“That’s not to say I think that’s wrong in principal, but that’s getting quite complex. It would be wrong to address only one side of that equation," he said.

Finally, the party was giving no consideration to a land tax, like the IMF had recommended.

“Their advice is very sound. But you can’t do everything," Parker said.

From David Parker's notes:

IMF

“Staff supported the recommendations of the Savings Working Group on tax reforms to raise saving and improve the efficiency of the tax system.  They include a further switch from income to consumption taxation over the medium term, while maintaining the broad base of the GST, and that interest income and expenses be indexed at a standard rate for tax purposes that reflects the rate of inflation (e.g., 2 percent per annum).  Staff also advised continuing efforts to broaden the tax base by looking at capital gains tax settings and introducing a land tax to fund growth-enhancing tax rate reductions”

OECD

The Overview of the 2011 OECD Economic Survey of New Zealand states that:

“Favourable tax treatment of housing and inefficient regulatory constraints on supply should be removed.  These distortions exaggerated the surge in house prices, given rise to wider wealth inequalities and a heavy dependence of households’ long-term financial positions on volatile property values.  The shallowness of capital markets that results from low national saving also contributes to the attractiveness of housing as a savings vehicle relative to financial assets.  Despite the slump in housing demand, property prices remain at high levels relative to rents and average incomes, keeping affordability low for less affluent households and intensifying pressures on the social housing sector.  While the government has made progress in addressing some tax distortions and inefficiencies in social housing delivery, policy priorities should include further tax reforms to level the playing field for savings and investment decisions, while improving the efficiency of land-use policies and the overall urban planning system”.

“The exclusion of imputed rents and capital gains from the NZ tax base contributes to diverting household portfolios towards housing.  Because nominal interest income and dividends are taxed, the absence of a capital gains tax raises the relative returns to assets with good prospects for price appreciation, which tends to favour property and farm investments, given their greater leverage possibilities and a thin domestic equity market.  In addition, rental property investments benefited from generous tax provisions that led to increasing losses claimed by investors against their other income in order to reduce overall tax liabilities.  The tax advantages helped to prolong the housing boom, further inflating property values.  They are also regressive in that they benefit high-income investors more, at least to the extent that losses can be deducted at the marginal tax rate, and low earners are priced out of the market.  The government addressed some of these distortions in the 2010-11 budget. 

 Introducing a comprehensive realisation-based tax on capital gains would further reduce the bias towards housing investment relative to other assets.  Excluding primary residences from taxation would diminish the effectiveness of such a tax, but partial exemption or rollover relief could act as a “second best” solution so as to facilitate public acceptance.  The government has so far refrained from introducing a capital gains tax.  In such circumstances, it should consider other alternatives including reducing the taxation of alternative savings to level the investment playing field and further limiting the extent to which property investment losses can be deducted for tax purposes.  Such measures should be accompanied by higher property or land taxes that could be designed to achieve the same objectives as a tax on imputed rent”.