By Andrew Coleman*
New Zealand politicians are discussing taxes again. Just like normal, these discussions are about the rate of tax: should income tax rates go up, or down, or get adjusted for inflation. Strangely, we hardly ever discuss the two largest differences between the taxes used in New Zealand and the taxes used in other OECD countries, which concern the ways we fund public retirement incomes and the ways we tax private retirement incomes.
For the last 35 years New Zealand has ignored standard tax theory and the practices of almost all OECD countries and gone off on in its own tax path. Instead of using some of the most efficient taxes in the world, we have designed a tax system that artificially distorts investment decisions and inflates property prices. If we could boast that our distinctive tax arrangements had generated a high wage, equitable, and high productivity economy, this would be some achievement. But we haven’t even achieved one of these things, let alone all three.
It doesn’t have to be this way. New Zealand could keep major elements of its distinctive retirement income system even if it changed the taxes that are used to fund them. Alternatively, younger New Zealanders could redesign the retirement income system they want for themselves and the taxes they use to fund it. (They should have this choice.) Either way, it is reasonable to ask whether our tax system is helping us achieve our goals – and if not, whether we should change it to build a brighter future.
This article examines why most countries use social security taxes to fund contributory retirement income systems. The distinctive way New Zealand taxes private retirement savings will wait until next week.
Social Security taxes
Most OECD countries use social security taxes to fund the contributory components of their government pensions. A social security tax is a special tax on labour incomes that is used to fund social security benefits, particularly old age pensions. The amount a person pays each year is recorded, and their lifetime tax payments are used to determine how much pension they get when they are old. It is collected at the same time as ordinary income taxes, but it is not paid on capital incomes such as interest, dividends, or rents.
This means that different types of income are taxed at different rates: more precisely, labour incomes are taxed at higher rates than capital incomes. This tax system is deliberately chosen to reduce the distortionary effects of taxes and develop a well performing economy. Even though New Zealanders do not have a contributory retirement income system – although a younger generation may wish to adopt one for themselves –we still could use social security taxes, just as Ireland does.
For many years, many New Zealanders have argued that fairness requires all types of income to be taxed in the same way. It should not matter whether you earn $50,000 from working in a shop or a farm or from interest from the bank, the tax should be the same. Consequently, many New Zealanders will find it surprising that most countries tax different types of income at different rates. Can his be fair? It turns out that this is not the right question as fairness is only one characteristic of a tax system, along with effectiveness and simplicity. A better question is: how you design a tax system that is simple, effective and fair? Economists call this question the “optimal tax” problem, after two Nobel prize winning economists, Peter Diamond and James Mirrlees.
Diamond and Mirrlees argued it is often a good idea to have low tax rates on activities people can easily change, and high tax rates on other activities, even if this does not seem fair. According to this argument, it can make sense to tax labour incomes at higher rates than capital incomes, since most people go to work no matter the tax rate but they can easily change their investments if tax rates are high. This grates against the fairness principle, particularly as investment income tends to be concentrated amongst rich people. On the other hand, businessmen and businesswomen may be less willing to expand profitable businesses if capital incomes are taxed at high rates, or they may shift part of their businesses to other countries.
Ordinary wage earners might find they are worse off if the government taxes all income at the same rate, because lower wages more than offset the lower taxes they pay. (Evidence from Germany and (the US suggests that when business profits are taxed, half of the tax falls on workers because their wages are lowered). There is no easy way around this conundrum. Taxes that are fair may not be effective, and taxes that are effective may not be fair. Most countries have decided that the best response is to tax labour incomes at higher rates than capital incomes to ensure wages can be as high as possible.
One solution pioneered by Norway, Sweden and Finland - countries that are widely regarded as some of the most progressive and equitable nations in the world - is to tax labour incomes on a steeply progressive scale but tax capital incomes at a lower rate. In the 1990s these countries were so concerned that their businesses would invest too little or move to other countries if they taxed capital and business incomes too heavily that they decided to tax all capital income at the bottom labour income tax rate.
However, labour income taxes are steeply progressive. That means that people earning high labour incomes not only have higher average tax rates than people on low incomes, but they have higher tax rates than people who have high capital incomes. Whether or not you think this “Nordic tax system” is fair, Scandinavian countries have adopted it because they think it is an effective way to have an equitable and high-income economy. The US tax expert Joel Slemrod argues that the introduction of this system in Scandinavian countries since 1990 is probably the largest advance in tax practice in the last 30 years – and notes that Scandinavian countries have some of the least inequality despite this tax system.
While the Nordic countries have made this equity-efficiency trade-off explicit, most countries do something similar by levying social security taxes on labour earnings but not capital earnings. This means that capital income is taxed at lower rates than labour income, which reduces some of the distortionary effects of taxes on saving and investment. It is true that the higher labour income taxes may increase labour market distortions, but most countries (and most economists) think that tax causes worse capital market distortions than labour market distortions. People are better-off if labour taxes are a little bit higher and capital taxes are a little bit lower.
Many countries raise 25% to 30% of their tax revenue from social security taxes that are used to fund retirement incomes and some other forms of social assistance. In contrast, New Zealand only collects 3% to 4% of its taxes as social security taxes, to fund the Accident Compensation Corporation. The absence of a social security tax or compulsory saving scheme is by far the most distinctive aspect of New Zealand’s tax system.
Because New Zealand raises so few funds from social security taxes, average income tax rates in New Zealand are high relative to many other OECD countries. As a result, New Zealand has one of the lowest “combined” labour income taxes in the world (income tax + social security tax), but one of the highest taxes on capital incomes. If taxes on capital income are high, investors and businesspeople may choose to invest less. This means that firms will typically be less productive since they will have fewer resources in terms of machinery and capital. Furthermore, there is a greater incentive to invest in low-yielding assets that are taxed at low rates such as real estate. High capital income taxes may also encourage businesspeople to relocate to countries with lower capital income tax rates. All these problems can be reduced by having higher social security taxes but lower income taxes.
Social security taxes have a second benefit. Even though income taxes applied to labour incomes are less distortionary than income taxes applied to capital incomes, they are still distortionary. A social security tax has a smaller effect on labour market participation decisions than an ordinary income tax.
Because work is an unpleasant or boring activity for many people, they are tempted to do less of it when a large fraction of their earnings are paid to the government. Labour taxes may change behaviour in other ways as well, which may be more important in practice. People may avoid well-paid but unpleasant work in favour of less demanding and less-well paid jobs. They may avoid moving from one city to another to take advantage of better paying jobs, because they only keep a fraction of the pay increase. Why not live near the beach in Tauranga on $80,000 per year rather than move to Auckland for $100,000 per year if the government takes 33% of the extra $20,000 as income tax, and 15% as GST?
Social security taxes reduce this behaviour. Because people know they will be getting at least some of their social security taxes back as higher retirement incomes, people respond to the social security taxes they pay differently than to the income taxes they pay on their wages. Most people know the income taxes they pay are gone for good, but that is not the case with social security taxes.
Similarly, if people are required to make compulsory contributions to their own personal retirement income account, they may behave differently than if they had to pay the same amount of money as taxes. Ask any Australian whether they treat the money that is paid into their personal retirement account the same as the money they pay in taxes. When a portion of the taxes people pay determine their retirement income, they may not induce the same tax-avoiding behaviour as the income taxes that are levied in New Zealand.
It is not possible to be dogmatic about the relative distortionary effects of social security taxes and normal income taxes on labour incomes as there is not much statistical evidence on the topic. Nonetheless, most evidence from cross-country research programmes supports the common-sense position that people behave differently when the taxes they pay increase their retirement incomes than when the taxes they pay are gone forever. (Also see this, and this).
Social security taxes tend to be regressive, but this does not mean that the tax system overall must be regressive. Most countries with social security taxes reduce other income taxes on low-income people, and raise top marginal income tax rates on high income workers. If New Zealanders were to adopt social security taxes or a compulsory saving scheme to fund retirement incomes, the government could do this as well. Low-income individuals would be required to pay social security taxes on their labour incomes, but might not need to pay income taxes until they reached a high income threshold.
A social security tax could also be combined with a family tax credit so low-income household would get an income tax refund while still paying social security taxes or making contributions to a compulsory saving scheme.
Social security taxes are a deliberate choice to reduce the distortionary effects of taxes. Peter Lindert, a historian of government welfare systems, observes that European countries with the largest governments and the most redistribution are most likely to use social security taxes precisely because they are most fearful of the bad effects that can occur if they use poorly designed taxes to raise revenue. Fifty years ago, when the Labour government introduced a compulsory saving scheme, New Zealand also went down this path. It is time we considered doing it again.
*This series and an accompanying paper are based on work I started in 2020 with Jeanne-Marie Bonnet while we were both at the University of Otago. I am very grateful for her assistance and insights. All errors remain my own.
(This article is part 8 in the series. Part 1 is here, part 2 is here, part 3 is here, part 4 is here, part 5 is here, part 6 is here, and part 7 is here).
**Andrew Coleman is a visiting professor at the Asia School of Business. This article is his personal view of retirement policy in New Zealand, based on academic study.
Coleman is on extended leave from the Reserve Bank of New Zealand, while working overseas. The views expressed in this article do not represent the RBNZ and are unrelated to work conducted at the Bank, which has no responsibility for retirement policy in New Zealand.
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