By Andrew Coleman*
New Zealand has one of the most unusual tax systems in the OECD. The main reason for this is its unusually large reliance on income taxes rather than expenditure taxes or other forms of taxation. Income taxes distort the pattern of saving and investment, which can lead to poor long term economic outcomes, particularly if the taxes are badly designed. In many countries, including New Zealand, poorly designed tax systems encourage too much investment in housing at the expense of other asset classes, and result in artificially inflated house prices.
New Zealand has a much larger reliance on income taxes than most countries. Last week, I discussed the single largest tax difference, which is the small amount of tax raised from the dedicated social security taxes. Social security taxes are much less distortionary on saving and investment patterns than income taxes and in most countries they are used to fund government pensions.
This week the topic is the way that specialized retirement income savings schemes such as KiwiSaver are taxed. New Zealand deliberately departed from the standard taxation method used internationally in 1989 and in doing so created one of the most distortionary taxation environments for retirement savings and housing in the OECD. Fortunately, New Zealand’s approaches to taxation are not written in stone. The tax system has been changed before, and it can be changed again.
The peculiarities of our tax system revolve around the differences between income taxes and expenditure taxes. (Expenditure taxes are sometimes called consumption taxes and are the same thing). Income taxes are paid in the year when income is first earned, and they are generally progressive. This means people on high incomes have a higher average tax rate than people who earn low incomes.
In contrast, expenditure taxes are paid when income is spent rather than when it is earned. This is the same thing if you spend everything as you earn it, but if you save some of your income the tax is delayed. One of the main benefits of expenditure taxes is that they help to compound the returns on your savings at a faster rate.
As we shall see below, the return from saving for retirement can easily increase by 75% if the earnings from savings are taxed on an expenditure basis rather than an income basis. More generally, expenditure taxes distort saving and investment decisions less than income taxes, which is why they are favoured by most OECD countries. They are much less affected by inflation, for instance.
There are several types of expenditure taxes, but the main one New Zealand uses is a value added tax, GST (Goods and Services tax). France was the first OECD country to adopt a value added tax, in 1958, and New Zealand eventually followed in 1986. (Yes, we can copy good ideas used elsewhere!)
It is applied to almost all goods and services, so whether you are buying umbrellas, utilities or uber rides you are paying tax when you spend your money. Because all items are taxed at the same rate, New Zealand’s GST is not progressive.
This is widely considered to be a disadvantage of value added taxes, which offsets their efficiency advantages. However, it is possible to design progressive expenditure taxes, and many countries have gone some way to transform their tax system so that it has a progressive expenditure tax basis. One way of doing this is to tax the difference between what people earn and what they save.
Retirement income taxes
Most countries tax the income earned in special retirement savings accounts such as KiwiSaver differently than the income earned from other assets. They do this by taxing retirement savings on an expenditure tax basis - income saved for retirement is not taxed when it is first earned, but when it is spent in retirement. The system they use is called an EET (Exempt, Exempt, Tax) system.
Under this scheme, when people put some of their labour income in a special retirement savings account, it is untaxed until the money is withdrawn. It is known as EET because:
⦁ Income put into a retirement fund is Exempt from tax when it is earned;
⦁ Interest and dividends and capital gains earned on this money are Exempt from tax as they accumulate; and
⦁ Tax is paid on all of the money once it is withdrawn.
This method of taxing retirement savings was first proposed in the 1930s by a famous Yale economist, Irving Fisher.
In contrast, most income in New Zealand including the earnings in KiwiSaver and other retirement income accounts is taxed on a “TTE” basis.
⦁ All income is Taxed as you earn it, with no exemptions for saving;
⦁ Interest and dividends are Taxed as they accrue; and
⦁ Savings and accumulated earnings are Exempt from further direct taxation when they are withdrawn or the investments are sold.
For example, suppose a person earns $60,000 a year, and saves $5000 in an ordinary bank account. Under the current TTE system an amount of $60,000 less tax is paid into their bank account as a regular paycheque. This is the first “T”. The person puts $5000 of the left-over money in a savings account. Any interest earned is taxed. This is the second “T”. When the money is withdrawn, no additional tax is paid to the government except for GST on items you purchase. The withdrawn funds are “E” for exempt from taxation.
An EET system is different. If a person put the $5000 savings in a special account like a KiwiSaver account, they would only pay tax on $55,000, not $60,000. This is the first “E”. The money in this account accumulates without any extra tax. This is the second “E”. When they withdraw the money in retirement, all of it is taxed as no tax has ever been paid on this money. This is the final “T”.
This small difference in taxation can have large effects on accumulated savings. Suppose the interest rate is 5% and a person pays tax on interest at 33%. If they place $1000 after-tax income in a saving account at the start of every year from age 25 to age 65, and then withdraw it slowly in equal instalments until it is all spent by the time they are 90, they would have 75% more to spend every year in retirement under an EET system than a TTE system.
Under TTE, the person accumulates $84,410 by age 65. This will allow withdrawals of $4,875 every year until they are 90, after tax. Under EET the person can place $1,492 into the account every year, and still have the same after-tax income. This accumulates to $189,310 by age 65. This allows annual withdrawals of $12,792, but since the full amount of the withdrawal is taxed, $8570 remains after tax.
EET taxes also have a second benefit: they significantly reduce the tax advantage enjoyed by owner-occupied housing. In fact, an EET system for retirement savings reduces the tax on saving to a similar although not identical level to the tax on owner occupied housing. This reduces the incentives for people to bid property prices to artificially high levels and it does without increasing taxes on housing.
Why is this? In most countries, including New Zealand, housing income is taxed on a “TEE” basis. You can probably guess what this means:
⦁ Houses are purchased and/or paid off from income that has already been Taxed when it was earned;
⦁ Imputed rent is tax exempt (see below); and
⦁ The value of the house including any capital gains that accrue when it is sold are also exempt from tax.
It turns out that there is not that much difference between TEE (housing) and EET (retirement saving) because the returns (housing services, or interest and dividends) are not taxed each year but are only taxed at the beginning or the end. You do not pay an extra tax penalty every year on your retirement savings if they are taxed on an EET basis, so they compound at a much higher rate.
This result was first demonstrated by a famous University of Cambridge economist, Lord Kaldor, in the 1950s.
However, when housing is taxed on a TEE basis and income is taxed on a TTE basis, there is a big difference, as retirement savings are more heavily taxed than housing (the “middle letter” tax). This difference creates incentives to build larger houses and pay more for owner-occupied property. Who in New Zealand doesn’t know that the best way to save for retirement in the last 30 years has been to buy the most expensive house you can afford and wait for it to appreciate? When everyone has these artificial tax incentives, the result is artificially high land prices.
Since New Zealand started taxing retirement savings on an TTE basis rather than an EET basis tax in 1989, new houses have become much larger and land prices have gone up significantly – in fact, between 1990 and 2020 New Zealand has had a faster increase in house prices than any other OECD country. Tax is not the only reason for both of these changes, and in fact it is impossible to know how important the tax changes were because so many other things have gone on in the economy since then. Nonetheless, the way housing and retirement savings are taxed in New Zealand mean we are likely to have one of the most distortionary housing-related tax policies for owner-occupiers in the OECD.
EET taxes have many desirable properties, so it is reasonable to ask why all capital income is not taxed in this manner. One reason is that EET requires people to pay tax to the government when they spend their savings. Governments suspect people may “forget” to pay their taxes when they spend their savings, so they restrict EET taxes to easily monitored accounts. Retirement savings accounts are easily monitored, and in most countries they are peoples’ biggest asset after their house. If a country taxes these assets on an EET basis, it covers a big fraction of savings. But some countries also extend EET to other assets. For example, in the United Kingdom money banked directly from a person’s income into special bank accounts is taxed on EET basis. The money is taxed on withdrawal whether it has been in the account for 20 weeks or 20 years, and that way the person gets the advantage of lower taxes on their interest earnings.
New Zealand did not always tax retirement savings on an TTE basis. The Government changed the way retirement savings were taxed in 1989. This was done for two reasons. First, the government wanted to tax retirement savings in the same way as other investments, but rather than reduce distortionary taxes on other investments they chose to increase them on retirement savings. This not only made the tax on saving more distortionary, but it also increased the tax advantage enjoyed by owner-occupied housing over other asset classes. (If you read the original documents, the government didn’t even consider the effects on house prices, even though housing is the biggest asset class in New Zealand).
This was an ill-wind that served property-owning baby-boomers very well, for it artificially inflated house prices. Secondly, the government wished to collect taxes earlier, as tax is paid much later under an EET system than a TTE system. This helped reduced the government deficit and the government debt in the medium term. To some extent, however, this reduction is offset by a corresponding increase in private debt as private agents exchanged later tax obligations for earlier tax payments.
The good news going forward is that it is possible to reintroduce EET taxation on the KiwiSaver accounts of younger New Zealanders. This can be done without changing the tax rules for older New Zealanders, as the one thing you can’t change in your life is your birthdate. Younger New Zealanders should consider adopting the international standard approach, not just because it raises the return from their KiwiSaver accounts, but also because it should reduce the extent that house prices are artificially inflated by the tax system. As any young person will attest, reducing factors that artificially inflate house prices is likely to have a very big effect on their welfare.
EET taxation of retirement income is not, of course, the only way New Zealand’s tax system affects housing. The overall way tax distorts housing is a much bigger topic, to be explored next week.
*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 9 in the series. You can find all other articles in the series to date 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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