Bernard Hickey: Tax break attracts serious thinkers

Encouraging New Zealanders to invest more in term deposits would help reduce reliance on foreign borrowing. Photo / Thinkstock

This week the mandarins in Wellington seemed to agree on the need to look at a tax break for savings in bank accounts and bonds.

Treasury and the Reserve Bank say the Savings Working Group is looking at such a break, which should be considered as part of measures to get New Zealand saving more and reduce the economy's imbalances and vulnerabilities.

Currently, interest payments on term deposits and bonds pay tax at regular income tax rates, often collected by banks as a withholding tax. It is the major reason many savers have chosen rental property and other types of investment.

Once inflation has done its dirty work, savers are effectively paying a much higher tax rate than on returns from other sorts of assets.

"At present, the marginal tax rate on the real income earned on a pensioner's modest bank deposits may well be considerably higher than that on a wealthy business person's labour or entrepreneurial income," the Reserve Bank said in its submission to the Savings Working Group.

The other side of the interest coin had added to the demand for rental properties as investors could claim the full nominal interest payments as a cost against taxable income, effectively widening the tax advantage compared with term deposits. The Reserve Bank suggested only the real component of interest paid could be claimed.

Treasury estimated this week that savings in bonds and term deposits pay an effective real tax rate of almost 50 per cent, double the effective real tax rate on rental property. No wonder it has been so popular over the past decade.

But what if the inflation component of interest returns were tax exempt? Currently term deposits pay around 5 per cent. Once the effects of inflation of around 2.5 per cent are taken out that would about halve the tax on interest returns.

The Inland Revenue Department has estimated such a tax break would cost the Government around $1 billion a year. In the year to June the Government reaped $1.8 billion in tax from withholding payments from $92 billion of term deposits.

Such a tax break would help level the playing field with property, but would be expensive.

There are other benefits though.

Encouraging New Zealanders to invest more in term deposits would help reduce reliance on foreign borrowing. The Reserve Bank's core funding ratio is pushing banks to raise more funding from local term deposit and longer term sources, reducing vulnerability in the event of another Lehman-style freeze.

Such a tax break would also reduce the incentive for many elderly savers to chase higher yields in riskier schemes at a time they can least afford it. The finance company collapses are a lesson here.

One counter argument is that it effectively provides a government subsidy for savings in banks, thus, in theory, boosting the profits of the Australian-owned companies.

It will be a debate the Government considers as it prepares to improve savings in the Budget next year.

bernard.hickey@interest.co.nz