Brian Fallow: The case for a tax revolution

Phil Goff. Photo / Mark Mitchell

To arms, citizens! Form your battalions!

Something less rousing than the Marsellaise is likely when Labour officially launches its tax policy today, Bastille Day.

But the prospect of a more comprehensive capital gains tax does seem to have joined National's plans to sell down state assets as a defining issue for the election.

In judging the merits of the tax it is important to keep two things separate.

One is the fiscal policy question - how much to tax?

The other is the tax policy question - what to tax?

All else being equal, like a government's revenue requirements, the broader the tax base, the lower tax rates can be.

And the less likely it is economic decisions will be driven by tax considerations.

The case for taxing capital gains is pretty straightforward, even if the tax itself would be anything but.

It is that capital gains are economic income, and we have an income tax.

Boy, do we have an income tax.

Even after last year's "tax switch" New Zealand stands out among developed countries in the extent to which it relies on taxing personal and corporate income for tax revenue.

We are also an outlier in not taxing most capital gains.

Some are taxed, of course, essentially the gains made by those who actively trade in assets, including the fund managers to whom we entrust retirement savings.

A more comprehensive capital gains tax would make the tax system more progressive and in that sense fairer.

Statistics New Zealand's survey of family, income and employment, known to her admirers as SoFIE, found the richest 10 per cent of households own 44 per cent of investment assets (excluding the family home).

The distribution of assets is even more unequal than the distribution of incomes.

And the ownership of business assets in particular is heavily concentrated in the top decile.

A capital gains tax would address the anomaly that some of the returns to investment are taxed - rents and company profits - while the capital gain portion of the investor's return is not.

The prospect of capital gain can be a large part of the price the investor pays.

It would be impossible to justify the prices rental properties have commanded in recent years solely on the basis of the taxable income stream they could be expected to generate.

Which brings us to the macro-economic case for a capital gains tax that would include investment properties.

New Zealand just cannot afford a fresh bout of the property fever that marked, one might say disfigured, the last decade.

House prices doubled in the space of five years; incomes did not.

The rise in the ratio of house prices to incomes has pushed the first rung of the housing ladder much further off the ground than it used to be, creating one more reason for young people to try their luck overseas.

The associated accumulation of debt, much of it funded offshore, will weigh on the economy for years.

The associated inflation drove interest rates and the dollar to levels that did all sorts of collateral damage to sectors we rely on to earn our living as a trading nation.

The Government argues that the tax changes in last year's Budget dealt to that.

Scrapping the top income tax bracket reduced the value of highly leveraged investment properties as a tax shelter, while tougher rules on depreciation and LAQCs also reduced their relative attractiveness as investments.

Labour, Prime Minister John Key declared on Monday, is "fighting a problem they had when they were in office, not a problem we have today".

But it is dangerously complacent to assume New Zealand is immune from another bout of house price inflation.

It's a simple matter of supply and demand. The population continues to grow, but there has been a slump in new residential construction over the past three years.

The construction sector faces huge demands on its resources: the rebuilding of Christchurch and billions of dollars of leaky homes still in need of repair, as well as any pent-up demand from the recent slump in building.

The last thing we need is for any surge in prices driven by those fundamentals to be amplified by highly leveraged band-wagoning speculation in pursuit of untaxed capital gains.

That is not say a capital gains tax would preclude a repeat of the housing market boom. As critics of the tax point out, other countries which have a capital gains tax also had housing booms - though New Zealand's was particularly strong.

But even if last year's tax changes provide some inoculation against a return of property fever, a booster shot by way of a capital gains tax is a precaution worth taking.

More generally, tax changes which anchor the prices investors are prepared to pay for an asset more securely to the taxable income stream it will generate should be less distorting and more efficient.

Timing is important, too.

It is likely that a capital gains tax would be designed to capture only future gains, not past ones, and upon realisation rather than the theoretically purer accruals basis.

If capital losses can only be used to offset taxable capital gains, it makes sense from a government's point of view to introduce such a tax at or near the bottom of the cycle, in order to minimise such losses being carried forward.

It is also likely that the rate of the tax would be significantly lower than investors' marginal income tax rate.

That would provide some offset for inflation over the period an asset is held, mitigate the risk of lock-in and recognise the desirability of not discouraging risk-taking too much.

Key on Monday implicitly invoked the spectre of a flood of tax exiles under Labour's policy.

A new tax was unnecessary, he said, and would just be a dagger through the heart of growth.

"We don't need another tax in New Zealand. We need more taxpayers. Labour is saying if you are a top taxpayer your [income] tax is going up, you will certainly pay more capital gains tax and frankly you're not welcome in New Zealand."

Such rhetoric may resonate in some quarters, but it reduces a debate we need to have about equity and efficiency in the tax system to the crude idea there is some sort of binary choice between the politics of envy and the politics of aspiration.

People who can realistically aspire to being in the top income bracket are leaving anyway on current policy settings, and so are people with more modest aspirations, like owning their own home. When they go a little bit of the tax base goes with them.

In these circumstances broadening a perilously narrow tax base is not an option to dismiss out of hand.