Capital gains 'loophole' in NZ tax system

An alternative way of taxing rental properties would be to ignore rents and interest deductions and have tax a deemed rate of return instead. Photo / Janna Dixon

The lack of a general capital gains tax is a giant gaping loophole in the New Zealand tax system, which mainly benefits the rich, says American tax expert Professor Len Burman.

Burman teaches at Syracuse University, New York, and formerly headed the highly respected Urban-Bookings Tax Research Centre, used as a source of unbiased analysis of candidates' tax plans in last year's US presidential election.

He delivered a paper on taxing capital gains, co-authored by David White of Victoria University, on Wednesday to the tax working group which is looking at how to overhaul the New Zealand tax system.

In most ways New Zealand's tax system is much better than in most other countries', he said, with the conspicuous exception of the absence of a capital gains tax. It creates incentives for people to invest in tax-free assets and not enough in more productive assets, and to engage in tax shelters.

"With a 38 per cent top income tax rate and 0 per cent capital gains tax rate, a tax shelter that could transform $1 million of ordinary income into capital gain is worth up to $380,000 to create. That is why geniuses who might otherwise do productive work have been drawn into financial engineering," the Burman and White paper argues.

With such huge tax incentives the investments that produce capital gains do not even have to be particularly productive. In the end, capital gains were income and should be taxed, Burman said.

There is an equity argument, too. Taxing capital gains would boost the overall progressivity of the tax system.

"The richest 10 per cent of New Zealand households hold 44 per cent of non-housing investment assets," he said. "In the United States, millionaires get 50 per cent of their income from capital gains."

The most common argument advanced again capital gains taxes is the "lock in" effect: That they encourage people to hold on to assets longer than they should or otherwise would.

Burman's own research leads him to conclude that effect is overstated. Other factors, like prevailing asset prices, are much more of an influence on when people sell things.

The concern is more relevant in the case of owner-occupied housing, where people might stay in houses the wrong size for their current circumstance. But owner-occupied housing tends to be exempt from capital gains tax either altogether, as in Australia, or up to a fairly high threshold, US$500,000 in the United States.

PricewaterhouseCoopers chairman John Shewan is sceptical about the case for a capital gains tax. New Zealanders are particularly heavily invested in housing, two-thirds of it owner-occupied, Shewan said. "If you are going to carve out two-thirds, is it worth the trouble to deal with the other third?"

Other options are a land tax or property tax, he said, or a more targeted solution to deal with rental properties.

Around $200 billion is invested in rental properties and the tax yield is "disappointing", Shewan said. They provide no net tax revenue in fact, but rather $150 million in tax losses available to shelter other income from tax because rental yields are so low. An alternative to capital gains tax as a way of taxing rental properties would be to ignore rents and interest deductions and the rest and have tax a deemed rate of return instead.

"But if you do that you would expect rents to go up."

Burman and White emphasise the importance of making such changes as part of a package of reforms which would have to be viewed as a whole. Any extension to the tax base, like a capital gains tax, or increase in, say, the GST rate would be likely to be accompanied by taxpayer-friendly moves like a lowering of income tax rates and adjustments to transfer payments to those on low incomes.

"You try to inflict the pain equally so that you are not just picking on one group and there is a sense the burden is being shared fairly," White said.

Burman said that the last time the capital gains tax rate was raised in the United States, during the Reagan Administration, it was part of a tax package that also lowered the top income tax rate from 50 to 28 per cent.

Preliminary estimates are that a capital gains tax would bring in $1.5 billion if housing is excluded and $4 billion if it is not. That assumes gains would be taxed at the same rate as the taxpayer's other income, whereas many countries tax gains at a lower rate. In 2006/07 Australia's capital gains tax brought in A$17 billion.

The theoretical ideal would be to tax only real gains and on an accrual (or annual) basis. In practice it is nominal gains that are taxed and only when the asset is sold.

That is partly because of the difficulty of valuing unrealised gains for many kinds of assets and because of the unpopularity of tax bills which occur when there is no associated cash flow out of which to pay them.

Charting course on tax policy

The tax working group was set up in May under Government auspices to chart a course for tax policy over the medium term.

It is chaired by Victoria University's Pro Vice-Chancellor, Professor Bob Buckle, and brings together leading private sector tax practitioners, academics and officials from Inland Revenue and Treasury.

Its most recent meeting, on Wednesday, looked at revenue raising options, including capital gains tax.

Its deliberations are expected to be presented in a report early next year.

Papers presented to the working group and its minutes are at:
www.victoria.ac.nz/sacl/CAGTR/taxworkinggroup/index.aspx