Gareth Morgan: Capital gains tax best way to tackle rot

Those of greatest need are often not those receiving the most under New Zealand's redistribution system. Photo / Brett Phibbs

Opinion

The tax move would help fix damage from years of exploitation, writes Gareth Morgan.

All capital yields a return. It may be in the form of taxable income, it may not. But people own or rent capital (land, structures, plants and equipment) for the services provided.

We own or rent our houses for the shelter they provide, our plant and machinery (cars, boats, home appliances, sausage-making machines) for the widgets or services that are generated.

What's produced we either sell or use ourselves but it is income.

Theoretically at least all income should be taxed if it is a fair income tax regime we seek. Practical difficulties can compromise achieving that goal but we must take great care over the inequities and inefficiencies created when we step back from the purist's "ideal" income tax.

The second aspect of equity with tax regimes is that the ability of someone to pay tax is a fundamental differentiator in a mixed capitalist and government economy like ours.

The principle of taxation is that those with the greatest ability to pay tax should shoulder the greatest burden and those with the least should be the greatest beneficiaries of State redistribution.

Governments redistribute in a couple of ways - by providing equal access to a number of services, such as law and order, education and public health, and via direct transfers from the well-off to those who are not.

Redistribution is not just about absolute need it also reflects a government's values about wealth distribution. We have plenty of examples in the world where a wide division between rich and poor leads to political and social instability.

Societies like New Zealand have, at least in theory, eschewed that societal model long ago and so redistribute via the tax, transfer and government spending regime to achieve goals around capping disparities between rich and poor.

Labour looks like it's about to announce a capital gains tax. This type of tax has long been the subject of debate in New Zealand and at present we have a selective capital gains tax.

Tax applies if the purpose of your investment is to make a capital gain, in theory. I say in theory because a paradoxical feature of our investment landscape is the large number of assets that do not yield an income rate of return even equal to the risk-free rate the Government pays on its bonds.

Why then, you would wonder, would folk invest in assets whose income return is so deficient, if their purpose of investment was not capital growth, and why if this is the true objective do they not pay tax on capital gains? They will argue they're waiting for the long term when the income will grow, so really they are after income.

Rubbish. The reality is commonly quite different, capital growth is a very attractive objective given that in reality it is easy to make it tax free. So long as the tax regime is so porous, we're encouraged to think along these lines, and to the extent we all do, we will all behave in the same manner and the capital gains will be assured. It is a self-fulfilling consequence of a compromised tax regime.

The allocation of our capital in New Zealand is not consistent with maximising productivity, or the generation of income. It is this that is responsible for our poor growth in per capita incomes over several decades now, and our slippage down the OECD league tables.

But from the individuals' perspective, if you can make the most of your return from asset price appreciation then income generated is of secondary importance.

Back to tax. The vertical equity principle is one the tax and welfare regimes of most Western societies were founded on. It takes from each according to their means, and gives to each according to their needs.

The horizontal equity principle holds that persons in similar circumstances should have the same opportunities and be treated the same by the Government's redistribution regime. These are two of the rulers analysts run over a tax and benefit regime to measure its effectiveness.

On both counts the New Zealand regime has long been defunct. The highest contribution to the tax collect is not made by those with the greatest means, it is made by those with the highest taxable income.

These are not the same thing. I have a lot of wealth but very little income, I know of income earners who pay a lot more tax than I do.

Similarly, the greatest beneficiaries of the State redistribution regime are not those with the greatest need. I know of many folk receiving benefits (Working for Families and NZ Superannuation are total crocks in this regard) who have assets to die for.

Our redistribution regime is broken, it cannot be rectified with still more patches to a rotten core. We have a chronic misallocation of capital. Investment in capital here has very little to do with the taxable income generated, in some cases it is inversely proportional, people with the greatest means to pay tax are commonly asset-rich and deliberately income-poor. The time for a tax on capital is overdue.

Specifically the tax should be levied on the value of the capital; should be liable every year with very limited scope for deferral; and should equate to the tax that would be paid if that capital was returning the minimum required rate of return we expect our capital to furnish. That is, the Government bond rate.

Income tax on capital earnings should then be levied in addition, albeit only upon the excess income earned above the minimum required rate. There should be no exemptions, certainly not the family home which is the biggest tax shelter presently available.

Reform of just this part of the tax and benefit regime is necessary but not sufficient to get our redistribution regime back on the rails and I'll outline more about what else is required in a later piece.

But a country with such a poor record on capital allocation cannot continue to be oblivious to the reality that the tax burden is skewed, without risking a major and damaging capital markets crisis eventually.

Labour looks like it's got its head at least around the issue that we have a huge hole in the efficient and equitable taxation of capital. The rumoured capital gains tax on realisation though, with an exemption for the biggest loophole of them all, the owner-occupied home, is a very poor way to address the issue. Tax dodging on capital gains taxes is simple, issues arise around impeding the pace of capital trading via lock-in, and revenue is volatile.

But Labour should at least be congratulated for addressing what we all know is the biggest tax rort in the country and one that has cost us all dearly in terms of efficient allocation of capital, economic growth and employment.

* Gareth Morgan is a director of Gareth Morgan Investments and, with Susan Guthrie, the author of the forthcoming book The Big Kahuna about tax and welfare in New Zealand.