Brian Fallow: Tinkering won't fix creaking tax system

Exempting farms from a land tax would not eat into potential government revenue as much as one might think. Photo / Mark Mitchell

There was a whiff of incrementalism, even complacency, about Finance Minister Bill English's comments to the tax working group's conference on Tuesday.

"We are not in a state of emergency with respect to revenue. We can take a long-term view," he said.

"Not all the choices we might take need to be taken at the start."

Those comments suggest next year's Budget may not be the game changer people are looking for.

Had he been able to stay for the rest of the conference and listen to the presentation by some of the working group's members he would have got a clear message that the tax system has deteriorated beyond the point where tinkering and tweaking are enough.

"There is a strong view the current system is not working as effectively as it could and needs reform if New Zealand is to have a fair tax system and one that is less damaging to economic growth," the working group's chairman, Bob Buckle, said.

Serious consideration should be given to the options for broadening the tax base, he said.

In deciding what to make of the working group's conclusions, most likely to be released in the new year, there are some basic propositions the Government needs to keep in mind.

First is the view among tax economists at the OECD and elsewhere that we are taxing the wrong things.

From the standpoint of maximising economic growth and living standards, the worst things to tax are those which can up stakes and leave, like capital and labour.

Taxing consumption is better, but tends to be regressive.

The best, least-distortionary thing to tax is something which is immobile and the supply of which is not sensitive to taxation, like land.

The second essential thing to remember is that New Zealand's productivity level is low relative to Australia and indeed most other developed countries. That in turn reflects capital shallowness - too little capital invested per worker.

So internationally respectable rates of investment, as a share of GDP, and productivity growth will not cut it, because they are off a low base.

That suggests tax reform needs to lessen the taxation of capital income.

In any case - and this is a point English readily acknowledges - the [Treasury Secretary Ken] Henry tax review in Australia may force our hand if it significantly lightens the corporate tax burden there.

But tax reform cannot just be about what is good for economic growth. It also has to be, and be seen to be, reasonably fair.

English stressed the political threshold tax reform would need to clear.

To be effective it needed to be durable which meant commanding enough parliamentary and public support to outweigh its "controversial" aspects - code for the howls of pain from whatever Peters get robbed to pay Pauls within a revenue-neutral package.

One feature of the status quo English singled out as unacceptable is that, within little more than a decade, fiscal drag will have pulled someone on the average wage into the top tax bracket.

So what sort of options is the tax working group likely to come up with?

They will all involve significant broadening of the tax base, both in order to reduce distortions in investment behaviour and to fund tax cuts elsewhere in the system.

Ernst and Young managing partner Rob McLeod, who chaired the 2001 tax review, said the estimated revenue cost of lowering the top personal income tax rate from 38 to 30 per cent, to align with the company tax rate, was $1.6 billion a year.

Bringing the trust rate down from 33 to 30 per cent would cost another $250 million.

There might be pressure to lower the company tax rate as well, especially if Australia did, he said. Dropping it to 27 per cent would cost another $500 million.

PricewaterhouseCoopers chairman John Shewan outlined various base-broadening measures and what they might yield in revenue.

He is not a fan of a capital gains tax. Nor is the Prime Minister or Inland Revenue or anyone much, apart from the unlikely combination of the Treasury and the Green Party.

If capital losses were recognised as well as gains there might not be a lot of revenue in it, Shewan said.

Exempting owner-occupied houses would immediately take 60 per cent of real estate outside the scope of the tax, a distortion that could encourage people to pour more money into the roofs over their heads - sometimes called the mansion effect.

Taxing gains on the sale of shares could be seen as double taxation of retained earnings.

A capital gains tax could lock people into assets they would otherwise happily sell, in order to avoid the tax.

It would be very complex to administer and the 2001 McLeod review had counselled against it, Shewan said.

The working group received from officials the arresting revelation that more than $200 billion invested in residential rental housing, representing about 37 per cent of the housing stock, yielded overall a net $500 million in tax losses to offset other taxable income, so that the revenue yield from the sector was negative to the tune of $150 million last year.

"Is this justifiable on any rational policy grounds?" Shewan asked.

A capital gains tax is not the only way of addressing that issue.

An alternative would be to tax a deemed return of, say, 6 per cent on the net equity in rental properties.

Officials estimated that would bring in around $700 million in revenue instead of the negative $150 million of the status quo.

So it would meet about half the fiscal cost of aligning rates at 30c in the dollar.

But it would be likely to have an impact on rents, Shewan said, and it was not good for the integrity of the tax system to tax just one kind of asset.

Another proposal is to limit the ability to use losses from rental properties to offset other taxable income.

As well as being ad hoc, this option has a relatively modest revenue - between $165 million and $195 million a year.

"We used to have it and it was easy to circumvent ," Shewan said.

What would bring in serious money by way of broadening the tax base is a land tax.

Motu economist Arthur Grimes, who is also in the working group, told the conference a tax of 0.5 per cent on land would yield around $2 billion a year.

A political decision to exempt farm land would reduce that but not as much as one might think.

Farm and forest land represent about a quarter of the potential tax base.