With the influential Victoria University Tax Working Group's final report due this month, the Business Herald launches a series of reports looking at the way the Government gathers its revenue.
In the first, Professor Craig Elliffe looks at the problems that currently exist in the New Zealand tax system.
'The nation should have a tax system that looks like someone designed it on purpose.'
So said William Simon, who was a US businessman and US Secretary of Treasury in the Nixon Administration and a philanthropist. Throughout the past year the Victoria University Tax Working Group has laboured to analyse problems facing the tax system and to suggest reform.
The group of academics, accountants, economists and lawyers worked closely with tax policy officials from the Treasury and the Inland Revenue.
This month their final report will be released with recommendations for the Government. Some of these suggested tax changes may be incorporated into Government policy, perhaps in the 2010 Budget.
It would be easy to assume the international financial crisis was the catalyst for this tax review, but in fact the current and forecast Budget deficits are only part of the picture - a hugely worrying part, even with the economy starting a tentative recovery.
Secretary to the Treasury John Whitehead disclosed that Budget forecasts for growth show the economy nearly $50 billion smaller over the next three years compared with what was forecast last year.
Next year the economy is forecast to be the same size as it was the end of 2007. Budget deficits (currently $7.7 billion and $9 billion for 2010) are forecast until 2016, at which stage the Government debt will be 43 per cent of GDP. Every single New Zealander will owe roughly $28,000.
Before this huge Budget deficit, successive briefings by the Treasury and Inland Revenue highlighted some problems with the tax base. The most significant problems facing the tax system can be simplified as follows:
The mobility of the tax base: New Zealand is heavily reliant on both its corporate tax take and on the personal taxation of high-income earners representing a low percentage of the total workforce. Companies have the third-highest tax burden in the OECD (measuring tax revenue as a percentage of GDP), and the Treasury is still concerned the company tax rate is among the highest in the smaller OECD economies.
The burden of personal tax is also high, with New Zealand again the third-highest in the OECD in percentage terms. In the 2009 Budget the top 1 per cent of taxpayers pay 15 per cent of the tax, while the top 3 per cent pay 26 per cent. It is not known if these high effective rates of tax contribute to our having the highest diaspora (population of New Zealand-born expatriates) of skilled workers in the OECD, but highly skilled people are mobile and sought after in the global economy.
Taxes that damage economic growth: A related problem to our high taxation of business (in particular company) and personal income taxes is that, according to the Treasury, there is growing evidence these types of taxation are bad for productivity and the most negative for growth.
In general terms, while spending on infrastructure and education in particular has a positive effect on economic growth, taxation has a negative effect. Some taxes are worse than others and about 60 per cent of our tax revenues comes from these two sources.
A lack of horizontal equity: Horizontal equity is a principle used to judge the fairness of taxes. Taxpayers who have the same income should pay the same amount in tax. But as an individual is subject to tax at 38 per cent on the highest rate of income, the company in which he or she invests, or carries on business through, is subject to tax at 30 per cent. Meanwhile the family trust, of which he or she is the beneficiary, pays tax at 33 per cent. Investments are taxed at 30 per cent under the portfolio investor entity (PIE) regime.
The most stunning example of a lack of horizontal equity is of course capital profits. Someone who earns a wage or salary of $100,000 and pays tax of $27,550 (at the varying progressive tax rates) can be compared with someone who sells their holiday home with a profit of $100,000 and pays no tax.
The fairness of a tax system is at the very heart of good taxpayer compliance. Public perception of a tax system is crucial to compliance because people pay their taxes upon the understanding that others do the same.
The result of having different tax rates has meant significant time and energy has been spent on tax planning.
The evidence of this behaviour is irrefutable based upon Inland Revenue statistics which include:
The number of taxpayers who fall just below a threshold in increasing tax rates (illustrative of individuals paying a salary from a business of an amount just below the threshold for the highest marginal tax rate);
The increasing amount of retained earnings in companies and associated imputation credits (this indicates that profits are not being distributed after they have been taxed at 30 per cent because the shareholders will have to pay a higher 38 per cent tax rate);
Increasing amount of trustee income retained by family trusts (this indicates the trust will pay tax at 33 per cent upon income it has received and then the trustees have not distributed this income to beneficiaries who would otherwise pay tax at 38 per cent).
I am sure the individual taxation of investment income will be also significantly reduced as investors divert their investments into entities with the same investment profile that pay tax at 30 per cent rather than 38 per cent.
Such behaviour is understandable, and some would say rational, given the system's lack of coherency.
Extremely high effective marginal tax rates (EMTRs): EMTRs measure the proportion of an additional dollar of income lost either through taxation or through an abatement of some credit or social assistance.
The major contributor to this problem is the Working for Families tax credit scheme, designed to help families with children by adjusting tax payments. Sometimes these payments are adjusted so some people pay "negative amounts of tax", that is, they get larger transfer payments than they pay in income tax. As their income rises the amount of aid they get abates.
The rate of abatement in some cases can be greater than 100 per cent. In 2008 nearly 170,000 people in the country were on tax rates above 50 per cent.
At least two problems arise from high EMTRs and to a certain extent from the tax transfer system itself. The first is a limited incentive to earn extra income if the benefit to an individual is small after suffering the EMTR. Why earn a dollar if it will be taken away?
The second problem, consistent with any egregious rate of tax, is that a taxpayer is incentivised to devise tax planning structures. An example of this may be the nearly 10,000 families who get Working for Families tax credits who also offset rental losses against their other income. They may not be eligible for the tax credits unless they had organised to reduce their income through the rental loss offset.
As recently as 2001 overseas tax experts were lauding the New Zealand tax system, describing its broad base and low-rate policies, with an excellent consumption tax, as a model system. 2010 provides the opportunity to recover lost ground.
* Craig Elliffe is the professor of taxation law and policy at the University of Auckland Business School and a consultant to Chapman Tripp, barristers and solicitors. Any opinion expressed in this article is that of the writer and not the University of Auckland or Chapman Tripp.
