Brent Sheather: New tax has savings industry under threat

It is a more than little ironic that a Labour Government, which bravely floated the New Zealand dollar in 1985, thereby permitting New Zealanders to invest overseas, should now be effectively legislating against the practice.

Make no mistake - the proposed capital gains tax on overseas investments will, if enacted, fundamentally change the nature of the savings industry - for the worse. Returns will be lower, risks will be higher and history may well record Michael Cullen's legacy alongside that of arch-market meddler Sir Robert Muldoon.

Don't count on Mum and Dad or their advisers seeing this proposal for what it is and doing the right thing: New Zealanders have a long history of letting silly tax laws push them into sillier-still investments.

Goodness knows how much capital was wasted on ill-conceived horse and forestry investments in the 1980s. This capital gains tax will be easily and popularly avoided. We have been given two years in which to get our affairs in order so Mum and Dad will likely forget the standard investment theory that says one should diversify far and wide, forget relative yields and forget diversifying by currency.

It will be just a matter of picking the low on the exchange rate, bringing the funds home and finding a reasonably priced two-bedroom apartment in Auckland to reinvest in.

So what prompted Cullen to introduce such bias to investment decisions? The discussion document gives the ridiculous example of a hypothetical New Zealand investor who bought Dell shares 10 years ago. This lucky person has apparently enjoyed a 50-fold increase in his/her wealth without paying any New Zealand tax. It's a great story, but does this person exist anywhere but in the minds of Cullen's advisers? Hands up all those investors who bought Dell shares 10 years ago? My guess is that you could get all these long-term local Dell shareholders into the back seat of a small Japanese car.

Anecdotal evidence suggests that increasingly, "overseas" for most Mum and Dad investors is Australian shares such as Westpac, BHP, ANZ.

Unlike Dell, stocks such as Westpac pay a decent dividend, thus producing a meaningful income stream, which can be taxed.

Westpac shares yield about 6 per cent, which means that the IRD is getting as much tax revenue from $1000 of Westpac as it is from $1000 in a bank deposit.

No big avoidance deal there - in fact, Westpac has increased its dividend by about 15 per cent per annum over the last 10 years.

The IRD, and thus New Zealand, benefit from the growth of the Australian economy, and incidentally diversify their own earnings stream.

The good news is, of course, that the tax changes are only proposed and there is an election looming.

Our best hope is that Cullen will realise the magnitude of the error he is proposing and scrap the plan or, failing that, New Zealanders will realise the folly of the proposal and scrap the Government.

What is perhaps of more concern is that Cullen's advisers would even let such a silly proposal out into the public arena. What else might they dream up to disrupt rational decision-making - car-less days, or perhaps a price freeze. Little wonder the New Zealand dollar has started to fall.

So, apart from a weaker dollar and the possibility of a change of Government, what are the implications of the proposed capital gains tax for Mum and Dad, retired in Mt Maunganui?

Whichever way you look at it, lower prospective returns from overseas growth assets imply higher weightings back home for all but the ultra-wealthy who can afford to take a truly low-risk and long-term view. To calculate the impact of the proposed capital gains tax on Mum and Dad portfolios, we need to estimate the prospective capital growth of overseas shares.

Economics tells us that the return for shares is equal to the current dividend plus the rate at which the dividends will grow in the future.

For most investors, dividends are and always have been taxable, and the proposal is to tax the growth as well. So let's calculate tax on growth.

In the US for the past 100 years or so, growth has averaged 1 per cent plus inflation of 3 per cent to give a total of 4 per cent. On this basis, Cullen's tax on growth will reduce after-tax returns from international shares (assuming dividend yields are equal to 2 per cent and the tax rate is 33 per cent) by 1.3 per cent, that is to say from 5.3 per cent to 4 per cent.

With prospective returns already extremely low on international shares the capital gains tax proposal might well be the straw that breaks the camel's back.

Also remember that the 4 per cent return is before management fees, which will no doubt move upwards because of these increased compliance costs.

What makes the Cullen proposal all the more significant is New Zealand investors' historic love affair with international shares.

According to fund manager UBS Global Asset Management, investors in Australia, Britain and the US have an average of 40 per cent, 35 per cent and 19 per cent of their shareholdings outside their domestic markets.

But here, according to Aon Consultants, at the end of March the average pension fund had shipped 71 per cent of its share portfolio to greener pastures.

Some of this is due to the dismal performance of New Zealand stocks in the 1980s and 1990s and the scandalous behaviour of some New Zealand executives in the past.

It's also due to clever marketing by the local financial planning industry.

And, of course, investing overseas makes particular sense to New Zealanders because of the small size and narrow focus of the local market.

Even today, many financial planners typically allocate 60 to 70 per cent of a retired investor's share portfolio to overseas stocks.

Fund managers, financial planners and consultants have constructed highly profitable businesses selling the "invest offshore for growth" story on the basis that this will achieve higher returns and be less risky.

Cullen's proposal thus poses a huge threat to the structure and profitability of the savings industry - from the financial planners who are able to charge higher fees on international portfolios to the consultants who specialise in offshore multi-manager mandates to the banks that buy and sell the foreign exchange.

They will be watching the election closely and if Labour is re-elected, the lobbying will start in earnest.

* Brent Sheather is a Whakatane based investment adviser.