Brian Fallow: Desperate search for the tax-hole plug

If the tax man had had a decent feed out of the $300 billion house-price gain between 2002 and 2007, we might well be in better shape today. Photo / Paul Estcourt

The recession's impact on business has punched a $2.5 billion hole in the Government's revenue.

It has also highlighted structural weakness in the tax system.

By the end of April - five-sixths of the way through its financial year - the year-to-date corporate tax take was running 27 per cent lower than over the same period last year.

That represents $2.5 billion less tax and it means corporate taxes will contribute less than 14c in every dollar of tax collected this year, compared with 18c last year.

While the Treasury's forecasts have the economy expanding again, albeit feebly, by the end of the year they do not expect corporate tax flows to return to 2007/08 levels until 2012/13.

And that assumes, unsafely, that New Zealand will not have to respond to whatever the Henry tax review in Australia decides to do. What if it decides to scrap dividend imputation and have a deep cut in the corporate tax rate?

At 30c in the dollar the company tax rate is above the average for smaller OECD countries and rates have been trending down.

In a globalised world no country, least of all one as reliant on imported capital as New Zealand, can afford an uncompetitive corporate tax regime for long.

The revenue looks vulnerable on another front too. The 9 per cent of taxpayers who are in the top tax bracket, $70,000 plus, are expected to contribute 42 per cent of the income tax take this year.

Given how mobile people who can aspire to be in the top tax bracket are and the size of the income gap which has opened up between New Zealand and Australia, and most other developed countries too, such a steeply progressive tax scale does not look very smart or very sustainable.

And it is not just the high income earners who face high rates of tax on the next dollar of income they earn. The abatement of family tax credits can slap an additional 20 percentage points on the effective marginal tax rates of people on relatively modest incomes - pushing them over 50 per cent for about 15 per cent of primary earners (the main income earners in households), according to Treasury secretary John Whitehead.

Meanwhile, the rules for taxing investment income are riddled with anomalies, inconsistencies and fuzzy boundaries. How much tax you pay depends on what asset class you invest in, what country it is in and what vehicle you use.

The aversion to the concept of a capital gains tax is widespread.

This is odd, on the face if it, in a country with at least some residual pretensions to egalitarianism. If you increase your wealth by working you get taxed, and often quite hard, but if you increase your wealth by owning the right property over the right period that is supposed to be sacrosanct. Well, why?

Between 2002 and 2007 house prices doubled, adding over $300 billion to the assets side of households' balance sheets. Household debt also doubled, but incomes of course did not.

If the tax man had had a decent feed out of that $300 billion we might well be in better shape today, with a stronger Government balance sheet and perhaps some lower tax rates.

Prime Minister John Key does not support capital gains taxes. They don't prevent bubbles, he said, they are hideously complex and they impede people moving their assets around.

Well, they may not prevent asset bubbles but if you are going to have a bubble maybe you should tax it. Isn't there a case for taxing things you want less of rather than things you want more of?

They may also prevent the bubble from inflating quite as much as it otherwise would before it bursts all over everybody. The OECD notes that during the housing boom the ratio of house prices to incomes rose more in New Zealand than in any of 18 other developed countries it has comparable data for.

But a capital gains tax is not the only option for reducing the distortions the current tax treatment of housing gives rise to.

The tax laws treat someone who buys an investment property as having gone into business, the landlord business. Costs incurred in earning a taxable income (rent) are deductible, including interest. Nothing unusual about that.

Except that few other investments allow the same degree of gearing. Good luck going to a bank with nothing but a business plan and a proposition that begins, "Now with $5 of my money and $95 of yours, I'll be able to ..."

The Reserve Bank sees the central distortion as between investments undertaken for (untaxed) capital gains and those undertaken for an interest stream, which is taxed.

It has argued, so far in vain, for reducing the gap between them by only taxing the real interest rate paid, and not that part which is compensation for inflation. Likewise only real interest costs should be deductible.

There have also been periodic suggestions to "ring-fence" property investments so that if deductions exceed income the tax losses cannot be used to shelter other income. It is hard to make a principled case for that, however.

The 2001 tax review chaired by Rob McLeod, who is also on the new tax working group set up to mull over these issues, proposed a radical change, a wealth tax to fund serious cuts in income and company taxes.

Assets would be deemed to return the same as Government stock and that return, less an allowance for inflation, would be taxable income. In practice it would be little over 1 per cent of the value of the asset per annum.

Perhaps unwisely they extended this to the family home, on the rather pure ground that owner occupiers benefit from imputed rents.

But at least it illustrates that a capital gains tax is not the only way of skinning this cat.

Talking to the tax working group last Friday Whitehead reiterated the Treasury's (and OECD's) mantra that we "need to shift taxes from bases that are internationally mobile and have the most detrimental impact on growth to those that are less mobile and less damaging to productivity growth".

That means, he said, reducing high marginal personal tax rates, equalising rates of tax on different forms of income and moving towards a tax system more heavily weighted towards consumption taxes and a greater contribution from property taxes.

Quite. But even if we can agree that that is the way to go it leaves the political problem of how to get there from here: Gingerly, gradually and in a bipartisan way.