Reserve Bank favours lighter capital tax

The IRD says the plan would mean a big drop in tax revenue. Photo / Mark Mitchell

As a measure to boost national savings, the Reserve Bank is advocating the Nordic tax system where income earned on capital is taxed much more lightly than the top tax rate on labour income.

In its submission to the Savings Working Group it also pushes, as it has in the past, the case for taxing only the real or inflation-adjusted interest income of savers, while allowing businesses and landlords to deduct only their real, not nominal, interest expense.

But like the Treasury the bank argues that the biggest and fastest thing the Government could do to lift national savings would be to return its own operating balance to the black as soon as possible.

It estimates that the Government is running a structural deficit (that will not close automatically as the economic cycle improves) of around 5 per cent of gross domestic product

"The large deficits are now probably exacerbating the overvaluation of the exchange rate, simply because they are providing support for domestic demand in ways that mean the official cash rate is set higher than it need otherwise be," it says.

Raising government savings would to some extent be offset by lower private savings, but probably by no more than half.

"If the structural deficit is now around 5 per cent of GDP, closing that deficit quite quickly would also quite quickly add 2.5 percentage points to the national savings rate, with a commensurate reduction in the current account deficit. No other plausible policy changes could reasonably be expected to have effects on that scale over, say, the next five years."

The bank likes the Nordic system where capital income, such as profits, rents, interest and dividends, is taxed at a flat rate lower than the top marginal tax rate on labour income.

"Business investment (and saving) typically responds more aggressively to tax changes than the willingness of people to work does," it says.

While this would appear to be a change that favoured investors and employers, "research evidence is clear that the bulk of taxes levied on owners of capital are actually, in economic effect, borne by wage and salary earners. Less private investment means, over time, less productivity and less wage growth".

But Inland Revenue in its submission to the Savings Working Group says it would be administratively complex and involve a complete redesign of the income tax system.

It would only be worth considering if the tax on capital income were cut way below the current 28 per cent company tax rate.

If it were cut to, say, 17.5 per cent, it would reduce tax revenue by more than $3 billion. That would require either substantial cuts to Government spending or substantial increases in other taxes.

A less radical change in the same direction would be to extend the PIE regime which already limits the tax on income earned in a portfolio investment entity to 28 per cent while other income can be taxed at up to 33 per net.

Tax officials say that extending the 28 per cent rate to interest earned on bank deposits and dividends from widely held companies could cost about $300 million a year in revenue.

While money would be likely to flow out of PIEs into other assets, tax officials doubted there would be large amounts of new investment as a result of such a change.

On indexation - making only real interest income taxable and real interest costs deductible - the bank questions the fairness or efficiency of a system than can see the real income of a pensioner's modest bank deposits taxed more heavily than a wealthy business person's labour or entrepreneurial income.

And allowing full deduction of nominal interest for investment properties may have exacerbated the housing boom, it says. But officials also argue that adopting a system unique among developed countries might create opportunities for tax avoidance.

Nordic system
Capital income - such as profits, rents, interest and dividends - is taxed at a flat rate lower than the top marginal tax rate on labour income.