Dialogue: Everybody wants tax cuts, but govt must still be paid for

By BRIAN FALLOW

The McLeod committee, charged with undertaking a comprehensive review of New Zealand's tax system, is due to deliver its first fruits next month - a preliminary report laying out what it sees as the issues for further debate and consideration.

The tax system was radically overhauled in the 1980s. Since those reforms, however, much has changed:

* The income tax scale has become more progressive.

* Measures to target benefits have created high effective marginal tax rates for people moving back into work - the "poverty trap" effect.

* New Zealand's reliance on imported capital has increased.

* The after-tax income gap between New Zealand and other developed countries makes it harder to retain and attract skilled labour.

* Household savings rates have declined and what saving there is remains heavily concentrated in bricks and mortar.

Nevertheless, an OECD study rates New Zealand's tax system as still one of the most efficient and neutral of its member nations.

Most of the more than 100 submissions received by the tax review committee do not propose radical changes. Few challenge, for example, New Zealand's unusually high reliance on direct taxes such as income taxes.

The submissions give the committee, chaired by Arthur Andersen's managing partner, Robert McLeod, plenty of advice about what taxes should be cut.

But it has received rather less assistance on the central question of how to maintain an adequate level of funding for future Governments in a changing world.

Though the committee has before it several taxing questions, so to speak, they do not include the fundamental and supremely political one of how much tax must be raised in the first place.

New Zealand's tax burden - the ratio of tax revenue to gross domestic product - is similar to the OECD average, at 35 per cent. It has fallen from a peak of 39 per cent in 1989. But it is higher than that of our three largest trading partners, Australia, Japan and the United States.

The Manufacturers Federation says that while the amount of tax paid per head rose 44 per cent between 1975 and 1998 in inflation-adjusted terms "at the same time there is a public perception that the Government is providing less than it did previously in terms of social support and access to services."

One of the issues in the committee's terms of reference is how progressive the income tax scale should be - that is, how much (if at all) should marginal tax rates rise with levels of income.

The 1980s reforms made the tax scale flatter. They created only a 5 percentage point gap between the middle tax rate of 28c and the top rate of 33c.

But since then the scale has become more progressive: the previous Government cut the middle rate to 21c, and the present Government has created a new top rate of 39c for incomes above $60,000.

There is also a "bracket creep" effect. Although the threshold for the 33c rate has been raised, it has not been raised enough to offset inflation, and the threshold between the lowest and middle rates remains at $9500, where it was set in 1986.

Predictably, the committee has received several submissions arguing for a reversal of this trend.

The Employers Federation favours a flat tax scale and Federated Farmers says it is inappropriate to use progressive taxes on income as a means to redistribute wealth.

The Manufacturers Federation wants the 39c rate removed, the threshold for the 33c rate raised to $60,000, and the exempting of personal income below $5000.

The Corporate Taxpayer Group, representing many of the largest corporates, wants flatter and lower individual tax rates as well as a lower company tax rate.

The Business Roundtable argues that much of the redistribution of income caused by the current graduated tax scale does little to improve the well-being of low-income individuals.

"A large proportion of the income raised from imposing higher marginal rates of tax on middle and high-income households is given back to those households in the form of subsidised services. This does little to improve equity with which income is distributed."

The Roundtable says the top 40 per cent of households, by market income, receive 76 per cent of market incomes, pay 74 per cent of direct taxes such as income tax and 68 per cent of all taxes. But they also receive 28 per cent of all Government benefits, including 49 per cent of student allowances and 51 per cent of non-cash education benefits.

"Since the incomes of most individuals increase over their working lives, progressive tax rates tend to redistribute income over people's lifetimes. Once again, such redistribution is not necessary and does little to improve equity."

The Roundtable also argues that increasing the progressivity of the tax system increases the deadweight costs of raising tax revenue. "It does this by increasing disincentives to work, save and invest, and reduces New Zealand's ability to attract and retain skilled labour."

No less predictably, there are calls for tax relief at the low end of the income distribution.

The Child Poverty Action Group argues that the increase in benefits in 1986 to compensate for the introduction of GST was more than reversed by the benefit cuts in the Mother of All Budgets in 1991. There was no compensation for the 1989 increase in GST to 12.5 per cent.

The bottom rate of income tax, 15 per cent, is high by international standards. The Blair Government cut the British rate to 10 per cent, and many other countries, including Australia and the United States, have what is effectively a zero band.

Overstrict targeting of benefits has led to perverse incentives, the action group says. The thresholds and rates at which benefits are abated need to be moderated.

"When people earn extra income they not only face tax and ACC levies but may also face an assortment of other measures which reduce the return from work, including student-loan repayments, child-support payments and abatement of Family Support."

The action group says that merely to compensate for the slow attrition of past inflation, the first income tax threshold, unchanged since 1986, should be raised to $12,000.

The weekly amount a beneficiary can earn ($80, unchanged since 1986) should be raised to $135. And the abatement threshold for Family Support payments should be raised from $20,000 to $27,000.

Over time the tax system should move towards introducing a bottom band of tax-free income, the action group says.

The Roundtable says reducing the bottom statutory tax rate would reduce the poverty trap effect but could be fiscally expensive - 27 per cent of all income tax (around $4 billion) is collected from taxing the first $10,000 of taxpayers' income.

* Tomorrow: Company and international tax issues.