Discarded tax solutions deserve another look

By now it will be apparent to those who read business newspapers that New Zealand has a problem.

The Government is borrowing $300 million a week. The deficit expected this year has been revised upward from the $13.3 billion forecast last May to $15.6 billion.

Net Government debt is expected to peak (for the medium-term) at 28.5 per cent of GDP or $70.5 billion by 2015.

Servicing that level of debt would cost us $5.6 billion in interest - more than the expected spending that year on law and order and defence combined.

Lurking towards the end of the Government's projection window (the next 14 years) is the ageing of our working population. The expected result: lower tax revenues, higher pensions and higher healthcare costs as a percentage of GDP.

That's just government. New Zealand's net international debt position (including both private and government sectors) is expected to be $221 billion or 90 per cent of GDP in five years' time. This outlook is rosier than expected, but partly because of bad news: things like insurance inflows from the Canterbury earthquake and weak profits accruing to New Zealand-based but overseas-owned firms.

HOW DID WE GET HERE?

New Zealand's poor growth track, household debt burden and emerging fiscal problems are nothing new.

What is new is that Budget 2010 introduced a major tax package. The package was intended to improve the tax system's structure, and lay a foundation for growth and fiscal security.

Some of the changes (including the increase in GST and cuts to marginal income tax rates) have occurred. Others (including cutting the corporate tax rate to 28 per cent) will apply for the income year starting April 1, 2011.

So why is the fiscal situation worse than expected at the last Budget? Did the tax package help build a solid fiscal platform? The 2010 Budget tax package was in fact expected to increase deficits until 2012-13. It was only in later years that the hoped-for positive growth impacts of the tax changes were expected to feed through into more income, increased tax revenues, and reduced deficits.

Compounding the short-term fiscal hit from the tax changes, tax revenue last year was $3.2 billion less than even Budget 2010 estimated. The main culprit is slower than expected growth. Corporate income tax, tax from the self-employed and GST are all down on last May's projections. Companies incurred $18 billion of gross tax losses in the 2009 tax year.

This is a lot of stockpiled losses for companies to chew through by using them to soak up current and future profits, likely depressing the corporate tax take now and in the near future.

Earthquakes and leaky buildings haven't helped, but unwelcome shocks are sadly to be expected, and the books must be in a position to weather more.

WAS TAX SHIFT ENOUGH?

Despite the tax package of the last Budget, it seems obvious that we still have a fiscal problem (and our children and grandchildren a worse one, if we don't act to fix it).

Not all the 2010 Budget tax changes have yet taken effect. But even if the growth dividend from the tax package is eventually as was hoped for, it will have a very modest impact in the medium-term.

The 2010 tax package was expected to generate less than $200 million extra tax revenue in the 2013-14 year, compared to a deficit that year expected to be $6.1 billion.

The Government's efforts to manage core crown expenditure are useful and necessary, but controlling spending growth or cutting spending alone is unlikely to be sufficient.

Cuts to big-ticket spending items such as superannuation have been ruled out. Cuts of the size needed to put the books in order (without other changes) could cause other problems with undesirable long-term social and economic impacts.

Efforts to better manage the Government's assets are commendable and could help. But the size of the fiscal problem - and the fact that we have still yet to seriously confront the long-term fiscal outlook - mean that further changes to the tax side of the ledger look necessary.

ELEPHANT IN THE ROOM

In this context, the 2010 tax package can be seen as not doing enough to strengthen the fiscal position and growth outlook of the country. We need more revenue on a broader base.

No new, perfect solutions that are both politically painless and fiscally sound are likely to present themselves. Instead, we seem destined to revisit some of the ideas already considered and rejected. These are likely to include some old elephants that have previously been ignored.

Background documents to the May 2010 Budget disclose that the Inland Revenue and Treasury consider that the tax base needs to be broadened, even beyond the reforms in the 2010 Budget. They concluded "at a theoretical level, there is a strong case for a comprehensive capital gains tax. It would broaden the income tax base and make it more comprehensive".

They added: "Not considering these taxes in Budget 2010 does not preclude the consideration subsequently as part of a continuation of strategic tax reform", and agreed such options would form part of a work programme.

In the next of this three-part series, we consider options for extending the revenue base. What solutions did we reject last year, and why?

* Craig Elliffe is professor of taxation law and policy at the University of Auckland Business School and consultant to Chapman Tripp.

* Chye-Ching Huang is a senior lecturer at the University of Auckland Business School.