Mark Lister: Triple tax take does nothing to help savings

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Government debt levels are getting a lot of media attention at the moment because of what is happening in Europe.

While New Zealand also has too much external debt, government debt levels are actually quite reasonable and it is the household sector that is the problem.

In 1980, household debt represented just 44 per cent of disposable income. By the end of 2010, this debt burden had grown three-fold, with debt now representing 151 per cent of income.

This high level of indebtedness and low savings rate leaves households, and the country, extremely vulnerable to shocks, such as any recurrence of the crisis seen in the global financial sector in 2008.

New Zealand has a well-documented savings problem, with households spending roughly 2 per cent more than they are earning. Clearly this situation would be helped if incomes were higher, with our GDP about 15 per cent below the OECD average, and even further behind Australia.

However, our current tax settings on investments are not helping the situation either. With no capital gains tax or inflation indexing, the existing regime favours borrowing over saving, and capital assets over income assets.

In its final report, released in January, the Savings Working Group (SWG) suggested that households would be more inclined to save if the Government considered a number of changes to the taxation of investments.

Tax settings are an important driver of investor behaviour and there are a number of changes that should be implemented to deliver a less distorted, more investor-friendly and efficient environment for New Zealand investors.

To begin with, let's focus on what is wrong with our tax rules on investments. Investment capital in New Zealand is essentially taxed three times. The money that is saved has been taxed already, because it comes out of your after-tax income that has seen PAYE deducted.

The income generated by the investments is then taxed again and when you finally spend that income, you are taxed via GST. It makes sense, therefore, to avoid a layer of tax by simply earning it then going straight to the spending phase, rather than earning, saving and then spending.

With no capital gains tax, the system further distorts investment decisions. It makes more sense to borrow (and obtain the interest deduction) and buy capital assets like rental property than it does to save in higher-income investments such as deposits (and higher-yielding shares, for that matter), which incur tax on this income with no adjustment for inflation.

Regardless of its merits, there is no chance of a capital gains tax being introduced in New Zealand. Successive governments have stated this quite clearly, so we can safely assume that any future tax changes looking to achieve similar objectives will be a work-around rather than a capital gains tax.

Overseas experience suggests that to encourage investing, investment income needs to be taxed at a lower rate than other income. So a sensible starting point for improving the tax environment for investors would be to reduce the tax rates charged on PIEs (Portfolio Investment Entities - which is what most of our KiwiSaver funds are).

Most investors in PIEs are able to access a slightly lower tax rate than their marginal tax rate. The SWG recommended that this average gap between PAYE rates and PIE rates be increased further, potentially closer to 10 per cent.

Significantly, the SWG also recommended that these lower PIE tax rates be applied to interest and dividends earned by New Zealand residents.

Our firm is a very strong supporter of such a change and has previously lobbied the Government in this regard. It is simply a matter of fairness - why should professional investors and those who choose to invest in a fund receive a lower rate of tax than people who choose to invest directly in fixed income and shares? It makes no sense to penalise direct mum and dad investors in this way.

Another inequity that exists between PIEs and direct investors is that PIEs are not taxed on trading gains in shares, while direct investors are. This difference in treatment is a frustration for direct investors.

It's not that we would recommend clients go out and start trading their share portfolio, far from it. But at times proactive decisions are required and private investors face the uncertainty of possible tax consequences during the prudent course of managing their share portfolio while PIE managers do not.

The SWG also recommended imputation credits be refundable. This is the situation in Australia and it should be the case here too. The current situation has the potential to penalise investors with a tax rate below 28 per cent who choose to invest in shares.

To ensure capital flows efficiently to the most productive part of the economy, the tax settings need to encourage equity investment rather than penalise it.

Although complex, indexation is one of the most interesting arguments put forward by the SWG. In the absence of a capital gains tax, it could play an important role in equalising the tax treatment of income and capital gains.

At present in New Zealand, nominal returns are taxed, but indexation would allow for the effect of inflation. For example, assuming inflation of 2 per cent, a 5 per cent term deposit would only be taxed on a return of 3 per cent, not 5 per cent as is currently the case.

On the other side of the coin, an investor who borrows money at a rate of 5 per cent to buy an investment asset would only be able to claim 3 per cent as a deduction, not 5 per cent.

Indexation could be a very powerful neutraliser across our tax system and remove the current inequitable treatment of savers in higher-income investments like term deposits relative to leveraged investors in capital assets.

One of the most pressing issues for New Zealand investors that we see is our inability to use Australian franking credits (which are the same as our imputation credits).

Australian shares are an important component of New Zealand investors' portfolios and the loss of franking credits has a material impact on returns.

While some may say that allowing the recognition of franking credits could potentially harm our own sharemarket, I doubt that this would be the case. Our market would still be a core holding for local investors, but it is prudent from a diversification perspective to complement a New Zealand portfolio with Australian stocks.

The fact that we do not have a capital gains tax may be a reason for Australia's reluctance to allow cross-recognition of franking and imputation credits. Perhaps implementing indexation, or other measures, may help appease their concerns. The Government should continue to negotiate with Canberra to try to find a solution to this issue.

Finally, the Fair Dividend Rate tax regime on overseas investments should be abandoned. Its complexity is discouraging many people from diversifying portfolios into global investments and that is reason enough to scrap it, in my view.

Any potential gaming of the tax system via overseas funds investing in local assets should be dealt with on a case-by-case basis and they should, quite rightly, be legislatively quashed out of existence.

Global shares should be treated the same as local shares and, if needed, a (greatly extended) grey list should be put in place.

* Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as personalised investment advice.