Tax concessions 'too distorting'

In the first of a three-part analysis of tax issues, economics editor BRIAN FALLOW examines the McLeod review's suggestions for taxing savings.

The independent tax review chaired by Robert McLeod has rejected a concept dear to both Finance Minister Michael Cullen and the managed funds industry - tax concessions for retirement savings.

Under the present TTE (taxed, taxed, exempt) regime, people save out of their after-tax income (the first T), returns on those savings are taxed (the second T), but withdrawals are exempt (the E).

Dr Cullen has floated the idea of introducing a TET (taxed-exempt-taxed) regime, which the Treasury estimates would cost about $500 million annually in lost revenue in its early years at least.

But the McLeod committee said: "We are not convinced that tax concessions would result in higher national savings or that, even if they did, the benefits would outweigh the costs of the distorting effects of concessions on the quality of people's savings decisions. We therefore favour the retention of the TTE regime."

Reducing the tax on income from savings would, of course, boost people's ability to save. But this has a cost of its own.

Either the Government would raise other taxes to offset the loss of revenue, reducing the ability of households or businesses to save, or it would not, reducing its own contribution to national savings.

Secondly, the review committee says the evidence on whether individuals save more in response to higher after-tax returns is mixed at best. If there is an increase, they suggest, it is likely to be because the tax concessions mostly benefit higher-income households, which are more likely to save.

By contrast, they say, there is plenty of evidence that tax considerations influence choices about how people save. The concessionary treatment of housing is reflected in the fact that New Zealanders have half as much again as the OECD norm of wealth tied up in bricks and mortar.

"A tax system which biases investment away from more profitable (from a national standpoint) but more heavily taxed investments will stunt national income and hence savings."

But within the context of a TTE regime, the committee suggests that a risk-free return method (RFRM) - the same one they propose for housing - could affect the middle T, to the benefit of savers.

This involves taxing not the actual return on the capital but what the real yield would be if it had been invested in a risk-free instrument such as Government stock.

The approach could apply to a range of savings vehicles, including shares, superannuation funds, unit trusts and property. That neutrality would steer savings to the highest yields, the committee argues.

And because only the inflation-adjusted notional yield would be taxed, it would avoid distortions arising because even low rates of inflation can result in the over-taxation of real returns.

Under this regime, dividends and returns of capital would be tax-exempt. But something akin to the imputation regime would be necessary to ensure that company income was not taxed twice - once at the company level and again under the RFRM.

There is also the question of how to handle the acquisition or disposal of assets within a tax year.