Busting the myths of a capital gains tax

A capital gains tax could be the way to reduce New Zealand's debt mountain. Photo / Greg Bowker

This series has explained why New Zealand's unsustainable debt track is likely to make future tax reform necessary, in combination with governments cutting spending and better managing their assets.

One option is a capital gains tax. Its benefits include fairness, strengthening the tax system and generating revenue. These benefits are the reason why such a tax keeps being raised as an option for reform.

New Zealand keeps rejecting capital gains tax largely because of three persistent assumptions about how capital gains tax works in practice: that it would be too complex, not generate enough revenue, and become a Swiss cheese of exemptions over time.

These concerns meant that the Government and some members of the Tax Working Group rejected capital gains tax about this time last year.

Surprisingly, these assumptions have not been tested, but it should be easy to test them.

Most developed countries, and many others, have a capital gains tax. Did they encounter these problems in practice?

For example, South Africa adopted a capital gains tax in 2001. There is much about South Africa that New Zealand wouldn't want to emulate.

But its tax system is one bright spot in its recent history, earning praise from the International Monetary Fund and Organisation for Economic Co-operation and Development. South Africa's experience is that the three key criticisms levelled against capital gains tax have been largely myth.

MYTH 1: THEY'RE TOO COMPLEX

In New Zealand we've assumed that a capital gains tax would be too complex for taxpayers to comply with and for the IRD to administer.

But South Africa's experience shows that careful design can keep the tax simple.

South Africa's capital gains tax has features that effectively exclude taxpayers of moderate wealth from the capital gains tax net.

About $3000 of capital gains are excluded annually for each taxpayer.

The equivalent of about $300,000 gain or loss on primary residences is excluded, as are gains and losses on assets for personal use, for instance furniture, boats or stamp collections.

These features, and others, helped to make the capital gains tax politically feasible.

They were also designed to limit their efficiency and revenue costs.

For example, the dollar amount cap on the primary residence exclusion limits the tax incentive to over-invest in residential property.

South Africa effectively taxes capital gains at a lower rate, intended to offset the effects of inflation without the complexities of inflation indexing.

South Africa implemented its capital gains tax in 2001 with minimal fuss, despite its Revenue Service being in a woeful state.

World Bank/PwC studies show that despite introducing capital gains tax, in recent years South Africa has reduced overall tax compliance times for corporations.

By comparison, the lack of a capital gains tax has caused considerable complexity in New Zealand. Arbitrary and ad hoc tax rules have developed to limit taxpayers' exploitation of this large exemption in our otherwise broad tax base.

MYTH 2: THEY DON'T GENERATE ENOUGH REVENUE

According to South Africa's Revenue Service and Treasury and the International Monetary Fund, the capital gains tax - with other base-broadening and tax collection measures - has enabled South Africa to reduce corporate and personal income tax rates.

Studies have concluded that most countries vastly underestimate the revenue generated by such a tax before implementing it.

MYTH 3: THEY BECOME A SWISS CHEESE OF EXEMPTIONS

It has been suggested - for example, in the 2001 review of New Zealand's tax system - that benefits of a capital gains tax inevitably erode over time because they are amended more often.

South Africa's experience shows that its capital gains tax has been amended no more often than other types of tax in South Africa.

The amendments have not been of the type (significant new exemptions and preferences, for example) that critics of capital gains tax are concerned about.

New Zealand's experience is that because of the constant need to clarify and protect the boundary between capital gains and ordinary income, a system without capital gains tax is subject to frequent ad hoc amendment.

ARE WE SPECIAL?

Capital gains tax has been the elephant in the room over 40 years of discussion about tax reform in this country.

But we have a mountain of debt to move, and an elephant could be a useful way to help move it. South Africa's experience shows assumptions about a capital gains tax being unworkable are largely hyperbole.

But perhaps New Zealand is special in some way that means a tax would deliver fewer benefits here than in other countries?

We know of no good reason to think so. No evidence has been offered that the economy is peculiarly impervious to the inefficiencies created by not having a capital gains tax.

New Zealand's sub-par economic performance suggests that we cannot afford to be any less concerned than other countries are about those distortions.

New Zealand's tax administration is internationally lauded. The IRD may be in a better position to administer a capital gains tax more efficiently than in many other countries.

As a latecomer to capital gains tax, New Zealand can cherry-pick the best features from other countries' systems.

South Africa's policymakers chose to reject features of existing taxes in Australia and the UK that had proved ineffective or too complex in practice.

GETTING OFF THE HAMSTER WHEEL

Before 2001, South Africa, like New Zealand, considered and rejected capital gains tax over and over again.

The same objections to capital gains tax raised here had been raised there: assumed complexity, lack of revenue, and a tendency to degenerate over time.

In 2001, South Africa's policymakers got off this hamster wheel by looking carefully at the international evidence.

They found that common objections to capital gains tax were not supported by other countries' experiences. New Zealand has yet to look carefully at this international evidence.

We should. The fiscal situation demands further reform to the tax system to avoid a debt mountain.

The tax changes in last year's Budget did not do enough to address that looming problem.

While some have called capital gains tax political suicide, fiscal suicide is also unattractive.

South Africa's experience shows that a capital gains tax can be designed to alleviate political objections, while keeping it simple and delivering its well-known benefits.


* 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.