Gareth Morgan explains why Rodney Hide's arguments against corporate tax are dubious and naive; income tax base would collapse; GST rate would have to rise; Hide playing into hands of tax-free capital gains farms

By Gareth Morgan

Lately Rodney Hide has informed us that multinationals equilibrate their after-tax returns across all the markets they operate in.

So if one country (NZ for example) hikes up company taxes then the multinationals simply invest elsewhere where the after-tax return isn’t so high. In other words we cut off our noses to spite ourselves if we dare to tax multinationals, we are so desperate for foreign capital on Rodney’s argument we should be a tax haven.

The evidence seems to be against him. Why aren’t all multinationals sited in Bermuda? The reason is obvious – the markets for multinationals’ goods and services are all over the world, not just in Bermuda. And they pay tax (to varying degrees) where they earn revenue. That limits Bermuda’s prospects. And indeed it also highlights why the race to the bottom by various tax authorities to attract multinational investment by offering corporate tax rates as close to zero as possible, has limited returns for such countries. Tax havens only work to the extent that the tax regimes of other countries have loopholes the multinationals can exploit and shift income. And for sure, many do have such holes.

Rodney has a further argument vis a vis corporate tax that is also of dubious merit. He argues a company is the property of shareholders and hence its income should only be taxed once it arrives in the hands of shareholders - i.e.: as a dividend, or when the firm winds up and proceeds are distributed.

The argument is weak. In Rodney’s world we would all be incentivized to form companies and sell our labour via that company. All our costs of providing labour (such as eating, housing) would be deductible and any surplus could be ‘re-invested’ in whatever we deem as necessary to ensure our “own-labour-company” can pay dividends, albeit as far in the future as possible. For example with this year’s surplus I think I need a holiday in Hawaii to recharge my batteries - definitely an investment in my future ability to happily earn for my company. Or perhaps a second house - one that provides a nice change of scenery to keep my spirits up at the level necessary to keep my labour-only- company earning well into the future. Only once I retire will I sit back and start cashing in all the assets my company has bought over the years. Then, and only then, when my company is distributing, need it produce any taxable income.

The income tax base of the government (currently 65% of all tax collected) would collapse. GST would have to rise to 60% - or as Rodney and his fellow libertarians dream, we could trim the State back to a law and order function only - keep the riff raff at the gate. Let’s ignore the latter agenda, lest we get distracted from the topic - the income tax base.

It’s for this reason that in modern mixed capitalist economies that we have income tax and all income-earning entities (except charities, which is another story well worth expounding on), pay it. So whether you singularly - or with a group of your mates - disguise yourselves as a corporate, rather than simple wage earners, your income will be taxed whether it ends up in your hands personally or in your collective hands within the company arrangement you’ve constructed. This is why a line is drawn around what legitimate business expenses are and what is not deductible for the purposes of taxation. Except in particular circumstances the latter includes food, and housing for the company operands - whether employees, employee-shareholders, or shareholders. And that income is taxed whether distributed or not. 

Our imputation regime tries to ensure it’s not taxed twice. Most countries don’t have imputation regimes, they tax dividends twice. This has led to companies retaining far more earnings than they actually need to insofar as operating the business or even covering investment in reasonable growth opportunities. In response many countries have a differential between the tax rate applying to dividends and that to retained earnings, as an alternative to the imputation regime we deploy. But still, there remains a bias in the income tax regime that encourages companies in those jurisdictions to retain profits. That is economically inefficient, and we get successful companies often using those funds to buy back their own shares - thereby offering  shareholders an opportunity to realise all or some of their stake. 

Plugging leaks in the income tax base is a legitimate endeavour - if you want an income tax base. And before you get excited and think it’s all too hard, that we should just go to GST alone, spare a thought for how much GST is arbitraged away in New Zealand - by all those guys and gals doing cash jobs for folks but still claiming GST on their inputs. GST leaks in conjunction with undeclared income is the most lucrative tax evasion out there.

'Tax-paid profits not only factor in land values'

Now let’s turn to yet another of Rodney’s claims re taxation over recent weeks. This one is that capital gains are taxed already. The argument runs that insofar as the market price for an asset reflects the discounted future income stream, and as that is taxed, then the market price reflects only the present value of tax-paid earnings.

Well if that was always what the market price was he’d have point. But it is not.

There are various ways a market sets the price of an asset, in the valuation game it is common to see three at work – which often leads valuers to adopt triangulation when reaching an assessment of value. One is the present value of future income - that one is critically dependent not just on the forecast accuracy of the earnings stream but also the discount rate applied, and market discount rates are driven by a range of determinants, one of which is the liquidity of the investment. If the market for the asset is deep the discount rate is low, because traders know they can flick the asset easily and before any of those future expectations on earnings are realised or not. This is why sharemarket prices are so volatile - the market is daily reassessing all the drivers of that earnings expectation.

A second common valuation technique is the market price - what are like assets selling for? This is common in the real estate market and of course often augmented by an allowance for trend in market prices. If we’re in a channel of rising prices then the market will often see the trend as its friend and further bid up the prices beyond latest recorded sales. This is all hunky dory until some fundamental pops up and smashes that complacency - often called a “shock”. 

And a third method is to undertake a valuation based on price to earnings ratios. So how many dollars are being paid per dollar of earnings that this asset class is providing? This price will certainly take account of tax on those earnings. 

Now the point is that not all three valuation approaches necessarily provide a market price that incorporates the future tax impost on earnings. The market price methodology pays a lot more attention to what the momentum in market pricing is. If it’s rising then the price is likely to keep rising and vice versa. So when we have a situation where the market is favouring momentum pricing, then there is serious money to be made - either way actually, you just ‘short’ a falling market and buy the asset back later to deliver. Now the market theory would hold that a momentum pricing situation cannot last for long before the reality of earnings come to bear and that check corrects the pricing. But as we have seen in many markets over the last few decades that period can be very long - property and farms are illustrations. Meanwhile there is serious hay to be made by those buying and selling, especially when they manage to escape the IRD denoting them as being ‘traders’. Achieving that’s all in the way you wiggle your hips.

'Naive to think capital gains are taxed'

The important point then is that the gains one makes which are not taxed could well have nothing whatsoever to do with the future taxable earnings of the asset as Rodney asserts. It ain’t necessarily so I’m afraid, and in those situations Bernard Hickey is right - professional (don’t tell the IRD) investors stand to make outrageous tax-free fortunes simply trading on the momentum. Of course Rodney is right and it won’t last forever - it doesn’t need to. Ten or twenty years - as we have seen with residential property - is long enough to profit and fly away before the tax-paid earnings fundamentals come to bear.

It is naive therefore to argue that capital gains are taxed. It is true for the market as a whole, and over a sufficiently long period of time. But I don’t need either of those.

What to do then - what should a responsible taxation authority do to ensure that its income tax regime is not such a leaky boat that the market ridicule is so strong as to misallocate investment and profit all in a drive to avoid tax? The key it would seem to me - and Susan Guthrie and I covered this in our 2011 book on tax and welfare form, “The Big Kahuna” - is to ensure all forms of income are taxed in the year they are earned. This does not mean a capital gains tax, that is way to unwieldy and volatile. But it does mean plugging the loophole in the income tax regime wherein certain forms of income to capital are exempt income tax, namely the income from imputed rent.

Without that, the rentiers will thrive at the expense of all other taxpayers, capital will be misallocated across the economy, an economic growth and income generation will suffer. The comprehensive capital income tax we advocate is a step in closing the loophole that Rodney would far prefer was left ajar.