Andrew Coleman on how the Tax Working Group produced a report that anything but looks to 'The Future of Tax'

Rock stars are lucky because they are remembered for their best songs, not the worst things they do.

For politicians it is usually the other way around.

I hope Michael Cullen is remembered for the NZ Superannuation Fund. The Fund is a serious attempt to reduce the extent taxes will need to increase in the future to pay for retirement incomes (assuming these are not drastically cut). It partially places the government retirement system on a save-as-you-go basis which means it accumulates assets and takes advantage of the power of compound returns.

I think that it is a good idea for the Tax Working Group (TWG) to recommend that the Superannuation Fund will not pay tax as the fund accumulates. This means the fund will accumulate at a faster rate and further reduce the extent that taxes will have to be increased on future generations.

Unfortunately, much of the rest of the report is disappointing.

The main argument of the report is that New Zealand’s tax system is different from the rest of the world's because we don't have a capital gains tax or many environmental taxes. This is true, but it ignores the single biggest difference: social security taxes.

Social security taxes are paid on labour income but not on capital income like interest, rents, or dividends. Unlike almost all other OECD (rich) countries, New Zealand does not use social security taxes to fund retirement incomes (or have a compulsory saving scheme) – the average country collects 8% of GDP more tax than New Zealand from this source. This is an enormous difference, and it has two implications that the report glosses over. First, it means New Zealand has the third lowest taxes on labour income in the OECD – that’s right, working people pay low taxes. Secondly, by many measures New Zealand has some of the highest if not the highest taxes on capital incomes in the OECD.

Given these differences it is surprising that the main recommendations of the report are to increase taxes on capital incomes and reduce them on labour incomes. Why is this surprising? If you impose high taxes on capital and business incomes there is a lot of international evidence that you get less investment and less innovation and this reduces productivity growth and incomes - including labour incomes. New Zealand has low levels of business capital and low levels of productivity already and raising taxes on capital incomes when they are already very high seems like a questionable strategy. The TWG report hardly discusses this issue at all.

It is also surprising because standard tax theory and standard international practice suggests capital income should be taxed at lower rates than labour incomes. The TWG report repeatedly states that all incomes should be taxed at the same rate without mentioning that this idea was rejected 50 years ago by the Nobel prize winning economists James Mirrlees and Peter Diamond because it is not a very effective strategy.

It is not effective because if you tax capital incomes at high rates you lower investment and people end up with lower incomes than they otherwise would have had.

Scandinavian countries, amongst the most progressive in the world, deliberately tax capital incomes at lower rates than labour incomes.  They raise revenue by imposing high taxes on people with high labour incomes. They do this because they fear high capital income taxes will lead to an outflow of capital and reduce everyone’s wages. Most other prosperous countries in the OECD also have lower taxes on capital incomes than labour incomes because they use social security taxes. The TWG report appears to believe the rest of the world (and tax theory) is wrong – but they scarcely discuss either issue.

One of the downsides of increasing taxes on capital incomes is that it will further reduce the ability of young people to use the power of compound interest to build wealth - unless it is through owner-occupied housing. Most countries in the world reject this idea as silly and allow saving placed in retirement income accounts like KiwiSaver to compound before they are taxed, which leads to a much larger saving total. The government decided this was a bad idea in 1989, when they rejected the “Exempt-Exempt Tax” regime for retirement income savings that is supported by economic theory and used by most countries in the world. (Under this system you don’t pay tax on any money you place in a retirement saving account when you earn it, the earnings accumulate without tax, but the whole sum is taxed when it is withdrawn.) It appears that harnessing the power of compound interest is good for the NZ Superannuation Fund but not for middle or higher income individuals – unless they invest in owner-occupied housing. 

Standard economic theory suggests that if you tax the income from housing less than the income from other assets, you will drive up the demand for housing and increase its price. (This is one of the key advantages of an EET retirement scheme – it taxes the income from all assets held in retirement income account on the same basis as the as owner-occupied housing. This has the added benefit that owner-occupied housing can be exempt from a CGT without causing such large tax distortions.) The TWG apparently hopes that taxing owner-occupied houses more lightly than other classes of assets will not cause people to build and buy larger houses, and will not lead to artificially large housing prices. They also hope that a capital gains tax will not lead to higher rents.

Unfortunately there is precious little evidence in favour of any of these propositions. If they are wrong, the costs will fall on current and future generations of young people.

The TWG report – “The Future of Tax” has very little to say about one predictable aspect of the future – it ignores the rising cost of government superannuation, which will necessitate higher taxes on young people in the future.

It doesn’t debate whether young New Zealanders might be better off with a different social security system, one which reduces the taxes they pay but uses the money to purchase stakes in businesses. Economic theory suggests that such a strategy should reduce long run wealth inequality by increasing the wealth of low income people, but this is not discussed in any of their reports.

Why do they assume that a social security system first designed in the 1930s and modified in the 1970s is the ideal system for the 21st century?

It may be because the TWG didn’t have anyone on it who was under 40.

Indeed, it is scarcely a document about the future of tax at all. Its chair was the associate minister of finance when the tax reforms of the 1980s were undertaken, and its lead economist was the chief economist of the IRD who advised him back then, Robin Oliver. Yes, Taxman and Robin.

What do you get if you call up Taxman and Robin to solve the tax problems of the future? – you get an attempt to relitigate the problems they didn’t solve last time (or the time before that, or the time before that), especially capital gains taxes.

Unfortunately, I have news for them.

They waited for the house price horse to bolt before doing anything about it. This is very good for Taxman and Robin’s generation of baby-boomers, which has already made its fortune from untaxed capital gains on residential property. It is not so good for younger people who might have to pay higher rents going forward.

And did Taxman and Robin argue that taxes should be raised on their own generation to reduce the future increase in taxes that will be needed to pay their own generation’s superannuation payments? No, they forgot that problem too, hiding behind the shelter of the terms of reference that instructed them not to raising the top marginal tax rate, one of the lowest in the world.

The funding of New Zealand Superannuation and the taxation of retirement savings may seem like small problems, but they are related to the biggest problem facing the world - how the burgeoning numbers of poor people in Africa and South Asia can develop without cooking the planet. No countries have developed without using more energy, and in the past this has meant coal, oil, or gas. Fortunately there is a potential solution to this problem– the savings of rich ageing countries in the OECD and East Asia can be recycled to the countries around the Indian Ocean to build large quantities of capital-intensive green (non-carbon) energy projects. Unfortunately, by staying with a tax-funded retirement income system that accumulates no capital and by further tilting the tax system to favour investments in owner-occupied housing, they are undermining New Zealand’s ability to participate in the solution to the biggest problem of our time.

You can see from these remarks that I don’t believe the TWG has delivered a report designed to address the future of tax. (And I haven't even started on the substandard analysis involved that argues that capital gains should be taxed without making an allowance for inflation because interest is taxed without making an allowance for inflation: suffice it to say that two wrongs do not make a right. Taxman and Robin seem obsessed with the idea that real interest income and should be taxed at rates considerably higher than statutory rates.)

The Tax Working Group has delivered a report that is essentially backward looking, that ignores a lot of standard economic theory and the experience of other countries.

It wishes to increase the incentive to invest in owner-occupied housing, without properly analysing the consequence of that choice.

It pretends a capital gains tax is the major issue in New Zealand while ignoring the biggest differences between our tax system and those in other countries, differences that mean we have unusually high taxes on capital incomes that may be harming productivity.

It talks about the need to combat environmental problems without reforming the tax system so that people will accumulate the capital equipment that will actually solve those problems.

It ignores the major intergenerational issues facing the country.

In short, it’s rather disappointing. Maybe we should celebrate the Cullen Fund and hope this becomes the Culled Report, without preventing a proper investigation of these issues.

Perhaps the next report on the future of tax will even be led by the young people who will actually live in the future and deal with its problems. After all, as Ralph Waldo Emerson pointed out nearly two centuries ago, you need young people to generate bold ideas because old people have a bad tendency to spend their time defending the bold ideas they had when they were young.

*Andrew Coleman is a senior lecturer in the economics department at the University of Otago. He's also a principal advisor and economics lecturer at Treasury.