So the details of this government’s tax review is out.

Depending on who you read it will either be revolutionary or not radical.

Now even though this blog has come as a response to the Left’s – and fairness’s – relatively recent introduction into the tax debate – I couldn’t see anything I could competently add to the random number generator that is the current public discussion. That was until I read one commentator – who actually understands tax – talk about the last Labour government’s tax review – the McLeod Report.

He referred to that report as having analysis that stood up 16 years later. And with the underlying analysis found in the issues report I would wholeheartedly agree. But in terms of the recommendations in the final report I would say, however, that it was very much of its time.

And by that I mean that while the issues report fully discussed all issues of fairness/equity as well as efficiency – when it came to the final report efficiency was clearly queen.

Now by efficiency I am meaning ‘limiting the effects tax has on economic behaviour’. And fairness as meaning all additions to wealth – aka income – are treated the same way.

The tax review kicked off in 2000 at about the same time I arrived at Inland Revenue Policy. In early 2000 there was:

• No working for families
• No Kiwisaver
• Top personal tax rate was about to increase to 39% but with no change to company or trust tax rate
• Interest was about to come off student loans while people studied.

That is the settings generally were the ones that had come from the Roger Douglas Ruth Richardson years.

Also in tax land the Commissioner was having a seriously hard time as the Courts were taking a very legalistic attitude to tax structuring. High water mark was a major loss in 2001. And unsurprisingly in such an environment the banks had started structuring out of the tax base. But it would be a while before that became obvious.

Housing was affordable. Families such as mine could be supported on one senior analyst salary – and live walking distance to town.

The tax review was headed by a leading practitioner Rob McLeod; and had two economists, a tax lawyer and a small business accountant. One woman. Because that is what progressive looked like 2000.

And so what were their recommendations/suggestions?

No capital gains tax but an imputed taxable return on capital This one is both efficient and fair. And did materialise in some form with the Fair Dividend rate changes to small offshore investment. It is the basis of TOP tax proposal. At the issues paper stage it was proposed to include imputed rents but the public (over) reaction caused it to be dropped. Interestingly it is explicitly out of scope with the Cullen review.

Flow through tax treatment for closely held businesses and separate tax treatment for large business

What this is about is saying entities that are really just extensions of the individuals concerned should be taxed like individuals not the entity chosen. This is effectively the basis of the Look Through Company rules – although they are optional. It means the top tax rate will always be paid. But it also means that capital gains and losses can be accessed immediately.

Now this is definitely efficient as the tax treatment will not be dependent on the entity chosen. And it is also arguably fair for the same reason.

It does mean though that if a company structure is chosen and the business gets into trouble: the tax losses can be accessed as it is effectively the loss of the shareholder but the creditors not paid because it is a separate legal entity. Which probably wouldn’t exactly feel fair to any creditor.

But all this is unreconciled public policy rather than the McLeod report.

Personal tax scale to be 18% up to $29,500 and 33% thereafter.

The tax scale at the time ranged from 9.5% to 39% at $60,000. The proposal would have had the effect of increasing the incentive to earn income over $60,000 as so would have been more efficient than the then 39% tax rate. As the company and trust rate were also 33% it would have returned the tax nirvana where the structure didn’t matter.

However it would have increased taxes on lower incomes and decreased taxes on higher incomes. So while efficient – not actually fair according to the vibe of the Cullen review terms of reference.

New migrants seven years tax free on foreign income

At this time our small foreign investment – aka foreign investment fund – rules were quite different to other countries. While we didn’t have a realised capital gains tax – for portfolio foreign investment we could have an accrued capital gains tax in some situations. This was considered off putting to potential high skilled high wealth migrants. So to stop tax preventing migration that would otherwise happen; the review proposed such migrants get seven years tax free on foreign income.

This proposal was the other one that was enacted with a four year tax free window – transitional migrants rules.

And again a policy that is efficient but arguably not fair. As the foreign income of New Zealanders in subject to full tax. However Australia and the United Kingdom also have these rules that New Zealanders can access.

The logical consequence though is that no one with capital lives in their countries of birth anymore. And not sure that is ultimately efficient.

New foreign investment to have company tax rate of 18%

Again this is the foreign investment – good – argument. But it ultimately comes from a place where foreign capital doesn’t pay tax because it is from a pension fund, sovereign wealth fund or charity. Or if it is tax paying that tax paid in New Zealand doesnt provide any form of benefit in its home or residence country. So by reducing the tax rate by definition this reduces the effect of tax on decision making.

However doesn’t factor in the loss of revenue if there are location specific rentswhich aren’tsensitive to tax. And not exactly fair that domestic capital pays tax at almost twice the tax rate. Unsurprisingly didn’t go ahead.

Tax to be capped at $1 million for individuals

This again comes from the place of removing a tax disincentive from investing and earning income. Yeah not fair and also didn’t go ahead.

Restricting borrowing costs against exempt foreign income

This was the basis of the banks tax avoidance schemes that ended up costing $2 billion. It is only briefly mentioned in the final report with no submissions. It is to the review team’s – probably most likely Rob McLeod – credit that it is there at all. This proposal was both efficient and fair. Stopping the incentive to earn foreign income as well as making sure tax was paid on New Zealand income.

It will be very interesting to see where this review comes out with the balance between efficiency and fairness. Because both matter. Without fairness we don’t get voluntary compliance and without efficiency we get misallocated capital and an underperforming economy. But the public reaction to the taxation of multinationals and ‘property speculators’ would indicate a bit more fairness is needed to preserve voluntary compliance.

And as indicated 16 years ago – taxation of capital is a good place to start.

Andrea