Other capital taxes – what are the options?

Last Thursday I had the very great pleasure of talking about tax to smart young people – here and here – at the Social Change Collective alongside Marjan van den Belt and Max Rashbrooke.

One of the questions was if not CGT and we wanted to tax capital more – what are the options? Answered it on the night but as the sharing individual I am I thought I’d do it for you all too.

This version might even be more coherent. Fingers crossed.

To me the options seem to be:

  • Net equity tax or risk free rate of return method (rfrm)
  • Wealth tax
  • Alternative minimum tax
  • Land tax

Net equity tax / risk free rate of return method

Susan St John is proposing the net equity tax – or risk free rate of return method for residential property.

This means a notional rate comparable to that a risk free rate of return – say 5 year bank term deposit – is applied to the equity held in residential property. This amount then becomes the income that is subject to tax.

For example if a property has a value of $1million – land $800k building $200k – but has a mortgage of $600k – it has net equity of $400k.

If a rate of return of say 3% is applied to the equity of $400k this will generate taxable income of $12,000. This $12k would then be taxed at the tax rate that applies to that particular taxpayer. Say 33% if top rate individual or trust. 28% if a company.

This $12k would replace any existing taxable income from that asset. That is rent would no longer be taxable and so there would be no associated deductions allowed.

As Susan is only proposing that it apply to residential property there would be no particular problems with getting a valuation to work out ‘net equity’ as land is regularly valued.

There could be issues if the debt that is attached to a property funded other investments and not the property itself. However there are lots of issues with debt and how it is allocated generally – I don’t think that is a deal breaker here.

There are also the issues that I raised in my comments on the officials note. For landlords who are currently charging below market rent this may incentivise rent increases. It may also further disincentivise landlords maintaining their properties as there is no tax benefit for doing so.

However that is more the place of regulation rather than tax.

Interim conclusion: Some technical issues with debt allocation and possible adverse behavioural effects by landlords but quite doable. No issues with valuation.

Wealth tax

Max Rashbrooke is proposing a wealth tax on all wealth.

An annual tax of a small percentage of the value of wealth held. As per the previous example – assuming no other wealth was held by the taxpayer – a small percentage – say 1/2% would apply to the $400k and an extra $2000 wealth tax would be payable on top of any other existing taxation.

Unlike net equity tax, this is not a proxy or an alternative calculation of taxable income for income tax to apply to. It is an additional tax on a different base in the same way GST is.

And just like GST it is a form of double tax. Consumption – and GST – is made from tax paid income. That is the same income is taxed twice. It is a feature. The beauty of GST is can also ensure one level of tax is paid when income wasn’t taxed in first place. Say if an untaxed capital gain.

Wealth taxes are similar. If tax has been paid at every level we would get:

  • 1) Original wealth coming from unconsumed tax paid income (current situation) A
  • 2) Investment return on wealth taxed (current situation) B
  • 3) Total wealth A plus B subject to wealth tax (new situation with wealth tax)
  • 4) Wealth if consumed – subject to GST (current situation)
  • For some asset classes such as bank deposits – or possibly foreign shares – this is absolutely the deal as there is no part of the income that is untaxed. In those cases wealth tax seems a bit like over kill/taxation.

    For other classes such as shares, investment in small businesses and unleveraged residential rental property where some part of the return is taxed but there is still an element of untaxed capital gain – depending on the rate of tax – a wealth tax absolutely has merit.

    For serial entrepreneurship or land banking where the whole return is a capital gain – in a world without the capital gain taxed – this is an absolutely bang on approach.

    Assuming this can be got through – maybe with different rates for different types of wealth although that will then bring in issues of debt allocation – the most significant issue will be that of valuation.

    This is particularly the case with valuing goodwill in unlisted businesses. To have to value every year would make the valuation industry very rich.

    Now I know it is possible for the tax administration to come up with some rules of thumb but having been upclose and personal in the Michael Cullen/Troy Bowker spat on exactly this issue – it is definitely a practical thing that will slow this option down.

    Interim conclusion: Need to clarify conceptual basis for including asset classes already fully taxed. Valuation issues likely to be a significant hurdle in practice. But could work.

    Alternative minimum tax

    Geoff Simmons and TOP are proposing an alternative minimum tax on all wealth. A bit like Susan’s proposal but instead of the rate being applied to residential property it would apply to all the wealth of a taxpayer.

    But unlike Susan’s option, instead of the rfrm number becoming the taxable income figure it would be compared to the taxable income that arises under the current tax rules. Tax would then be payable on the higher of the two numbers.

    So in our example above if the property was the only source of wealth and currently returned no taxable income, then the $12,000 would be taxed at whatever the appropriate tax scale is.

    However by including all wealth this option suffers from the same valuation issues as a wealth tax.

    But because it calculates an alternative minimum income level, rather than an additional or alternative tax, there is no issue of double or triple taxation. Its aim is to simply ensure the income that level of wealth should (or is on an imputed basis) be generating is subject to tax at normal rates.

    Interim conclusion: Conceptually the most coherent of all the options but significant issues with valuation. Could work though.

    Land tax

    This would involve an annual tax of a small percentage of the value of land held. Like a wealth tax it would be a separate and additional tax but unlike a wealth tax it is levied on the value of the land – in this case $800k – with no reference to the debt borrowed to purchase it.

    By focussing on land it doesn’t have the valuation issues that a wealth tax or an alternative minimum tax does. Also there are no issues with allocating debt.

    It does, however, seem arbitrary to pick on one asset class only. But as this is the asset class that is currently undertaxed by reference to the level of capital gains earned (1)- such an argument doesn’t stress me.

    It is, though, the current tax base of local authorities so if central government were to move into their tax base, local authorities’ arguments for a portion of GST could become more compelling.

    Interim conclusion: Conceptually the least coherent of all the options. Minimal practical issues. Could definitely work.

    The key difference between all these options is that a land or wealth tax is an additional tax separate to income tax. Net equity or alternative minimum taxes, however, are still within the income tax system but trying to get a better measure of taxable income than the status quo.

    But they have many more things in common.

    Similarities between the options

    Thresholds

    I think all options will need some form of threshold before they apply. No one – thank goodness – is keen on a family home exclusion. But all have additional complexity and compliance cost so something like $500k threshold for an individual could take out personal assets including a home (and maybe KiwiSaver) for most people. This would then mean the taxes could focus on the top end of the income and/or wealth scale.

    May not have cash to pay the tax

    None of these options are realisation based. That is they apply irrespective of whether any cash – or income other than imputed income – has been generated from the assets or wealth. Now I know that Susan St John explicitly doesn’t care about that as she feels then the property should be sold if that is a problem for the owner. I am guessing that is also the view of TOP as it is only cash poor pensioners that can get any deferral.

    I get why economists might not care about this and/or see it as a design feature to encourage more efficient use of assets but not sure that is how the general public would see it. Even with a threshold.

    As an example the Tax Working Group only considered rfrm on residential rental properties as it was only that group that would have the cash to pay it.

    Impact on Māori collectively owned assets

    Māori currently own a tiny fraction of the land they did at the time of the signing of Te Tiriti. And the settlements they have received were only 2% or so of the value they lost through crown action. (2)

    Now the deal with the settlements was that they were to be full and final and that there are no special tax rules. But any tax isn’t linked to cash income earned and targets their assets or wealth, even if not the basis of a potential contemporary Waitangi Tribunal case, will be considered more bad faith action from the Crown.

    As a woke Wellington snowflake I would have no problem exempting assets held collectively under a Māori Authority. Not for tax policy reasons but as a way of preventing further injustice. But as the equivalent noise showed with capital gains, this would not be a universal view.

    Would raise shed loads of money

    Rfrm on residential rental property only was found to raise a $1 billion (3) a year more than the current taxation of residential rental property. This was even when the extension of the brightline test to 5 years and loss ringfencing was allowed for. That was with a rate of 3.5% which was the 5 year bank term deposit rate at the time of the report.

    $1 billion. Every year.

    Let that sink in.

    Final conclusion on all options

    So all options even with quite modest rates could raise seriously useful dosh for the Government.

    But this money wouldn’t come from thin air. Like capital gains it comes from people of means. A section of whom – much like with capital gains – are well organised, connected and resourced.

    So I am not holding my breath for any of these being adopted by a major party any time soon. No matter their merit.

    Andrea


    (1) Paragraph 60.

    (2) For readers interested in more background. Here is the officials paper on the subject for TWG and here is mine as I didn’t feel officials went far enough.

    (3) Paragraph 41

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    6 responses

    1. First you need to define your objective. If it is to redistribute wealth and income more equally – be clear what gini co-efficient are you aiming for precisely? If that is the sole objective many ways to achieve this the easiest being not to allow high wealth people into NZ or encourage those here to emigrate. Historically most efficient is plague (black death of 14th century very effective at increasing equality then world war 1 and 2). This is clear from Piketty data. Mao tse Tung, Pol Pot, Lenin and Stalin also did a good job of killing high wealth. Got results. No idea why this should be a policy objective as compared with something that seems reasonable to me – reducing poverty. Agree that in 18th century all wealth in inherited land handed down to eldest sons (never females) leading to most people living subsistence living and small group enjoying life of debauchery. Case there for doing something but hardly seems comparable.

      Land tax and RFRM seem better options if you want to attack wealth held in this form. But also more reasonable to me argument is that in growing country land values rise in value systematically and a case for taxing such income. Concern about all NZ savings invested in land but RFRM only real way to respond since reduces post-tax returns. Land tax just imposes one off cost or confiscation of land – then back to norm. Trouble is fairness – most land held by Maori, farmers and elderly. How do you justify increasing the tax burden on this section of society and not others? Good for me I have little land. But the fairness does not look good.

      What has not been raised is the most obvious with the greatest support in the literature- that is increase the rate of GST. This taxes the value of all accumulated wealth because that wealth will be spent and be charged with the higher GST rate. That is why VAT was supported by academic left in UK -see the Meade Review of the 1970s.

      Anyway my thoughts.

      Liked by 1 person

      1. Thanks for this Robin.

        My objective is simply that all income is taxed comparably. Horizontal equity if you will rather than getting the tax system to do anything per se for wealth and inequality. Other than stopping what it currently does to exacerbate it.Personally I preferred taxing more capital gains – albeit probably more according to your design as that seemed more likely to work around the political issues.But as neither can happen I am open to one of these options as a way of levelling the playing field. Probably though with in a land tax, rfrm residential property, ToP, wealth tax order which I think is also the sliding scale for complexity.

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    2. Your comment “Suppose I am sitting on a $1 million house that is largely vacant as I wait for capital gains, an imputed taxable income of $30,000 might force me to rent it or sell.” is interesting. I didn’t buy my house to get any capital gains, these ‘gains’ were forced upon me by government inflation policy. Why should I be forced to rent or sell something I have worked and saved damned hard for? I’m not a “R… P….”, but saved everything I could from my wages as a mechanic and bought a piece of bare land and built a house on it. Doing so circulated my hard earned money back through the tax system again in the form of GST on supplies and income tax on tradesmen and bank profits via a mortgage. I find the suggestion of taxing me out of my own home abhorrent just because ‘economists’ think my money should be given to someone more deserving!

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      1. Thanks Mark. I think your arguments are in large part why the TWG only felt comfortable considering this approach for residential rental property where there was already a cash flow and was already in the tax system.

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    3. Andrea
      Thanks for setting that out so clearly and it is the debate the TWG should have had more openly.
      I have many comments on your paper and on the TWG contributions to the RFRM. Can I make a quick one to start. What is the problem NZ faces? If it is the growing wealth divide with massive wealth at the top 10% end and debt and homelessness compounding at the bottom end, driven in large part by a rampant speculative property market then lets make sure we address that. Any feasible CGT on realisation will only affect further widening of wealth, and only if it can actually be introduced- which we have seen it wont be under this government. The lock in effect is real. The problem of future losses is real.
      The theoretical example in your TWG paper shows, under some strict assumptions including that realisation actually occurs, the equivalence of the CGT and the RFRM, but only if we start from scratch. We actually start from a highly unequal ownership of residential assets. Introducing a RFRM today will capture past tax free capital gains in the base. On horizontal equity grounds, the owner should generate at least the bank rate of return on net equity held in residential land and housings otherwise why would they hold this asset? Suppose I am sitting on a $1 million house that is largely vacant as I wait for capital gains, an imputed taxable income of $30,000 might force me to rent it or sell. Perhaps rents/prices of housing would fall? Suppose that I have borrowed so have only $500,000 net equity my costs of borrowing at say 5% are $25,000 but I cant claim rental losses and I have to pay a tax on imputed income of $15,000-once again this incentivises renting and better allocation of resources in housing. I support an individual exemption of $1 million in an owner occupied home so that the vast majority of people would not be affected by the RFRM, but we would have a base that included luxury homes. This would encourage a better use of those housing resources and the tax would be payable by those with the most resources to pay it.
      Lots more to respond with but thanks for taking the RFRM seriously. I don’t deserve any credit for promoting it. I taught the economics of tax for many years and was very influenced by the clear logic of the McLeod Report and how the RFRM accords so well with the principle of horizonal equity – treating all sources of income, including imputed none cash income from owning assets the same, especially housing whether owner occupied or investment. NZ has led the world in this principle- especially in the taxation of saving- which has been such a good thing for a rational retirement income policy. Many other countries are so blogged down with their regressive and expensive tax incentives that make their pensions systems so difficult to reform.

      Liked by 1 person

      1. Thank you for explaining the equivalence point. At the time I remembering thinking it sounded odd but my energies were focused elsewhere.

        The fiscal forecasts for rfrm – on only residential rental property- didn’t align with that point. And I focussed on the respective forecasts.

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