Let’s talk about tax.
Or more particularly let’s talk about tax and fairness.
On leaving the bureaucracy last year there were two issues that drove me absolutely mental and I wanted to put my energies into. The first was the rising prison population at a time of falling crime rates and the second was homelessness. Since then with the former I have become the policy coordinator for JustSpeak and a trustee for Yoga Education in Prisons Trust. For the latter – zip.
So with that in mind I went to a recent Labour Party thing on Housing stuff. But about mid way Phil Twyford said that the Labour Party in its first term of office was going to do a comprehensive review of the tax system to improve its fairness. Now I have heard them talk about this before – but comprehensive review. Wow.
Since then Andrew Little has said they aren’t putting up taxes. So maybe this means this working group will be ‘tax neutral’ in the way Bill English’s was?
Now on the basis that this isn’t simply code for a capital gains tax, I thought I’d do a bit of a scan as to what this could mean in practice. My focus will be on the revenue positive items as the tax community will have their own laundry list of revenue negative ‘unfairnesses’ they will want fixing.
But first I am going to get over myself. Yes fairness could mean a poll tax but when the Left talks about tax and fairness it is implicitly a combination of horizonal and vertical equity. Horizontal equity where all income is taxed the same way and Vertical equity where tax rises in proportion to income.
Alternatively tax and fairness to the Left can also mean using the tax system to remove or reduce structural inequities in the economy and not just in the tax system itself. So here we go:
Now the most obvi unfair thing is the way capital income is taxed more lightly than labour income. Always loved Andrew Little’s comment about the average Auckland house earning more than the average Auckland worker. Dunno why he doesn’t use it more.
Now the lighter taxation might be there for some good reasons including:
- Long periods before it is realised. Is it fair to tax people when don’t have cash to pay the tax?
- Valuation issues. Although this goes once move to realisation based taxes.
- International norm. Soz unfortunately everyone taxes capital more lightly – sigh.
- Lock in effect. If have to pay tax would you ever sell?
- Incentive for entrepreneurship which is a good thing apparently.
Oh and not being able to get elected.
Options include a realised capital gains tax or Gareth’s wealth taxation thing. Both have issues but both would be an improvement if fairness or horizontal equity is your thing.
Alongside the not taxing capital gains is that we don’t tax imputed rents. Remember how owning your own home is effectively paying non-deductible rent to yourself and earning taxable rent? Except the value of the rent is not taxed? Awesome. But its non-taxation also offends the horizontal equity thing – even if it is your house – and so is unfair.
Active income of controlled foreign companies
New Zealand companies that earn foreign business income in their own names are taxed. New Zealand companies that earn foreign income through a foreign company aren’t. Why? International norm. Not fair but everyone else does that too. Also brought in by Michael Cullen. Nuff said.
Capital or wealth taxation
While Gareth’s thing is potentially wealth taxation it really is taxation of an imputed or deemed return on wealth rather than a tax on wealth per se. Actually taxing capital or wealth is where inheritance or gift duties come in.
Now neither of them are actually income taxes. They are outright taxes on capital. And if that capital arose from taxed income then would be very unfair to tax. However not entirely sure that is the case and these taxes are relatively painless as they tax windfalls; don’t effect behaviour and only apply to the well off. So they potentially promote fairness from a ‘reducing inequality’ sense rather than a horizontal or vertical equity sense.
There are a few things here. There are all the issues with interest and capital gains but they reduce if you ever tax capital gains or do Gareth’s thing. Others include:
- Borrowing for PIE investment can get deductions at 33% while PIE income is taxed at 28%
Donations tax credit
Now this isn’t an obvious one as everyone can get a third back of their donations up to their total taxable income. So that is pretty fair. But the more taxable income you have the more subsidy you get. And it can go to a decile 10 school; your own personal charity or a church with an interesting back story. But dude – seriously – who can afford to give away all their taxable income? Perhaps worth a little look.
Labour income that is earned as an employee is subject to PAYE and no deductions are allowed. Labour income that is earned as a contractor is only sometimes subject to withholding taxes and deductions are allowed. Aside from deductions which are likely to be pretty minimal with most employee type jobs – there is an evasion risk when people become responsible for their own tax. Spesh when such people are on very low incomes. Whole bunch of other ‘fairness’ issues too like access to employment law; but this is just a tax post.
Labour – and any income – can also be earned through a company. And a company is only taxed at 28% while the top rate is 33%. So if you don’t need all that income to live off you can decide how much stays in the company and how much you pay yourself. Is that fair?
Now of course there is always the old staple – increasing the top marginal tax rate. And yes that does enhance vertical equity but it also causes other problems elsewhere. So if you are going to make the system more misaligned please make sure that it doesn’t become the backdrop for widespread income shifting as it did last time.
Oh and secondary tax. Now there are many things that are unfair including precarious work and over taxation. Not sure secondary tax is one of them. While you have a progressive tax scale and multiple income sources – you get secondary tax. It appears that under BT – page 22 – the edges can be taken off getting a special tax code which should help but secondary tax in some form is structurely here to stay.
Look forward to it all playing out.
Let’s talk about (the recent Greens’ press statement on) tax.
Recent data has shown there is a spike around $70,000 of reported taxable income for individuals – convienently the point where the top marginal tax rate of 33% starts. And according to the Greens this shows evidence of tax avoidance by rich people which can be fixed by – among other things – increasing Inland Revenue’s investigation budget. Mmm maybe.
Before I go on, I am working on the assumption that when the Greens talk about tax avoidance it is in the colloquial ‘not paying as much tax as I think you should’ kinda way rather than tax avoidance according to the actual law. All cool but unfortunately (or fortunately) the department is constrained by what Parliament has enacted and how the Courts have interpreted it.
Now in the mid 2000s – it is true – similar spikes were evidence of widespread tax avoidance among self-employed professionals. The wheeze was that they were employed by trusts which were taxed at 33% on the income the individuals earned – not the top individual’s rate of 39%. And then the trust paid the individuals a below market salary for their services to the trust.
Only the below market salary was taxed at 39% and the rest of the income at the lower trust rate. And then any tax paid income of the trust could then be distributed tax free to beneficiaries. Too easy and too good to be true. Hence tax avoidance according to the actual law.
Moving to 2017. The trust and top personal rate are the same so that particular wheeze won’t work. But now we just have misalignment between the company rate at 28% and the top personal rate of 33%.
Except that under a misalignment with the company rate there is no distributing the income tax free. When income is distributed from the company to the shareholder – a dividend – it is subject to another 5% tax. Now any ‘tax avoidance’ – in theory anyway – is just timing until the shareholder needs the money. There should be no ultimate reduction in tax. Although timing advantages can be a big deal and can also make something tax avoidance under the actual law.
But the only way I can see of moving this from tax avoidance – not paying as much tax as I think you should – to tax avoidance under the actual law is if the department can show that the $70k is not a market salary – as they did with the self employed professionals.
And while that wasn’t simple for the department last time – now all tax advisors know about the need for a market salary – possibly from painful personal experience. So anyone giving advice that $70k is an acceptable salary – when the market rate is higher – does so knowing it could be attacked by the department and will have all the supporting arguments ready.
But the Greens are right the spike is still there. Last time the spike was widespread tax avoidance according to the actual law – so why wouldn’t it be this time too? Not the first time I have lacked imagination.
Just in case tho I am right – I am also all about the solutions. And there is at least one way of getting rid of the spike without increasing anyone’s budget. Think of all that extra money Greens you could spend on cleaning up the rivers instead of tax inspectors.
One way is to increase the company tax rate to the top marginal rate.
Another way is to make the look-through company (LTC) rules compulsory.
Currently any company with five or fewer shareholders can choose not to be taxed as a company. Instead income and losses are taxed as if the shareholders had earned the money themselves. Except currently those rules are optional. Make them compulsory and the spike goes. No more income in more lowly taxed closely held companies as no more closely held companies for tax purposes. Simple.
And the really good news for the Greens is that there is currently a bill in the House making changes to the LTC rules; so a Supplementary Order Paper doing just that would be totes in scope. Oh and it is an ‘annual rates’ bill too so they could also have a go at the company tax rate at the same time. Awesome.
Now lots of people who haven’t made an LTC election may not like that and say so quite loudly. Coz that’s what you get when you are strong on policing tax avoidance – lots of upset people all with lots of incentive to write to you and come and tell you how upset they are.
But unless the current law with closely held companies – or company tax rate – changes I can’t see any level of increased funding will get rid of that nasty spike.
Let’s talk about tax.
Or more particularly let’s talk about secondary tax.
Early on in my mothering life as a good middle class parent your correspondent – or probs a family member as I was pretty much exhausted for the first couple of years with each baby – bought Dr Seuss’ ABC.
Aunt Abigail’s Alligator A – A – A
All the letters had rhymes with words that started with the ‘profiled’ letter. The exception – pun coming – was the letter X. Because I guess xylophone and xenophophia were outside the target range for preschoolers – the rhyme became X is very useful for words like ax (with no fricken e) and extra fox.
Now while I was still 5 plus years away from discovering tax, Mr your correpondent and I always read that as extra tax. Coz I mean what is an extra fox for goodness sake? Aunt Abigail’s Alligator now that makes sense but – Dude really – an extra fox? What’s that about?
Now amonst the Precariat secondary tax is very much considered to be an extra tax. And according to the Council of Trade Unions the Labour party has promised – as they did last election – to repeal it on coming to government.
Thing is they haven’t actually promised that. They have said in the detail of recommendation S8 that the Government as part of Inland Revenue’s business transformation should look to remove secondary tax. These are subtle but important distinctions which we will come back to. Lucky for them Labour actually has someone on their team that gets tax.
So what is secondary tax?
Well it is the tax deducted on second jobs. It is a function of having the progressive tax scale that the left loves so much.
First jobs get code M which I guess stands for main job. It takes the pay and multiplies it by the number of pay periods to get an annual amount ; calculates the tax and then divides that by the number of pay periods to get the tax for the income in the period. While it is relatively simple it does mean those with lumpy pays – overtime; seasonal workers – are overtaxed as a high pay is assumed to be a high annual income.
Second jobs however people have to choose a flat rate – secondary tax – based on how much they earn from other jobs. And there is a view – clearly shared by the CTU – that this overtaxes their income. Now it is true that it taxes second jobs more than first jobs but this is really just to reflect that extra income means higher tax.
Coz remember how progressive taxation means the more income you earn the proportionally greater tax you pay? Yeah well this is how it is implemented for those with second jobs und the current PAYE system.
Now I fully get that as it is a flat rate and if you don’t earn as much as you thought you will be over taxed. But that is a function of our PAYE system being inherently middle class. As it works beautifully for those on stable incomes ie salaries.
Everyone else with unstable incomes – even if it is only from one job – runs the risk of being overtaxed and then yes needing the claim a refund. And then yes if you go to those refund companies they’ll take a cut. There is an IRD option but they don’t have the marketing budget of the refund firms so it is less well known.
The real issue though is the changing face of employment and precarious work – something the Labour Party is at least acknowledging and trying to address. Yeah I am not sure about the training levy either – but at least they are trying.
So yeah trying to get BT to address lumpy incomes is a good idea. So good that Hon Mike may have his officials on it already.
Just repealing secondary tax though is a really dumb idea.
Unless you are happy with undertaxation and people needing to file and/or becoming non-compliant with all the associated risks. Alternatively it is an argument for widening the bottom bands. But rich people will get that benefit too. So Labour Party – trying to get technology to solve it is the right direction.
Real issue though is the numbers outside the withholding systems coz they’re not employees.
Let’s talk about tax.
Or more particularly let’s talk about about a case I mentioned last week in the alignment post. It was quite controversial at the time within the tax community and did leak out a bit into the general public. As is often the ‘case’ tax is just an overlay on other interesting stuff.
Also thought of it again wot with the junior doctors strike and how the consultants would be helping over that period. I guess coz its Health that means its not strike breaking?
Anyway back to the case. Penny and Hooper (last names) were both specialist doctors earning shed loads of cash in Christchurch fixing the bung knees of those who were in denial about the length of their running careers and had yet to find yoga.
Now these gentlemen were unremarkable in that they weren’t big on paying tax according to the progressive tax scales that applied to little people and so adopted a structure recommended by their accountant. I mean everyone was doing it and what could possibly go wrong. In fact even John Shewan – of Shewan report fame – said it was bog standard behaviour.
The wheeze was that they put their businesses into a trust which at that time had a lower tax rate (33%) than the little people faced who earned over $60,000 ( threshold increased at some point but detail not relevant) 39%.
The Commissioner who was a he at the time – yes Virginia men can be senior public servants – was not best pleased. He used a bunch of words like ‘tax avoidance’,’market salary’ and ‘not’and made them pay tax like the little people. Go Team Commissioner.
The tax community also used a bunch of words like ’emmently foreseeable’; ‘lack of certainty’; and ‘chilling effect on investment’. Well maybe not the last set but that is never far away when the big people are being made to pay tax.
Anyway the Commissioner won; tax accountants lost; largely graciously ate that and everyone moved on to the next tax dept v tax community stousch.
There was some commentary at the time about how this was more than a tax case – at which point I got very excited – only to find it was about trusts could be looked through and weren’t as inviolable as people thought.
But what was never discussed was how two men who were educated at the state’s expense presumably before student loans; weren’t bonded; and whose business was almost wholly paid for by the taxpayer via ACC were earning so much money. I guess it was before the days of ‘joined up government’.
I also guess Labour’s ‘three years free’ policy will also remove what little royalty we currently get from the taxpayers’ investment in such lovely people.
All the more reason then guys to make sure misalignment works and they do actually pay the top tax rate.
Let’s talk about tax.
Or more particularly let’s talk about tax; interest deductions and private expenditure in companies.
Your correspondent has returned from her ‘retirement cruise’; is recovering from jetlag and has returned to what passes for work these days. That will dear readers include a return to twice weekly posting. As a change from some of the more political posts I thought I’d return to a technical issue for a bit of light relief.
Earlier this year while I was still inside I went to a dinner party in a provincial city. At the party was a delightful gentleman I had met previously and was more than pleased to see again. The feeling appeared to be mutual and our conversation broadly went like this:
DG – Now Andrea tell me – which is better? To pay my mortgage or to pay my tax?
Me – cough, splutter, mumble – well the thing is it isn’t a choice as tax is a legal obligation.
DG- oh don’t be silly of course I know that. What I mean is it better to have a mortgage on my house get the tax deductions and then have money to invest in shares and things for capital gains or have no mortgage not get the tax deductions but have more disposable income?
Me – Ah what makes you think you get a tax deduction for the mortgage on your house?
DG- This is the country – we get tax deductions for all sorts of things and besides I’m the director of a land owning company!
Me – Is that wine over there?
Now dear readers I am sure after Zen and the art of tax compliance you all know that to get tax deductions the expenditure has to be:
- Connected to the earning of income or in the ordinary course of a business and
- not private or domestic expenditure.
So therefore if DG owns his house in his own name – or in a family trust – as neither 1) or 2) is met there is no deduction for interest expenditure.
There is the possibility that if the money were borrowed on his house and used to buy shares THAT WERE DIVIDEND PAYING then the interest would be deductible. But if the money is borrowed to construct the house for him to live in – nuh.
The complication though is the comment about being a director of a land owning company. The rules above do not apply to a company and interest deductions. From about 2000 or so the rule broadly became:
- Are you a company resident in New Zealand?
- Have you incurred an interest expense?
If yes to both, then ‘would you like interest deductions with that?’
The private and domestic test still applies to such expenditure but I have always struggled to align any concept of private and domestic to a company.
So at first pass – yep – if DG holds his house in a company – in your correspondent’s view – he will get an interest deduction.
And yeah the Mixed Use Asset rules won’t apply here because ironically it isn’t a mixed use asset – it is wholly private and domestic.
But – not so fast – the music hasn’t stopped.
While there are special rules for companies and interest deductions there are also special (dividend) rules for transactions involving companies and shareholders aka ‘are policy makers really that dumb?’
These dividend rules say where ever there has been a transfer of value from a company to a shareholder there is a taxable dividend to the shareholder to the extent of the value transfer.
Ok again in English.
If a company gives a shareholder stuff – goods or services – that is a taxable dividend for the shareholder. Here the company has given the shareholder use of a house – so the shareholder DG – gets a taxable dividend.
And by ‘taxable dividend’ yes this means you need to put that value on your tax return and pay tax on it. And yes I know you didn’t get any actual cash but that doesn’t matter. You know how when you tick the box for dividend reinvestment on your publicly listed shares – you know how the dividend is still taxable even though you didn’t get any actual cash. Consider this as the same.
So what is the value that DG has received from the ‘land owning’ company? He has received the benefit of living in that house. And what do people usually pay for the benefit of living in a house they don’t own? You’re onto it – rent.
DG is then up for tax on the value of the rent not paid to the company as a dividend. And once more with feeling – it doesn’t matter that no cash has been paid from the company to the shareholder.
So the benefit DG received – use of the house without paying rent – is taxable to DG.
Now if DG has a tax rate of 33% – as the company tax rate is 28% – there will be a net 5% tax paid on the ‘imputed’ or deemed rent. That is he pays tax at 33% on the deemed rent and the company gets a deduction at 28% on the interest expense. In other words a gift to the people of New Zealand and how tax planning can go wrong. And if he didn’t know this was the case until my former colleagues come along – it will be 33% tax plus interest at about 8% plus a penalty of between 10% and 100%.
Awesome. Can only hope he didn’t also pay an agent for this wizard advice.
If his tax rate though is lower than the company rate this is where it could get really interesting. Technically even with DG putting the value of rent on his tax return there will still be a net tax deduction that ostensibly can be offset against other income.
In this case though the structure – or ‘arrangement’ as my former colleagues may start to call it – is really putting pressure on the whole ‘companies can’t have private expenditure’ thing. And from here we move into a complete world of pain – or ‘good case’ depending on which side you are on this – known as tax avoidance. Now the entire interest deduction is at risk with tax avoidance penalties of between 50% and 100%. Fun huh.
And don’t even think of paying rent to your company and making it a look through company so you get the deductions directly against your other income. The department was very clear with look through companies – the prequel – that this was tax avoidance too.
So DG I am not sure there really is any ‘country immunity’ for interest on your personal mortgage. Pay it but step away from the tax system. There be dragons.
Let’s talk about tax (and tax rate alignment).
Your (foreign) correspondent is finishing up her ‘retirement cruise’ and gearing up to make that execrable journey home – also known as long distance economy class travel.
The yoga is going well too – thanks for asking – even without regular access to a studio. In large part to now knowing how alignment needs to work with my skeleton rather than that of a textbook Indian man.
So I have been thinking about this, how foreign tax systems are pretty much all misaligned, and that I promised to talk about the tail chasing stuff needed to make a higher top marginal tax rate work – or at least not not work. Because like misaligned bodies in yoga; misaligned tax systems also need props to work.
So today dear readers you get top personal tax rate alignment issues.
A couple of years ago while I was still a Treasury official I was at a social engagement and found myself talking to a Greens’ supporter. We were talking about the Christchurch earthquake and the rebuild and stuff – yes I do have all the fun – and the convo went something like this:
GS: You may remember that Russel proposed an earthquake levy as a means for the whole of the country to support Christchurch.
Me: yeah I remember that and on the face of it it did have merit – the problem is that whenever you increase the gap between the personal rates and the trust and company rate – you get people moving income into different forms. You may not collect all you think you will.
GS: [eye roll] you’re not one of those people are you? Other countries cope.
Well yeah I am ‘one of those people’. I really do like alignment and again not from a ‘purity of the tax system’ thing but because – like keeping R&D tax incentives out of the tax system – it serves us. It serves us because no matter how clever people want to get with their structuring – you always get the same result.
Alignment – like a capital gains tax is not a silver bullet and – doesn’t mean:
- everyone magically starts earning income in their own names or
- income that isn’t taxed magically starts becoming taxed
It just means that there is no incentive to start finding a bunch of non-tax commercial reasons that coincidently mean current taxable income is now earned in different lower taxed forms.
But next lefty government if you do want to raise the top rate for individuals – you are going to need some tax props to stop or reduce the tax injuries. That is how othe countries cope. Have a look at page 36 of IRD’s 2005 BIM.
First thing that is beyond key is the trust or trustee tax rate. This must be raised too as income taxed at the trustee rate can be then given to beneficiaries without any more tax to pay. Australia has. All the Penny and Hooper drama happened because the trustee rate wasn’t raised too.
However there are potentially some collateral damage issues from this – aka political risk:
- Will estates
- Trusts for the ‘handicapped child’ or the disabled relative
Australia deals with these respectively by taxing at the progressive tax scale and giving the Commissioner a discretion to alter the rate. In the last – and possibly both – cases face palm. Given our tax administration’s aging computer and business transformation programme – a better option would be treating them like widely held superannuation funds and giving them the company tax rate.
You could also do something like giving them a non-refundable tax credit to get the rate back down to 33%. That technology was used in cashing out R&D losses. But this is all second order design detail and nothing officials and/or your working group can’t sort out. No biggie. It might be a bit messy but nothing compared to the carnage involved with not aligning the trust rate.
Next issue is companies and that is a bit harder. I am assuming raising the company tax rate is off the agenda – yeah thought so.
Misalignment with the company rate – as we do now – is marginally less risky as distributions from companies – dividends – are taxed in the hands of the shareholders. And they use my personal favourite technology – the withholding tax. There is currently an additional withholding tax on dividends when they are paid bringing total tax up to 33%.
You could keep the additional withholding tax at 5% and make people file who need to pay more tax – as there was no withholding at all last time there was a 33% company rate and a 39% top rate. But there also wasn’t alignment with trusts and that went well.
Or you could raise the withholding tax to – say – 11c and people who need refunds would then need to file. Or possibly a progressive withholding system from say 5c to 11c. All technically possible. But all options will raise compliance costs on taxpayers and/or administration costs on IRD. And remember the aging computer thing?
The real issue is whether our dividend rules last properly looked at almost 25 years ago can stand the strain of say a 11c difference between the company rate and top personal rate. There are ultimately limits to how long people can pay themselves $70k salaries but have a $200k lifestyle. You need to make sure you get that extra 11c when they decide to sort out that gap.
Alternatively you may like to consider making the look through company rules compulsory for all closely held companies. This would mean the company wasn’t taxed and all the income went to shareholders personally.
Neither issue will need to be part of the first 100 days tax changing under urgency that is de rigeur for new governments. It can be sorted out with consulation and will be better for it. But you will need to be prepared to use these tax props if you don’t want the 2000 – 2009 mess again.
Think that’s it.
Hardest thing will be reprioritising the existing BT and BEPS work programme to get space for this and your new fairness working group stuff.