Tag Archives: Fairness

My fair tax review

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

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Fairly efficient or efficiently fair?

Let’s talk about tax.

Or more particularly let’s talk about the fairness v efficiency tension in tax policy.

You correspondent is now about two thirds through her gap year. There have been perks to not going to work. Meeting people I would never have met as a tax bureaucrat; working without getting out of bed; and morning yoga classes now being conceptually possible. And of course becoming your correspondent tops it out.

On the con side though is no income; a carefully curated wardrobe that just looks at me; and that not going to (paid) work is simply exhausting. I am the most demanding person I have ever worked for. There is no concept of downtime. 

Another con as a chartered accountant is there is no benevolent employer meeting my training needs – and my CPD hours – without me realising it.  So with this in mind earlier this year I arranged to attend – without credit – a postgrad course on International Tax. Two days which should sort out my CPD. Or at least push out the problem for another year. And after all those years in tax I know the benefit of deferral.

Now as a participant I need to give a talk. So I heroically offered to talk about the tension between the tax fairness people and the tax efficiency people. As at that time I thought I had reconciled them. Now not so sure. So I thought I’d riff to you dear readers and see how we go.

It is an internal discussion I regularly have – yes I really am that interesting. As in my heart I am a tax fairness person but one whose head worries about tax efficiency.

Let’s start with the wot these guys say:

Fairness people say: Everyone should pay their fair share; People should pay in proportion to their income; Tax is the price you pay for civilisation.

And Gareth has a nice general take on all this which can be paraphrased as an unfair economy is inefficient. But while I am quite attracted to that as I can’t explain it without hand waving – I won’t.

So going back to things I do understand.

Efficiency people say: New Zealand needs be an attractive place to invest; it is important tax doesn’t distort decisionmaking; company tax is a tax on labour.

Now in a domestic setting – New Zealanders using New Zealand capital employing New Zealanders; through the use of withholding taxes and imputation – efficiency and fairness cohabit happily.  Wages are deductible by firms and taxable to employees. Tax is deducted by the employers on the wages and this offsets the tax liability of the employee. Company tax can be used as a credit when dividends are paid. 

There is a progressive tax scale for individuals which applies no matter how they earn their income. There can be deferral benefits if money stays in a company; a concessionary PIE rate for top income earners; and interest is deductible when capital gains are earned. But all of this is cohabitation peace and harmony compared to the situation with foreign capital and New Zealand workers.

Now with foreign capital, tax paid here is next to worthless. The fairness argument is that it is that the tax is the price for using the infrastructure and educated workforce paid for from taxation. Reasonable argument but problem is that the use of that stuff is not conditional on paying tax. Classic public good/freerider thing in economics which is supposed to be stopped through the use of taxation. Mmmm.

And foreign countries give no credit for company tax paid here. They might give credit for withholding taxes but there is this whole ‘excess foreign tax credit thing’ that means they don’t. For serious tax nerds, yes there is the underlying foreign tax credit given by the US when dividends come back. But we all know how much they come back. So foreign tax is a net cost of doing business. And like all costs something they will minimise if they can.

This becomes all the more compounded when the foreign investor is a charity or pension fund or sovereign wealth fund and doesn’t pay even tax in their home country.  

So then the options are invest through deductible debt or pay tax but only invest if expected return is high enough to allow for paying tax.

Right. Then so how do we get the price of civilisation thing actually paid? Working on the assumption that foreign investment is good  – when I think the analysis is a bit more nuanced than that – do we just have to suck up lower foreign investment if we want more tax paid?

If only we had some New Zealand based studies to see what happened? Oh yeah we do. Company tax was cut once by Dr Cullen and then again by Hon Bill.

Did we see an uptick in foreign investment? Nah – according to Inland Revenue foreign investment as a percentage of gross domestic product pretty much didn’t change. 

Now of course there is a lot of noise in that; not the least that it happened over the GFC where normal rules did not apply.  And Inland Revenue did have a go at reconciling all the stuff. Maybe.

But the best expanation I ever got for tax and how it influences foreign investment came from a tax mergers and acquisitions person I met during my time inside. They said there are two types of foreign investment:

  • Normal foreign businesses who are looking to buy an equivalent New Zealand business. They make their decisons to purchase based on the headline tax rate and say the headline thin capitalisation ratios. Once that decison is make the tax people then swing in and look to minimise the tax further.
  • The second type was the private equity lot for whom minimising tax was very much part of their MO. They turn up with elaborate templates – which include tax savings – which then all fed into the decision to purchase and at what price.

Is this right? Dunno but it has always made sense to me. And helps explain the often ‘inconclusive results’ found when two sets of behaviours are blended in any data set.

And who do the private equity lot include? Pension funds, sovereign wealth funds and charities who have zero tax rates.

Ok so what does all of this mean to tax fairness people? I think what it means is be aware that the zero tax rate of significant international investors combined with the internationally lighter taxation of income from capital – none of which is addressed in the OECD BEPS project – mean that getting tax off foreigners may bounce back on locals in the form of higher prices or reduced investment.

To the tax efficiency people though – settle down – any impact is not one for one. The Inland Revenue stuff does show that there is a degree of taxation that is just sucked up by the owners of capital. Coz ultimately all business income comes from people who can get a bit p!ssed if they think you are free riding on their taxes paid infrastructure. And maybe they’ll spend their money somewhere else. Assuming of course that there is a taxpaying alternative coz it’s not like domestic capital is free from loopholes.

So will I say all this in my talk this week? Dunno but thanks for the chat dear readers. My head is clearer now. Thanks for listening.

Andrea

Fairness – Take two!

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:

Untaxed income 

Capital income

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?

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. 

Imputed rents

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.

Deductions

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

Withholding taxes

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.

Personal companies

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?

Other things

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.


Andrea

Who is the fairest of us all?

Let’s talk about tax (and fairness).


Fairness (or equity) and her sister Efficiency are two of the touchstones for tax policy. There is also a younger sister Simplicity but she tends to get left at home the second anything gets contentious or revenue is at risk. For Jane Austen readers think Margaret in any Sense and Sensibility adaptations.

For years Fairness was only paid lip service to and Efficiency was the queen. But now with news of multinational non-tax paying and the fallout from the GFC, Fairness is getting profile. At this point having got in a Margaret reference I was  wanting to make a Kate and Pippa reference or even a Kim and Khloe one. But neither of them really work as an analogy so I won’t.

Now as pleased as my inner left leaning tax geek is about Fairness/Pippa/Khloe getting the attention now, unlike Efficiency, Fairness means different things to different people.

I am sure dear readers that a number of you have either raised children or are still in the trenches.  I am sure also dear readers that while you always try to be fair; quickly you find fair is a relative concept.

You spend more time with the child who finds reading difficult. Now that is fair to you because that child has difficulties your other children don’t have. Strangely the other children may not see it that way.

They may not see the learning difficulty. Even if they do their view may be that is just how the cookie has crumbled and as your child they have an equal right to your time. Anything other than equality is simply unprincipled favouritism.

With tax the equivalent arguments run like this:

To the left what is fair is those who have the most should pay the most. And the more you have the more you should proportionately pay. This is also known as vertical equity and is the basis of the personal progressive tax scale; lower incomes pay a lower proportion of their income in tax than higher incomes.

To the right what is fair is that everyone pays the same or at least everyone pays the same proportion of their income.

The former which was taught to me in ECON 101 – in the same year I voted for the NZ Party – is a flat or poll tax. It is the economically most efficient tax as it doesn’t distort decision making at all kinda like a negative universal basic income. It is also arguably very fair as every person pays exactly the same amount of tax. And what could be fairer than that?

It is however HIGHLY regressive meaning it hits the poor far worse than the rich as potentially it could take all their income. But it is the same as the child without the learning issues wanting the same amount of time from a parent as the one with the learning difficulties.

Your correspondent has memories of her farewell party  in 1990 before going to London. Actually lots of memories as her darling friend R was making her drinks. But on the telly there were riots in Trafalgar Square as Margaret Thatcher was bringing in a poll tax. And that was only to replace rates.

So perhaps for this reason or just genuine human decency I have never heard the right in New Zealand proposing taxation being the same amount per person. But if fairness is the touchstone a poll tax could be considered fair as well as highly efficient.

Normally the right advocates flat (or flatter) tax rates. They tend to invoke the other sister Efficiency when doing so but there are also fairness arguments to support their position.

The main one is that it is fair that everyone contributes the same proportion of their income to society. And the left doesn’t need to stress as those who earn more will by definition always pay more in absolute terms.

Right. So what is a future lefty government to do that wants more fairness of the tax system. [I know you’ll want to reach for raising the top tax rate because – sigh – that increases vertical equity. But tax rate alignment does matter and if you want to do this you’ll need to do a bunch of other tail chasing stuff too. A future post I feel. And yes I will talk about multi-nationals at some point.]

As a good former bureaucrat I am all about the solutions. The key to improving the tax system is a combination of an examination of the application of horizontal equity – is income of different sources taxed the same way – combined with some old fashioned integrity measures aka closing some loopholes. Most of which will involve refinements of income classification, deductions and timing. But there is no silver bullet. 

Should give you an opportunity to also throw around Andrew Little’s quote about the average Auckland house earning more than the average Auckland worker. I do enjoy that one. Whether you get re-elected is beyond my ken as every hole in the base has a highly motivated constituency for whom equality feels like oppression. Imputed rents anyone?

Will also need to watch out that you don’t give away the farm. Coz a tax base is built on asymmetries and nothing feels less fair than being on the wrong side of an asymmetry.

But if this talk of fairness is code for raising substantially more revenue then in that case you need higher rates across the board not just on high income earners; a different base or to stop adjusting thresholds for inflation. Treasury has already done that work in the 2013 Long Term Fiscal Forecast which is worth a read. None of that should be too hard to package as fair as even a riot inducing poll tax can be packaged as fair.

I am on a yoga course this  week so it seemed appropriate that the Friday post be on tax and yoga. But I will return to this topic when I have the energy. I will also think about who Labour should put on their working group.

Namaste.

 

 

 

 

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