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New Zealand's Long-Term Fiscal Position [June 2006]

5   Taxes and Other Revenue

This chapter discusses the financing of government expenditure.

The tax system

Total tax revenue in any one year is the product of the tax base and the rate at which taxes are levied on that base. In New Zealand, the main taxes are: GST, which is levied at a constant (“flat”) rate on virtually all consumption that takes place within the country; an income tax, which in turn is composed of a company tax, levied at a flat rate of 33%; and personal tax, which is levied using a progressive rate structure. In addition, the government levies excises on petroleum products (a fixed dollar amount per unit), tobacco products (fixed levy rate per kilo of tobacco) and alcoholic beverages (fixed levies per litre of alcohol, with different rates applying to beer, wine and spirits). Other sources of tax revenue include some tariffs on imports, road-user charges and some stamp duties.

For many taxes, the base is simply projected to grow in line with GDP, since this is either explicitly (eg, with income tax and GST) or implicitly (in the case of excises on petroleum products) the tax base. Tax rates are assumed constant.

In the case of the personal tax system, however, the progressive nature of the rate scale adds a complication.

Under the current rate scale, marginal rates of tax increase with income. There is currently a four-step scale (three main statutory rates of 19.5%, 33% and 39%, plus a low-income earner rebate that reduces the effective rate on incomes below $9,500 to 15%). Traditionally, the thresholds at which the different rates apply have been fixed in nominal terms, giving rise to “fiscal drag.” This occurs when increases in nominal incomes result in people moving up the income tax scale, lifting their average tax rate.

Given the assumption discussed in the previous chapter that wages grow on average at 1.5% a year above increases in prices, nominal wages will increase significantly over the projection period: by 2050, the average nominal wage (QES) will rise from the current level of around $42,900 to over $200,000. After adjusting for inflation, this average wage will be over $84,000 per annum in 2050 when expressed in today’s dollars. Keeping the current rate scale in place would mean people on the average wage paying tax at the top marginal tax rate. The average tax rate on this average wage would increase from 21% to 35%.

Traditionally, New Zealand governments have addressed fiscal drag by adjusting the tax scale in an ad hoc manner. In the 2005 Budget, the Government announced the introduction of an automatic system of adjusting the tax thresholds for price inflation. 33 This change has yet to be legislated.

Interaction between fiscal drag and the New Zealand Superannuation Fund 

A further issue that needs to be addressed is the interaction between contributions by the government to the New Zealand Superannuation Fund and the personal rate scale.[33]

This interaction between the tax scale and the contribution to the Fund involve a series of steps, the implications of which are not always obvious.

Under the New Zealand Superannuation and Retirement Incomes Act, the annual contributions to the New Zealand Superannuation Fund are directly related to the dollar amount of superannuation expected to be paid in the future. That dollar amount is, in turn, directly related to after-tax income, via the operation of the indexation formula in the legislation. The indexation formula says that benefits are adjusted annually by movements in the CPI, but must remain within a band of 65% to 72.5% of the average after-tax wage.[34]

The after-tax part of this formula is important. It requires the Treasury, when advising on the amount of contributions to the Fund, to form a view of the rate of tax to be paid by a person earning the average wage in each of the next 40 years.

This leads back to the issue of fiscal drag.

In operating the mechanism for calculating the contributions to the New Zealand Superannuation Fund, the Treasury has to date assumed that there is no fiscal drag and that the thresholds in the personal tax scale have been increased in line with movements in wages.[35] As noted above, this is a strong assumption, but one that is justified given the structure of New Zealand Superannuation.

Tax revenue projections

For these reasons, and for modelling simplicity, previous studies of the long-term fiscal position in New Zealand (and studies undertaken by other governments) have tended to assume that the tax-to-GDP ratio remains constant through the projection period. This tradition is continued in this Statement, with the bottom-up projections in this chapter assuming a constant ratio (see Figure 5.1). This assumption is relaxed in some of the top-down projections discussed in Chapter 11.

The impact of varying the fiscal drag assumption is also discussed below. Using the announced three-yearly price indexation of the tax thresholds means that the effects of fiscal drag would be reduced, but not eliminated.

Assuming a constant tax-to-GDP ratio is a strong assumption. It means that the effect of demographic change and other policy changes are left only on the spending side, when governments do have the option to increase taxes to finance increases in spending. But to go further and impose the precise mechanism by which the ratio is held constant may seem to be especially prescriptive.

Notes

  • [33]The details of the policy are that once every three years, starting in 2008, the various thresholds in the personal tax scale would be increased by the cumulative increase in the CPI over the previous three years.
  • [34]The confidence and supply agreement between the Labour Party and the New Zealand First Party requires the floor of the band to be 66% during the current term of Parliament.
  • [35]The recent strong growth in employment has had this effect: the number of people on benefits has fallen and the number of people in employment has increased markedly. Fiscal drag also occurs if the distribution of earnings changes. That is, if the number of people earning higher incomes increases, then the tax-to-GDP ratio will increase even if the personal tax scales are indexed to wages.
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