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Tax policy

The design of tax policies can have a significant impact on economic growth. Tax policy is a major tool that can assist in promoting economic growth.

Compared with other OECD countries, the current New Zealand tax system is robust. Tax bases are relatively broad and free of concessions. Headline personal tax rates also tend to be relatively low. The independent 2001 Tax Review found that the New Zealand tax system is fundamentally sound. Since then, good progress has been made to further strengthen the tax regime: targeting reforms to remove specific tax barriers to growth, simplifying the regime to reduce compliance costs for business, and continuing to maintain and broaden the tax base.

However, the most recent evidence suggests that, while sound, reform of the tax regime could better support economic growth.

All taxes affect people’s decisions to a greater or lesser degree. However, high marginal tax rates on personal and company income are more likely to have a negative impact on growth than others, by inhibiting the decisions that drive investment and enabling people to make the most of their economic opportunities. In an economy like New Zealand’s – with high participation rates and mobile labour and capital – these dynamic effects of high marginal tax rates on productivity are likely to have the greatest impact on growth.

Figure 7: Channels of influence of high marginal tax rates
Figure 7: Channels of influence of high marginal tax rates.
Source: The Treasury

Applying this growth analysis to New Zealand, the Treasury has identified three medium-term priorities for tax reform:

  • Reducing high marginal personal tax rates (33% and 39% rates). These create disincentives to people making the most of their talents and opportunities, discourage them from moving up the ladder of economic opportunity, and limit a key source of finance for investment.
  • Reducing the company tax rate (33% rate). High company tax rates reduce the finance available for investment and discourage investment in the ways that businesses can start up, grow and succeed.
  • Reducing high effective marginal tax rates (EMTRs). These discourage important parts of society from participating in the workforce, and making the most of their talents and economic opportunities.

Moving to lower high marginal tax rates is all the more important because other OECD countries have made significant tax reductions in recent years.

Figure 8: Marginal company tax rates
Figure 8: Marginal company tax rates.
Source: OECD and The Treasury
Figure 9: Marginal personal tax rates
Figure 9: Marginal personal tax rates .
Source: OECD and The Treasury

Since the company tax rate was set at 33% in 1990, there has been a consistent trend downwards in company tax rates around the world. As a result, the New Zealand company rate has moved from being well below the OECD average of 40% in 1990, to above the OECD average (around 31% for 2005).

While top personal rates are still below the OECD average, the gap has been closing and the top rates in New Zealand apply to a substantial proportion of the population, at relatively low incomes. For example, someone earning less than the average full-time wage faces the 33% marginal rate.

Reductions in tax rates can be achieved through a variety of ways. The Treasury believes that reducing rates directly will have the most substantial growth impact.

Increasing the thresholds at which rates apply reduces marginal rates for people who are above the old threshold and below the new one, but for people above the new threshold it only reduces average tax rates. The evidence suggests that marginal rather than average rates affect growth, so each dollar spent on reducing average rates will do less for growth.

Shifting abatement rates and thresholds for welfare assistance can reduce the EMTRs faced. The design of this is not straightforward. A lower abatement rate would reduce EMTRs faced by primary and secondary earners, but would also mean that the reduced EMTR is faced by a larger number of people across a wider range of income. This would probably increase the overall fiscal cost and increase the number of people affected by disincentive effects.

The most effective way to reduce high marginal tax rates on businesses is to reduce the company tax rate. Businesses can invest in capital, new products, people and markets in a wide range of ways, both during the start-up phase and as they continue to grow. Narrowing the company tax base, by providing concessions for particular kinds of business or activities, is likely to be less effective in creating economic growth as it can prompt tax avoidance, distort flows between different investments, and result in higher company rates for those without concessions.

Empirical evidence on the economic impacts of tax

There is relatively little direct evidence of the effects of taxes on growth for New Zealand. However, there is a richer body of international studies that can inform and support our analysis. These studies have made significant advances in recent years, analysing the aggregate effect of taxation on the economy, and analysing the specific channels through which taxes impact on growth. Taken together, these studies strongly suggest that high marginal tax rates damage growth, though there is still some debate about the scale of this effect.

Traditionally, empirical studies have found limited effects of taxes in aggregate on economic growth. This has changed in the more recent studies (broadly since 1999), as better methodology and techniques have been applied. These new studies have found that taxes on personal income, company income, payroll and property damage growth, while taxes on goods and services have a more muted effect on growth.

While significantly these studies suggest that high marginal tax rates on personal and company income are the most damaging to growth, they tell us rather less about why these taxes are damaging. This is where the more detailed studies of the effects of tax on particular decisions can help. Specific studies have found empirical support for a significant bias on decisions affecting the quantity, quality and productivity of the inputs used in the economy.

  • Between the 1960s and early 1990s, studies found that tax had a weak effect on labour supply. However, where survey techniques have taken account of the sample selection bias inherent in labour force surveys, studies show a stronger labour supply response on decisions to work or not.
  • Studies also show that high marginal tax rates:
    • discourage people from investing in their own skills and human capital, because the higher wages they could earn are taxed more heavily
    • discourage people from looking for (and moving to) better jobs that utilise their skills and pay more
    • make businesses less willing to undertake risky investments because successful investment is taxed disproportionately, reducing the expected return
    • discourage people from becoming entrepreneurs and starting their own businesses, inhibit the growth of these businesses, and increase the likelihood that entrepreneurial businesses will exit the market, and
    • discourage businesses from investing in physical capital and research and development.

Tax policy is also important for achievement of other government objectives, such as income distribution. High marginal tax rates are not necessary to ensure that high income earners pay a large share of total taxes. Currently, the top 10% of taxpayers pay about 45% of total income tax. Large reductions in the 39% and 33% tax rates would reduce this proportion to nearer 40%. Well-designed expenditure programmes can achieve far greater degrees of redistribution than can be achieved through the tax system alone.

Overall, reducing high marginal tax rates on personal and company income and reducing EMTRs are high priorities for growth. To help achieve the objective of reducing high marginal tax rates, we are keen to see tax reductions considered alongside potential new spending, as possible new initiatives for the Budget. Reforming the tax system could also be reflected in a long-term tax policy objective – to give greater clarity over the direction of tax policy over the next 10 years – as part of the fiscal strategy.

There is some flexibility to sequence, structure and phase the particular components of tax reform to reflect other policy objectives. For example, tax cuts could be deferred until the fiscal position is supportive, and then be phased in only to the extent that the fiscal position continues to support shifts between expenditure and revenue initiatives. The potential growth benefits from an improved tax system suggest to us that the incoming government should seek to pursue this policy within the shortest possible timeframe.

Recommendations

  • Reduce the higher marginal rates on personal income (33% and 39%), the marginal rate on company income (33%), and the high effective marginal tax rates at low to medium incomes (in particular for secondary earners)
  • Consider tax reductions alongside potential new spending as new Budget initiatives, as the fiscal position permits
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