Nature and magnitude of the problems with current personal tax settings

Consistency with broad base low rate tax policy framework

The modern criteria for an efficient tax system typically focus on minimising ‘dead-weight costs' (e.g. the loss in efficiency as a result of tax-motivated choices), taxpayer compliance costs, and administration costs (of the collecting revenue authority), while taking into account tax incidence and equity issues and the informational limitations of policymakers. The number of tax system frameworks that are able to achieve this is small. One tax framework which more consistently meets these criteria is known as the Broad-Base-Low-Rate (BBLR) framework.

The best evidence available suggests that the BBLR framework is the optimal approach to tax policy for New Zealand in the medium-term. This framework aims to improve economic efficiency (and ultimately enhance economic growth performance) by reducing the distortions to economic decision-making caused by taxes. The BBLR framework achieves this by employing extensive tax bases and applying low tax rates to those bases in order to reduce the behavioural distortions caused by the tax system as far as possible. In other words the BBLR framework aims to make tax a neutral factor in decisions, so that decisions can be made based on their underlying economic merit rather than being influenced by tax considerations. The BBLR framework attempts to do this while at the same time raising the revenue required to fund government expenditures (and striking a balance between the associated taxpayer compliance and Inland Revenue administration costs incurred to achieve this revenue objective). High tax rates are inconsistent with the BBLR tax policy framework, which seeks to minimise the economic harm caused by taxes. While pursuing a BBLR framework, other factors such as equity and the tax system's redistributive role are also taken into account in tax policy design.

High Marginal and Average Tax Rates are damaging to Economic Growth

For income taxes in particular, the BBLR framework involves taxing a wide base of income at low MTRs on the basis that high MTRs are damaging to economic growth. High MTRs negatively impact on economic growth by unduly influencing decisions to work, save, invest, and consume, leading to inefficient allocation of scarce resources. Studies show that, by reducing the associated after-tax returns, high MTRs:

• discourage individuals from investing in their own skills and human capital;
• discourage people from seeking more productive work opportunities;
• make businesses less willing to undertake risky investments;
• discourage innovation and entrepreneurship;
• inhibit business growth; and
• increase the likelihood that productive businesses will exit the market.

Total New Zealand income tax revenues, as a percentage of GDP, are higher than the OECD average and have a particular emphasis on labour taxes. Although high MTRs reduce the incentives to increase hours worked, and the decision to undertake further employment, high average tax rates (ATRs) influence labour participation decisions, and particularly the decision to enter the workforce. Unless changes are made, fiscal drag will result in many taxpayers facing ATRs at 20-year highs by 2018, even with the tax cuts provided in Budget 2008. It is known that within the overall New Zealand workforce participation figures, particular groups of taxpayers (e.g. non-primary earner household members) have low participation rates but are relatively responsive to tax rates. Australian data has shown that non-participants in the labour market are responsive to ATRs, and it is estimated that Australia’s recent tax changes will encourage a significant increase in participation from new labour market entrants. Therefore, although participation rates in the New Zealand labour force, like Australia, are relatively high, it is likely that reductions in tax rates will improve productivity and participation in the labour market.

Further, New Zealand statistics show that, based on the current personal tax rate structure (including working for families tax credits (WfF)), around 35% of all primary earners will face MTRs of 39% or greater (rising to 50% by 2018). There is also significant evidence of tax-planning to mitigate the exposure to high MTRs which is undermining the integrity and efficiency of the tax system. For example, IRD data shows increasingly large ‘spikes’ in the taxpayer income distribution at incomes around $38,000 and $60,000, with ‘troughs’ immediately above those values. This is shown by the graph below:

Figure 1 - Aggregate taxable income of individuals by $1,000 bands of taxable income (year ended March)

Sources: Policy Advice Division, Inland Revenue

There is also evidence of the growing use of trusts (where income can be taxed at a final rate of 33%) since the increase of the top personal tax rate to 39%. Also, the difference between the top personal tax rate of 39% and the company tax rate of 30% creates distortions such as tax-motivated incorporation.

As well as affecting participation within New Zealand, in an increasingly globalised environment high tax rates also affect the decision of workers, especially highly-skilled workers, to stay in New Zealand or to work abroad. New Zealand’s highly-skilled labour has become increasingly mobile and sought-after globally. This is underscored by trans-Tasman migration in particular, causing problems for New Zealand in terms of skills and knowledge retention and the ability to foster an environment of innovation and entrepreneurship. This labour mobility issue is highlighted by the fact that around 25% of skilled New Zealanders now live abroad. The substantial magnitude of this expatriation is illustrated in the table below:

Figure 2 - 2000: New Zealand expatriates as a % of all native born (OECD countries: total population and highly skilled)