Appendix: Some considerations for the reform of the taxation of financial intermediaries

The purpose of this paper is twofold, first to demonstrate the importance of financial systems to economic growth and second to outline the potential influence of policy on the effective functioning of financial systems. Because this paper has discussed the tax issues at some length, this appendix provides a brief sketch of one way to view a financial intermediary for the purposes of taxation.

New Zealand’s lack of a capital gains tax is driven by practical considerations rather than as an application of economic theory to define the appropriate tax base. The resulting differential taxation between direct and indirect investment appears to create economic harm such that changes to tax policy are suggested on practical grounds alone. It is still valuable to attempt to reconcile an appropriate tax base for financial intermediaries from an economic perspective, in a country with a tax base that deviates from comprehensive income as defined by economists.

The concern that savings through financial intermediaries may be over taxed or taxed inconsistently has been frequently raised, and as a result several proposals have been circulated to address these issues over time. The approach to reform, the selection of reform options, and the design of any reform option would be assisted if economic theory could provide some guidance as to how to conceive of the function of financial intermediaries and their position relative to savers in a tax base that does not tax comprehensive income. In this appendix we outline such an attempt at reconciliation – albeit one that would require further policy development work. At a high level, we suggest that, in a country that does not have a capital gains tax, it may not be necessary to tax all cash flows from financial intermediaries to savers in order to tax this industry at the same level as other services providers.

Across the economy, and particularly with reference to transactions between firms, the current approach to delineating capital gain and income has much to recommend it. As demonstrated previously however, the application of the capital-revenue boundary to financial intermediaries used by savers may not be working well at present. To some extent this is because it fails a fundamental test of tax policy – taxing close substitutes in a widely divergent manner.

There are two overriding economic objectives guiding current tax policy in this area. One is the desire to tax traders (whose business is to generate income through the realisation of capital gain) to avoid distorting labour allocation decisions and to prevent erosion of the substantial services tax base.[60] The second objective is to tax the productivity of the financial services sector as any other sector of the economy. There is a third practical objective against which any change away from the current approach must be measured, which is to avoid opening avenues to additional tax avoidance.

None of these objectives demand that the capital gains of savers whose funds are managed by intermediaries must be on revenue account (i.e. classified as taxable income) or that otherwise untaxed gains received by intermediaries (on the sale of shares for example) must become taxable when these proceeds are distributed to savers. This does not mean that the economic contribution of financial intermediaries should escape tax or bear a reduced tax compared to other industries – they should not. Neither should savers who use intermediaries be over taxed.

With respect to the financial system, the business and purpose tests separate the taxable gains of “traders” from the untaxed gains of regular savers. A trader is defined by tests that reference their practices associated with investment. By analogy, an intermediary that conducts those same practices as a trader is taxed in the same manner as a trader, and if those services are conducted on behalf of a saver then the same tax treatment flows through to that saver. Extending this analogy, “mum and dad” savers effectively become traders if they use an intermediary.

While this analogy sounds intuitively compelling, it does not actually follow from the economic objectives of taxing the sector and in fact following this approach may be economically harmful. The implied approach is in some ways out of line with the way other services would be taxed. Further, in practice, such an approach results in widely varying tax treatment for closely substitutable behaviour. This is because, generally speaking, if “mum and dad” savers did undertake many of the practices done on their behalf through intermediaries, the result would often be that their capital gains would not be taxable.[61]

As in other industries, it would be expected that the portion of the benefit an intermediary can provide to a saver that is a potential basis for taxation would be captured in the fees an intermediary can charge savers to provide those services. The basis of taxation of services generally is the fee paid for that service (less expenses). This is despite the fact that it is well understood that the value of the services provided to the consumer is expected to be higher than the fee paid (since they were willing to pay the purchase price). When a service provider is managing the financial assets of a saver, one of the benefits returned to that saver is the potential for increases in the value of the saver’s assets. For a saver, this benefit is delivered as money, but the benefit is no different than the added value a consumer experiences from a taxi trip, over and above the price paid to the driver for the ride (in a country with no capital gains tax). Simply because a benefit if delivered in money does not mean that the benefit is defined as income. To tax the benefit a financial services provider delivers to its clients, when the benefits provided by other providers of services remain untaxed is to apply a more comprehensive definition of income to some services than to others. As a result, in a system without a capital gains tax, it is not necessary to tax the capital gains of savers who use intermediaries in order to effectively tax the production of intermediaries paid to generate those gains.

Further, taxing capital gains on investments through intermediaries is not necessary to effectively tax individual traders or to prevent them from avoiding their tax obligations.[62] It is not desirable to create a tax subsidy for individual traders. Tax policy is aimed at taxing the productivity of traders in the same manner as other businesses, and does not seek to create an incentive for trading activity relative to the tax burden on other labour. As a result, with respect to investment decisions effectively made by a financial intermediary, to whom a taxable fee for service has been paid, it is not clear that resulting capital gains provided by that intermediary to a saver must also be subject to tax by the analogy that the intermediary is effectively carrying out the will of the saver.[63] Often, a saver has ceded control of their investment decisions to an intermediary, in order to gain the benefit of that intermediary’s talents in return for a fee. This lack of control is particularly apparent in the operation of pooled investment vehicles, which are also the type of intermediary that typically faces tax hurdles of the type described in this paper. Capital gains delivered to the saver in excess of fees paid would represent a benefit to the consumer (consumer surplus), of the type consumers realise with respect to many of their transactions, and which the tax base generally does not seek to take an interest despite the fact that it is sometimes measured in money. There are many instances where an individual might contract a service provider to perform a service that results in the increase in value to a capital asset (such as a house), which does not imply that the asset in question falls on revenue account as income. By contrast, when a trader is effectively conducting the services of a financial intermediary to generate increases in capital value for their own benefit, there is logic to taxing that trader on their capital gains.

Figure A1 considers a transaction between a buyer and a seller in the presence of a tax. This simplified diagram contains a number of implicit assumptions, but it is useful in the context of considering the taxation of financial services in the same vein as the taxation of other services. In this diagram, a typical upward sloping supply curve and downward sloping demand curve are represented. The demand and supply of financial services are both relative to a market fee level. The tax in this diagram is a tax on fees paid. Note that the size of the tax (the difference between the pre and post tax supply curves) is larger than the price increase resulting from that tax. This is because, in this diagram, producers and consumers are sharing the incidence of the tax. The area of the triangle marked as a, below the demand curve but above the market price, represents the value to consumers from purchasing services at a price below what they would be willing to pay for those services. It is the additional value delivered to savers by intermediaries, some of which may be in the form of capital gains. The area of the triangle marked as b, above the supply curve but below the market price represents fees charged in excess of the expenses of an intermediary.

This simple diagram represents the general case of a per unit tax on supply, and demonstrates that such a tax is typically measured relative to income (price times quantity) less expenses (represented by the supply curve). In this case it would be expected that there is an additional untaxed value derived by a consumer (consumer surplus), which is not at all surprising or unusual. If this surplus is represented by capital gain then to tax such gains is to place an additional tax above the one represented in Figure A1, which for the consumer would represent a percentage of the triangle marked as a. An industry that generates such gains for clients would be taxed more comprehensively than other services industries, which may generate less tangible gains. In a country without a capital gains tax, to tax such gains when they occur as the result of contracted services will distort against the use of an industry providing such services.[64]

In order for any changes to the tax treatment of the capital gains of savers using intermediaries to have their full effect, those gains could not be clawed back on distribution by the intermediary, as is the case at present. This claw back function also serves to limit certain types of abuses of the tax base, and so any move to change in this era would have to evaluate potential impacts on the tax base.

Figure A1 – Consumer and producer surplus

With respect to non-controlled share purchases by savers through a financial intermediary, net fee for service may be the appropriate tax base for that transaction. It does not follow that the appropriate tax base is the same for investments made by financial intermediaries for the benefit of themselves, their owners or their shareholders.  With regard to these transactions, where the intermediary is conducting services on their own behalf the current taxation of capital gains appears to be appropriate in those cases.

This framework considers the appropriate tax treatment of investment income obtained by an intermediary for the benefit of a saver.  The financial system includes a broad range of transactions and tax issues.  As a result, this is a brief overview of an area where further work is recommended rather than a detailed policy proposal.  Several initial questions of detail are raised by this alternative approach, just as a number of detailed questions remain unresolved about the current tax system in this area.  If it is determined that the capital-revenue boundary is an issue worthy of policy attention, this brief outline provides one starting point for a reform process.

One benefit of taxing capital gains and distributions of intermediaries as companies is that it restricts their incentives to participate in certain attempts to circumvent the capital-revenue boundary through lease inducement payments, capital contribution payments, and the like.  Any such gains would be clawed back at present when they were passed back to savers as dividends.  Any policy movement along the lines suggested in this paper would require that the objective of economic growth be balanced against any potential base maintenance concerns.  An important consideration as to whether a change in the basis of taxation for financial intermediaries would be worthwhile is the level of economic cost associated with the current tax regime.  The information asymmetry framework used in this paper suggests those costs may be substantial.