7.2 Tax policy
The SWG's Terms of Reference required consideration of the impact of the tax system on the level and composition of national saving and investment decisions, and of options for improvement (including taxing income from labour and capital at different rates, and taxing income on a partly or fully indexed basis).
Our Terms of Reference also noted that the Government “has recently said that it will not introduce broad and widespread taxation of capital gains or land.” Accordingly, the SWG undertook its consideration of tax assuming that this position will remain unchanged.
The SWG acknowledges earlier reviews of the tax system (most recently by the Tax Working Group (TWG)) and the policy principles underpinning that work. Taking that legacy as its starting point, the SWG considered these specific savings-related questions:
- What is the likely influence of the structure of the tax system (i.e., broad-based income tax and GST) on the decision to consume rather than save, and what could thus be changed to increase the level of savings?
- What is the likely influence of specific features of those taxes (particularly income tax) on the decision of what to save/invest in, and what could be changed to improve the quality of saving/investment overall?
7.2.1 Taxes and saving: a brief overview
Income can be taxed when it is earned (income taxes) and when it is spent (expenditure taxes). Taxes are often classified according to whether income is taxed (T), taxed at a concessional rate (t) or exempt (E) at three different stages:
- When income is first earned.
- When investment returns are earned if income is saved before it is spent.
- When income is spent.
Income taxes are TTE, because they apply to (1) labour income when it is earned (the first T) and (2) any capital income when the earnings are invested (the second T) and (3) because there is no further (income) tax when the earnings are spent (the third E).
Most countries use three types of taxes:
- General income taxes, applicable to labour and certain forms of capital income (TTE).
- Payroll and social security taxes, applicable only to labour income (TEE).
- Expenditure taxes (EET).
In addition, most countries offer special retirement saving vehicles (such as 401(k) accounts in the US) that are taxed on an EET basis. Money placed in these vehicles is not taxed when first earned, is not taxed as it compounds, but is taxed, normally at income tax rates, when it is withdrawn from the fund.
A major difference between income and expenditure taxes is that income from saving (capital income) is allowed to compound through time before it is taxed under an expenditure tax, whereas it is taxed as it compounds under an income tax. For this reason, the after-tax return to savings is higher under expenditure taxes than income taxes. Moreover, in comparison with an income tax where certain forms of capital income are not taxed (e.g., capital gains, the returns to owner-occupied housing) or are taxed at different rates (income from offshore investments, real interest income), expenditure taxes are applied equally to all forms of capital income and thus lower the incentive to invest in one form of capital rather than another because of differential tax treatments.
7.2.2 Current structure of the New Zealand tax system
Income tax: Relatively broad-based, taxes nominal (not real) income, TTE model. In a saving/investment context, important exclusions from base coverage are income from: investment by charities, most capital gains (apart from non-equity financial instruments). Income taxes are used both as a delivery mechanism for Working for Families and collection mechanism for Student Loans, etc.
GST: The most broad-based, global exemplar.
Past reforms: The approach, in the past, has consistently acknowledged that taxes inherently distort decision-making, but there are advantages in making rate structures simple and bases broad (at least as much as possible without a comprehensive capital gains tax). The focus has been on shifting towards GST and reducing income tax rates to minimise potential distortions.
Tax structure from a savings perspective: Looking at each structural component in isolation:
- Income tax influences when people spend as it taxes income from savings while it is being earned rather than as it is spent. The effective tax rate on real income from savings over time can be very high and there is a consensus that this unduly favours spending immediately rather than later.
- Most taxes (including GST and taxes on labour) are likely to distort investment decisions and involve some economic cost. Further, high taxes on savings accumulating over long periods of time can be particularly distorting. For this reason, Banks and Diamond (2010) argue for a positive tax on the return to saving, but argue that it should not necessarily be as high as the tax rate on labour income.
- Income taxes levied only on labour/employment income (such as social security/payroll taxes) do not distort the spending/saving decision although they do distort decisions over how long and hard people work. New Zealand has no taxes of this nature except the ACC levy.
- GST is seen as a tax that does not distort the decision to spend income now rather than save for spending later.
Box 4: Why is GST better than income tax when it comes to encouraging saving?
Imagine a family has $100 left from their monthly pay packet after normal expenses have been met and are deciding whether to spend it now or save it in the bank for 10 years earning 6% interest per year.
Imagine, too, that the country they live in, called Saveland, does not tax income from savings but does have a 15% GST. If that family banks its $100 for 10 years earning 6% per year, it will earn $79 interest, giving it a total to spend at the end of 10 years of $179. Whether the family decides to spend its $100 now or save it in order to spend $179 in 10 years, the rate of tax it will pay in each case is the same, 15%.
Now imagine that same family lives in Spendland, which does not have GST but does impose income tax at 33% on interest earned each year. If that family banks its money at 6% interest, at the end of 10 years it will have $148 to spend (after income tax has been taken out of its interest income each year). The impact of tax on the family's decision to spend or save is quite different. If it spends the $100, it will pay no tax. If it saves it, paying tax over time will have cost the family $31, an effective rate of tax of almost 40%.
Which family is more likely to decide to save their money rather than spend it?
Which country is likely to have a higher level of saving?
Box 4 gives an example of the way income tax distorts a particular saving decision. A further observation is that the distortion is higher the longer the money is saved, and the degree of distortion is different for different investments. In the example above, if the Spendland family saved for 20 years, the effective tax rate would increase to over 45%, and if instead of putting it in the bank, it invested in properties or shares returning 4% dividends or rent plus 2% capital appreciation, the effective tax rate after 10 years would be about 27%, and after 20 years about 32%.
When considering priorities for tax change, it is useful to bear in mind that as income tax rates are lower than they otherwise would be absent GST, New Zealand's income tax model is ttE (where the lower case t denotes a tax rate lower than what would otherwise be the case). Given that the GST rate is not as high as it would be absent income tax, it could be described as EEt. Together our system can be described as ttt.
This is not unusual internationally. The key issue from a savings perspective is how big the t's should be. New Zealand tends to be more reliant (than most comparable countries) on income taxes than on other taxes, and does not have EET or TEE applying to any retirement savings. It is likely, therefore, that the structure of New Zealand's tax system is more biased against saving than in comparable countries. Further, with no capital gains tax, the New Zealand tax system is biased towards a large block of economic activity – property investment – that tends to be at the less productive end of the spectrum.
