7.2 Tax policy (continued)
7.2.7 Indexation
It is well accepted that taxing income on a nominal rather than real (i.e., inflation-adjusted) basis not only lifts the effective rate of tax on savings (and exacerbates the bias to current consumption), but it also changes the after-tax return to different investments and therefore can have a detrimental impact on quality of savings/investment. Although inflation rates have been relatively low for some years, they are nonetheless significant in the context of real investment returns, particularly if nominal interest rates are also low. This is perhaps most evident in relation to interest, where a lack of indexation is potentially doubling effective rates of tax for many investors (while at the same time providing a significant subsidy to borrowers). The SWG recognises that indexation is not common in other countries (and even then, usually only short-lived in times of high inflation), and that it would add complexity to the tax system and involve significant fiscal cost. However, the SWG:
- Finds it incongruous that income from the simplest saving products – bank deposits or loans – face the highest real effective income tax rates in New Zealand.
- Sees no reason for subsidising investment financed by foreign debt (by allowing firms to deduct nominal rather than real interest payments for tax purposes) and thus discouraging foreign equity financed investment.
- Sees no reason why depreciation allowances or inventory costs are not indexed for inflation.
- Notes that failure to index the tax system increases the tax incentives for New Zealanders to invest in owner-occupied housing rather than other forms of saving products, and for investors to invest in property rather than other classes of assets. There are reasons to believe that the-non-indexation of the tax system contributed significantly to the recent house price boom, and may have, as a result, lowered home ownership rates.
Box 6: Effective tax rates on different classes of investments
The following figure shows the effect of inflation and other factors on the effective real tax rates on different classes of assets for investors on 17.5% and 33% marginal tax rates, when the inflation rate is 2% and nominal interest rates are 6%. For rental housing, 50% of the return is assumed to be rent and 50% in non-taxable capital gains.
- Figure 7.1: Real effective tax rates
- Source: Treasury (2010b)
The large differences in effective rates distort the way people hold their savings and are likely to have played a part in New Zealanders' attraction to owner-occupied and rental housing since these asset classes are tax preferred over shares and debt instruments. The SWG's tax proposals, including broadening PIE and inflation indexation, would reduce these differences by lowering tax rates on the returns from non-property saving options. They would provide a higher after-tax return and thus a more attractive alternative to property investment and would be likely to raise the efficiency of investment and restrain house prices.
There are two reasons why non-indexation may be more distortionary in New Zealand than other countries.
- Most other countries impose capital gains taxes, which reduce the incentive to borrow to invest in asset classes that increase in value when there is inflation.
- Most other countries provide households with retirement saving vehicles that are less distorted by inflation because they are taxed more according to expenditure tax principles rather than income tax principles.
In the absence of indexation, the New Zealand government will continue to impose significantly penal tax rates on lenders and offer significant tax subsidies to borrowers.
The SWG notes the conclusion of the 1989 New Zealand Government Consultative document on the taxation of income from capital (the Caygill report) that indexation was not infeasible.
The SWG therefore recommends that the Government considers two options for indexing the tax system:
- At a minimum, index interest income and expense (arising from all non equity-type financial arrangements) by a notified standard rate that reflects the rate of inflation (e.g., 2% per year)
- Alternatively, index interest (as above), together with asset cost bases for depreciation purposes, and, potentially, trading stock opening balances.
The SWG acknowledges that other recommendations it is making (such as reducing income tax rates both generally and on income from savings) may ameliorate the adverse effect on saving of not indexing for inflation. However, it considers there is merit in indexation even if other changes proceed.
7.2.8 Company tax rate
The SWG saw no compelling saving-based case for unilaterally further reducing the company tax rate. In the New Zealand domestic context, company tax is akin to a withholding tax: tax is paid by the company on its profits pending a credit against each (New Zealand resident) shareholder's own tax liability as and when such profits are distributed through dividends and bonus issues. With respect to non resident shareholders (who do not get the benefit of imputation credits) a reduction in the rate of company tax in New Zealand will usually just involve a windfall benefit (and for those few countries that provide a credit for New Zealand tax, just a shift in where it is paid). While adopting very low rates of company tax is a mechanism used by a number of countries to make themselves more attractive to foreign investors, the SWG is sceptical of New Zealand's ability to compete effectively in this regard - both due to fiscal affordability, and other countries having ‘deeper pockets'.
The SWG recognises both that there may be net benefits for the economy in reducing the company tax rate, and that there may be a case for reducing it in light of changes to other aspects of the income tax regime (e.g., if PIE and resident withholding tax rates are further reduced).
7.2.9 Other
The following features of any system that taxes income from savings/investment can adversely affect the quality of savings/investment by impacting on decisions on what to invest in and how to structure investment: inequity/inappropriateness, inconsistency, and complexity. These are all inevitable to some degree in any income tax system, and New Zealand does better than most. However, the SWG recommends that the following areas should be examined in more detail in order to create a better environment for quality investment decision-making.
Inconsistent tax treatment of different forms of savings
While the taxation of income from savings may justifiably be different from the taxation of other income, the SWG strongly supports a continued focus on ensuring as much consistency as possible in the taxation of different forms of savings. The tax rules for the main savings asset classes and also the treatment of the different entities savings are commonly held in are complex, result in often inconsistent outcomes, and are sometimes arbitrary.
Mutual recognition of imputation/franking credits
The SWG notes submissions calling for the mutual recognition of imputation/franking credits between Australia and New Zealand and supports that view.
Tax rules for off-shore investment
The SWG is aware of investor frustration in relation to the fair dividend rate regime that applies to the taxation of non-Australian-listed off-shore portfolio holdings, both due to the perceived arbitrary and unfair nature of the regime itself, and the complications in correctly calculating taxable income from such investments.
