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National’s ‘Let’s Tax This’ ad from 2017
National’s ‘Let’s Tax This’ ad from 2017

BusinessSeptember 18, 2018

Capital gains tax? Yeah, nah, definitely, maybe

National’s ‘Let’s Tax This’ ad from 2017
National’s ‘Let’s Tax This’ ad from 2017

Will the latest review of our tax system be another instance of New Zealand dancing around a capital gains tax? Tax specialist Terry Baucher investigates.

The news that the Tax Working Group’s interim report due out very shortly won’t specifically recommend a capital gains tax (CGT) begs the question:  Is this the fifth such group in 50 years to have considered the issue before concluding ‘Yeah, nah’?  

Not quite.  Firstly, this is an interim report which is intended to invite further commentary on the Tax Working Group’s (TWG’s) initial proposals.  This is broadly similar to the process followed by the McLeod Tax Review in 2001. My understanding is that the interim report will analyse in some detail not only the merits or otherwise of a CGT but also how it might work in practice.  It will probably be the most comprehensive review of the issues around CGT since the Consultative Document on the Taxation of Income from Capital in 1990.

Although the issue of CGT is dominating attention, the TWG has a wide brief and its interim report will examine other issues such as the overall design and fairness of the tax system, environmental taxes, the taxation of savings, GST exemptions for particular goods, the taxation of companies and multinationals, the possibility of a land tax and taxpayer rights in dealing with Inland Revenue.  The resulting report will be substantial and is probably likely to run to over 200 pages. Yet, for all that, the focus will be on the TWG’s proposals around the taxation of capital.

Rather like Banquo’s Ghost, the issue of CGT has been an unwelcome guest for every tax review since the 1960s.  During that time the CGT debate has developed a Groundhog Day quality to it. Every few years a review of New Zealand’s tax system is announced. Some months later, after due deliberation, a report is released which includes passages summarising the pros and cons of a CGT before concluding, somewhat reluctantly, it is not appropriate. In between each review, a major change is introduced widening the scope of income tax to include transactions previously treated as exempt capital gains. These legislative changes essentially undermine the previous review’s reasoning against a CGT. At frequent intervals, international organisations such as the OECD and the International Monetary Fund (IMF) will call for a CGT to address imbalances in New Zealand’s economy around housing and saving.  The IMF’s recommendation in March 2017 for a CGT was just the latest such instance.

Meantime, as if thumbing their noses at each tax review’s arguments against a CGT, the list of countries introducing capital gains tax legislation grows: Canada in 1972, Australia in 1985 and South Africa in 2001.  

This rather pusillanimous pattern began with the Ross Committee in 1967 which after declaring On grounds of equity there is strong justification for taxing realised capital gains,” concluded “we have finally decided against such a recommendation”.  The Ross Committee was followed in 1982 by the McCaw Task Force. which opined “the Task Force considers that failure to tax real capital gains is inequitable in principle, and is seen by many to be so”. Ultimately, the McCaw Task Force was “not convinced of the need for a separate capital gains tax, does not propose its introduction, even though capital gains are being made by some which should in principle be taxed”. 

The McLeod Tax Review in 2001 determined New Zealand should not adopt a general realisation-based capital gains tax. We believe that such a tax would not necessarily make our tax system fairer and more efficient.” It then proceeded to hedge its bets by adding “Nevertheless, we also remain of the view that the absence of a tax on capital gains does create tensions and problems in specific areas.”

In 2010 it was the turn of the Victoria University of Wellington Tax Working Group. In time-honoured fashion its report concluded:

“The most comprehensive option for base-broadening with respect to the taxation of capital is to introduce a comprehensive capital gains tax (CGT). While some view this as a viable option for base-broadening, most members of the TWG have significant concerns over the practical challenges arising from a comprehensive CGT and the potential distortions and other efficiency implications that may arise from a partial CGT.”

And yet, despite all this previous consideration and rejection, another tax review finds itself confronting the CGT issue anew.  There are several key factors as to why this pattern endures but three merit closer review.

Tax Working Group

Firstly, in the absence of a comprehensive CGT, there is presently no clear legal framework to deal with the taxation of capital gains in general, let alone the arrival of completely new asset classes such as cryptocurrencies like Bitcoin.  This results in confusing uncertainty as some taxpayers report gains as income whilst others treat the gains as tax-free. Although issues still arise in other jurisdictions with capital gains regimes, investors know that returns will be taxed either as income or under the relevant CGT regime.  By contrast, investors in cryptocurrencies are presently unsure about whether gains are taxable or exempt. This all-or-nothing approach understandably tempts investors to treat gains as tax-free sometimes on the most dubious of grounds. Even though the bright-line test relating to sales of residential property has been law now for almost three years, there appears to be widespread non-compliance.

Secondly, as every tax review has acknowledged to varying degrees, the present tax treatment of capital is inequitable and creates unfairness. Differing tax treatment applies to different classes of assets leading to what the 2010 review called ‘incoherence’. The TWG’s brief includes reviewing the overall fairness of the system and in this regard, the background issues paper noted that real property held for more than two years (soon to be five) is undertaxed relative to other investments when there are capital gains”.  Since peaking at 73.8 % in 1991 homeownership has fallen steadily to 63.2% in 2016.  This means those substantial untaxed capital gains are being derived by fewer people.

Separate from the issue about unfair tax treatment, the TWG is also considering the issue of wealth inequality.  A background paper on the taxation of capital Income and wealth commented:

“Something that may not have been given enough attention in the discussion until recently has been that wealth ownership has a very skewed distribution, and reducing the tax on capital income may have contributed an increasing level of inequality in many developed countries in recent years.”

This combination of growing wealth inequality and favoured tax treatment for some assets, most notably property, means that the issue of a CGT is unlikely to fade away even if the TWG decides not to recommend it. At some point, the nettle must be grasped either through a comprehensive CGT or some other tax such as a land tax.

Finally, there’s plain, simple self-interest. Not just of groups such as the NZ Property Investors Federationbut of our elected representatives. As Thomas Coughlan pointed out last week, currently 113 MPs own 306 properties between them or an average of 2.6 each. At a time of falling home ownership only seven MPs do not own any property meaning property owners are greatly over-represented in Parliament. Even if the TWG does recommend a CGT, getting it into law will require a large number of MPs to decide their self-interest in getting re-elected outweighs their pecuniary self-interest.   

We’ll know in a few days whether the present TWG is proposing to break the pattern of five decades or whether we’ll find ourselves re-hashing the same arguments in ten years’ time.  I’m hopeful that we will see the TWG signal a change of approach, either in the form of a CGT or some other mechanism such as a land tax. For now, it’s a question of wait and see.

Keep going!