The Tax Working Group’s first report cautiously backs a capital gains tax, but has been stymied from the start in addressing a massive and inequitable loophole, writes Danyl Mclauchlan

The government’s Tax Working Group, led by former deputy prime minister and finance minister Michael Cullen, released its interim report today. What does it say? Depends who you ask. According to the Herald, “Introduce capital gains tax, says Cullen’s working group”. Stuff is less dogmatic. “Capital gains tax would have ‘pros and cons’ says Tax Working Group”.

That gets us closer to the conclusion of the actual report, which is that they’re not recommending anything yet but rather considering two possible forms of capital gains tax for their final report in February next year. But whatever tax they come up with will already exempt “the family home”, creating a loophole massive enough to drive most of our trillion-dollar residential property market through. What’s going on?

This isn’t the first or even the fifteenth time some group of experts has considered a capital gains tax as a policy solution to New Zealand’s tax system. Every few years some international agency does an audit of our economy and financial infrastructure (last year, it was the International Monetary Fund) and they always say the same thing: ‘Not bad; we’ve seen worse – but your lack of a broad-based tax on capital is terrible. You REALLY have to fix that because its distorting your economy, leading to dangerous levels of household debt and killing your productivity.’

But nothing ever happens.

What’s the actual problem here? And if it’s so terrible, why don’t we fix it? Let me answer with an anecdote. A few years ago, a friend of a friend of mine came back from a few years in London contracting as a software developer. He’d done pretty well, saved hard and got a good deal on the FX rate so he had about a million dollars in the bank. His initial plan was to use most of his savings as seed capital to set up a software development company. Hire a bunch of junior java programmers, train them up, and make use of the 12-hour time difference to do overnight patches and bug-fixes for his clients back in Europe.

And the finance minister at the time – one Dr Michael Cullen – would have loved for him to do that; loved for him to create “knowledge economy” jobs in high-income tax brackets; loved for him pay loads of company tax; loved for him to bring in overseas revenue and offset our terrible terms of trade.

The problem is the tax system that Michael Cullen – and then Bill English, and now Grant Robertson – oversaw strongly incentivises people not to do this. The smart thing to do with your money, a financial adviser explained to this friend of a friend, was to use it as collateral, borrow a lot more, put it all into the property market, live off the rents and get rich off the tax-free capital gains. And that’s what he did. No jobs were created; no tax was paid; money went offshore in the form of interest to whatever Australian bank loaned him his mortgages. The tax system overwhelmingly incentivises New Zealand investors to do the exact opposite of what’s good for our economy.

It’s also incredibly unfair. People on the minimum wage pay tax on everything they earn. People living in poverty pay tax on everything they buy. Nurses pay tax; teachers pay tax; but people who own vast property portfolios, or derive their wealth from owning financial assets can pay virtually no tax. Many of those who benefit the most from living in a developed economy with an educated, healthy workforce, stable institutions and modern infrastructure contribute the least towards maintaining those things.

But wait: if this loophole in our tax system is so stupid and so unfair, why doesn’t anyone fix it? Cynics point to the very high rate of multiple property ownership among members of parliament. But that’s a symptom of the deeper problem. Because it’s been the smart way to invest for so many decades, a huge proportion of the working population invested heavily in the property sector.

MPs have more houses than most because they earn more than most of us. But for many lower-income New Zealanders, their primary retirement plan is to have a mortgage-free house – “the family home” – which they can sell for a large, tax-free profit.

If you start taxing capital gains, then property will no longer be such a profitable investment, so the value of houses will go down. It will be great for those priced out of the market, like millennials and the working poor who don’t vote, and terrible for hundreds of thousands of older voters in high-turnout demographics who have spent decades banking on a tax-free sale of their home when they retire.

Back in the 2014 election, Labour campaigned on a 15% capital gains tax. It exempted the family home and KiwiSaver, and this led to such complicated, distorted outcomes that John Key humiliated David Cunliffe by demonstrating in a live debate that Cunliffe didn’t actually understand how his own policy worked. Labour got its worst election result in almost a hundred years. They ditched capital gains during the 2017 campaign, and in their terms of reference for Cullen’s Working Group Labour preemptively ruled out any reform that would see taxation on the sale of “the family home”.

Australia has a capital gains tax with the family home exempted and their economists blame this exemption for that country’s massive housing bubble. Instead of building up massive property portfolios filled with poor quality rental homes, wealthy Australian households maximise the resale value of their primary home; or register separate properties to separate family members.

So there’s the core problem. Because our economy has had this distortion for so long, it’s difficult to implement a capital gains tax that (a) effectively taxes the rich, (b) doesn’t also tax so many lower and middle-income earners that the whole thing is just politically impossible, or (c) doesn’t have such large exemptions that the tax is ineffective.

There’s one solution to all of these problems: a progressive capital gains tax. Most capital gains taxes are flat – the one Labour campaigned on in 2014 was 15% – so if you sold your bach in Invercargill for $30k profit, or your bach in Ohama Beach for $3 million profit, you would pay the exact same rate of tax.

The income tax system doesn’t work like this, because that would be incredibly unfair. Instead, someone earning less than $14,000 pays 10.5%, and someone earning over $70,000 pays 33% (on their income over that threshold). There’s no reason a capital gains tax can’t work the exact same way, with a tax-free threshold at the bottom. So poor and middle-income earners who slowly accumulate capital over decades would pay little or no capital gains tax, and wealthy people – MPs, say – selling more expensive homes would pay much more than they do now (which is nothing). But that option has, ironically, been prohibited by Labour’s terms of reference. Cullen’s Group couldn’t recommend it even if they wanted to.