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OPINION: Reality check on capital gains tax

February 22, 2019

Contacts

Partners Barney Cumberland
Special Advisors Stuart Hutchinson
Senior Associates Nick Bland, Paul Windeatt

Tax reform (Tax Working Group)

The mood of Ministers Robertson and Nash at their press conference following the release of the Tax Working Group’s final report on Thursday was guarded, to say the least.

They were at pains to stress that the report contained a “range of options”, no decisions had yet been made and that the government’s response (due in April) would be shaped by the realities of the MMP environment. Indeed, the centrepiece of the final report, a radical proposal to tax almost all capital gains in the same way as ordinary income, has massive political significance.

The design of the CGT proposed by (a majority of) the Working Group is extreme by international standards, covering a very broad base of assets with limited exemptions, applying at ordinary income tax rates with no discount and (strikingly) not incorporating any indexation or other allowance for inflation. As well, capital losses would in most cases be able to be taken against ordinary income. This, along with the (acknowledged) uncertainty in projecting how much tax a CGT would raise over time, would create great fiscal risk for the government, especially as the lower marginal income tax rates would be expected to be dropped in anticipation of introducing the CGT.

As a number of media have written in the past couple of days, the extreme nature of the proposal makes it an almost impossible sell politically.

Labour must now cross an extremely hazardous political, and electoral, minefield.  We believe there is no prospect whatsoever of New Zealand First putting its support behind anything but a heavily watered-down version of the Working Group’s core recommendation.  As proposed, the CGT would simply drain the wealth of New Zealand First’s constituents, baby boomers and farmers, so New Zealand First cannot back it. But Labour will want to make sure New Zealand First does not get middle New Zealand’s credit for saving them from the Working Group’s nuclear option, while at the same time taking care that reaching political compromise is not perceived as an embarrassing climb-down.

Something of a blue-print for compromise is found in a memorandum to the Working Group from the three members who dissented on the core CGT proposal. The trio includes none other than former Deputy Inland Revenue Commissioner Robin Oliver. Few in the New Zealand tax community would disagree that Mr Oliver is amongst the very best tax policy thinkers New Zealand has ever had. His advice was relied upon by successive governments for decades.

We expect that the dissenters’ clearly articulated position will be latched onto by New Zealand First and the moderate elements in the Labour caucus. It rejects a comprehensive CGT but supports targeted expansions of the income tax base into property classes where there is clear evidence that the benefit of doing so will exceed the costs:

 “…in our view the incremental approach of extending the tax base carefully over time is preferred. It has served New Zealand well over many years of tax reform.”

The dissenters suggest that in the first instance, the government’s focus be on non-owner occupied residential housing (and perhaps other real property dealing and investment activity). The existing income tax rules for land sales, including the bright-line rule for non-owner occupied residential housing, are malleable and could be extended very easily.

As the dissenters point out, IRD officials advising the Working Group estimated that over a ten year time period, some 39% of the total revenue that would be raised from a full blown CGT would be from residential housing alone.  Thus a far more targeted measure could raise a significant proportion of the revenue that a comprehensive CGT would raise, while avoiding the imposition of an unnecessary and compliance-heavy handbrake on areas of the economy that are underproductive.

One such area is the capital markets, with the dissenters noting that the majority’s CGT system would have the adverse effect of increasing tax on New Zealand, but not foreign, owners of shares in New Zealand companies, at a time when the government is promoting wider initiatives to improve local participation in equities. As well, the projected extra revenue from imposing the CGT on share gains is relatively low, while the government would underwrite investors’ downside exposures by allowing a deduction for share losses. As the dissenters wryly point out, the government could assume the same risk and reward position by instead investing directly in the share market.

As we see it, the dissenters have presented an option for compromise which should be not only palatable to New Zealand First but would also enable Labour to demonstrate to its core constituents that it is taking a strong (albeit incremental) tax measure to tackle speculation in what has been the most tax-distorted area of the economy.