The Capital Gains Tax (GST) and 39% top marginal tax rate proposals will test the political wisdom of going into an election proposing new taxes.
Those with longer memories will recall that a Labour Government proposed a CGT (Consultative Document on the Taxation of Income from Capital) in 1989.
The proposal did not proceed.
The Tax Working Group (TWG) considered CGT last year to widen the tax base.
While a majority of the Group did not recommend CGT, the arguments for and against are worth a closer look.
CGT is compelling from a tax system coherence perspective.
The New Zealand Treasury and OECD, amongst others, have strongly and consistently argued for its introduction on this basis.
New Zealand is an outlier in the OECD from not having a CGT.
Both these points have been heavily emphasised by Labour in support of its CGT.
Not taxing capital gains favours those assets which appreciate in value over those that return an income stream.
Proponents of CGT have pointed to the tax advantages from investment in residential property, for example, where a sizeable portion of the return may be by way of capital appreciation.
This compares to investment in a bank deposit, the interest on which is fully taxable. They also argue that the current lack of CGT is unfair, as it favours higher income New Zealanders who disproportionately own capital assets.
These “equity” (or fairness) arguments were also emphasised by Labour.
On the other hand, opponents of CGT, including the current National Government, argue that it will introduce additional distortions and complexity.
They point to the “lock-in” effect of a CGT which distorts investment decisions (i.e. when to sell is driven by tax considerations) and encourages deferral of capital gains but early realisation of losses.
The way around this is to tax capital gains on an accrued basis, but this is not common. Interestingly, New Zealand’s financial arrangements taxation regime and, to a lesser extent, the Fair Dividend Rate (FDR) method for taxing offshore share investments currently tax accrued capital gains.
Opponents also argue that narrowing the CGT base by excluding family homes (a necessary political compromise) reduces the potential revenue from such a tax.
National has argued the tax take from CGT excluding primary residences and at a 15% rate will be relatively modest.
Labour estimates that its CGT, if introduced in 2013, will raise around $2.8 billion per annum by 2025 (based on a study by Business Economics Research Limited Economics).
This is approximately half Treasury’s estimate of the revenue from a realised CGT (excluding the family home).
One of the complexities of CGT arises from determining what gain should be taxed. Most economists argue that only real, non-inflationary capital returns should be taxed. However, inflation indexing capital gains has its challenges, including determining the appropriate inflation rate (Consumer Price Index and Purchasing Power Index), tracking the real versus inflationary gains over time, not to mention fiscal cost.
Unsurprisingly, therefore, CGT regimes in other countries have built-in a range of compromises such as discounts on the gain amount or applicable tax rate subject to a requirement to own the asset for a minimum period.
Labour’s CGT does not deviate from this formula – no indexation but a reduced 15% rate. Its CGT policy document contains some high-level details on how the regime will operate. Labour also announced that it will set up a panel of experts to consider the detailed design of the CGT, if elected in November.
The proposed CGT is reasonably broad based: it would apply to land and property, shares, leases, goodwill, intellectual property and financial instruments. The exemption for principal private residences is consistent with similar exemptions from CGTs around the world, although the carve-out for home offices will create complexity.
Apportionment rules may be complicated.
We expect the exemption for gains on sale of small business assets, up to $250,000, will also create some additional complexity, if taxpayers attempt to structure into the exemption.
The tax policy document notes that the definition of ‘small business’ is yet to be determined.
New Zealand currently taxes gains on investments as income, if a taxpayer’s business is trading in the investments or where the particular asset is acquired with the purpose of resale.
Labour is proposing to keep this test.
However, the resulting differential in tax rates between capital gains and revenue gains (24% if the top marginal rate is increased to 39%) will create strong incentives to characterise amounts as a capital gain to pay less tax.
Conversely, the incentive will be to characterise losses as being on revenue account.
Editor’s Note: The above analysis belongs to KMPG New Zealand. See related reports and analyses in this issue.
Labour’s key tax policies
• Capital gains tax (CGT) for implementation by 2013
• Ring fencing investment property losses and clamping down on avoidance
• New marginal rate of 39% on incomes above $150,000
• Tax-free threshold of $5000
• 12.5% tax credit for Research & Development expenditure
• Removing GST on fresh fruit and vegetables