Capital gains tax debate is about to go nuclear

Brace Yourself

“The Government shouldn’t regard this as a take it or leave it proposal,” says Tax Working Group chairman Sir Michael Cullen, who – perhaps more than anyone – understands the politically charged nature of the Capital Gains Tax report he is about to deliver to the Government.

All indications are that the Working Group, which has now finished its report, will recommend a comprehensive capital gains tax.

While plenty of countries have them, the very words “capital gains tax” have been political poison in New Zealand, where the path to wealth has long been paved with rental property.

This Government kicked it for touch at the last election. But next month the Working Group – led by the former Finance Minister and stacked with senior tax experts, economists, business, union and iwi representatives – will throw it back into play.

Expect to see the debate go nuclear.

The recommendation is likely to be for a broad-based capital gains tax (CGT), capturing all asset classes other than the family home, which was ruled out in the original brief.

That means businesses, sharemarket investors and retirement savers will all be in its sights.

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The proposal is required to be revenue-neutral, bringing in neither more nor less total tax money. That means the political payoff may be some form of income tax cuts – probably aimed at low- or middle-income earners.

It will set the CGT at the marginal tax rate – which means 28 per cent for business and 33 per cent for most individuals.

It is also expected to have ruled out concessions that would involve inflation indexing of capital gains tax.

“We would have the harshest and most extreme capital gains tax of anywhere in the world,” says Troy Bowker, executive chairman at Wellington-based investment advisory group Caniwi Capital.

All the major CGT regimes around the world include concessions and exemptions, he says.

Overseas

In Canada half the gain is exempt, as it is for individuals in Australia. “So straight away, it’s half the marginal tax rate,” Bowker says.

“In the UK the [capital gains tax] rate is 20 per cent, in the US there is a multitude of exemptions depending on how long you hold assets, and the starting point is zero.”

If the proposal was adopted in full, we could end up with a system that is more draconian than in Russia and China, he argues.

Cullen – who won’t talk specifics before the release – makes the point that the Working Group’s brief was to focus on issues like fairness and workability, and to weigh up the pros and cons.

“Its not our job to say: ‘we think this could lose you the election therefore we don’t think you should do it’ … that’s a job for the Government to think about.”

The traditional view among tax experts is that the more you try to soften a tax regime, the more complexity you add and the less efficient it becomes.

“Simplicity is always the goal with tax policy but that comes with tradeoffs around fairness for individuals and groups with unique or specific circumstances,” says Cullen.

“Once you start to carve out concessions, a whole range of complexities emerge around definitions and suddenly the compliance and enforcement costs start to erode the value and enforceability.”

Of course, there’s not much in the tax world that stays simple for long. “Income tax is an incredibly simple system,” Cullen quips. “It’s just that it requires three volumes to express that simplicity.”

EY tax policy leader David Snell, who no doubt would appreciate the joke, believes the Working Group’s proposal could transform the economy – although he’s reserving judgment and would also favour some concessions and exemptions.

“Opportunities like this do not come along very often,” he says. “It’s a well-resourced powerful team with a good set of circumstances behind them, in favour of reform.

Tax Review

“Every other tax review in New Zealand – and there’s been one every 10 years or so for the past 50 years – has said there is a case for some form of capital gains tax but that it would be quite problematic to enforce. Every government has shied away from doing anything about those reforms.”

Cullen agrees that this time is different.

“This is the first time anyone in any of these reports has gone beyond saying it’s a good idea,” he says.

“We’ve actually explored it in detail. We’ve laid out a comprehensive and integrated view. We’ve emphasised the fact that there’s a balance between the equity and other arguments versus the complexities. And possible downside impacts in some regards.”

He notes that the Working Group’s final recommendation will be a split decision.

“Basically, a clear majority came to the view that the package we proposed should proceed; a minority takes a different view on the balance.”

While the report will be detailed, Snell suggests it should still be seen as a starting point for a public policy debate.

“The Working Group won’t deliver a working piece of legislation even if it has a detailed proposal,” says Snell.

“It will be important to make sure that there are no more costs imposed by the mechanics of that legislation than needs to be the case. That will take time.”

Within the senior Labour Party leadership, there is almost certainly sympathy for a capital gains tax.

Some, like Grant Robertson and David Parker, have campaigned on it before – unsuccessfully.

By its very nature, a capital gains tax will balance the system back in favour of dollars earned through work – or labour. That fits with traditional Labour Party goals.

The very words "capital gains tax" have been political poison in New Zealand.
The very words “capital gains tax” have been political poison in New Zealand. Cartoon by Rod Emmerson

But to make any reforms, Labour will need to get re-elected. Pragmatism suggests the decision is far from a foregone conclusion.

“In my opinion Labour has backed itself into a corner. It will be interesting to see if they come out and back it,” says Bowker

Is Capital Gains Tax Fair?

“The problem is that once they go down the path of diluting it, which they almost certainly would for two reasons – 1) to ensure it’s fair and 2) the practical consideration that they can’t get it passed without NZ First – then the revenue that’s been forecast just drops away.”

Blue sky calculations in the Working Group’s preliminary report suggest a CGT could generate around $300 million in Crown revenue in its first year and as much as $6 billion by 2031 (any implementation is proposed for 2021).

“So you get all the downside without the upside of taking the revenue you’re supposed to have in the pot,” Bowker says. “Because the devil is in the detail and that’s going to get lost on the public … all they are going to hear is that we’ve got CGT.”

While recognising there is an imbalance in the current system, Snell also says reform will be very difficult.

“If you were going to build a tax system from scratch, you’d say: a dollar is a dollar is a dollar. And you tax it regardless of where it’s from,” he says. “But once you’ve built a system where one class is not taxed and there are industries built around that, it’s very hard to unwind.”

So what about the case for incremental changes to the status quo?

We now have a bright line test on investment property which requires tax to paid on sales made within a five-year timeframe.

But “with the fixing of bright lines and ring fencing of losses, we’re not really tackling the fundamental problem,” Snell says. “We’re addressing symptoms.”

Snell would like to see the CGT blow softened with allowances for the impact of inflation on capital gains tax and something called “roll-over relief” – where investors can defer tax payments as long as they reinvest the capital gains.

That could be either within specific asset classes or specific timeframes, or even broader relief as long as the money is reinvested somewhere, he says.

Fund manager Matt Goodson – managing director at Salt Funds Management – is one of many people working in the equity market who makes a compelling case for the unfairness of the current regime in regard to property investment.

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But he also remains cautious about the prospect of comprehensive, broad-based capital gains tax.

He notes that the gains from rebalancing returns on investment in property have to be weighed against the costs a new tax could impose on companies and the impact on valuations.

“Having a capital gains tax increases companies’ cost of capital, and particularly for growth companies that tend to retain most of their earnings.”

That’s exactly the kind of productive investment we are supposed to be encouraging in New Zealand to expand and diversify the economy

A comprehensive CGT could encourage companies to potentially hold less capital and pay out more in dividends – rather than reinvesting and growing.

Nightmare for Private Businesses

It could be a “particular nightmare” for private businesses where there is a very wide range of plausible valuations, he says. “As always, the lawyers and accountants will get rich.”

But these kinds of issues haven’t been ignored, says Cullen.

“We note precisely that,” he says. “If you go through a set of asset classes one by one you can see the balance in favour of proceeding [with a CGT] reduces until you come to the active business sector where the complexity becomes the largest.

“As I say, I don’t think the Government has to regard this as a take it or leave it in regards to capital gains tax.

“People are assuming because there is a report it has to happen,” he says. “There is a long way to go in terms of internal government discussions, in terms of discussion papers, the generic tax policy process, select committee and then of course a small thing called the election.”

By: Liam Dann