The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.
Leonard Burman is a Senior Fellow at The Urban Institute, a Codirector at The Tax Policy Center, and a Research Professor at Georgetown University. David White is an Associate Professor at Victoria University of Wellington, and an Associate Director at the Centre for Accounting, Governance and Taxation Research in Victoria University of Wellington.
© Brookers Ltd 2003. All rights reserved. Published in (2003) 9(3) New Zealand Journal of Taxation Law & Policy 355-386.
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1.0 INTRODUCTION
"[The New Zealand Government] ... agrees with the [Tax Review] that [New Zealand] would not be better off with a general capital gains tax, death duties or similar tax measures used in other countries."2
The proper taxation of capital gains in New Zealand was one of the key issues addressed by the McLeod Committee in the Tax Review 2001's Final Report and its preceding Issues Paper.3 New Zealand has never had a separate capital gains tax and the New Zealand courts have traditionally excluded appreciation in the value of property from income and thus from income tax. The current law in New Zealand, though, is far more complex. The untaxed nature of capital gains provided investors a very strong incentive to try to convert otherwise taxable income into non-taxed capital gains. New Zealand has tried to stem such tax avoidance by defining at least 25 kinds of assets and transactions as "revenue"—that is, taxable by nature.4 As a result, New Zealand now has a hybrid tax system in which some gains are excluded from income, some are taxed as they accrue, and others are taxed only when the underlying asset is sold.
The Tax Review 2001, while rejecting the notion of a general tax on capital gains, identified several areas in which current tax law creates problems:5
- The inconsistent treatment of different savings vehicles. Individuals who own company shares are generally not subject to tax on gain or loss, but actively managed savings and investment entities have to pay tax on any gains or losses on sales of shares in their portfolio. Some other assets held by savings and investment entities, like real property, may be taxed the same way. But share gains and losses of passively managed entities, like index tracking funds, are exempt from tax.
- The impact on the treatment of offshore portfolio investment. Returns on investments in most foreign companies, superannuation schemes, and life insurance are taxed using one of four methods, including accrual, and a deemed rate of return method similar to that contemplated by the Tax Review. Gains and losses earned from "grey list" entities—those resident in Australia, Canada, Germany, Japan, Norway, the United Kingdom, and the United States—are exempt from tax. This creates the perverse situation that a foreign entity residing in certain grey list countries that do not tax entities directly can actively manage a portfolio of New Zealand shares (or shares from any other country) exempt from tax in New Zealand, whereas a domestic entity holding the same portfolio might owe substantial tax on the same transactions.
- The possible effects on investment in housing. New Zealand has one of the highest rates of home ownership in the world.6 New Zealanders are also much more likely to invest in rental housing than people in other countries. The non-taxation of gain on sale of housing is considered a likely factor behind this diversion of capital away from possibly more productive uses.
- The opportunities that the absence of a capital gains tax may give for taxpayers to transform otherwise taxable income into capital gains.
In short, capital gains are taxed in different ways under different circumstances and often, but not always, not at all. Moreover, the capital-revenue boundary is not clearly defined in law or precedent, so taxpayers face a great deal of uncertainty in trying to determine whether the gains on an investment will be subject to tax and, if so, how.7
The current regime violates all of the norms of tax policy. It is inefficient for at least three reasons. First, it taxes different sources of income at different rates, distorting the pattern of investment among assets in New Zealand as well as between New Zealand and the rest of the world. Second, because similar transactions can be taxed very differently, it creates arbitrage opportunities, for example, by arranging to take losses on income account (ie, deduct them from income) and gains on the exempt capital account. Thus, capital can be diverted from its most productive use into investments that only make sense because of the tax consequences. Third, it adds unnecessary uncertainty to investment decisions because the tax treatment of some investments is unclear.
The current regime is unfair relative to the economic benchmarks of tax equity. It is horizontally inequitable because taxpayers in similar positions may end up paying much different amounts of tax depending on how they structure their investments or where they are made. It is vertically inequitable because the general exemption of capital gains most benefits taxpayers with very high incomes. Thus, wealthy taxpayers with many untaxed capital gains may pay less tax as a share of income than their lower-income counterparts whose income arises primarily from wages.
Finally, the existing regime is complicated both for taxpayers to comply with and for the tax authorities to administer in a coherent fashion.
It is easy to make the case that the current regime is far from ideal. The question is what might be done to improve it. The Tax Review concluded that efforts in the rest of the world to tax capital gains more comprehensively suffer from flaws as serious as New Zealand's hybrid system and are thus not worth pursuing. Instead, it recommended consideration of targeted incremental options to mitigate the most serious shortcomings of the current taxation regime without radical overhaul.
The Tax Review 2001's hesitancy about taxing income from capital is consistent with the tone of public submissions on the topic. Among those who commented on capital gains taxation, most favoured reducing it.8 The Tax Review 2001's analysis and recommendations, however, contrast markedly, in substance and tone, with the last comprehensive review of New Zealand's taxation of income from capital. In 1989, the Minister of Finance in the then Labour Government characterised New Zealand's tax rules in this area as a "mess".9 The 1989 consultative document proposed to eliminate many capital income exemptions and to index the whole income tax base. With a few relatively minor exceptions, these proposals have not been implemented.
Broadening the New Zealand income tax base by including capital gains in a more comprehensive way as well as introducing a tax on imputed rental income of owner-occupied housing were the two most important (second-order) tax recommendations made by the OECD in its bi-annual report on New Zealand in 2000.10 'Extreme, socially unacceptable and economically unnecessary' was the New Zealand Minister of Finance's reported response. "The Government is not interested in a capital gains tax, either in the short or the long term. Basically it is political suicide in New Zealand," the Minister's spokeswoman said.11
This article examines the taxation of capital gains in New Zealand as compared with the approaches taken in the rest of the world, especially the United States. It considers first the question of whether capital gains should in principle be taxed. Then the article considers several specific options for explicitly taxing capital gains, including: the theoretically correct (but far from perfect in practice) method of accrual taxation; the creative approach recommended by the Tax Review 2001 of taxing only the risk-free component of asset returns; and a tax based upon realisation, which is the method used in most of the rest of the world.
This article is not a comprehensive assessment of the taxation of capital gains in New Zealand. What we hope to bring to bear is our experience in studying capital gains taxation in the United States, New Zealand and the rest of the world, as well as working in tax policymaking in the United States and New Zealand.12 We aim to do that in a way that will help move forward the debate about what is best for New Zealand.
Notes from this Section
1. Burman's work on this project was conducted while he was the PriceWaterhouseCoopers Visiting Research Fellow in Taxation at Victoria University. We are grateful to the many experts in New Zealand and elsewhere who were exceptionally generous with their time and advice, including Colin Blair, Phil Briggs, Bob Brown, Stephen Burnell and members of Victoria University's School of Economics and Finance, Paul Brown, Kim Clausing, David Feslier, Peter Goss, Martin Lally, members of the Wellington Branch of the International Fiscal Association, Ewen McCann, Rob McLeod, Robin Oliver, John Prebble, Diane Ramsey, Bill Randolph, Peter Roche, Grant Scobie, Doug Steel, Bob Stephens, Paul Stocks, Clive Thorp, Tony van Zijl and the tax policy and policy development groups at the New Zealand Treasury. Additionally, the discussion group organised by the Wellington office of PricewaterhouseCoopers was extremely helpful. Jenny Dunmore, Nahren Eshow and Deborah Kobes provided extraordinary research assistance. Burman wishes to express his special debt of gratitude to John Shewan and PricewaterhouseCoopers for financing his fellowship, and to Keitha Dunstan of Victoria University of Wellington's Centre for Accounting, Governance and Taxation Research for setting it up. Views expressed in this article are ours alone and should not be attributed to PricewaterhouseCoopers or any of the institutions with which we are affiliated.
2. D Cunliffe, Parliamentary Private Secretary for the New Zealand Minister of Finance, "Ministerial Update", Speech to The Institute of Chartered Accountants of New Zealand 2002 Tax Conference, Christchurch, 11 October 2002.
3. The McLeod Committee was an independent, five-person team appointed by the New Zealand Government to review developments over the last 20 years and to advise government on an appropriate framework within which to make tax policy in future. The McLeod Committee sought submissions, released its Issues Paper in June 2001, sought further submissions, and then completed its Final Report in October 2001.
4. The term "tax avoidance" is often used in New Zealand to refer to legal arrangements that are void for income tax purposes under general anti-avoidance legislation. We use the term as it is defined in textbooks on public finance to refer to the gamut of legal methods taxpayers use to reduce their tax liability, including avoiding highly taxed activities, altering the timing of transactions to reduce tax, and exploiting nonlinearities in the tax system to profit from tax arbitrage. See discussion in J Slemrod, "Optimal Taxation and Optimal Tax Systems" (1990) 4 Journal of Economic Perspectives 157. In contrast, "tax evasion" is typically used to refer to illegal activities undertaken to avoid tax, such as not reporting income or overstating deductions. For a non-exhaustive list of legislative provisions that subject both realised and unrealised capital gains to New Zealand income tax; see K Holmes, The Concept of Income — A Multi-Disciplinary Analysis, Amsterdam, International Bureau of Fiscal Documentation, 2001, p 383.
5. McLeod Committee, Tax Review 2001: Issues Paper, Wellington, June 2001, available at <http://www.treasury.govt.nz/taxreview2001/default.htm>, pp 31-35; McLeod Committee, Tax Review 2001: Final Report, Wellington, October 2001, pp 26-27, available at <http://www.treasury.govt.nz/taxreview2001/default.htm>.
6. More than 70 percent of total household savings are in housing in New Zealand. The average of all OECD countries for this statistic is less than 50 percent. McLeod Committee, Tax Review 2001: Issues Paper, Wellington, June 2001, p 29, available at <http://www.treasury.govt.nz/taxreview2001/default.htm>.
7. The current General Manager (Policy) in Inland Revenue has said that, " ... in both my private sector and public sector work, manipulating and enforcing the border between taxed income and untaxed gains has been a central part of that work.... From my perspective, the most marked effect of not having a specific capital gains tax has been on the inconsistencies and complexity of our income tax rules that have resulted. Our income tax system is especially open to manipulation as a direct result of not having a general body of rules taxing capital gains. Moreover, in some areas our tax rules defy policy logic, creating problems that defy an obvious policy solution for the same reason." R Oliver, "Capital Gains Tax — The New Zealand Case", a paper prepared for the Fraser Institute 2000 Symposium on Capital Gains Taxation, Vancouver, Canada, p 3. For a discussion of the unsatisfactory state of the current New Zealand rules for determining whether and when gains are taxable, see this paper by Oliver at pp 3-5, 7-11 and K Holmes, The Concept of Income — A Multi-Disciplinary Analysis, Amsterdam, International Bureau of Fiscal Documentation, 2001, pp 383-420.
8. The Tax Review 2001 received 197 written submissions that were considered in writing its Issues Paper and 245 submissions prior to writing its Final Report (McLeod Committee, Tax Review 2001: Final Report, Wellington, October 2001, pp 1-2, available at <http://www.treasury.govt.nz/taxreview2001/default.htm>). Of these, a minority (36) focused their comments on capital gains taxation. Twenty-two submitters favoured less taxation of capital gains than at present (mostly business lobby groups, companies and professional firms, but also including six individuals and the spokesperson for one political party, the Association of Consumers and Taxpayers (ACT)). Three submitters expressly favoured the Review's analysis and approach of targeting specific capital income exemption problems (one business organisation and two lobby groups). Eleven submitters favoured more taxation of capital gains than the Review recommended (seven individuals, two social action groups, one investment fund company and one political party—the Green Party).
9. D Caygill, Consultative Document on the Taxation of Income From Capital, Wellington, Government Printer, 1989, p iv. "The real issue is that the present tax treatment of income from capital is a mess. It is widely acknowledged to be capable of substantial improvement."
10. OECD, OECD Economic Surveys: New Zealand 1999/2000, Paris, OECD, 2000, pp 18-19.
11. "OECD Tells Us to Tax Capital Gains," New Zealand Press Association, 30 November 2000.
12. Burman was deputy assistant secretary for tax analysis at the United States Department of the Treasury from 1998 to 2000 and a senior staffer in executive and legislative branch tax agencies for more than a decade before that. White was a chief analyst in the tax policy branch of the New Zealand Treasury from 1987 to 2000.
Note: This report is available in its entirety in the Portable Document Format (PDF).
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