PROTECTING NEW ZEALAND’S TAX SYSTEM: Five Rules for a Fair Capital Gains Tax January 2019

PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 1 INTRODUCTION

The Tax Working Group is Working Group1 and the 2025 expected to recommend the Taskforce2, the Government is introduction of a capital gains well within its rights to amend, tax in its final report, due to be exclude, or add to any list released soon. of final recommendations from the Working Group if its The Taxpayers’ Union is not recommendations are too opposed to the introduction of a radical, too unpopular, or too far capital gains tax, in theory. The removed from economic reality. Union’s support or opposition to the introduction of a capital There will also be significant gains tax will depend heavily on room at the Select Committee the detail of the tax: how assets stage to amend any capital will be taxed; when they will be gains tax legislation if, once it taxed; at what rate they will be has consulted with the public taxed; and the structure of any and industry, the Government tax exemptions or roll-over relief. finds certain details or provisions in the proposed capital gains If the Government treats the tax regime are unpopular or Working Group process as an unworkable. opportunity to improve, clarify and re-adjust the tax system, Given that, if at any stage reform could be acceptable. the Government decides to abandon an otherwise If instead the Government ideological and aggressive uses the ‘expert-advice’ from capital gains tax, the Taxpayers’ the Working Group as a thin Union could accept reform. ideological veil to excuse the aggressive expansion of taxation Our opposition to aggressive and the state, the Taxpayers’ tax reform is not tribal or based Union will be strongly opposed on ideological distrust of a to reform. centre-left Government: some

Fortunately, recommendations provided by the Working Group 1 https://www.victoria.ac.nz/ are not necessarily final. sacl/centres-and-institutes/cagtr/pdf/tax- report-website.pdf As with recommendations 2 https://treasury.govt.nz/ reached by the 2009 Tax publications/information-release/2025- taskforce

2 PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 of the most important reform to taxed on their real capital the economy in New Zealand’s gains, rather than nominal history occurred under a Labour gains which merely keep up Government between 1984 and with the cost of living. 1990. 3. Revenue Neutrality: Any Our test of the capital revenue from a capital gains gains tax will be based on tax must be used to fund tax five criteria, which for the cuts in other areas so that sake of transparency, we the total tax burden does are publishing prior to the not increase overall. announcement of any details 4. Roll-Over Relief on Death: regarding the Working Group’s When a family member recommendations. passes away and chooses If the Working Group’s to leave their assets to recommended capital gains tax friends or family members, violates any of the Five Rules, the capital gains tax should the Union is likely to will oppose not be levied on the the tax, and will continue to inheritor at this point. oppose the tax if the violations 5. Discounted Rate: Any capital are not remedied when gains tax should apply at a any legislation is put before discounted rate, instead of Parliament or amended at Select at the full personal income Committee stage. tax rate. Our Five Rules for a Fair Capital This report will explain why Gains Tax are: each Rule is necessary for a fair 1. No Valuation Day: Any capital gains tax. capital gains tax regime should exclude a valuation day approach in favour of grandfathering assets into the system upon sale.

2. Indexation for Inflation: Any capital gains tax regime must discount inflationary gains, so taxpayers are just

PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 3 RULE 1: NO VALUATION DAY

While this would reduce any revenue from the capital gains tax as assets Any capital are progressively brought into the regime (once they are traded), the gains tax regime cost to asset owners from valuation is too large to justify that approach. In addition, valuations are inherently subjective – something that should should exclude be avoided. a valuation While some assets won’t require independently verifiable valuations (publicly listed stocks have accurate daily prices, for example), all day approach assets subject to the capital gains tax that aren’t regularly traded (rental in favour of properties, commercial properties, privately held businesses, etc.) will. grandfathering THE COST OF VALUATION assets into the OliverShaw1 provide a ‘conservative’ estimate in their reply submission2 to the Tax Working Group of the costs of adopting a V-Day approach, system upon outlined in the table below: sale. Table 1: Conservative Estimates from OliverShaw on costs of ‘Valuation Day’

If the Government and Working Number of $m valuation cost Asset Cost of Val Group want the capital gains tax valuations estimate to apply to all assets from the 600,000 (say Rental Homes $600.00 300 date of introduction (expected 500,000) to be 1 April 2021), assets will 534,000 (say Enterprises $2,000.00 1,000 require a valuation effective at 500,000) that date (hence, ‘V-Day’). This Second homes and ? will force asset owners to pay for holiday homes independent valuations of their Minority share ? assets at a huge total cost. valuations A better alternative would be Lifestyle blocks ? Total cost for the Government to simply $1,300 grandfather assets in. Assets (conservative est.) would only be subject to capital In their submission, they explain: gains tax once they have been traded at least once and therefore have an official ‘traded 1 OliverShaw is comprised of tax experts Mike Shaw and Robin Oliver. Mike Shaw value’, preventing asset owners was a member of the 2009 Government Tax Working Group; Robin Oliver is a member of from being forced to pay for an the current Government’s Tax Working Group. 2 Prepared solely by Mike Shaw, given Robin Oliver’s membership of the Tax independent valuation. Working Group. Available on the Tax Working Group’s website.

4 PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 “The cost of the initial valuation will be in excess of [$1 billion], possibly well above [$1 billion], possibly [as] high as $2 to $3 billion. … (I have sought advice from valuers regarding their level of fees for residential and commercial property valuations including valuations in provincial New Zealand). This level of costs compared with the revenue that may be collected is unwarranted.”

“Adjusting for the above conservative estimates, the total cost on taxpayers of the valuation day option could be $2-3billion.”

The submission is correct to label $1.3 billion as too conservative.

PROPERTIES LARGER THAN 4,500M²

In the Working Group’s first report, they explain that while a household’s principal residence (‘the family home’) would be exempt from capital gains tax, there would be circumstances where an exemption would not apply.

PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 5 For the purposes of calculating number of principal residences their industry, many companies the total cost of valuation, the on land larger than 4,500m², will dispense with whole going- most relevant of these is that if a if the average lifestyle-block is concerns, or purchase whole property is larger than 4,500m², approximately nine-times larger going-concerns from other it would not receive the ‘family than the threshold, there’s likely businesses, in order to maximise home’ exemption. In absence of to be a significant number of shareholder value. - an exemption, these properties homes not classified as lifestyle This happens regularly in the will require independent blocks that still exceed the New Zealand market. valuations, just like every other threshold. asset subject to the tax. In 2017, it was announced that If we assume (based on the Our First NZ Capital would purchase There is a huge number of these Land 2018 figures) that there ANZ’s online trading platform for properties. The Our Land 2018 are approximately 204,000 an undisclosed sum6. report prepared by the Ministry lifestyle blocks around the 3 for the Environment highlights country, these properties Late last year it was announced that as of 2013, there were alone will increase the cost of that Fletcher Building had 175,000 lifestyle blocks covering Valuation Day to asset owners agreed to sell Formica to 873,000 hectares, and that the by approximately $122.5m (if we Broadview Holding BV for number of these properties was conservatively assume the cost $1.226 billion7, after having growing at a rate of 5,800 a of valuing lifestyle blocks with an acquired it in 20078. year, indicating that the number average size of 4ha is the same of these properties may now as valuing an average rental More recently it was announced have exceeded 200,000. property5). However, this figure that Fonterra planned to “[sell] could easily explode. If lifestyle the livestock division of its Farm Perhaps more importantly, blocks are more expensive to Source store and online support the average size of these 9 value (by virtue of being larger, network to Carrfields Livestock.” properties is significantly larger with additional buildings or than the size required for the If a company expects to sell any structures) the total cost will property-owners to lose their of their going-concerns at any grow even higher. ‘family-home’ exemption: the point in the future, these going- figures from the report indicate concerns will need their own an average size of 49,885m², INTRA-CORPORATE valuations so that companies while the threshold to lose the VALUATIONS either pay an accurate amount of capital gains tax in the future or exemption is only 4,500m². The availability of price receive an accurate deduction 4 information for publicly listed Based on reporting , that seems for any capital losses. companies does not completely to be an accurate estimate of solve the problem of valuing life-style block size: the cited these companies. average lifestyle block size is 6 https://www.nzherald. 4ha (or 40,000m²). Many large publicly listed co.nz/business/news/article.cfm?c_ id=3&objectid=11945900 companies are horizontally or While it’s difficult to estimate the 7 https://fletcherbuilding.com/ vertically integrated across their news/fletcher-building-announces-sale- industry. To manage the degree of-formica-dividend-reinstated/ 3 This report is available at to which these companies 8 https://fletcherbuilding.com/ http://www.mfe.govt.nz/sites/default/files/ integrate themselves across investor-centre/reports-presentations- media/RMA/Our-land-201-final.pdf and-webcasts/2007-acquisition-of- 4 https://www.nzherald. formica-corporation/ co.nz/the-country/news/article. www.stuff.co.nz/business/8740710/Pros- 9 https://www.newsroom. cfm?c_id=16&objectid=11757794; https:// and-cons-of-lifestyle-block co.nz/@pro/2019/01/09/393035/ thisnzlife.co.nz/4-things-to-consider- 5 $600 per property, based on fonterra-announces-sale-of-farm-source- when-buying-a-lifestyle-block/; http:// OliverShaw’s submission. livestock-division

6 PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 The cost of obtaining accurate years, putting further pressure However, given the proceeds valuations of many going- on the total cost of Valuation of Valuation Day are a ‘one-off’, concerns (each of which can be Day. any incentive to train as a valuer large complex institutions in their could be quite limited (i.e. even OliverShaw’s submission notes own right) could be incredibly if there was capacity to train the likely shortage of valuers: costly. new valuers, attracting people “Even if the cost of the to an industry on the basis of a This is a problem for privately- valuation was acceptable one-time ‘dividend’ from training held companies as well as to the government, New might be extremely difficult). publicly listed companies. Zealand simply does not The result: current expectations If, for example, one of the large have sufficient valuers of valuation costs are probably ski operators in New Zealand to undertake the work too conservative to be reliable. chose to sell one of their fields that would be required. With over a million assets to an international operator, This shortage of supply requiring valuation, there will be the field itself (as well as the of valuers would result significant price competition for whole company) would require a in either sub-standard a very limited number of trained valuation. valuations and/or valuers professionals, who will naturally coming in from other Importantly though, even if increase their prices. countries.” a company is not currently pursuing the sale of an asset, This is a problem, given the MORAL HAZARD AND if there’s a possibility of future submission also correctly notes OVER-VALUATION sale, the company will need that “valuation is an art, not a At the Future of Tax Symposium to pursue valuation on V-Day science.” in Wellington on 28 November regardless, given that valuations Simply bringing in valuers to 2018, Working Group Chair Sir will need to be accurate as of the New Zealand market, who Michael Cullen, claimed that the date of tax introduction (i.e. have very little experience with asset valuation could be “rough the company could not simply the commercial environment is and ready” because the real pursue valuation when they unlikely to result in high-quality goal was to ensure assets were proceed with an asset sale at a or accurate valuations that quickly brought into the capital later date). asset owners can rely on for tax gains tax regime. This will have the effect of purposes. Adopting a “rough and ready” forcing companies to receive The lead-in time to train new approach makes sense. It a series of valuations, split by valuers is also extremely limited. would be impossible for Inland various wings and departments Revenue to audit over a million of the company as a whole, Valuations will be required to different assets. That would increasing the total cost of the be accurate as of 1 April 2021 – require Inland Revenue to hire Valuation Day approach. less than two years from when its own valuers to travel around legislation will be introduced the country assessing valuations to Parliament and, with the SHORTAGE OF and ensuring the independent introduction of the capital gains VALUERS valuation is a fair reflection of the tax likely dependent on the There will also likely be a value of the asset – at significant result of the 2020 election, 10 shortage of qualified valuers, cost to taxpayers . approximately six months allowing prices for their time to from when taxpayers can be be bid up in response to the confident the tax regime will be 10 https://www.stuff.co.nz/ extraordinary amount of work introduced. business/108796278/capital-gains-tax- required compared to regular valuation-day-will-cost-kiwi-businesses- billions-of-dollars

PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 7 In absence of widespread gains tax – particularly in the that would minimise auditing of valuations, there will early years of the policy, when compliance costs. be plenty of opportunities for asset valuations rather than “Any suggestion that asset owners and valuers to last transaction price inform the we would deliver a provide valuations which merely baseline price for capital gains recommendation that aim to reduce asset owners’ tax tax payments. would saddle New obligations. Providing artificially Ultimately, the gameable nature Zealand businesses high valuations, for example, of these valuations creates with billions of dollars would either reduce any capital unfairness, as asset holders that in compliance costs is gains tax liable on the first sale pursue honest valuations are absurd and is just blatant of the asset, or even provide penalised relative to those with scaremongering. asset owners with deductions fewer scruples. to be applied to their remaining “While an approach that tax bill. includes assets already RESPONSE BY THE owned would require Valuers will probably be able WORKING GROUP some valuations, the to justify artificially high values. Group is not considering Asset valuation – particularly for After an op-ed which outlined options that would privately-held companies – is some of the issues from require every asset to be incredibly subjective. Xero, for adopting a Valuation Day professionally valued, or example, has never made a approach was published, the all valuations to be carried profit, yet is currently valued by Working Group released an 11 out on the date that the the stock-market as a $6 billion official response : tax would come into company: its valuation is driven Tax Working Group Chair force. by growth eventually translating Sir Michael Cullen says into strong profitability. there’s no proposal “Valuation issues, including options to In the case of Xero, the under consideration help small and medium public market has made that that would require every businesses reduce assessment and reflected the New Zealand business the compliance costs company’s potential profitability to obtain a professional associated with valuing in its share price. Privately- valuation all on the same assets, are still being held companies, however, are day. considered by the not subject to share market The assertion is made Group and will form part valuation but might similarly today in a Stuff opinion of the final report to deserve a valuation above the column by Troy Bowker. Government.” book value of the company on the basis of strong growth Sir Michael says the While it would be good news if potential. Evaluating the Group is still examining the Working Group had chosen company’s growth potential design options for an to abandon the Valuation Day for the purpose of valuation extension of tax on approach, the careful use of would have to be the subjective capital income for its final language in this press release determination of the valuer report due in February indicates that is not the case. employed by the asset-owner: and is looking carefully giving significant room to at a range of options For example, while Sir Michael artificially inflate the reported Cullen specifically says there is value of the company. no proposal that would require 11 https://taxworkinggroup. valuations all proceed “on the This could significantly reduce govt.nz/resources/tax-working-group- same day.” While that might any revenue from the capital responds-stuff-article-valuation-day

8 PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 be true, it misses the point. valuation costs for small and Valuation Day simply requires medium businesses would be to that valuations are effective subsidise the cost of valuations, and accurate as of the date but this simply moves the cost of introduction. Even if IRD of valuation onto taxpayers, generously allows businesses without reducing the total cost of up to a year-long window to V-Day. Further, a widely-available obtain a valuation, the costs to subsidy for valuation may inflate businesses are still significant. the price of valuation services, putting more fuel on the fire. The statement also claims that while “assets already owned would require some valuations”, CONCLUSION the Working Group “is not Adopting a Valuation Day considering options that would approach will cost taxpayers require every asset to be billions of dollars to verify the professionally valued”. value of their assets. The total cost is likely to be inflated by This similarly misses the issues the need for lifestyle block and of Valuation Day. While publicly semi-rural property owners, listed companies will not require complex companies requiring valuations, many privately-held multiple valuations, and a companies and properties will. nation-wide shortage of qualified While the Working Group might valuers. recommend that Inland Revenue In the absence of a cost- accept Government or Council effective auditing process from valuations of properties, these Inland Revenue, there will be valuations are notoriously significant scope for asset unreliable predictors of current owners to over-value their asset market property prices. holdings, putting downward House prices for many pressure on any revenue from properties in Auckland, for a capital gains tax, and unfairly example, could exceed their rewarding dishonest accounting. C.V. by hundreds of thousands While grandfathering assets of dollars. Unless asset owners until their first transaction want to pay capital gains tax following the introduction of based on an artificially low base- the tax would reduce revenue price for any property they own, in the early years as assets a professional valuation will be are progressively moved into required. the capital gains tax regime, The Group finally argues that imposing billions of dollars of they are “considering options immediate compliance costs to help small and medium (with significant uncertainty businesses reduce the regarding the final cost to the compliance costs associated economy) cannot be justified. with valuing assets”.

The only obvious way to reduce

PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 9 RULE 2: INDEXATION FOR INFLATION

gains, rather than nominal gains. Any capital Taxing nominal capital gains gains tax regime punishes asset owners when the price of their asset may only must discount be keeping pace with inflation, rather than delivering real inflationary increases in wealth. gains, so Any capital gains tax must index asset prices for inflation so that taxpayers are taxpayers are not punished just taxed on for holding assets that do not increase in value in real terms. their real capital This chapter will open with a gains, rather brief mathematical description of failing to index for inflation, than nominal before moving on to provide some examples of families who gains which could be punished by this style merely keep up of capital gains tax. with the cost of FORMAL DESCRIPTION living. OF INFLATION The nominal value of assets INDEXATION increases every year by the rate More formally, where: of inflation, in addition to any real capital gain. While real capital t C1 = C10(1 + i + r) gains represent an improvement in the owner’s wealth (in terms of (Ct is the value of an asset at purchasing power), the inflation time t, C0 is the opening value of component of capital gains the asset, i is the average rate of merely represents the asset inflation between periods0 and keeping pace with the value of t, and r is the average rate of money. real capital gain over the same time period.) Given that, any capital gains tax should solely tax real capital then, supposing the asset is

10 PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 realised at period t, the tax paid on the asset under a system which taxes nominal gains is equal to:

t τN = θC0[(1 + i + r) - 1]

Such that τ is the total tax paid, and θ is the tax rate on capital gains.

In contrast, if the capital gains tax is indexed for inflation such that the asset owner is only taxed on real capital gains:

t τr = θC0[(1 + r) - 1]

Given that, we can derive a simple mathematical description of the amount of ‘over-tax’ (i.e. the total amount of tax paid on purely inflationary, rather than real games). This can be simply expressed as the

difference between τN and τR:

t t (τN - τR) = θC0[(1 + i + r) - (1 + r) ]

Recall that, because this tax applies to assets whether they increase in real terms or not, the inflation ‘over-tax’ is tantamount to confiscation of a proportion of the real value of an asset, as a function of inflation, the length of time an asset is held, and the rate of tax.

Finally, it may be useful to calculate the value of ‘over-tax’ in real terms (i.e. what is the size of the tax in real period-zero dollars), which we can obtain with:

t t t (τN - τR) = [θC0[(1 + i + r) - (1 + r) ] / (1+i) ]

EFFECTS OF FAILING TO INDEX FOR INFLATION

To illustrate these effects, we will use an example with some basic assumptions.

Suppose someone purchases a small lifestyle block property for $800,000 that nonetheless exceeds the 4500m² principal-residence exemption limit. Suppose they sell the property 20 years later and that over that period of time inflation and real capital gains both run at two percent per annum, and that the taxpayer pays 33 percent tax on any capital gains.

PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 11 After 20 years, the property live in the same economic unit will be worth $1,752,898.51 in (in the same home, sharing nominal terms and $1,179,650.45 the same resources, such as a after adjusting for inflation – a married couple) will be treated real capital gain of $379,650.45. as a realisation event – which Assuming a capital gains tax means capital gains tax will which applies to nominal gains, apply to any gains since the the property owner will pay asset was last sold or the tax $314,456.51 when the property is was introduced. sold, which adjusted for inflation So, when each of the couple die, is $211,620.22. whoever inherits the bach – a This is equivalent to a 55.7 child, niece or nephew, or cousin percent tax on real capital gains, – may be liable to pay capital even though the statutory rate gains tax. For the purposes of is only 33 percent. If inflation this example, let us suppose runs slightly higher on average, that is the case, and that the at say three percent per annum, couple has owned the bach the effective tax rate on capital for 25 years since the tax was gains will be even higher – introduced, over which period 64.4 percent, nearly twice the of time inflation averaged two statutory rate. percent per annum.

Failing to inflation index capital Even though the asset has gains is also punishing for assets not appreciated in real terms that don’t appreciate in real by one cent, the inheritor of terms. the bach will be forced to pay $80,181.32 in capital gains tax, Suppose a married couple or $53,959.73 in real terms – owns a run-down bach which which is itself equivalent to 10.8 has been owned by various percent of the real value of the members of the family for a few bach, $500,000. generations. Since the bach is not the principal residence of the couple, it is subject to capital THE WORKING gains tax, so the couple pays a GROUP ON INDEXING valuer, who assesses the bach FOR INFLATION as worth $500,000. From the Working Group’s perspective, adopting a capital Because the bach is run-down gains tax regime which fails to and not in a summer hotspot index for inflation is justified for such as Queenstown or two reasons. Whangamata, the value of the bach only increases by the rate Firstly, they argue that since no of inflation with no annual real other form of tax is indexed for capital gain. inflation, capital gains tax should similarly not be indexed for The Working Group has inflation. Secondly, “the lack of indicated that passing property inflation adjustment is something down to a relative that doesn’t of a quid pro quo for taxing on a

12 PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 realisation, rather than accrual, essential for analysing the basis.” effect of a tax on nominal gains. Unfortunately, it is not explained Tax Working Group member by the Working Group why they Craig Elliffe makes this point choose to use a five percent real again in an interview for Stuff1. capital gains rate, instead of the He argues that “because a formerly justified one percent capital gains tax is a “deferred rate, and the Interim Report does tax”, not one that people pay not discuss the effect of the real every year, and the benefit that gains choice on the effective tax investors get from only paying rate. tax when their profit is realised through a sale can be quite By way of example, using a substantial.” five percent real rate of capital gains implies a 42.7 percent The second argument (as capital gains tax rate, whereas presented in the Interim if we instead use a one percent Report) misses the significant capital gain rate (as argued distortionary effect of taxing for on page 136), the effective inflation, even on realisation. capital gains tax rate is 90.9 While there is very little percent. difference between an accrual capital gains tax and CONCLUSION a realisation capital gains tax Failing to index for inflation applied to inflation when the real imposes artificially high tax return on capital is five percent burdens well exceeding the (as assumed on page 152 of the statutory rates currently being Interim Report) over ten years, argued for. the report argues earlier that a one percent annual real capital While the Tax Working Group gain is an appropriate figure to might see non-indexation as a use (page 136) for property. quid-pro-quo for choosing to tax on realisation, taxpayers who Similarly, in the background hold assets that deliver only paper Potential high-level modest annual real capital gains effects of proposals to extend will face very high effective the taxation of capital income, tax rates – in some scenarios prepared by the Working Group exceeding 90 percent. For the Secretariat Westpac model is capital gains tax regime to avoid cited which assumes an annual becoming punitive, any gains real capital gain of 1.5 percent. should be indexed for inflation. [re-read this para and previous]

The choice of real gains is

1 Available at https://www.stuff. co.nz/business/109818642/capital-gains- tax--what-we-know-about-how-it- would- work

PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 13 RULE 3: REVENUE NEUTRALITY

Any revenue from a capital gains tax must be used to fund tax cuts in other areas so that the total tax burden does not increase overall. On 20 September 2018, Minister of Finance Grant Robertson wrote to Sir Michael Cullen1 in his capacity as Working Group Chair requesting that the Working Group provide “measures that could result in a revenue-neutral package” in its Final Report.

More recently, Tax Working Group member Bill Rosenberg has indicated that the Working Group plans to meet this expectation by either introducing a tax-free threshold on income up to $7,000 or by halving the tax rate on income earned up to $14,000 from 10.5

1 15 Correspondence is available at https://www.beehive.govt. nz/sites/default/files/2018-09/TWG%20 letter%20final.pdf

14 PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 Figure 1: OBEGAL Forecast from Half Year Economic and Fiscal Update 2018 available at https://treasury.govt.nz/sites/default/files/2018-12/hyefu18.pdf

percent to 5.25 percent.2

Regardless of the measures the Working Group provides to allow for revenue neutrality, it is crucial that the Government follows through and ensures taxpayers do not face a net increase in their tax burden.

REVENUE ADEQUACY

There is currently no need for additional revenue.

Unlike the United States and the United Kingdom, both of which are operating persistent deficits3,4, the New Zealand Government is running healthy surpluses which are expected to strengthen in coming years.

2 https://www.stuff.co.nz/business/109818642/capital-gains-tax--what-we-know- about-how-it-would-work 3 https://www.ons.gov.uk/economy/governmentpublicsectorandtaxes/ publicspending 4 https://www.cnbc.com/2019/01/10/fed-chairman-powell-says-he-is-very-worried- about-growing-amount-of-us-debt.html

PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 15 “Capital-reallocation requires a liquidation of an investor’s position. Any gain in asset value over the period it has been owned would be taxed. Capital re-allocation is now subject to transaction costs as a proportion of the previous success of the stock.”

“That disincentivises re-allocation of capital to more productive investments, reducing Figure 2: OBEGAL and CAB Surplus Forecasts from Half Year Economic and Fiscal Update investor returns and 2018 available at https://treasury.govt.nz/sites/default/files/2018-12/hyefu18.pdf economic growth. This is described in the literature The Crown’s OBEGAL (operating balance before gains and losses) as the ‘lock-in’ effect.” surplus is expected to grow to more than $5 billion per annum by 2020, before growing to $10 billion per annum by 2023: the Government Therefore, any revenue gained should be proposing tax cuts, not tax hikes. from a capital gains tax should be used to cut distortionary, The data shows these are sustainable surpluses. growth-stunting taxes.

The cyclically-adjusted balance (CAB) is an adjusted form of OBEGAL Company tax in New Zealand surpluses which corrects for the economy’s business cycle position, is very high, for example. The allowing forecasters to establish whether annual surpluses can be OECD noted in their 2017 attributed to structural factors, or simply an over-heating economy. Economic Survey of New Zealand (page 35): The CAB is expected to grow as strongly as a percent of GDP as regular OBEGAL surpluses, indicating that surpluses are structural and there is “A higher cost of capital than in no need for additional revenue to fund Government services. most other advanced economies contributes to low capital While there might be a reduction in revenue during a recession, the investment. Also, owing in part Government is structurally taking in more than it needs to operate to its small size, New Zealand services and fund transfer payments, so fiscal recovery would quickly has thin venture capital, stock accompany economic recovery – in contrast to the years following the and bond markets.” Global Financial Crisis when deficits were structural and persistent. “Low rates of capital investment ECONOMIC COST OF TAXATION depress wages, with negative consequences for income In the absence of a structural need for revenue, increasing the burden distribution and inclusiveness.” of taxation on the economy would just put the brakes on economic growth, reduce future prosperity and worsen living standards. In addition to company tax cuts, personal income tax cuts could In particular, a capital gains tax would make portfolio re-allocation more be implemented to ensure expensive. revenue neutrality.

This was discussed in the Taxpayers’ Union’s submission to the Tax In our 2017 report, Five Options Working Group:

16 PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 for Tax Relief, we highlighted the cost of fiscal drag. Fiscal drag describes the effect of inflation on tax obligations, where incomes are pulled into higher tax brackets, even if taxpayers are not earning any more in real terms.

Since no Government has implemented tax cuts since the 2010 Budget, the average income earner is worse off by approximately $500 per year solely due to the effect of inflation. Correcting for this effect (via either personal tax cuts or the permanent indexation of tax thresholds to inflation) should be a priority use of any revenue gained from a capital gains tax.

CONCLUSION

The Government’s books are extremely healthy: there is simply no need for additional revenue to fund Government services. Meanwhile, a high cost of capital and a failure to correct tax rates for inflation is hampering prosperity. Any revenue gained from a capital gains tax should be used to fund tax cuts in other areas to ensure taxpayers are not unnecessarily punished.

PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 17 RULE 4: ROLL-OVER RELIEF ON DEATH

When a family member passes away and chooses to leave their assets to friends or family members, the capital gains tax should not be levied on the inheritor at this point. Many assets expected to be subject to capital gains tax have sentimental value to families outside of their economic value. Farms, baches, family homes, and businesses built over generation all have value to their owners outside of any income or economic benefit they might generate.

Rollover relief refers to an exemption to a realisation event, with the effect that capital gains tax is not paid when it should have been paid. If rollover relief is granted, capital gains tax will

18 PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 be liable next time the asset is a farm, bach, or business for sold on the full amount of capital generations might grant a gain including the period prior to relative tax benefit to families the rollover relief since the last (in so far as assets are not sold). asset transaction. However, the family also faces an opportunity cost, as they If rollover relief is not granted are restricted from freeing up on death, asset inheritors would capital where it might be more be liable to pay capital gains efficiently allocated to more tax on any capital gains since profitable ventures. the asset was last sold. If a family bach had increased in Where assets have been held value by $500,000 since it was by the same owners for a long purchased, for example, the period of time, the capital gains inheritor would immediately be tax obligations on death (in forced to pay $165,000 in tax. absence of relief) could be significant. A large family farm Few New Zealanders are held for the last 40 years may financially positioned to pay have appreciated in value by Inland Revenue such a sum at hundreds of thousands, if not short notice – and especially millions, of dollars. Imposing not in the case of a sudden, a capital gains tax on death unexpected death in the family. could drive families off their A bill from Inland Revenue farms, forcing the farms to be would be salt in the wound for a sold in order to meet the tax family member or friend already obligations. grieving the death of a loved one. Roll-over relief should also be granted when capital gains are The practical response for re-invested in the same asset many inheritors would be to class. For example, if you sell mortgage, or even sell, an asset your farm to purchase a larger with sentimental value that has farm, you should not be forced been held within the family for to pay capital gains tax. The generations. investor is not liquidating their Some may argue that this is position, but rather just recycling desirable, because, under a their capital into a similar asset: capital gains tax regime, holding investors should only pay tax once they exit their position.

PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 19 RULE 5: DISCOUNTED RATE

Any capital INTERNATIONAL COMPARISONS gains tax should In Australia, individuals can discount capital gains by 50 percent if they have held the asset for longer than a year. This means that while the top apply at a rate of tax in Australia is 45 percent on income earned over $180,000, the top capital gains tax rate for individuals is only 22.5 percent – discounted rate, approximately one third lower than the proposed 33 percent rate in New Zealand. Taxpayers earning between $90,000 and $180,000 would pay instead of the capital gains tax starting at just 18.5 percent. full personal The United Kingdom has a similar ‘discount’ system. For ‘higher-rate’ income tax rate. taxpayers (earning over GBP 46,350), capital gains are taxed at 28 percent on residential property and 20 percent on all other assets If, as is expected, the capital subject to capital gains tax. gains tax will apply at income earners’ marginal tax rates, Canada also has a ‘discount’ system, where only 50 percent of capital the vast majority of taxpayers gains are subject to tax. The exact rate varies by province. subject to capital gains tax will While the United States does not have a formal discount system, its face a rate of33 percent. This is capital gains tax rates are much lower than 33 percent. The maximum much higher than any previous capital gains tax rate is 20 percent on assets held for longer than one proposal. Labour campaigned year. on a capital gains tax of 15 percent at the 2011 and 2014 According to analysis from the Tax Foundation, as of 2011 a 33 percent elections. tax rate on long term capital gains would place New Zealand as the third most punitive jurisdiction in the world, behind Italy and Denmark.

20 PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 DISCOUNTING CAPITAL GAINS This is despite high property prices often being used as a New Zealand should focus on becoming more friendly to foreign justification to introduce a capital investment, rather than more hostile. In the rest of the world, corporate gains tax. taxation is trending downwards. The OECD has recently acknowledged that there has been significant downward pressure on corporate tax Naturally the severity of the rates. capital gains tax will exacerbate any effects on the residential The best way to reduce the burden of capital gains taxation would be to property market and applying apply a discount rate in a similar way to Australia, the United Kingdom, a discount rate would limit the and Canada. Failing to do so would worsen New Zealand’s competitive extent of any damage on rents economic environment and dampen inward foreign investment. and housing affordability.

A high capital gains tax rate would worsen any lock-in effects, worsening the economic efficiency implications of a capital gains tax.

Coleman (2009) discusses the effect of capital gains, arguing that they increase house prices and raise rents. Similar results are discussed in a Background Paper prepared by the Working Group Secretariat with reference to a model developed by Coleman and Binning that outlines the likely effects of capital gains taxes. The likely outcome is higher property prices and higher rents.

PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 21 CONCLUSION

While some on the political left will find a punitive capital gains tax desirable, the Working Group and the Government need to keep the focus of a capital gains tax based on technical reform, rather than the aggressive expansion of the state.

To test that, the Taxpayers’ Union will be applying our Five Rules for a Fair Capital Gains Tax to the various proposals and amendments that will emerge in the coming months. Each of the Rules are sufficiently independently important that we will oppose any capital gains tax that violates any single one of our Five Rules.

Fortunately, even if the Working Group releases a proposal which violates one or more of these criteria, there will be opportunities to amend the proposal: when the legislation is put before Parliament and during the Select Committee process. With the legislation likely to take over a year to pass into law, our position on the tax could change if the Government lightens the burden of the tax in response to public consultation.

Each of the Rules represent instances where significant costs would be imposed on taxpayers unnecessarily if they are violated. If the purpose of a capital gains tax is to simply re-balance the tax system towards capital taxation and away from labour taxation – as was discussed at length by members of the Working Group at the Future of Tax Symposium in Wellington on 28 November 2018 – then a discounted, grandfathered, revenue-neutral regime that applies to real rather than nominal gains should be sufficient to make that change. Taxing accrued capital gains on assets that family members have no intention of selling upon death would also be an overreach of that purpose.

22 PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 ABOUT THE TAXPAYERS’ UNION

Founded in 2013 by David Farrar and Jordan Williams, the Taxpayers’ Union is New Zealand’s largest taxpayer advocacy group, with more than 36,000 subscribed members and supporters. The Taxpayers’ Union’s vision is a prosperous New Zealand, with efficient, transparent, and accountable Government. Our mission is: Lower Taxes, Less Waste, More Transparency.

The Taxpayers’ Union is a member of World Taxpayers Associations: the global network of more than 55 taxpayer protection groups representing more than two million supporters in some 40 countries working together for lower taxes, limited and accountable government, and taxpayer rights.

PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019 23 Lower taxes, Less Waste, More Transparency www.taxpayers.org.nz

24 PROTECTING NEW ZEALAND’S TAX SYSTEM: FIVE RULES FOR A FAIR CAPITAL GAINS TAX JANUARY 2019