The Savings Working Group (SWG) report, released yesterday, makes grim reading. New Zealand's net foreign debt, at 85% of GDP, puts us in the same company as Greece and Ireland. Over half of this debt seems to have been used to bid up the price of residential houses and farms.
As a result we are now "standing on top of a cliff that may collapse dramatically, or crumble slowly". To avert either a sudden economic crisis, or a continued gradual deterioration in our economic standing, we need to save more and more wisely, and to work more productively across both public and private sectors. The SWG has a swag of recommendations as to how this might be done, including reduced government spending, increased government productivity and changes to the tax system.
In this Brief Counsel, we look at the proposed tax changes and guess which of them might be adopted in the near term. We will discuss the SWG's proposals to lift KiwiSaver participation rates in a companion Brief Counsel.
Tax policy recommendations in brief
- Index interest income and expenses at a standard rate to reflect the rate of inflation (e.g. 2% per annum).
- Target PIE tax rates at 5 to 10 percentage points below investors' marginal tax rates.
- Apply PIE tax rates to interest and dividends earned directly, collected by way of residents' withholding tax (RWT).
- Reduce interest deductions related to PIE and RWT income consistent with the above lower tax rates.
- Make imputation credits refundable to the extent that an investor's RWT rate is below 28%.
- Continue the switch from income to consumption tax by reducing income tax rates and raising GST to 17.5%.
A general income tax rate cut would be best...
By reducing the after-tax return to savings, income tax encourages consumption now compared with savings and consumption later. The SWG's most favoured tax change, therefore, is for income tax rates generally to fall, funded by an increase in GST to 17.5%. But the Government, despite its success in 2010, is not interested in playing that trick twice. Accordingly, in a very tight fiscal environment, further broadly based income tax cuts are out. (A tax-free zone would have no impact on the decision to save or consume, since the drop in the rate occurs only on income which is required to meet basic living expenses).
followed by lower tax rates on savings.
In the absence of a general reduction in income tax rates, the SWG proposes reducing the rate of tax on income from savings generally. Its recommendations in this respect are based on two key ideas.
Extending the PIE rate concession...
Currently income earned through a PIE is subject to income tax at no more than 28%, and so investing through a PIE gives a definite 5% rate benefit to those in the top tax bracket. For others, because the PIE rates are based on the previous two years' income, and the thresholds were deliberately generous, the picture is confusing. PIE investors can get rate benefits of between 0% and 17.5%. Investors with declining income can even pay more on income earned through a PIE than income earned directly. The SWG suggests that the PIE rates be changed to give everyone a benefit of between 5% and 10%, though it is not clear how this would be achieved;
The Report then suggests extending this preferential rate to interest and dividend income earned directly (which would largely remove the need for Cash PIEs). It suggests that payers levy the reduced rates by way of withholding tax, with a cash refund in the case of dividends if the rate of imputation exceeds the rate of tax.
The extension of the preferential rates to dividends and interest earned directly raises real difficulties in the context of professionals and other SMEs. The incentive to transform personal services income into interest and dividends will increase substantially.
A part of this proposal less favourable to savers is that any interest cost incurred to earn the tax-preferred income would be deductible at lower rates. This is currently not the law where a person borrows to fund investment in a PIE.
and indexation for interest income.
The second basis for reducing income tax on savings income relates to debt rather than equity investment. A component of any interest rate is a return to the lender to compensate for inflation – the decline in the purchasing power of their money over the interest period. The taxation of this component can give rise to very significant over-taxation, even at modest rates of inflation. For example, if inflation is 2% per annum, interest rates 6% per annum and tax 33%, then the tax rate on real income is 50%. If inflation is 4%, then the tax on real income is almost 100%.
This phenomenon is particularly evident in the case of inflation indexed bonds, where current legislation specifically taxes the inflation component of the return.
The Report suggests that the attraction of housing over debt and share investments is due in part to this is over-taxation and recommends removing it by either:
- reducing the amount of a person's interest income (and interest expense where deductible) by a notified standard rate (e.g. 2% per annum), or
- indexing the tax system for inflation more generally, not only with respect to interest but also with respect to, for example, depreciation and inventory. The SWG notes that inflation indexation was considered "not infeasible" in a 1989 New Zealand tax report.
One favourable aspect of these proposals is that they should be largely self-funding, in that decreased interest income would be matched by decreased interest deductions. In fact, the high level of private indebtedness giving rise to the Report would lead one to think that there might be a net revenue gain.
However, there is no doubt that indexation is complex to comply with and administer, and these costs might outweigh the benefits. It could also be argued that the effect of inflation on effective tax rates is already taken into account when interest rates are set.
Rate cuts for income on retirement savings may be justifiable
The Report expresses scepticism about the merits of tax cuts targeted solely at retirement savings, or indeed at any particular form of savings. Like the other proposals, such cuts obviously increase government debt by the same amount as the tax foregone. They might also have the effect of actually reducing private sector savings, by reducing the amount of their own money people need to save to meet their savings goals. However, the Report says that rate cuts specifically targeted at income from KiwiSaver savings could be considered if KiwiSaver investment can be shown to be higher quality investment than alternative forms of savings.
Funding reduced rates
The SWG's covering letter notes that it has not had time to cost its proposals. However, in principle the Report states that if a rise in GST is off the table, its tax cuts should be funded by way of a tax on labour income, such as payroll taxes or social security contributions. This tax would not affect the save/consume trade-off. Furthermore, New Zealand is the only country in the OECD not to have such taxes. From an international comparison perspective, the case for their adoption is therefore strong, though politically it will face some "regressivity" obstacles.
The SWG's terms of reference did not allow it to recommend a capital gains tax. However, in our view it is disappointing that it did not raise the possibility of a tax on owner occupied housing. As part of a revenue-neutral package designed to encourage New Zealand to save more and more wisely, such a proposal might well receive a better reception than it did a decade ago, when proposed by the McLeod Review.
The information in this article is for informative purposes only and should not be relied on as legal advice. Please contact Chapman Tripp for advice tailored to your situation.