Closing tax loopholes for business and farmers

A principle of a good income taxation regime is that it is neutral, that all income gets taxed in the same way.

Unfortunately, ever since New Zealand moved from land and property taxes to income tax, an anomaly has been present and the effects of that distortion have built up over time. They are now at the point where inequality between property owners and others has become obscene. This anomaly is starkest with our largest export industries, as they are also our largest landowners.

What loopholes?
In most countries, loopholes in the income tax regime are somewhat imperfectly addressed by the use of wealth taxes, stamp duty, land transfer taxes and estate duties. None of these alternatives closes the loophole efficiently and instead gives rise to their own inequities, distortions and inefficiencies.

It is important all forms of income be taxed in the same way, most notably because it improves economic efficiency – both allocative (where we allocate our investments) and productive (ensuring those investments are used efficiently). An efficient economy is one wherein consumers and investors make the same choices, whether they consider the benefits in before-or after-tax terms or not.

If those relative benefits differ because of the way taxes are imposed, then there is a loss of allocative efficiency. If businesses (including farming) make different investment and production decisions because it reduces their tax bill, then people will invest in ways which aren’t ideal for the economy. In other words, the tax regime inhibits productive efficiency.

In our 2011 book, “The Big Kahuna: Turning Tax and Welfare in New Zealand on its head”, Susan Guthrie and I posit the Comprehensive Capital Income Tax (CCIT) as an overdue reform for the New Zealand income tax regime.

We point out that until it was introduced, our economy would suffer from over-investment in low returning capital assets – and by implication under-investment in high-returning capital assets. The argument was that the current income tax regime fails to tax the full return from investment in some asset-types and as a consequence, investors compete to buy those types of assets.

This is not because of the pre-tax return being created by the productive use of the asset, but rather because the favourable tax treatment makes these asset types attractive to hoard. The demand for asset types reaping at least some return outside the gambit of the income tax regime becomes excessive as investors clamber to take advantage of the tax break. This results in pricing an asset that far outweighs its ability to produce competitive risk-adjusted income.

The consequences
The CCIT is designed to remove that tax distortion – albeit only partially. It does that by subjecting to the normal income tax rates, a deemed minimum rate of return on the value of all major assets. So let’s say the cyclically-adjusted, risk-free rate in the economy (often taken as the long term average of the government bond rate) is 5%. Then under a CCIT-augmented income tax regime, all assets would have to return at least 5% for taxation purposes.

Consider the consequences. It means, for instance, owner-occupied dwellings would be deemed to furnish their owners a 5% return, and that return would be taxable. Such a step would remove the anomaly extant today between an investor's choice to put their money in the bank, earn interest and pay tax on that interest before they can spend it, or purchase a house with the cash and enjoy year after year the rental services the asset provides – tax-free.

This is a huge distortion in our economy and continues to drive the house price-to-income ratio up, placing that asset type beyond the reach of more and more people. Such an outcome is a nonsense result and totally unnecessary. As Europe’s most successful economy Germany attests, there is no need for the house price-to-income ratio to rise at all, if the effective return to housing is taxed fully.

How the CCIT applies to business & farming
Now turn to business. Why do some businesses persist year after year without even making the risk free rate of return on the assets deployed?

Of course, any half decent business test by the IRD would determine they’re not businesses at all – but rather lifestyle choices. And why? Because owners are able to effectively reap an income from the “business” in a tax efficient (re: “avoiding”) manner. Your friendly corner dairy or workman with a van could be this type of “pretend” business. The impact of the CCIT on such an activity would compel the business owner to declare at least a 5% return for the purposes of income tax. If the taxable profit from the business is already above 5% of the assets deployed, then the CCIT would have no effect.

So finally we come to farming which is a business just like any other. So under the CCIT regime, it would be subject to a minimum taxable income of 5% of assets deployed, each and every year. If a farm already exceeds this on average, then the CCIT has no impact. If it doesn’t average that then the tax impost on the farm owner would rise.

Now, of course, farm income is volatile and the concept above is a year-by-year deemed income. It implies that businesses with a volatile annual income would need a smoothing regime in place for the CCIT liability. This is not an option to escape the tax, but merely to smooth the cashflow effects. One would expect usage of money interest to apply and there to be a limit to how long tax could be deferred. Remember a business that doesn’t make the

Remember, a business that doesn’t make the risk-free return over time isn’t a business at all, so the assets are either being deployed lazily – or more likely – being deployed in order to reap benefits lying beyond the gambit of the income tax regime (anyone heard of capital gains?).

Inefficient and inequitable
On a final note, the CCIT regime we advocate is a little different to the current income and expenditure regime.

Rather than apply the 5% deemed income to the full value of the asset and make interest deductible, because the CCIT only applies to non-financial assets (interest and dividends are already subject to tax), the approach for assessment of the CCIT liability is to apply the 5% deemed income to the value of the productive asset, less the liabilities secured against the asset.

Remember the objective here. It is to ensure that all forms of income are subject to income tax to some degree. A CCIT would be a huge improvement on the distortive, inefficient and inequitable income tax regime we currently have. In the household sector alone we estimate there are $750bn of assets (net of financial liabilities) held delivering untaxed benefits to their owners.

On the principle that not an additional dollar of taxation is to be raised from deploying a CCIT, expansion of the tax base by the 5% of income deemed to come from those assets could provide a 20-25% cut in overall income tax rates.

It would also free up an enormous amount of capital currently sunk into housing, and other unproductive assets, to be invested in productive assets. We simply can’t get rich as a nation by selling houses and land to each other; we need to sell stuff to the world.

Nice.

Gareth Morgan is a New Zealand economist and commentator who in previous lives has been an investment manager. This post first appeared on Gareth's World.

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