Ten questions on capital gains tax

The tax working group released its interim report in September. No prizes for those of you that predicted that they’d recommend a capital gains tax on everything but the family home; the parameters around the mission were made rather clear by the Labour-led government.

There was a small chance that the group would come back with a recommendation of some kind of a tax on wealth – such as a land tax, as recommended by the previous tax working group. This time around the experts have eschewed a broad-based wealth tax, a land tax, and an inheritance tax. Although, I will argue below that one of the versions of the capital gains tax being considered resembles a wealth tax on certain assets.

Section six of the report discusses their conclusions on a capital tax to date.

1. Will taxation be based on ‘realised gains’ or on a ‘deemed return’ basis?

The interim report has narrowed-down the options to two very different approaches to taxing capital.

Under realised gains you are taxed based on the different between the sales and purchase price of the asset (perhaps less any improvement expenses incurred – see below). This method corresponds to how most of us understand how a capital gains tax works.

The deemed returns (or risk-free rate of return method of taxation) taxes the asset holder on the assumption that the asset earns a constant return. This could be 4% per year, for example.

The two approaches are very different and have potentially have vastly different implications for revenue stability, wealth and income distribution. See paragraphs 37-42, section 6 of the report, for further details on the two methods.

Although the group eschewed a broad-based wealth tax, the deemed returns approach is very much like a wealth tax, as it would be payable whether the asset was disposed of or not, and it is based on the value of the asset.

In what follows it will frequently be important to recognise the distinction between these two methods, since many of the issues only apply to one of the methods.

2. What kinds of assets would be subject to the “deemed returns” capital tax?

A tax on wealth is difficult to implement, since many forms of wealth can be hidden with the help of a creative accountant and a few overseas bank accounts. For these and other reasons, the working group dismissed a broad-based wealth tax (paragraphs 104-108).

Yet this begs the question: How is the deemed return method any easier to implement? If the tax rate is based on a deemed return of 4%, it is necessary to have an up-to-date estimate of the value of the owner’s interest in the asset.

That is easy for some assets, but harder for others.

These and other difficulties lead the working group to indicate that only portfolio investments and residential real estate would be considered for deemed return taxation. Rural, commercial and industrial land would be subject to the current income taxation. Equity interests in businesses that are not publicly listed would also, presumably, continue to be taxed based on the income generated.

The differences in the tax regimes applied to different land-use types (residential, commercial, industrial and rural) may require some form of harmonisation across different local government, and it is unclear how residential housing built on commercial land would be treated.

One last and very important point: Under the risk-free rate of return approach, the income from the asset (e.g. dividends or rents) would not be subject to taxation. But neither would the cost of improvements and repairs of real estate be deductible. See paragraph 79.

3. What is the tax rate?

It looks as though realised capital gains would be taxed at the same rate as other forms of income. Paragraph 72 states:

As this approach does not impose a new type of tax but significantly expands the capital/revenue boundary, taxation would generally be calculated and collected in the same way as currently applies for disposals of revenue account property — i.e. taxation would apply at ordinary income tax rates to nominal gains and losses (emphasis added).

To my reading, it is not completely clear what the tax rate would be for the deemed return or risk free return method, but it seems likely that the marginal tax rate would also be applied.

4. What are the expected effects of the capital gains taxes on economic mobility?

The working group is up-front about its goals and concerns in tweaking the tax system, with ‘Fairness’, ‘Distributional Impact’, and ‘Revenue Stability’ as stated priorities (see paragraph 47, section 5).

Yet no attention is paid to economic mobility – the extent to which people and families can improve their lot through hard work and savvy investment.

Working hard, saving and investing is how a person born of humble means climbs the income ladder. We already have a tax on interest and dividends; throwing in a tax on realised capital gains would make it that little bit harder for them to get ahead. It inhibits economic mobility.

A tax on wealth – as prescribed on some assets under the deemed return basis – is far better in this regard. It would be progressive. But rather than tax people as they try to make their way up the ladder, it would only tax them when they reach the top.

5. What is the distributional impact of the home exemption on renters?

As expected, the family home will be exempt from capital gains (paragraph 55, section 6).

This puts yet another disadvantage on tenants. Owner-occupiers are already gifted tax-free income when they put their savings into their house. Renters, on the other hand, have to pay income tax on their savings – and now they will also be hit with tax on any capital gains on their savings.

The working group claims that fairness and distributional impacts are an overarching concern – but it is difficult to see how the home exemption can be either fair or progressive.

Low income families have always found it difficult to get on the property ladder, and it is only getting worse. Like it or not, there will be more and more middle income families renting in this country as sky-high house prices in the big cities like Auckland put home ownership out of their reach.

The home exemption further exacerbates the gap between the haves and the have-nots, but it also exacerbates the gap between the young and old, making it that much harder for young families to build their lives in this country. About one in five people born in NZ live overseas – one of the highest rates of emigration in the OECD.

6. What are the economic and financial impacts of home exemption?

Needless to say, the home exemption also further skews incentives towards investment in the family home.

Imagine a couple in their mid-40s thinking about where to invest their savings. Option one is the stock market. Option two is a purchasing a rental. Option three is to trade up to a larger, more luxurious home that will then be sold once they reach retirement.

The first two investments will attract income and capital gains taxes. The third will not. When the couple plans to downsize for retirement, they recoup all of their investment via an untaxed capital gain (unless the bottom falls out of the property market).

This tax distortion could mean even less kiwi money invested in the kinds productive capital that sustain and generate jobs – and correspondingly more business profits flowing to foreign owners.

And what of financial fragility? The old maxim ‘don’t put your eggs in one basket’ comes to mind. More of us should be diversifying our investments and putting our savings overseas.

7. Why won’t capital gains be indexed to inflation?

Inflation is one way that the taxman can get away with taking a little more than what you think. What matters is not your nominal income, but its purchasing power, and inflation erodes that purchasing power. Even if your wages keep up with prices, you will be pushed into higher marginal income tax brackets, thereby reducing the purchasing power of your pay after tax. The Taxpayer’s Union calls this “bracket creep”.

The prospect of a capital gains tax not indexed to inflation is yet another way that the taxman can quietly take a little more. Indexing the capital gains to inflation would be an honest move. But apparently any CGT will not be indexed to inflation because other forms of income are not indexed either. But all of the tax system is up for review – not just taxation of capital. Surely now is the time to raise the issue?

8. How will improvements be treated?

For those DIYers who put their sweat and cash into doing-up all those properties listed under “Handyman’s delight” or “Renovate or detonate”, the prospect of a tax on realised capital gains could represent a big hit on all that effort.

Thankfully, the working group recognises that these improvements do not represent capital gains. Paragraph 54, section 6 states that: Taxpayers would be entitled to deduct their acquisition and improvement costs (to the extent that those costs have not already been depreciated) from the sale proceeds received on disposal, so only the net gain (or loss) would be taxable.

9. How will realised capital losses be treated under a realised capital gains tax?

Some forms of capital losses will offset other income. However, of some asset classes, capital losses will only offset against future capital gains. Paragraph 68, section 6 states: As a general rule it is proposed that capital losses would be able to be utilised against ordinary income. However, for base integrity reasons, in some cases capital losses would be ring fenced (only able to be carried forward against future capital gains from similar asset classes).

10. Where is the economic analysis of the impact of these taxes?

Beyond a simple analysis of the impact on government revenues, there is not a lot in terms of what the effects of these different taxes may be on the economy and households. The previous tax working group recommended a land tax, but also provides some work to show that a 1% land tax would reduce land values by approximately 25%. What impact would a 2% ‘deemed return’ capital tax have on house prices? It remains to be seen whether the group will take an evidence-based approach to their final recommendation in their full report.