Briefing for the Incoming Minister of Revenue - 2005 - Part 2

Taxes, distortions and the New Zealand tax system

Taxes are needed to finance government spending.  At the same time, taxes distort economic behaviour, which can inhibit growth.  When the tax system causes people to invest in particular assets or to structure their affairs in ways which are sensible only because of taxes, the tax system is said to be inefficient.  A goal of good tax reform is to raise sufficient revenue to meet government requirements as efficiently as possible, consistent with a government's equity objectives.

Although most taxes can distort economic behaviour, it appears to be income taxes where most pressures are emerging.  Income taxes can distort behaviour, harm economic growth and produce other undesirable effects in three different ways.  The possible distortions can be grouped as follows:

• those attributable to all marginal tax rates
• those attributable to differences in marginal tax rates and
• those primarily attributable to the top marginal tax rate.

It should be noted at the outset that in listing these potential distortions we are not suggesting New Zealand's tax system is poor relative to tax systems in other countries.  On the contrary, we will see that in many ways New Zealand's tax system is relatively well designed.  Being aware of the three different possible sets of distortions, however, is helpful in examining how efficient New Zealand's tax system is likely to be.

First, high marginal tax rates can hinder individuals from working as long, as hard or in as difficult and demanding jobs as they would if marginal tax rates were lower.  High marginal tax rates can also discourage individuals from saving when it would be desirable to do so if not for these tax rates, and encourage avoidance or evasion of taxes.  The degree of distortion will depend on an individual's marginal tax rate on any additional income, and different individuals will face different marginal tax rates on additional income.  Thus these inefficiencies will depend on the levels of marginal tax rates facing all individuals. 

Second, differences in marginal tax rates can produce another set of distortions.  If marginal tax rates rise with income, the high rates faced if a risky investment pays off and the low rates faced if the investment fails may discourage risk-taking behaviour.^[1]  Similarly, increasing marginal tax rates can discourage individuals from "investing in human capital" and acquiring new knowledge and skills.  It is also differences in marginal tax rates that give rise to problems in taxing different forms of savings vehicles, including trusts and companies, on a consistent basis and lead to biases in the ways that individuals save.  Moreover, differences in marginal rates provide scope for income splitting within a family.  This leads to perceptions of unfairness.

Third, some distortions may predominantly be affected by the highest marginal tax rates.  If certain forms of investment are tax advantaged relative to others, those who have the biggest incentives to invest are those on the highest tax rates.  Provided these individuals have or can borrow sufficient capital, it may well be the tax rate of these individuals that determines the efficiency cost of the distortion.

By international standards, New Zealand has broad bases for both its income tax and GST, and about 90 percent of total government tax revenue comes from these taxes.  Both tax bases have relatively few concessions by international standards.  This allows lower tax rates and a more efficient tax system than would otherwise be possible. 

The basic structure of our tax system was endorsed by the Tax Review 2001, which concluded that ". . . radical restructuring is not required.  The broad architecture of the tax system is sound."  The Tax Review commissioned Professor Alan Auerbach, a leading international expert on the economics of taxation, to comment on its June 2001 Issues Paper.  He prefaced his report by stating "New Zealand's current tax system already conforms more closely to the standard objectives of taxation than do the tax systems of many other developed countries.  Thus New Zealand's tax system is not obviously in need of major overhaul."^[2]

When comparing New Zealand's tax system with those of other countries it is important to note that New Zealand already has a relatively well designed tax system.  It should not be thought that any departure from norms in other countries is necessarily evidence of poor New Zealand policy. 

OECD data on tax rates and tax collections are shown in Table 1.  The year chosen in each case is the most recent year for which internationally comparable data are available.^[3]

These data suggest that:

• New Zealand's tax/GDP ratio is towards the middle of the range for OECD countries
• New Zealand's company tax rate is high relative to those of most OECD countries
•   New Zealand has a relatively high level of company tax as a proportion of GDP
• New Zealand has a relatively low top statutory marginal tax rate on earned income, although this is attained at a relatively low income
• There is a relatively small difference between the company tax rate and the top personal marginal tax rate.

The absence of any tax-free threshold in New Zealand and the relatively low top personal marginal tax rates are likely to lead to relatively small differences in New Zealand's statutory marginal tax rates.  Although the top statutory marginal income tax rate in New Zealand is low, the abatement of family assistance can lead to very much higher effective marginal tax rates.

Tax as a percentage of GDP

As shown in Figure 1, New Zealand's tax to GDP ratio of 34.9 percent in 2002 is towards the middle of the range for OECD countries.^[8]  It is slightly below the unweighted average of 36.3 percent but above the GDP-weighted average of 31.0 percent.  The OECD-weighted average is less than the unweighted average because the two largest economies in the OECD - the US and Japan (with 54.4 percent of GDP in total in 2002) are relatively low-tax countries. 

It should be noted that comparing New Zealand's ratio of tax/GDP with those of other OECD countries involves a comparison with relatively high-tax countries.  Many non-OECD countries within our region have lower ratios.  For example, ratios in Singapore and Hong Kong in 2002 were approximately 22 and 15 percent respectively.

Figure 1 - Total tax as a percentage of GDP - 2002

Click on image above to get a full size view

It is of interest to consider how New Zealand's tax to GDP ratio has been changing through time.  The ratio has increased slightly over recent years, but it is below the ratio in the early 1990s, as shown in Figure 2.

Figure 2 - New Zealand tax to GDP ratio

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Company tax

A number of commentators have pointed out that New Zealand's company tax rate of 33% is higher than the Australian company tax rate of 30%.^[9]  Figure 3 shows company tax rates for OECD countries inclusive of both federal and state tax rates.  New Zealand's company tax rate is now in the top third of tax rates for OECD countries but lower than the weighted average of 36.0%.  The weighted average is substantially affected by the largest economies (US, Japan and Germany), which have the highest corporate tax rates.  There appears to be a general tendency for smaller economies to have lower statutory company tax rates than those of larger economies.

Figure 3 - Company tax rate 2005

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It should be noted that high statutory company tax rates do not necessarily imply a large company tax base.  The countries with the highest company tax rates, Japan, US, and Germany, have respectively the fourteenth lowest, the third lowest and the lowest ratios of corporate tax collections as a proportion of GDP. 

A key feature of the New Zealand tax system is the importance of the corporate tax base.  In 2002, as shown in Figure 4, New Zealand had the sixth highest ratio of company tax as a proportion of GDP.  In New Zealand this has risen from 4.2 percent, as reported in Figure 4, to an estimated 5.1 percent in the year to March 2005.

Figure 4 - Company tax as a percentage of GDP 2002

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As discussed later in "Key challenges in tax policy", international moves are placing downward pressure on New Zealand's company tax rate, and whether we should lower this rate is an important issue for New Zealand to consider.

Personal tax rates

As shown in Figure 5, New Zealand's top marginal personal income tax rate of 39%^[10] is low by OECD standards, with only Mexico and the Slovak Republic having lower rates, and the OECD-weighted average being 46.6%.  While New Zealand has a relatively low top marginal tax rate, Table 1 indicates that it applies at a relatively low level of income (only 1.4 times the average production wage).

The data reported in Figure 5 show the top marginal tax rate on wage income, inclusive of contributions to social security.  Marginal tax rates on wage income do not tell the full story, however, since more than half of OECD countries have lower taxes on capital income such as interest.  New Zealand's top marginal tax rate may look relatively less favourable if compared with the top marginal tax on different forms of capital income.

Other things being equal, New Zealand's relatively low structure of marginal tax rates, the relatively small difference between marginal tax rates (varying between 15% on low incomes and 39% on high incomes) and its low top marginal tax rate are all likely to minimise economic inefficiencies.  Even so, problems related to the 39% and 33% tax rates are emerging, as discussed later in "Key challenges in tax policy".

Figure 5 -Top marginal personal tax rate 2004

Click on image above to get a full size view

Effective marginal tax rates

Statutory marginal tax rates are not the full story.  For families, effective marginal tax rates (EMTRs) can be very much higher than their statutory tax rates.  The EMTR measures the fraction of an additional dollar of an individual's income that is lost by way of tax payments and the abatement of social assistance.  The high EMTRs faced by many families are of policy concern, although how best to reduce them is a thorny issue.

The Working for Families scheme was designed to make entering the workforce more attractive to families with dependent children and increase their incomes.  Figure 6 shows the effects of these measures on disposable incomes after full implementation of Working for Families in 2008, under three different scenarios, all excluding the accommodation supplement.^[11]The first scenario concerns a wage and salary earner with no dependent children.  The second scenario shows a single-income couple with one child aged 0-12, and scenario 3 is for a single-income couple with three children (all 12-years-old or under).  In all three scenarios it is assumed that the family is not a beneficiary, so abatement of social welfare benefits is not considered.^[12]

Figure 6 - Disposable income (one earner family, non-beneficiaries)

Click on image above to get a full size view

The vertical differences between the graphs reported in Figure 6 for scenarios 2 and 3 and that for scenario 1 show the assistance provided to families.  While these measures assist lower-income families with children, as family assistance abates, families may capture little benefit from increasing their market incomes.  For households receiving the accommodation supplement, disposable incomes will be higher than reported in Figure 6.

Figure 7 shows the EMTRs faced under the three scenarios outlined earlier.^[13]

Click on image above to get a full size view

For families with dependent children, the EMTR is initially 16.2%.  This rises to 101.2% once the sole income earner is working sufficient hours to be classified as a full-time employee.  This is due to 79 percent abatement of the family tax credit, plus the 21% statutory rate and the ACC levy.  At a salary of around $21,000 the family tax credit abates in full.  EMTRs at higher incomes are affected by the abatement of family support and the in-work payment (at an abatement rate of 30 percent) and the ACC levy. 

The EMTRs reported in Figure 7 do not take account of the accommodation supplement, which abates at 25 percent from an income of about $24,500.  Some households face the additional 25 percent abatement for the accommodation supplement in addition to the in-work payment abatement rate of 30 percent, giving them EMTRs of 77.2 % (52.2+25) or 89.2% (64.2+25).^[14]  However, there are few households that receive the accommodation supplement and have incomes above $38,000 and are therefore subject to EMTRs of 89.2%.  Further, some households receive the accommodation supplement but not family support or the in-work payment. 

The EMTRs reported in Figure 7 do not take account of childcare subsidies, which also abate with income.  In addition, some of those required to make child support payments or repay student loans may regard such payments as a tax.  If they were included as taxes, EMTRs would be higher.

High EMTRs may not be a source of substantial inefficiency if they apply over narrow bands of income and do not affect work or savings decisions for many taxpayers.  Figure 7 suggests, however, that families may face high EMTRs over very broad ranges of income.  Figure 7 illustrates the EMTRs faced by sole income families, but high EMTRs can also be of concern for secondary income earners in two-income families.

For households in income bands where these high EMTRs apply, additional income may not always be taxed at high EMTRs.  If, for example, additional income is earned by way of fringe benefits or in superannuation funds, the income can be sheltered from abatement of family assistance.  This may ameliorate work and savings disincentives but, at the same time, it will distort the way that people are remunerated and the way they save.  There may also be scope for the self-employed to earn income through trusts and companies to shelter it from abatement of family assistance, which can lead to perceptions of unfairness.

This is a difficult area in which there are no easy solutions.  High EMTRs are a consequence of targeting income assistance.  If income assistance were not targeted, fiscal costs would increase.  The only ways of reducing EMTRs are either to deliver less in the way of family assistance or to make family assistance less closely targeted.

^[1] Corporate risk-taking behaviour may also be discouraged at times because firms with insufficient other taxable income cannot utilise any losses immediately.
² See page 2 of the Final Report of the Tax Review 2001.
^[3] All data are from the OECD website, mostly from the OECD Tax Database.
^[4]2004 data for Japan, Greece and Poland.
^[5] This is the proportion of the average production wage at which the top marginal tax rate is first reached.
^[6]The corporate tax rate figure for Italy excludes regional taxes.
^[7] Weightings based on 2002 or 2004 GDP at current prices and exchange rates from OECD data.
^[8] Based on 2002 GDP at current prices and exchange rates from OECD data.
^[9] Companies in Australia and other countries may also be subject to taxes that do not exist in New Zealand – such as a comprehensive capital gains tax, payroll tax and stamp duties.
^[10] Excludes ACC levy of 1.2%.
^[11] Disposable incomes are market income net of tax payments and inclusive of income assistance.
^[12] This is not necessarily completely realistic as people on low wages working less than 20 hours (30 for a couple) would be financially better off on a benefit if they qualified.
^[13] Including ACC levy of 1.2%.
^[14] In theory, it is possible for households to face an EMTR of 95.2% (70.2+25) but as far as we are aware there are no such households.

Continues in "Key challenges in tax policy"

Other pages in: Briefing for the Incoming Minister of Revenue - 2005 - Part 2

• Tax Policy
• Key challenges in tax policy
• Key themes in future work
• Administration of tax and social support programmes
• Addressing compliance issues

Date published: 17 Nov 2005

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