Briefing for the Incoming Minister of Revenue - 2008

Policy challenges

Compared with other OECD countries, New Zealand has broad bases for personal and company income and for goods and services tax. With the exception of the company tax rate, which is still relatively high by OECD standards, New Zealand has relatively low marginal tax rates. This helps the New Zealand tax system to be relatively robust and operationally efficient.

Nevertheless, pressures identified in our 2005 Briefing to the Incoming Minister remain. First, globalisation is continuing to put downward pressure on the company tax rate. Despite New Zealand's reduction in its company tax rate from 33 percent to 30 percent, it remains higher than most OECD countries. The incentives this creates for multinational companies to stream profits away from New Zealand means that New Zealand may be forced to cut its current company tax rate in the future. Second, domestically, there continues to be evidence of individuals using companies and trusts to shelter personal income from higher rates of personal tax. The greater the gap between the company tax rate and higher marginal income tax rates, the greater the benefits of doing so. There are a number of possible ways of achieving greater consistency in personal taxation, and this chapter concludes by considering some of these options.

Globalisation and downward pressure on the company tax rate

In the years beginning 1 April 1986 and 1987, New Zealand's company tax rate was 48 percent, which was around OECD norms. This is shown in figure 14.¹¹ In the year beginning 1 April 1988, the company tax rate fell to 28 percent and was raised back to 33 percent a year later, where it remained until the year beginning 1 April 2007, with a reduction to 30 percent from 1 April 2008. The company tax rate was relatively low compared with rates in other OECD countries from the late 1980s until about 2000. However, since the mid-1980s there has been a downward trend in company tax rates around the world and, even given New Zealand's recent cut in its company tax rate, New Zealand's rate is now above the average for OECD countries.

There are concerns with having a company tax rate that is too high. In particular, despite New Zealand's relatively broad company tax base, there will always be considerable difficulties in measuring income accurately. There will also be biases between business income taxed at the company rate and forms of income which are untaxed, such as the imputed income that people earn through owning and living in their own houses. Reducing the company tax rate will tend to minimise these biases.

Figure 14:

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A high company tax rate may also discourage innovation, constrain inbound investment and make New Zealand an unattractive place to base a business, all of which have the potential to reduce productivity and growth. There is, however, an offsetting economic consideration. Taxing company income is a way of taxing foreign residents on the profits they make through investing in New Zealand. If foreign-owned firms are making economic profits from their investments in New Zealand, reducing the company tax rate could potentially lead to higher economic profits for their shareholders with little effect on investment. In this case, much of the benefit of a company tax cut could go to foreign residents. Levying replacement taxes on New Zealanders may make New Zealand as a whole worse off.

There is another important consideration. A relatively high company tax rate can make it attractive for multinational firms to stream profits away from New Zealand and into lower tax countries. This might be achieved by firms "thinly capitalising" the New Zealand operations (by financing as much of their New Zealand activities as possible by using debt rather than equity) or by transfer pricing arrangements where New Zealand entities pay as high as possible prices and charge as low as possible prices on transactions with associated companies overseas. There are measures to prevent transfer pricing and thin capitalisation but these are not completely effective. Incentives to stream profits from New Zealand overseas will tend to arise when the New Zealand company tax rate is higher than in other countries, or when the other country has an imputation system.

As countries around the world have responded to these sorts of "tax-competition" pressures, company tax rates have fallen. However, as company tax rates have fallen across the world, company tax revenues have not declined as a proportion of GDP. Between 1985 and 2006 the average company tax rate fell from 48.3 to 28.1 percent but company tax collections increased from 2.6 to 3.9 percent of GDP (columns (1) and (4) in table 2). This is in large part because many countries have broadened their corporate income base while reducing their company tax rates to protect company taxation as a source of revenue. We believe that maintaining a broad and neutral income base is an important element in future New Zealand tax reforms.

The OECD experience is compared with that of New Zealand and Australia in columns (2)-(3) and (5)-(6) in table 2. In New Zealand and Australia, the increase in company tax as a percentage of GDP has been much larger than the OECD as a whole. In recent years a major reason has been the strong growth in corporate profitability in both countries. Part of the reason may also be the base protecting effects of our imputation schemes. No doubt part of the reason is also that our company rates are less than our top personal rate, which has created incentives for incorporation to shelter income from higher rates of personal taxation.

Table 2: Company income tax rates and revenues (in percent)

Year	Company income tax rate			Company income tax revenue as % of gross domestic product
	(1) OECD average	(2) New Zealand	(3) Australia	(4) OECD average	(5) New Zealand	(6) Australia
1985	48.3	45.0	46.0	2.6	2.6	2.6
1990	41.2	33.0	39.0	2.6	2.4	4.0
1995	36.7	33.0	36.0	2.7	4.4	4.2
1996	36.7	33.0	36.0	3.0	3.5	4.5
1997	36.7	33.0	36.0	3.2	3.9	4.4
1998	35.7	33.0	36.0	3.3	3.8	4.9
1999	34.8	33.0	36.0	3.2	3.8	4.9
2000	33.6	33.0	34.0	3.6	4.2	6.3
2001	32.5	33.0	30.0	3.5	3.8	4.6
2002	31.2	33.0	30.0	3.4	4.4	5.2
2003	30.7	33.0	30.0	3.3	4.7	5.1
2004	29.8	33.0	30.0	3.4	5.5	5.7
2005	28.6	33.0	30.0	3.7	6.3	6.0
2006	28.1	33.0	30.0	3.9	5.8	6.6

Source: OECD

The downward trend in company tax rates around the world shows no signs of abating.

A particular area of concern for New Zealand is Australia's imputation scheme and the fact that 54.5 percent of foreign direct investment into New Zealand at 31 March 2008 was from Australia.¹² At present, the Australian and New Zealand company tax rates are aligned at a rate of 30 percent. However, Australian parent companies with Australian shareholders have an incentive to stream profits from any New Zealand subsidiaries back to the parent companies. This is because the shareholders will receive imputation credits (called franking credits in Australia) for Australian but not for New Zealand company taxes.

One way to overcome these pressures would be mutual recognition of New Zealand imputation credits and Australian franking credits. If this were to proceed, it would involve a major step towards the creation of a single economic market in Australia and New Zealand. It would involve Australia and New Zealand cooperating to do what is in Australasia as a whole's best interest rather than competing on tax. New Zealand has responded to an invitation by Australia to make a submission on mutual recognition to the Australian Future Tax System Review.¹³ Decisions from the review not only on mutual recognition but also on tax reform more broadly are of strong interest to New Zealand because of our highly integrated economies.

Globalisation and international capital mobility can constrain choices in other ways. It is now increasingly less realistic for New Zealand to adopt tax policies without examining tax settings in other countries. For many years New Zealand stood out in the OECD as the only country to attempt to tax the foreign-sourced income of its overseas subsidiaries as this income accrued while allowing credits for foreign taxes. Other countries had rules which exempted foreign active income or taxed it with foreign tax credits but only when profits were remitted. The upshot was that firms wanting to expand internationally had incentives to relocate to other countries such as Australia with more generous offshore tax rules than New Zealand. It is no longer viable for New Zealand to impose rules which encourage dynamic firms which are expanding internationally to relocate to other countries. As a consequence, the International Tax Review¹⁴ has recommended that New Zealand introduce an exemption for active offshore income.

Robustness of personal tax system

Policy pressures also arise because individuals are able to shelter personal income from higher effective marginal rates using companies, trusts, portfolio investment entities (PIEs) and other savings vehicles. This can erode confidence in the fairness of the tax system and undermine voluntary compliance.

In terms of statutory tax rates, New Zealand has a progressive tax system, with increasing marginal and average tax rates. It also has a targeted social assistance programme under which assistance is abated as income rises, leading to high effective marginal tax rates at middle income levels for programme recipients. Information derived from tax collection data since 1999 indicates that there has been considerable rearrangement by taxpayers to minimise tax and avoid the full application of the apparent progressivity of the tax system.

From 1 April 2000, the top personal marginal rate was increased from 33 percent to 39 percent. At the same time, the company tax rate, trustee tax rate and tax rate applying to many other savings entities were kept at 33 percent. This provided scope for those on the top marginal rate to shelter income in these entities. From 1 October 2007, the new PIE rules were introduced, with a top rate of 33 percent on income earned in these entities.

From the year beginning 1 April 2008, the company tax rate, the top tax rate on PIEs and the tax rate on other widely held savings vehicles were all reduced from 33 percent to 30 percent. These tax rate changes have increased incentives and opportunities for individuals to structure their affairs in ways which reduce their exposure to higher personal marginal tax rates. However, this change is too recent to be picked up in the data.

The aggregate income of individuals in different income bands for the years ended March 1999, 2002, 2005, and 2007 is shown in figure 15. The year 1999 was before the introduction of the 39 percent top marginal rate for incomes above $60,000 and at that stage there was no spike of taxpayers clustered at $60,000. Since then there has been an obvious spike. For example, in 2007 there is much more income attributable to people earning between $59,000 and $60,000 than for other $1,000 bands of income on either side. This is evidence that those who would otherwise be facing the top marginal rate are using companies, trusts and other savings vehicles to shelter income from higher rates of personal tax.

Figure 15:

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There are a number of ways of escaping higher marginal and effective marginal tax rates by diverting income to lower-taxed companies or trusts. For example, by earning income through a company, an individual can ensure that income is taxed at a 30 percent rate so long as profits are retained within the company. While income may eventually be taxed at the shareholder's marginal rate when dividends are paid, there can be substantial benefits from tax deferral if income is retained for a number of years in a company before it is distributed as dividends. The saving can be permanent if the dividends are trapped in a trust and trustee tax of 33 percent is paid. A sharp increase in the amount of imputation credits held by closely held companies (see figure 16) suggests there is significant deferral of dividend payouts for such companies in order to avoid the higher personal marginal tax rates.

Figure 16:

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It is clear that there has been rapid growth in excess imputation credits of closely held companies following the increase in the top personal marginal tax rate to 39 percent in 2000. These pressures are likely to increase with the recent reduction in the company tax rate to 30 percent.

Annual growth rates in numbers of individuals in different income bands are shown in figure 17. Over the period from 1999 to 2007 there has been very slow growth in the numbers of taxpayers on higher incomes relative to growth rates in earlier years. Again, this seems likely to be evidence of greater income sheltering.

Figure 17:

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Trusts can be used to shelter income by having it taxed as trustee income (at a rate of 33 percent) rather than having it distributed to beneficiaries and taxed as their income. There is continuing evidence of trustee income growing much more quickly than beneficiaries' income, as shown in figure 18.

Figure 18:

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In summary, current tax rules provide considerable scope for taxpayers to use companies, trusts and other entities to shelter their income from higher rates of personal taxation. There is continued evidence that they are doing so, and recent reductions in the company tax rate and the capping of tax rates for PIEs have increased both the pressure and the opportunity for tax sheltering.

This raises concerns about whether it is fair for some taxpayers to be able to escape higher personal rates while others, such as salary and wage earners, face the top statutory tax rate. It also raises efficiency concerns. It is not without cost for people to set up tax-efficient entities. From the nation as a whole's perspective, the resources spent doing so is a source of economic waste.

There is also uncertainty among taxpayers and in Inland Revenue about when escaping higher marginal tax rates becomes unacceptable tax avoidance. This is costly for businesses and puts pressure on voluntary compliance. It also makes it difficult for Inland Revenue to fulfil its mandate of reducing compliance risk. Currently, significant Inland Revenue and taxpayer resources are being applied to disputes in this area, and it is a current priority area for Inland Revenue's compliance programme. This issue would appear to be best resolved by possible legislative options, discussed later, which could enhance the integrity of the tax system.

The current tax provisions raise questions about the achievement of the objectives underlying the current statutory personal tax rates and thresholds, and other measures which also affect effective marginal tax rates (such as abatement of Working for Families tax credits, student loans, and child support). These all apply if individual income is received and taxed as personal income, but not if earned in other ways such as through companies, trusts or PIEs.

Moreover, there are considerable differences between the tax treatments of sheltered forms of income. For example, an individual can set up a company which derives business income. If the individual earns income through the company, this will be taxed at the company rate of 30 percent so long as it is retained in the company. It will be subject to a wash-up tax on distribution and taxed at the individual's marginal rate so long as shares are held directly. If the individual is on a 39 percent rate and all income is distributed, income would end up being fully taxed at the 39 percent rate. For this person there may be little tax sheltering benefit from using the company if most of the profits are distributed soon after they are earned by the company to finance personal consumption.

However, there are more tax-efficient options. If, instead, a trust is interposed between the individual and the company so the shares in the company are held by the trust in which the individual is a beneficiary, the company's profits will once more be taxed at 30percent so long as they are retained in the company and not distributed. On distribution to the trust, however, these can be taxed as trustee income at a final tax rate of 33 percent. In this case, if all income were distributed to the trust, the company's income would end up being taxed at a 33 percent tax rate. Trusts are increasingly being used in this way not only to avoid the top marginal tax rate but also to avoid the higher effective marginal tax rates brought about by other social policy measures.

If passive forms of capital income are being earned, it may be more attractive for these to be earned through PIEs or other forms of widely held savings vehicles where 30percent will be a final rate of tax. Thus, the current tax rules often treat passive forms of capital income more favourably than active forms of income which, at least on distribution, may face a higher tax rate. It is hard to see a good reason for passive income being taxed at lower rates than active business income.

Table 3 shows the rates at which income would be taxed on accumulation and on distribution if those on different marginal tax rates are earning income in different ways. The table allows for the possibility of individuals on a range of effective marginal tax rates of 59 percent (a 39 percent statutory marginal tax rate plus abatement of Working for Families tax credits at 20 cents in the dollar), 39 percent, 33 percent and 21 percent. We assume that the distribution policy is tax efficient. For example, if income is earned through a trust it may either be taxed in the trust as trustee income (at a rate of 33 percent) and then distributed to beneficiaries or else be distributed to beneficiaries and taxed in their hands at their marginal rates. Thus, tax-efficient distribution means the tax rate will be 33 percent for a beneficiary on a 39 percent marginal rate and 21 percent for a beneficiary on a 21 percent marginal rate.

There is considerable variety in the way that income is taxed, depending on exactly how the income is earned.

Table 3: Company income tax rates and revenues (in percent)

Type of entity	Accumulated at entity level	Distribution/attribution of income Shareholder marginal personal tax rate
		59%	39%	33%	21%	12.5%
Direct investment	not applicable	59	39	33	21	12.5
Trust	33	33	33	33	21	12.5
Company/unit trust	30	59	39	33	21	12.5
Company owned by trust	30	33	33	33	21	12.5
Portfolio investment entity	not applicable	30	30	30	21	12.5
Widely held superannuation fund	30	30	30	30	30	30
Life insurance policy holder*	30	30	30	30	30	30

* Under the lapsed Taxation (International Taxation, Life Insurance, and Remedial Matters) Bill, life insurance would receive PIE treatment from 1 April 2009.

Case study - PIEs The practical implication of taxing income differently can be illustrated by considering the new PIE rules. Individuals saving through PIEs are taxed at a maximum rate of 30 percent on their PIE income. These rules have been designed to support government goals of promoting saving. But this means that those on the top (39 percent) marginal rate and those on higher effective marginal tax rates as a result of social taxes are much better off earning passive capital income through PIEs than they would be if they earned the same income directly. This has meant that it is now common practice for banks and other financial institutions to offer so-called cash PIEs. This involves a bank setting up a PIE for those who would otherwise be earning interest income, so a final top marginal rate of 30 percent can be offered. Even if PIEs are a more costly and less efficient vehicle, the tax benefits they offer can result in them being used ahead of standard savings accounts. The current tax treatment may also create arbitrage opportunities. Suppose an individual who has $100,000 of income taxed at a rate of 39 percent wishes to shelter this income from the 39 percent rate. By borrowing $1 million at a 10 percent interest rate and lending this through a PIE at a 10 percent rate, the individual might claim a deduction for $100,000, which would reduce the personal tax liability by $39,000. The PIE income would only bear $30,000 of tax. Thus, a scheme like this might be used to generate a net tax benefit of $9,000. At this time it is doubtful that any of these schemes could be struck down as tax avoidance without much greater clarification of that term by the courts. Exact borderlines are uncertain.

In summary, the current tax system suffers from a lack of consistency. Economically equivalent income streams are taxed at different rates, depending upon the arrangements under which the income is earned. The effect of the inconsistency calls into question a government's progressivity goals. If these are expressed by the statutory marginal tax rate schedule, people's ability to shelter income will undermine these goals and frustrate the desired targeting of other programmes (such as the Working for Families tax credits, student loans or child support) administered through the tax system. If, on the other hand, the government's progressivity goals are adequately achieved by having a top marginal rate of 30 percent, it is difficult to see why this opportunity is not available more broadly.

Of course, governments must juggle a wide variety of conflicting considerations when considering how best to tax different forms of savings entities. Moreover, New Zealand is clearly not alone in having different forms of savings taxed in different ways. But our inconsistency in tax treatment leads to unfairness as taxpayers in similar economic circumstances are treated differently. It undermines the integrity of the tax system and could reduce confidence in the fairness of the system. Over time this may reduce voluntary compliance. Finally, it adds to the costs of administering the tax system and to taxpayer compliance.

Enhancing the integrity of the tax system

Greater consistency in the tax system can be accomplished by reducing the variation in tax rates facing taxpayers in different situations. There are a number different ways in which tax rate variation could be reduced. Decisions by government are required in a number of areas:

• A fundamental decision, which frames other decisions on the rate structure, is the level of the company tax rate relative to the tax rates (particularly the top rate) on personal income.
• The second decision concerns the marginal tax rates to be applied at different personal income levels and, as discussed below, possibly on different types of income.
• The third addresses the degree to which social programmes are to be targeted using abatements, which add to effective marginal tax rates over their abatement ranges.
• Finally, decisions are required on the more detailed tax policy changes necessary to give effect to the government's general decisions on the three issues above.

Choices by government on tax rates applied to the income of individuals will reflect views on the level of revenues required to fund government spending programmes, the appropriate progressivity of the tax system, and efficiency considerations related to the effect of taxation on economic behaviour. Choosing the appropriate company tax rate reflects a balance of revenue objectives, international considerations and the structure of taxation of domestic income. Finally, the tax system must be administratively feasible and should strive to minimise compliance costs to the extent possible.

It is important to decide on a future direction for the tax system, so that tax changes are compatible with the government's longer-term goals. Ideally, the tax system should be flexible so that it can evolve as New Zealand's needs change. For example, fiscal demands may change as there are economic or demographic changes, or particular tax parameters may need to be calibrated as a result of external factors - for example, a lowering of the company tax rate in response to continued reductions in company tax rates internationally.

Fiscal considerations and administrative constraints may mean that consistency needs to be attained progressively over a number of years rather than in "one hit". In particular, the administrative constraints discussed in Introduction mean that it would simply not be viable to implement a major structural change to the tax system in the near future.

There is no one best way of balancing these considerations, and different countries have chosen different routes to achieving their objectives. These are summarised below as a guide for possible approaches to lessening the current inconsistency in marginal tax rates.

Conceptually, tax rates could be made more consistent in three different ways:

• By means of overall rate alignment - which is essentially a return in structure to New Zealand's pre-1999 alignment of the company, trusts and top personal tax rates.
• Through adoption of integrity measures - which would introduce provisions to prevent current tax deferral and diversion possibilities, while retaining a company tax rate lower than the top personal tax rate; with deep company tax rate cuts this could be considered similar to the Irish approach.
• Through use of a split rate system - which would introduce a lower tax rate applied to income from capital that aligns personal tax rates on investment income with the company tax rate, but continues to tax labour income at full personal tax rates; variations of this approach have been adopted by the Nordic countries.

These approaches are offered to illustrate the potential ways in which the integrity concerns facing the New Zealand tax system can be addressed. If the government wishes to increase the consistency of the tax system, an important question is whether one, or perhaps a combination, of these approaches is the best direction for future reforms.

Overall rate alignment

This approach would reduce the higher marginal tax rates on personal income to restore alignment of the top personal marginal rate with the current company tax rate. The trustee tax rate would also be reduced and aligned with the company tax rate and top personal marginal rate. This would remove incentives for many individuals to use companies or other entities to shelter income from higher personal tax rates.

Changing personal tax rates does not remove incentives for individuals with abating Working for Families tax credits to use companies or other entities to shelter income from higher effective marginal tax rates. In the context of a rate alignment approach, incentives could be eliminated by removing the 20 percent abatement of the credits by making them universal. But there are other reasons for high effective marginal tax rates (such as abatement of the accommodation supplement, childcare subsidies, student loan repayments or child support). These may make it difficult to prevent all forms of tax sheltering in companies or other entities.

Aligning rates is the most direct way to increase the coherence of the tax system. The major questions raised by the approach relate to cost, targeting and future flexibility.

In the absence of other changes, this approach would have a significant revenue cost. For example, reducing higher marginal tax rates to 30 percent would cost in the order of two billion dollars a year. One option would be to align rates at a higher tax rate than the current company tax rate of 30 percent. Given the international tax pressures noted above, this does not appear to be a feasible option. Alternatively, the change could be part of a shift in the tax mix away from direct taxes and toward indirect taxes by increasing the rate of GST to make these cuts in personal tax rates more affordable.

Cutting the top personal tax rates and/or introducing universality of the Working for Families tax credits reduce the progressivity of the tax system. Locking tax rates together also reduces the flexibility of the tax system. There will be continued international pressures for company tax rate cuts. In this event, either tax rate inconsistency would be reintroduced into the rate structure or the government would need to make difficult compromises between responding to international pressures and achieving its domestic objectives for the level of revenue required, the tax mix and the distribution of the tax burden. In the longer run, this direction of reform may require the government to consider either reductions in the rate of growth of government spending or an increase in the rate of GST. Increasing the rate of GST could allow personal tax rates to be lowered in a way which has little effect on progressivity while increasing the coherence of the tax system.

Rate alignment is by far the simplest approach for resolving current integrity concerns, as it does not require the introduction of new mechanisms or distinguishing between different types of income. It would eliminate the incentive for taxpayers to enter into complex and wasteful arrangements to avoid the higher marginal tax rates. The revenue cost of this approach could be mitigated by spreading rate alignment over a number of years.

Reductions in marginal tax rates and taxing income the same regardless of the form in which it is earned would increase the efficiency of the tax system and reduce disincentives to work and save.

Integrity measures

The second approach would introduce measures to make higher marginal tax rates stick. There are a number of possible mechanisms to achieve this result, the choice of which would depend upon concerns about complexity and the difference in the company and top personal tax rates. A mix of mechanisms would also be possible.

At the simplest, this would involve increasing the trustee tax rate and top PIE rate to align these with the top personal marginal tax rate. Assuming that international pressures prevent an increase in the company tax rate, companies could still be used to defer tax on personal income, but the imputation system would be relied upon to levy the personal tax rate when the funds are eventually distributed. If further company tax rate cuts occur in the future, this option becomes less viable, especially in the absence of a capital gains tax on the sale of shares.

A more comprehensive, but more complex approach, one adopted by a number of countries, would introduce anti-deferral mechanisms to be applied to investment income earned in closely held companies and private trusts. These mechanisms can take various forms, but essentially apply the top personal tax rate to investment income earned by closely held companies. Accordingly, such income would need to be distinguished from ordinary business income. Special rules might also need to apply to widely held New Zealand or Australian companies, which generate substantial amounts of interest or other forms of investment income.

The latter approach is more complex than simply adjusting the PIE and trust rates, but eliminates the potential for deferral by using companies, as illustrated in table 3. It allows more flexibility to accommodate future company tax rate cuts or for changes in the progressivity of the personal tax system.

In the absence of other measures, it would raise tax revenues and realise the progressivity implicit in the personal marginal rate schedule. It would also raise marginal tax rates for activities that have been structured to minimise tax, increasing tax rates on savings and work. These impacts could be reduced and efficiency improved if the funds raised were used to provide more general tax rate reductions for all taxpayers.

The choice between these two approaches depends critically on the difference between the company tax rate (current and future) and the top personal tax rate. With a small difference between the rates, the simpler rate adjustment approach would be viable. With a somewhat larger difference, explicit anti-deferral mechanisms for companies may be needed. In Ireland, which has a substantial difference between its 12.5 percent company tax rate and its top personal tax rate of 41 percent, dividends are double-taxed under a classical tax system, there is a capital gains tax and anti-deferral mechanisms are in place.

Changes to income tax rates would not stop companies or other entities being used to shelter income from the abatement of transfer payments. Making these abatement rates effective would require some form of look-through rules to include income earned indirectly through trusts and companies in the calculation of family income for abatement purposes. Such rules would be complex. Their form and the timing of any changes would need to be considered in light of the considerable resource pressures that exist in administering the current system.

Split rate system

A third approach would be to tax capital income at a lower rate than labour income. This approach has been implemented more or less comprehensively by the various Nordic countries.

The simplest option could provide that income from investments earned by individuals and trusts would be taxed at the company tax rate. On the other hand, labour income would continue to be taxed at full marginal rates. To preserve the integrity of labour income taxation, certain personal service income earned through companies and trusts could be taxed at the top personal tax rate, perhaps through extensions of the attribution rules. However, no attempt would be made to distinguish the labour income component implicit in the business income of a closely held company or unincorporated business, in contrast to what happens in Nordic countries.

A more comprehensive, and thus complex, option would be to make a formal distinction between labour and capital income for these businesses. This would involve a very substantial redesign of the tax system as it would require some method for identifying what part of the income of a closely held business is labour income and what part is capital income.

Either of these approaches involves a major shift away from the proposition that all types of income should be taxed equally. A key motivating argument for the Nordic countries adopting a dual income tax approach has been the belief that higher marginal tax rates on savings have more deleterious effects on economic activity than taxes on labour. However, it is clear that New Zealand has a highly mobile labour force and high taxes on labour incomes are also likely to be inefficient.

These approaches achieve their integrity objectives relating to the taxation of investment income by accepting the company tax rate as the appropriate personal tax rate for such income. Public acceptability of this direction of reform would require agreement that it is fair for those with high levels of capital income to sometimes pay lower amounts of tax than individuals with lower levels of labour income.

Problems with the diversion of labour income potentially remain and would need to be addressed as noted above. Concerns with avoidance of the abatement of transfer payments also remain. Moreover, the logic of the split rate system for income taxation, that investment income should be taxed at a reduced rate wherever it is earned, would suggest that investment income would not be included as income for abatement purposes, contrary to the objective of targeting such assistance to those most in need. This result underlines the different analytic frameworks applicable to a progressive tax system and a targeted social programme.

Either system would increase complexity of the tax system as a result of the line-drawing required between different types of income. In the experience of the Nordic countries, making a formal division of business income into income from labour and capital has been complex and problematic.

The system would also link the taxation of personal investment income to the company tax rate, which might be under pressure internationally for cuts that would be at odds with the distributional and revenue objectives of the domestic personal income tax system.

The way forward

Current inconsistencies in the tax treatments of different forms of income can create horizontal inequity, meaning that people with the same income end up paying different amounts of tax depending on how they earn the income. There is strong evidence that companies, trusts, PIEs and other savings entities are being used to shelter income from higher rates of personal income tax. We are concerned that, over time, this may reduce voluntary compliance and corrode confidence in the integrity of the tax system. At the same time, it pushes people to save in complex and costly ways and creates considerable uncertainty. There are a number of possible directions for reducing inconsistencies. A key decision for the incoming government is the best longer-term direction for reform in this area.

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¹¹ The data reported for New Zealand is the tax rate applying at 1 April of a given year. For example, the tax rate in 2006 is the tax rate applying for the year beginning 1 April 2006.

¹² Source: Statistics New Zealand.

¹³ New Zealand submission on mutual recognition to Australian Future Tax System Review - Mutual recognition of franking credits and New Zealand imputation credits (PDF 141kb).

¹⁴ Tax policy news article 4 December 2007 - Further consultation on international reforms.

 

 

 

Date published: 30 Jan 2009

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