Briefing for the Incoming Minister of Revenue - 2008
Taxes, distortions and the New Zealand tax system
Taxes are needed to finance government spending. At the same time, raising revenue creates administration and compliance costs. Moreover, taxes distort economic behaviour, which can inhibit economic performance in many different ways.
Although almost all taxes can distort economic behaviour, personal and company income taxes are likely to be particularly distorting. Taxes on labour income can influence decisions about whether people move into paid market work or not. They can also reduce entrepreneurship and discourage people from working as long or as hard as they otherwise would or from moving to a more challenging job. In extreme cases, they may even affect decisions on whether or not an individual chooses to continue to reside in New Zealand. High and increasing marginal rates may reduce incentives to take risks or upgrade qualifications. All of these distortions can affect productivity and growth.
Income taxes can also affect the amounts that people save and, if different forms of savings are taxed differently, the types of savings being undertaken. This can lower economic welfare by causing people to save in intrinsically less valuable ways - in other words, in ways they would not have preferred had there been no tax biases.
In theory, taxing investment income need not be very distorting if income is taxed at modest rates over a very comprehensive economic income base. In practice, difficulties such as measuring how assets actually fall in value and reflecting these in tax depreciation allowances mean that it is simply not viable to tax all forms of investment income neutrally. Moreover, certain forms of investment income such as imputed rental income (the benefits that people get from owning and living in their own houses) are not taxed either in New Zealand or in most other OECD countries. This means that taxes on personal and corporate incomes can distort decisions on the types of investment the country undertakes and thus lower capital productivity. Even if all forms of investment income were taxed neutrally, taxes would tend to discourage investment, reducing New Zealand's stock of plant and equipment and buildings, reducing labour productivity and growth. These distortions will be higher the higher income tax rates are.
A recent OECD paper, "Tax and Economic Growth", published in July 2008, ranks different taxes and argues that corporate and personal income taxes are likely to be most distorting. The OECD measures distortions in terms of their effects in reducing long-run GDP per capita. This is a partial measure because taxes can be distorting without necessarily affecting GDP per capita. For example, in a small open economy such as New Zealand's, taxes on savings could, in theory, have little effect on GDP but still be quite distorting. However, even if we were to measure distortions more broadly, it is still likely that corporate and personal income taxes will be particularly distorting because of difficulties associated with defining and taxing income comprehensively. Not only are income taxes likely to be the most distorting taxes, it is income taxes where most pressures appear to be emerging. International tax competition is putting downward pressure on New Zealand's company tax rate. However, a company tax rate that is less than the higher rates of personal tax creates opportunities for people to use companies to shelter their incomes from higher rates of personal tax.
New Zealand's main sources of revenue are personal income tax (48.7 percent of tax revenue), GST (19.7 percent of tax revenue) and company income tax (15.3 percent of tax revenue), as illustrated in figure 2.
Figure 2:
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By international standards, New Zealand has broad bases for both its income taxes and GST. This allows lower tax rates and a more efficient tax system than would otherwise be possible.
In this chapter, we present some data on the New Zealand tax system and benchmark it against the tax systems of other countries. The data presented below suggest that:
- New Zealand's tax to GDP ratio is towards the middle of the range for OECD countries.
- New Zealand collects a relatively high proportion of its revenue through taxes on income and profits.
- New Zealand has relatively broad bases for GST, company tax, and income tax. This allows substantial amounts of tax to be collected at rates which, with the exception of the company tax rate, are relatively low by OECD standards.
- New Zealand's taxes appear to have relatively low compliance costs.
- Despite New Zealand having a relatively low top personal marginal tax rate by OECD standards, many households face much higher effective marginal tax rates as a result of the abatement of Working for Families tax credits and other income-contingent measures.
Taxes in New Zealand and other OECD countries
Tax as a percentage of GDP
In 2007, New Zealand's tax collections amounted to 36.0 percent of GDP. This placed New Zealand towards the middle of OECD countries, as shown in figure 3.
Figure 3:
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It should be noted that comparing New Zealand's ratio of tax to GDP with those of other OECD countries involves a comparison with relatively high-tax countries. Many non-OECD countries have lower ratios - for example, the 2007 tax to GDP ratios for Hong Kong and Singapore were 13.8 and 14.8 percent respectively.5
Tax mix
Compared with other OECD countries, New Zealand collects a relatively high proportion of its taxes on income and profits, as shown in figure 4. This is in large part because New Zealand has no social security tax. Australia, which has no social security tax, and Denmark, which has a negligible social security tax, are the other two countries collecting the highest proportion of taxes on income and profits. Often social security taxes will fall on employees and may have similar effects to an income tax in distorting labour supply decisions.6 Since social security taxes, unlike income tax do not tax investment income, they do not distort savings decisions.
Figure 4:
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GST, company tax and income tax collections
Compared with most OECD countries, New Zealand has relatively broad bases for GST, company income and personal income. This means that it collects substantial revenue despite (at least in the cases of GST and personal income taxes) having relatively modest statutory rates of tax.
For example, New Zealand's GST rate is 12.5 percent. Setting aside the United States, which has no GST, this was the sixth lowest statutory rate of tax in the 29 other countries in the OECD. Nevertheless, in 20067 our GST collections amounted to 9 percent of GDP - the fourth highest level of tax collections (see figure 5).
Figure 5:
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The OECD measures the breadth of the VAT/GST base and the efficiency with which taxes are collected using the "C-efficiency" ratio. This is the revenue collected from GST as a proportion of the revenue that would be raised if the standard rate of GST were applied to all consumption. C-efficiency varies from a ratio of 32.6 percent in Mexico to 93.5 percent in New Zealand, as figure 6 shows. It is clear that the breadth of the New Zealand base allows substantial amounts of GST to be raised at a relatively low rate.
Figure 6:
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Company tax is also an important part of New Zealand's tax base. In 2006, New Zealand collected 5.8 percent of GDP in tax, which was the third highest level of company tax as a proportion of GDP in the OECD, as shown in figure 7. In that year, New Zealand's company tax rate was 33 percent, which was eighth highest out of the OECD countries.
Figure 7:
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New Zealand has a relatively low top personal marginal tax rate of 39 percent. In 2006, this was the eighth lowest top marginal rate for the 30 OECD countries, as shown in figure 8. Despite this, New Zealand raises 14.9 percent of GDP in personal tax collections, which was the third highest amount of tax collected in the OECD. One reason for New Zealand's relatively high level of personal income tax collections may be that New Zealand's top personal marginal rate applies from a relatively low level of income (at a multiple of 1.4 of the average wage). Many countries have higher multiples than New Zealand.
Figure 8:
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This suggests that New Zealand has a relatively broad base for these three main taxes. Levying taxes at a low rate across a broad base is generally likely to minimise distortions.
Compliance costs
New Zealand also has a tax system which is relatively easy for taxpayers to comply with. According to the World Bank, New Zealand has the second easiest system for companies to pay taxes amongst OECD countries, as shown in table 1.8
Table 1: Ease of paying taxes - ranking (2008)
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Source: The World Bank
A recent World Bank and PricewaterhouseCoopers study found New Zealand had the seventh lowest time to comply with taxes out of the 177 countries surveyed. Within the set of the 30 OECD countries, New Zealand had the third lowest time to comply, as figure 9 illustrates.9
Figure 9:
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Effective marginal tax rates
Despite having a comparatively low top statutory marginal tax rate, many families may face much higher effective marginal tax rates because of the interaction between taxation, abatement of various forms of social assistance, and payments or repayments which are income contingent. The effective marginal tax rate measures the proportion of an additional dollar of income that is lost either through taxation or in some other way such as abatement of social assistance or income-contingent payments or repayments. It is effective marginal rates rather than statutory marginal rates which will determine incentives to work and save. It is also gaps between these effective marginal rates and the tax rates in companies, trusts and other entities that will influence the tax integrity pressures that are discussed in Policy challenges.
One reason for effective marginal tax rates to exceed statutory marginal tax rates is the Working for Families tax credits scheme. This scheme provides support to families, reducing their net tax paid (as shown in figure 10) for the year ended March 2007. The dark solid line in the graph shows the net tax paid by an individual or a family with no children with a single income earner. Net tax is positive, which means that income taxes paid exceed transfer payments received. The light dotted and solid lines show the net tax paid by single income families with, respectively, one and three children. Net tax paid is negative for lower income families, which means they receive larger transfer payments than the amount they pay in income tax. Many people will be paying negative amounts of net tax. It is essential to ensure that those who end up bearing the tax burden are not discouraged from increasing their earnings by working longer or more productively.
Assistance rises with the number of children, which is why the light solid line is lower than the dotted lines which is lower than the dark solid line for incomes below the levels where assistance is fully abated. At incomes above about $12,000, net tax paid rises faster for families with children than for individuals or families with no children. This is because of higher effective marginal tax rates for families as a result of reduced transfer payments.
Figure 10:
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The effective marginal tax rates, taking account of statutory tax rates, ACC, and the abatement of Working for Families tax credits, are shown for the year ended March 2007 in figure 11. There is a short period where the minimum family tax credit, a component of the Working for Families tax credits package, is abated dollar for dollar in addition to ACC levy being collected. This leads to an effective marginal tax rate of 101.3 percent between incomes of $10,66010 and $21,658. For higher income families with either one or three children, Working for Families tax credits abate at 20 cents in the dollar for incomes over $35,000. This makes the effective marginal tax rate 20 percentage points higher than the statutory marginal rate and ACC levy. For both types of families, the effective marginal tax rate is 54.3 percent (a statutory rate of 33 percent together with a 1.3 percent ACC levy and 20 percent Working for Families tax credits abatement) until income reaches $60,000. After that, the effective marginal tax rate rises to 60.3 percent until Working for Families tax credits are fully abated.
Figure 11:
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There are a number of other income-contingent measures. For example, additional income can lead to the requirement to make higher student loan repayments or child support payments. Whether these should be considered as part of effective marginal tax rates is an open question. For example, as student loans are repaid, borrowers have the benefit of a reduced student loan, reducing the amount which must be repaid in the future. However, there is some tax element because making student loan payments now rather than in the future will increase the present value of these payments. Similarly, some parents paying child support may do so willingly because of the benefits their children receive. In this case, child support should not be seen as a tax. On the other hand, for those who do not choose to pay child support voluntarily these obligations are very much a tax.
There are also other measures which abate with income, including childcare assistance and accommodation supplement. These are not taken into account in figures 11 and 12. Thus, these graphs provide a lower bound on possible effective marginal tax rates. Benefit abatement has not been taken into account in figure 11 but has been taken into account in figure 12, which shows the numbers of taxpayers on various effective marginal tax rates above 30 percent.
Above $60,000, there are significant numbers in the 40 to 50 percent range, although many are only just in this range because of a statutory marginal tax rate of 39 percent plus an ACC levy of 1.3 percent.
Figure 12:
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In total there are around 3.3 million individual taxpayers. Of these about 668,450 people are on tax rates of 30 to 40 percent, 383,250 on tax rates of 40 to 50 percent and 167,250 on tax rates above 50 percent. Including other income-contingent measures such as student loans, child support, the accommodation supplement and childcare allowance would increase the numbers facing higher effective marginal tax rates.
It is clear that for some people there will be limited incentives to earn additional income, which may discourage productivity and growth. As discussed further in Policy challenges, New Zealand's high effective marginal tax rates also create scope for tax planning. But this is not an easy problem to resolve. Reducing these high effective marginal tax rates either requires providing less assistance, which could hurt many who are not well off, or involves abating social benefits more slowly, which could be costly. Nevertheless, the high effective marginal tax rates need to be taken into account when considering future reforms. It seems generally desirable to avoid adding to effective marginal tax rates and, where possible, to lower them.
Figure 13:
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Figures 11 and 12 reflect numbers on effective marginal tax rates in the past (year ended March 2007). Changes to personal tax rates announced since then will affect effective marginal tax rates. Figure 13 shows effective marginal tax rates for the income year ending 2010 under the legislated tax rate changes. It shows that the tax rate changes will extend higher effective marginal tax rates to higher incomes.
5 Source: Hong Kong Census and Statistics Department and Statistics Singapore.
6 If an individual benefits directly from his or her own social security contributions, these taxes may be less distorting than taxes on labour income.
7 This is the latest year for which data is available across the OECD.
8 This measure takes account of several factors: number of tax payments, time to prepare and file tax returns and to pay taxes, and total taxes as a share of profit before all taxes.
9 The indicator measures the time to prepare, file and pay (or withhold) three major types of taxes: corporate income tax, value added or sales tax, and labour taxes, including payroll taxes and social security contributions.
10 This assumes only one adult. Incomes below $10,660 are unlikely to qualify for the "full-time work" requirements of the minimum family tax credit.
Date published: 30 Jan 2009
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