The Treasury has released a speech delivered by John Whitehead, Secretary to the Treasury, to the New Zealand Institute of Management on 31 March 2010.
The speech is available in HTML and Adobe PDF format. Using PDF Files
|31 Mar 2010||Raising Living Standards: The Role of Tax Policy - Speech||
Good afternoon and thank you for inviting me to speak with you. I welcome the opportunity to speak to an audience such as this. The NZIM has a leadership role in the business community, and your members are leaders in their own organisations. As those directly involved in the overall performance of the organisations that make up our economy, I won’t have to remind you of the impact of tax – whether that is on decisions to work, invest, innovate or spend.
As you know from the title of this speech, I’m going to talk to you about tax. I’m not going to give a Budget preview – that’s not my prerogative and it’s still being worked on. So don’t look for hints about what may be in the Budget or what might not be – there aren’t any. But given tax reform is so topical, I want to provide some context around the debate, and pose some things you might want consider in forming your own views around tax policy.
We have an historic opportunity to shift the growth prospects for New Zealand. The world financial and economic crisis highlighted what policies helped, where we are vulnerable – and probably most importantly gave a new impetus internationally for governments to look at what policy works and what could be done better. Tax needs to be considered in that light.
And tax is not just about growth. Getting tax settings right is about people, fairness, and of course the lift in incomes and living standards that can come through economic growth, investment, jobs, and higher take-home pay.
Treasury has a direct responsibility, shared with Inland Revenue, for providing advice on tax policy. We are also the Government’s principal economic and fiscal policy adviser. While our primary objective is to raise New Zealand’s and New Zealanders’ standard of living, we are the department that has to think about the taxpayer: how people are taxed and what their money is spent on. Treasury is sometimes accused of being fixated on cost, but our actual vocation in this regard is much more noble – getting value for money for taxpayers.
That direct link between spending and revenue is now, I think, far better understood. Tax is about taking money away from people, so it is critical that it is well spent. The current tax system imposes the direct cost of taking $56.8 billion a year in revenue from the economy – nearly one-third of the economy. It also imposes the very substantial deadweight cost of collecting revenue - the cost of very real behavioural impacts. The negative effects of various taxes and tax rates were well documented by the Tax Working Group so I won’t repeat them now.
But the stark fact is we still need to cover the cost of government services and activity by raising revenue – principally through our tax system.
The question that we keep grappling with, that the TWG looked at and that the Government is trying to answer, is how best to do that.
Tax Working Group
Over the last year, the Treasury contributed to the ground-breaking public review of the tax system by the Tax Working Group. We provided the secretariat support to the TWG and, along with Inland Revenue, produced most of the background papers for the group.
We learned a lot from the Group both in terms of process, and through its deliberations we have sharpened and shifted our own views on tax policy.
I’m sure you’ve observed that the Tax Working Group process was different from your usual government taskforce. That’s because it wasn’t one. The TWG was something new: an independent group bringing together experts from tax policy, tax law, the tax profession and economists, backed by officials, to help with the policy process and provide some recommendations to Ministers.
We had some idea of what we wanted – Victoria University, Inland Revenue and Treasury had already held a conference that had identified some major issues with our tax system – and we needed to think about appropriate responses. But we also wanted to ensure that the policy work undertaken had the best chance of leading to practical reform. That’s why as well as being set up to deliver a broader range of thinking, the TWG was asked to establish a broad public discussion and debate on tax. In my experience, that’s a New Zealand first for public policy development. I imagine it’s a unique approach anywhere in the world.
The process taught us several things:
A policy process doesn’t have to happen behind closed doors. In fact, transparency and public information and debate can be important if major change may occur. People need to understand the issues and what the problems are. It is “easy” from a public sector policy perspective to focus on the quality of advice provided to government and devising solutions to issues that we understand. But the public, who the policy affects, will accept it a lot better if they know there’s a problem to begin with. Australian Treasury Secretary Ken Henry, who headed that country’s review of tax put it this way: “Tax policy is a community concern. Successful tax policy means the community must understand, appreciate and generally support the reasons for tax reform.”
The concept of fairness is critical to policy work. What got most public attention was the notion of unfairness, rather than tax structures or even economic growth. Fairness or “equity” is something that all public sector policy considers, and it’s a critical part of Treasury’s thinking, but we need to let people know that. Fairness – I’ll come to the issue of how you judge what is fair later – matters to New Zealanders. And look at the impact it can have on thinking. Last year I made a comment about capital gains taxes and the risk of talking about them and being pursued by folk with pitchforks. This year, given perceptions about some people not paying their fair share of tax, there is a far wider acceptance that looking at income that escapes the tax net is at least an option for New Zealand.
Test ideas and focus on results. Officials were part of the Tax Working Group, but officials alone wouldn’t have delivered what the TWG did with its mix of views and expertise. New Zealand is a small country and we should use the best ideas and best thinking from the public (including academia) and private sectors. One of the benefits of private sector thinking is it can be closer to the practical effects of policy. A challenge for the public sector is to think about the results of policy and to make our thinking count. Though Treasury and Inland Revenue have been increasingly worried about the structure of the tax system we would not, despite our best efforts, be working on a tax package for the Budget if it wasn’t for the TWG and its process. And the process of looking at all of the evidence, and discussing it through a different forum, saw Treasury challenge its own thinking.
In summary, the quality of policy benefits from getting all the facts on the table, and as broad an understanding of issues and alternative solutions as possible. There are never simple solutions, but having a full range of information and options makes the trade-offs which are inevitable around major areas of government policy both more understandable and more explicit.
So, with the facts on the table, what do we think? That means considering what we know about tax, and what we know about New Zealand’s economy and tax system. One way of thinking about this is: if we were designing a tax system from scratch, what would it look like?
The short answer is it would be a lot different today from 20 years ago. There have been very large shifts in tax thinking and in tax systems around the world and tax is becoming another area of international competition. New Zealand’s current tax system was considered to be very competitive in the 1980s, but the paradigm has moved. We can’t afford to get stuck with what we’re familiar with – in tax or any other policy area.
Over time people have taxed things as diverse as urine (Nero introduced it in Rome to gain revenue from those who collected it from public toilets for ammonia), beards (Peter the Great put a tax on these symbols of Russian Orthodoxy as he strove to modernise his country and encourage people to shave) and hats (an excise duty on “headgear” lasted in England for nearly 30 years from 1783.)
The taxes we are familiar with, such as personal income taxes with progressive rates for those on higher incomes and value-added taxes, such as our GST, only became common in the latter half of the 20th century. These taxes, together with social security taxes, which NZ doesn’t have, helped fund the welfare states that blossomed in most developed countries through the 1960s and 70s.
Now, the increasingly globalised world economy has seen changes in tax systems – essentially because the flows of people, capital and business mean countries’ tax policies are no longer simply domestic considerations. Globalisation has created and encouraged competition among countries. Across OECD countries as a whole, the ratio of taxes to GDP stopped growing in the 1990s. Internationally, there has been a clear continuous move toward lower tax rates and flatter tax structures amongst high and low income countries.
Income tax rates have been reduced in most countries in the past two decades. These are widely considered to be taxes that have the most negative impact on growth. In New Zealand, income taxes account for around 70% of total tax revenue.
As the TWG said, headline corporate rates are now well below New Zealand’s in many OECD countries. The average for small OECD countries is 26 % compared to New Zealand’s 30%. Top personal income tax rates have also been falling. A sample of ‘high income’ (predominantly OECD) countries shows that the weighted average top marginal rate of personal income tax has fallen from 58.0% in 1981-85, to 42.7% in 1991-95 and 38.9% by 2001-05.
The other major consideration in our thinking is the unique range of issues facing the New Zealand economy. No country provides a ready-made blueprint for us – in tax or wider economic issues. We are unusual in our distance from markets, our economic relationship with Australia and the mobility of our workforce. We are also very reliant on foreign capital and investment. Particular features of the economy are low productivity growth, a poorly performing tradable sector, high foreign debt and low levels of investment in everything but housing.
Tax has a much stronger impact on behaviour than we tend to think. History should have warned us this – a desert was created in Israel through a tax on trees and some early American colonists rather reacted to a tax on tea (admittedly among other things). Probably the most important thing the TWG did was to raise awareness of the ways in which New Zealanders have reacted to the tax system over the past 10 years. We need to look at the balance of taxes on different activities – working, spending, saving, investing in a property or owning a business.
The mobility of skills and capital – and international competition for people and investment – is of particular relevance to our tax system and economy. New Zealand has one of the most internationally mobile labour forces in the OECD and we have very high levels of inward investment. Unfortunately, this has been accompanied by a very high level of net international indebtedness.
- Businesses are the entities that invest and create growth and jobs and we need to be able to compete with headline corporate taxes internationally and especially with Australia. We need to create incentives for small businesses to grow, large businesses to stay here and for investment and overseas businesses to come to New Zealand.
- Lower personal rates lift after-tax wages and provide more incentive for people to work and raise their skills and incomes. It’s important that personal tax rates are as competitive as possible when talented New Zealanders can choose where they live, and they exercise this choice with a vengeance.
Growth also means shifting towards a different mix of taxes. Ideally for growth you would want to lower the burden of taxes across the economy. But given fiscal constraints, there is a strong argument for shifting the revenue base so that a greater share of tax comes from those taxes that do not have such negative behavioural effects. A switch from personal taxes to GST would mean the tax system can tilt incentives towards higher rates of savings which in the longer term will permit higher growth without increasing our external vulnerability. As well, New Zealand’s GST is considered the best tax of its type in the world. It is low cost and easy to administer.
We need to stop the tax system creating the wrong incentives. By illustration, 1996 was the last year that more people made profits than losses from rental properties and there were 115,000 private rentals (according to Inland Revenue data), yet the number of private rental properties has very significantly increased since then. Now why would increasing numbers of people – rational New Zealanders – invest billions of dollars collectively in an area that is “unprofitable”? It’s hard to believe it’s not because of some of the tax advantages. People can claim depreciation against their investment properties – even when most real estate was significantly increasing in value; they can deduct tax losses on property against their other income; and if they sell a rental property, the capital gain they make is usually untaxed.
Across the board, our tax system would benefit from a stricter application of economic principles to the design and implementation of taxes – examples the TWG gave in this area were depreciation and thin capitalisation rules.
None of these ideas will surprise any of you that have seen Treasury’s advice around tax over the last couple of years.
Current System and Fairness
What I have discussed are, from an economic perspective, the major considerations in designing a tax system for the 2010s. We do not, however, start from a blank page. Any change has to consider the existing system and how people will be affected. So working from a widespread understanding of the facts relevant to fairness is also important.
More than half of New Zealand’s tax revenue last year, 53% or nearly $25 billion was from personal income taxes. Around 17% was from company taxes and 21% from GST. So overwhelmingly government revenue is from individual taxpayers. Everyone who has income, be it from work or savings or from general government-paid pensions or benefits, has income tax deducted and anyone who spends money pays GST.
In terms of where the actual weight of tax falls, our progressive income tax system means that the top 10% of earners pay 44% of all income tax. And if the impact of Working for Families, NZ Superannuation and other benefit payments are included, the top 10% of income earners pay 76% of net tax, that is, income tax minus income transfers. Working for Families means that families in the bottom half of the income distribution – for single income families with two children, those who earn less than around $47,000 - in effect pay no income tax or actually receive tax credits.
If we look at net tax, most income tax is paid by PAYE earners who do not receive WfF. These are single people who work (including those on the minimum wage) and ‘higher-income’ families – those single-earner families who get more than about $47,000 a year if they have two children and $62,650 if they have four and two of them are teenagers.
And focusing on tax is less than half of the story. What people pay in taxes, and receive in tax credits doesn’t reflect what people actually get for their money – the education, health and justice systems, foreign affairs, pest control and investment in highways and SOEs like electricity and broadcasting companies that government spending provides.
So from where we start, tax as an instrument of income redistribution has its limitations. It is very difficult to provide major income tax cuts when people are not paying that much income tax, and when the relationship with the transfer system is so complex.
Fairness issues, particularly around support for those who are vulnerable or on lower incomes are very important and they are a crucial consideration in the design of tax policy. But there are other ways to help people than through tax. Overall, equity concerns are often more effectively addressed through suitably targeted transfers and spending. Government expenditure and especially economic growth and getting people into jobs (and better paying jobs) is much more effective at raising peoples’ incomes and tackling poverty and insecurity than tax policy.
Another major consideration when thinking about fairness (and tax) is that it is difficult to measure anything other than static changes. By that I mean it is easy to say that someone earning $100 before tax will be $3 better off if their income tax rate reduces by 3%. What is more difficult to show are the changes that we would expect over time. For example, we cannot quantify easily in the same way the gains to the country in growth and jobs and new business (or the risks we might nullify) from, say, reducing the company tax rate. For individuals, the static effects can be quite misleading when the reality is most people tend to move through different income bands over their lifetimes – earning less when they are young, most when they are around 50, and less when they retire. A bald income or wealth distribution at a single point in time doesn’t always help us all that much.
So much for facts and analysis, but how should we think about fairness and the tax system?
Well a key point is that, of course, fairness is a subjective issue and not absolute. Simple equations don’t capture the human dimension. Take an illustrative situation where a sinking ship with 100 people on board has 40 lifejackets. Maths would determine that the fairest distribution would be 0.4 each that – no-one gets one. However, that would simply represent a triumph of fairness over common sense. In a trade-off situation like this it would be far better to give some people a chance to live - that is be efficient and effective - than to insist on absolute fairness.
Of course, our broader concerns with policy are not to get in that situation. It is far better to design ships (or tax systems) that do not founder than worrying about a range of unpalatable distributional issues. That’s why our overall focus on growth and economic vulnerability is so important.
We could, of course, think about fairness in terms of societal groups - for example pensioners. Clearly our older people can be amongst the most vulnerable. But how many people know, for example, that by some OECD measures the poverty rate amongst pensioners in New Zealand is the lowest in the developed world, while for families with young children we don’t do nearly as well. However, that doesn’t really help us because of course some pensioners are genuinely poor, and many families with children can command plenty of resources.
Let me suggest two tests which might help you consider whether tax changes are a step in the right direction. First, there’s what economists call ‘horizontal equity’. Put broadly, and recognising that nothing is perfect in this world, the question is whether the tax reforms lead in a direction towards people in similar circumstances, on the same income (whatever the source), paying the same amount of tax. The second test is one of ‘vertical equity’, and recognises ability to pay. Given similar circumstances, we might expect people on higher incomes to pay more income tax than those on lower incomes. This test is then around the extent to which any reform begins the process of addressing the situation where the opposite applies and the burden, in reality, falls disproportionately on those with less resources.
There is a third test, perhaps more controversial, but one attractive to many economists because it may help to raise the overall standard of living – reducing absolute poverty – even if relative positions may end up more dispersed. This test would look at the opportunity and incentives the tax system provides people to help themselves by saving, or acquiring higher and better-paying skills, or just by shifting their leisure/work time balance.
My objective today is, from a policy advisor’s perspective, to help define some of the challenges around creating tax policies that raise living standards for New Zealanders. If our concern was only about growth we could simply cut taxes. But in the current fiscal environment, with Budget deficits forecast for some time yet, decisions on tax policy and tax reductions cannot be considered in isolation from those on spending and debt. And the need for revenue and fairness means that growth is not the only consideration.
In tax, as in all areas, there are a complex set of considerations and trade-offs. Getting the right mix of taxation is about balancing five key, sometimes opposing, objectives:
- Efficiency and growth - taxes that distort decisions, and the economy’s growth potential, as little as possible;
- Equity - tax burdens that reflect social expectations of what is fair across different people and situations;
- Fiscal integrity - minimising the extent to which people alter what they do and how they report their income for tax reasons;
- Compliance and administration - citizens understand their rights and obligations; and IRD and compliance costs are as low as possible; and
- Revenue – raising enough money to fund government spending, and doing so sustainably.
The reasons the current system fails against these objectives can largely be traced to three tax design choices. We rely too much on taxes which are particularly damaging to growth (the tax mix). Taxable income excludes significant economic income, raising significant fairness and efficiency issues (the tax base). And the move away from the old ‘aligned’ standard 33% top personal, trust and company rate has not been accompanied by sufficiently robust integrity and enforcement measures.
Although the tax debate tends to focus on the first two issues, the work this year has underlined the importance of the last point. Any principles-based tax policy needs to address the coherence and integrity problems that afflict the current system.
Public understanding of these issues through the TWG process means there is probably also a public expectation that something will be done to address them. Shape NZ’s polling showed that 65% of people think the current tax system is unfair (11% don’t), and 79% thought it needs reform (5% didn’t).
There are tough choices for the Government to make about what reform steps to take. But making the right ones may well give us more options in the future.
And given the process and debate about tax, there is also more likelihood that what the Government does will be understood, and there may be a greater chance of an enduring policy framework.
The challenge to Treasury and the rest of the public sector is to see if we can replicate the same sort of understanding and debate around areas such as spending, welfare, investment and growth.