The elephant in the room

The Capital Gains Tax (CGT) debate has long been an elephant in the tax room for more than 30 years.

Successive governments avoided any serious debate about introducing a CGT making New Zealand one of the few developed economies in the world not to have a comprehensive capital gains tax regime. The popular belief is that a government that introduces any form of CGT will feel the boot of the electorate on its backside.

The Reserve Bank and Treasury tell us our obsession with residential property is causing serious imbalances in the economy and the lack of a capital gains tax might be a contributing factor. The tax working group is taking a fresh look at New Zealand's tax system and the government, looking at significant fiscal deficits over the next 10 years, has stressed that nothing is off the table.

In September, Labour leader Phil Goff signalled the possibility of cross party agreement suggesting that Labour might not be opposed to a CGT, if family homes were protected. Soon after that the Prime Minister declared that CGT is unlikely on his watch.

Perhaps it is time to have an educated debate in New Zealand about a capital gains tax when viewed as part of the overall tax system. In the spirit of encouraging such a debate, let's look at some main issues surrounding the introduction of a CGT:

Many think the current tax system is broken
The debate about a capital gains tax needs to be put into some context. The government projects that it will be running fiscal deficits until 2017 and public debt will rise to 35% of GDP in the same period. At the same time there is concern that New Zealand's tax system has not been keeping up with international developments. Our main sources of tax revenue (PAYE and company tax) are mobile and could be lost to New Zealand if economic incentives are greater elsewhere (e.g. Australia). By international standards we are also becoming a high tax jurisdiction, which provides a disincentive for investing in New Zealand. There is a desire to move to a taxing system that is broad based and low rate.

Not taxing capital gains is unfair
Those in favour of a capital gains tax argue that the tax system is not equitable and that all economic gains should be taxed equally. For instance, proponents of this view suggest that a person who sells shares for a $10,000 profit is economically in the same position as someone that earns a similar amount in salary and wages and, as such, they should pay the same tax.

It is important to note that under the current tax system a number of capital gains, including gains on debt instruments, certain overseas equity holdings and various capital gains on property are taxed. So the question in New Zealand is not really whether to introduce capital gains but to what extent.

Not taxing capital gains creates investment distortions
Critics of the current system argue that an absence of a capital gains tax encourages investment into residential property causing price bubbles. However, recent housing bubbles in the UK, the US and Australia, all countries with capital gains tax regimes, suggest there is no causal link between house prices and the absence of a CGT. Also, while it is true that New Zealanders invest more of their capital in residential housing than other OECD countries, it is less clear that tax is the cause. Direct equity investments enjoy similar tax advantages but still constitute a small proportion of household investment.

CGT regimes are too complex
International experience suggests that CGT regimes are extremely complex and difficult to maintain. Many countries have introduced comprehensive regimes only to roll them back when compliance and enforcement becomes difficult and expensive.

Designing a CGT seems a pipe dream when there are vital ‘design issues’ to consider
For instance, to get a capital gains tax through parliament it is likely that it would need to include an exemption of ‘family homes’. This automatically excludes two-thirds of New Zealand's housing from the equation and, looking to the Australian experience, might mean that taxpayers will have an incentive to spend more on their family homes.

A decision would also need to be made on whether gains would be taxed on a realised on unrealised basis. Tax on realised gains could be avoided by not selling assets, while tax on unrealised gains is an issue if you are asset rich but cash poor (e.g. retired people).

Absence of a CGT has not resulted in simplicity
Removing capital gains from the tax net creates an artificial distinction in the tax laws. Defining the boundaries of this division has lead to considerable case law and complex legislation needed to protect the tax base. The distinction between capital and revenue is also futile ground for tax schemes.

Is land-tax a better solution?
Some of these issues mean that a CGT is just too hard with its benefit not justifying the pain. One alternative that seems to be gaining favour is a land tax. This would be a low rate tax assessed on all land in New Zealand. It is attractive because land is immobile, the tax would be broad base, simple to administer and difficult to avoid. It is also seen as being progressive in the sense that wealthier people are likely to hold more land assets and, therefore, pay more tax.

The biggest issue is that some taxpayers will find it difficult to find the case to pay it each year, especially retired people that might have an expensive family home. It is also bound to test the government's popularity with the farming community.

But it is unlikely that a land tax will make property investment less attractive even though there might a one off fall in land values.

Introducing a capital gains tax regime is not likely to be a silver bullet for the perceived over investment in residential property. But the absence of a CGT has not resulted in a simple tax system and, on fairness grounds alone, there does not seem to be any reason why salary and wage earners should be subsidising taxpayers' housing investment.

What is clear is that a CGT cannot be introduced in isolation. The revenue raised from its introduction needs to be part of a structural change that allows the government to move to the 30/30/30 rate alignment. Arguably this is not aggressive enough.

Gavin Holley is the Director of Business Advisory Services at KPMG