Episode 6 of the Curious Kiwi Capitalist Podcast
25 September 2019
My guest for this show is John Shewan—former chair of PWC, and serving Adjunct Professor of Victoria University and independent director.
In this episode we discuss:
- Why the Capital Gains Tax (CGT) 2019 recommendation failed
- Lessons from tax reform through the decades including:
- --the rebellion against Muldoon's tax rates,
- --wide support and importance of the broad-base / low-rate approach,
- --always talk about tax in terms of tradeoffs and how taxpayers will be no worse off e.g. Sir John Key selling the GST and income tax rate changes together,
- --unless there is a crisis then incremental tax change with compromises is the best approach,
- --the government needs to actively sell their tax changes or others will take over messaging.
- The strengths of a land tax especially if accompanied by decreased income tax and increased entitlements (super & WfFTC)
- Government and demographic spending requirements putting extreme pressure on personal tax rates—bracket creep is now resulting in low income levels paying a 30% rate.
- Either income tax or GST rates will need to increase within 10 years unless the tax base is broadened e.g. through a land tax or investment property CGT.
John Shewan has had a long career in accounting, business and now academia. He is an independant company director, former chair of PWC and serves as an Adjunct Professor at Victoria University.
He sat on the Buckle Tax Working Group in 2010 ("A Tax System for New Zealand’s Future", Victoria University of Wellington) and has been a tax practitioner throughout his career.
He is a past Chair of the Tax Education Office and the National Tax Committee of the New Zealand Institute of Chartered Accountants. He was awarded the CNZM in 2010.
He is truly not just NZ's top tax expert but also brings intellectual firepower together with practical shrewdness to our business community.
Transcript: Tax Reform including Capital Gains Tax with John Shewan
Bruce: What are we trying to do with taxs here in New Zealand?
John: There's really three major objectives with taxes aren't there. The first one and the primary one is to raise the revenue that government needs to run the country, and to put it in context in the year to 30 June 2019 government's expecting to collect around $84 billion in both Direct Tax and GST and other indirect taxes and another $5.8 billion and ACC, fire service levies and fines and other revenue.
So that's the primary focus, but two other really important aspects of text redistribution of wealth tax does have a role in that the primary means of redistributing wealth is through the wealth transfer system, but obviously progressive tax rates achieve that as well and then thirdly an increasingly there's a focus on corrective and behavioral taxes. Things like taxes on tobacco and alcohol and now we're looking at taxes around environmental waste etc. So those are the three primary objectives and one of the most important messages I try and convey on tax policy is let's work out what aspect of that we're talking about before we start talking about the text tool that might be best to achieve it.
Bruce: And it seems that the increase in taxs is expected to rapidly increase over the coming years..
John: Yes so the New Zealand tax system has performed extremely well over the last 30 to 40 years, its served successive governments well. We've basically got a sound system and the power of that can be seen in the 2019 budget where there's a projection of tax going up by about 25% over the next four years. Which is quite a significant amount obviously and that's driven off the strong bases of GST and also personal and company income tax. That kind of increase though is useful from a government perspective. However, We have to be cautious that we don't bake in spending that equals that exactly and then find that if there's a dip in the economy and the tax goes down. You've got a sudden budget imbalance. So that's a significant issue for the Minister of Finance.
Bruce: Yes. So that's the context if you like right now and going forward a little bit. What about let's go back to the 70s. I remember my father used to turn on the radio and listen them to the Muldoon budgets. The household was silent as we listen to what was going to happen to us the next day. What what was the tax system back then in the seventies?
John: Well, I fell into tax by mistake studying it at Victoria University in a postgraduate course in 1976 and at that time New Zealand was in really a pretty tough spot. Britain had just joined the European Union. Ironically. We had the energy crisis. We had a significant downturn on exports and we were facing significant budget deficits and the Muldoon response was increasingly with interventionist. And at the time to me as a student that scene entirely logical. Let's introduce tax incentives that will incentivize investment or incentivize people behaving in particular ways, but it really grew on top of itself far too much and by 1981 there were about 70 specific tax incentives which were gobbling up 42% of the tax take so to put that in context, today we're collecting about 84 billion a year in direct tax and GST. If you used 42% of that to incentivize Behavior, you have a real problem and that's exactly what Mr Muldoon as he was then called struck.
So by 1981 the tax system was in real strife because of the amount that was being spent. The response to that to bridge that gap was to put up tax rates and the top rate went up to 66% in 1982. And again at I that stage I was just starting working in tax policy or had been in it for about three years, I began to realize that actually a lot of these incentives were doing an enormous amount of damage and it really came home to roost once when Mr. Trotter subsequently Sir Ron Trotter who was head of Wrightson NMA as it was called in those days part of the Challenge Corporation group, chastised me for doing something which I thought he should be pleased about it. And that was that we had identified as his Auditors that his company right since was eligible for various very generous tax incentives on new grain silo installations, and they had not realized that and they got quite a substantial refund and I was asked I was requested to go meet with Sir Ron Trotter, which was pretty pretty traumatizing for a young graduate, and he was a big man. I remember walking to his office expecting to be congratulated and he was quite gruff and he said I hear you've saved some money, but I think this is just completely wrong. And I asked why and he said look as a board we made the decision to build those new silos some 5 or 8 years ago it had nothing to do with these incentives. This is a misuse of crown funds. And it was a very telling moment in my career because it made me realize actually that when you are as a government using item strong policy tool like the tax system to incentivize behavior, you really have to make sure you're doing it in a targeted way that doesn't result in wastage.
So I began to change my views and then as the 66 percent tax rate began to bite another kind of dramatic impact for myself and other tax advisors was that basically there was civil unrest. Entirely law-abiding citizens basically said I won't work 2/3 of the day for the government and they reacted very strongly by investing into a whole lot of farm ventures and film ventures and some mad things like the deer running all over the hills Peru, which probably the dear probably never existed in the first place, but my gosh, they generate significant tax losses. And people were basically refusing to pay the 66%. So the whole the whole tax system was coming down under its own weight and of course literally the country was in a state of a virtual bankruptcy by 1984 when the the significant changes began to occur following the change of government.
Bruce: So in the seventies the country was slowly being broken through a number of things economic and tax, perhaps other things as well, by '84 it in essence broke. And the Lange government came in what did the now Sir Roger and David Lange do over the coming years?
John: Well, the first dramatic change was not long after they were elected they announced of course that they had to bring in a GST and that was stunning.
Suddenly we had a government that had been elected. Had not campaign on a significant tax change but they announced they're going to do that and it heralded just a completely different approach. But whilst they announced that they also made it very clear that they were going to consult and I recall those involved with what was then called the society of accountants tax committee.
We had never been consulted by the government and we've been brought up to kind of oppose. So whatever Muldoon proposed would kind of oppose but I particular reason other than the fact that generally speaking we didn't agree with what the tax measures were doing. Sir Roger Douglas on the other hand announced that he would be coming and visiting our committee at our officers which was kind of stunning and it was again for me a real line in the sand because it marked the start of a tax policy reform process, which has endured to this day in a certain New Zealand really well.
But he genuinely said look, I don't want to debate with you guys the principle of GST because we're going to do it but I absolutely want detailed input as to how it should be designed and and of course that model has been picked up by subsequent governments and lives on today. So it was a very very dramatic change and it took quite a while for us to get used to and that's of course applied across all extras s fix the economy whether it be banking capital markets tax the whole reform agenda, but it was a period of enormous consultation enormous controversy, but was made much easier I think by the fact that because the country was on its knees financially everybody whether you be working in a supermarket or whether you be chief executive of one of New Zealand's largest companies everyone knew that we couldn't stay as we were. So it demonstrated to me at least that never waste a good crisis. And Sir Roger and David Lange didn't waste a good crisis they were able to achieve enormous change in a very short space of time.
Bruce: What were the key things that they did in your opinion?
John: Well, they go well beyond tax, of curse, ultimately a complete Reformation the economy,
Bruce: Just on tax...
John: If I focus on tax, the really biggest change was recognition by the government that taxes have a distortionary effect and therefore you need to go back to basics and work out what are the least distortionary taxes. All taxes create distortions one of the basic principles of tax policy is in the context of efficiency and growth. You want to make sure the taxes do the least damage possible. In a perfect world you'd have no tax, but of course can't work because you need to run though the government.
So they very quickly referred to the research done globally that demonstrated that the most distortionary taxes are taxes on salaries and wages and company profits. And so the rates were ridiculously high 66 percent for individuals top rate 48 percent for companies. They had to come down. So they very quickly reduced those rates and funded that by the GST, which was brought in from 1 October '86 at a rate of 10%. And then they also abolished all the incentives so that the 70 incentives that were gobbling up about 42 percent of the tax state, they disappeared within the space of about 12 months which caused enormous pain for some operations, particularly, obviously Farmers, but, and there is a real issue in this, they sold it very cleaverly by the trade-offs. That for everybody who was paying more tax than previously in a particular area in other areas they were receiving some form of discount or credit. And by and large there was general acceptance by the business community that these measures whilst painful were necessary and the fact that they haven't been reversed, you know, you hear about the failed policies of the 80s, which is complete nonsense because in successive governments have stuck with those policies and the been endorsed strongly by the likes of the OECD and the IMF and the World Bank.
Bruce: Perhaps a key lesson is the trade-offs that you're talking about. So never talk about a tax by itself, if you looking at a large tax reform package, but always as the the trade-offs from one tax versus a another type of of tax.
John: Yes trade-offs that crucial. If you look at more recent history, I think the one of the reasons in my view why the 2019 tax working group's recommendation of a capital gains tax in the end didn't proceed was because it was it was put up in a way really didn't deliver trade-offs other than in areas like the revenue from that capital gains tax would likely have been used to fund additional benefits or tax cuts at the very low end. Now that that's fine as a policy objective, but when you're asking one group to fund such a significant change for another group with no other compensating trade-offs that is a very hard message to sell. And so it proved.
If you look at what John Key managed to do in 2010 when the GST went up from 12 and a half to 15% but the trade-off was quite a significant drop in personal tax rates across the board and also an increase in working for families.
So those trade-offs are crucial in history if you look at the really big reforms that have come in tax over the last 40 years the ones that have been sold and have succeeded are the ones that have involved significant compensating trade-offs. And that's a really important I think a political lesson, but also it's a message for those wanting to advocate for tax policy reforms.
You got to present both sides of the equation.
Bruce: Just as an aside, did the Lange government ever look at some form of tax on capital.
John: Yes, so in the late 80s, they set up a group to in design a capital gains tax and ironically is seems to always happen in New Zealand when we set up groups to examine capital gains tax in the end it did not proceed because that particular group concluded that there were a number of other design features of the NZ tax system that needed to be solved first. By the time those were being addressed with had a change of National came in and the the capital gains tax didn't actually proceed. But they definitely looked at and I think to this day Sir Roger Douglas would say that's that's unfinished business as he would arge there are many other areas he would argue those unfinished business. The "cup of tea" in 1989 I think it was took care of that.
Bruce: Wasn't there a book called "Unfinished Business" , Prebble?
John: Yes Sir Roger Douglas.
But I don't want to give the impression that everything was was smelling of roses in the 1980s. The Douglas era did not cover all the bases. And one example would be when they deregulated the foreign exchange markets they didn't simultaneously bring in tax measures to deal with the taxation of profits that might arise from money being moved off to these offshore jurisdictions, which often have much lower tax rates than New Zealand. That that loophole was closed in the late 80s, but there were two or three years where it was open and there was quite a significant outflow of funds and tax lost as a result. Another example would be the delay in bringing in things like fringe benefit tax where that resulted in in some loss of revenue.
So they dealt with the really big issues. But you know, it was like drinking out of a fire hose. There was so much going on. So perhaps not surprising that some of those matters around the edges were not dealt with as expeditiously as they should have been.
Bruce: Do you remember, so right if now we're at about an 84 billion tax take, do you remember what the text take was nominal dollars back in the and then the 80s.
John: No, I can't recall those figures but it obviously was a fraction of that but it was also very concentrated on on individuals and companies and of course very high sales taxes. But the strength of, what's been the, what's turbo charged the New Zealand tax system is the GST. It's an enormously powerful instrument as other jurisdictions are found as well. And it's relatively less distortionary and that's been hugely successful. And I think it's not surprising that John Key resorted to the GST in 2010 when he wanted to implement a further rebalancing of the tech system.
Bruce: Okay, so that's the 80s and then we have the new Bolger government. What approach did they take?
John: Well the Bulger Richardson era largely in tax terms continued the Douglas era, continued with the reform program. It was it was more granular in the sense that some of the big ticket items will be dealt with and so they were dealing with some of the more detailed matter.
But the most significant change that occurred in the Bolger era and the Richardson era was the introduction of what what sounds really boring but it was really important, which was the generic tax policy process. What that is, and it was designed by Sir Ivor Richardson former President of the Court of Appeal and a tax specialist. But it arose because the Bolger government identified, as did Sir Roger Douglas actually that when you are designing tax policy, you will benefit a lot from private sector input. You need to have contestable advice so officials and this country like other Commonwealth countries at least have enormous power because they have access to the politicians and they provide the advice. Sir Roger Douglas and subsequently, Mr Bolger and Ruth Richardson recognized though the power of private sector input. So the the generic text policy process formalized what Sir Roger had started by requiring Treasury and Inland Revenue to involve the private sector in in-depth consultation around tax policy. And that came in a 1984 and this again the success of subsequent reforms, reforms subsequent to '84 in large part, I think is attributable to the success of that process.
I think it's quite tough on officials because they have to deal with private sector input. It's not so much these days but in the 90s and early 2000s, there were private sector people seconded the ministerial offices the Minister of Finance and the minister of Revenue had private sector people in their offices, and that was extremely valuable in terms of robust debate and getting a really good conclusion.
Unfortunately to some extent that processes is not as wholesome as it used to be., We seem to be reversing a little bit the old days of the officials doing 90% of the work or 95%, and that's one area where I have some nervousness about the way the tax policy process is going now. I think we need to go back and freshen up the generic tax policy process or we risk going back into some of falling back into some of the traps of the past.
Bruce: One of those traps being the tax incentives for business and we seem to be having more and more, and perhaps this was in the Key government as well, I'm not sure but, more and more business tax incentives thereby putting holes in that broad base low rate system that I think you're a strong advocate
John: I fear that the broad base flow rate system is under real threat because there's very high expectations today in relation to what the tax system might be able to achieve. And I think we have to, and Sir Robert McLeod who chaired the 2001 tax review coined the phrase we must proceed with Extreme Caution before tasking the tax system with functions for which it's ill-equipped to deliver, or words to that effect. That I absolutely endorse his comments and yet these days not helped by the kind of one-liners across social media which then become headlines in the mainstream media, many people with the best intentions view taxes being a logical and easy way to deliver changes which will incentivize behavior. And it ranges from business tax incentives, like strong focus on lets incentivize research and development and I'll come back to that right through to whether it be sugar or red meat or other sort of evils that are seen as causing and they do cause problems in society, let's use the tax system to fix them and I think we have to be really careful. There has to be a very high burden of proof in my view before you resort to tax. And like if I take sugar as an example, and it's a very ill defined debate at the moment and quite rightly the 2019 tax working group on sugar said to the government you go away and tell us what you actually want to achieve from a policy perspective with sugar. Because if we want sugar consumption to drop dramatically, well let's regulate for that or ban it or not ban it completely obviously but you put in restrictions on the amount you can have. It's unlikely that the text system will be able to achieve that and
tobacco tax is a huge revenue earner. And yet it's a contradiction because actually if we're serious about wanting to reduce tobacco consumption to Zero by it's a 2030 then you'd want to wipe out the several hundred million that's collected each year from that source. And yet we know what the excise tax on cigarettes do they result in actually the poorer into society being subjected to very very high rates of tax.
So I think we have to be careful. If I come back to the business tax incentives research and development incentive personally. I don't support I argued against it in the early 2000s when the then labor government bought it in and the subsequent national government repealed. It is now coming back in it will without doubt have some positive effects, but you've also got I evaluate to what extent is that subsidizing activity which would carry on in any event at quite substantial cost. So I have real reservations over that and I keep in my top drawer at home the 1981 tax information bulletin which which is a really good illustration of once you start down the slippery slope of tax incentives then you start with the research and development and it's very easy to end up with about 60 or 70 others and a very narrow base and that comes at a cost. That means everybody else is cross subsidizing and you'll have tax rate inevitably will go back up and that's my biggest fear. I think the outlook is for a narrowing of the text base and an inevitable increase in both personal and company tax rates.
Bruce: I almost wonder if it a board level people are saying, this is not right of course, but it illustrates the point, they are saying shall we spend some dudget on a lobbyist or shall we spend some budget on an export manager or a overseas distribution channel. And it feels as we increase the level of incentives offered to government either direct cash or tax that decision is going more towards the lobbyists and towards being the normal business growth decision.
John: I hope that's not right certainly the organizations I'm involved in we don't spend anything on lobbyists, but I've always had the view that are actually have got a coherent policy objective, NZ is a country where you can get access to the decision-makers, it's one of the great features of New Zealand without going through a lobbyist who probably doesn't understand the technical detail on any event.
Bruce: So then in 2010, you were part of the Victoria University tax working group and your work led to Sir John, delivering some increases in GST and decreases in personal tax rate.
But you also recommended a land tax as well. Perhaps talk a bit about that working group and end where you came from in terms of the land tax.
John: So the 2010 tax working group was interesting because if we look we have these tax reviews around about every ten years typically at the start of a new government.
So we had back in 1982 McCaw report, Valabh group in the late 80s, had Sir Robert Macleod tax review in 2001, those ones were all government appointed. The 2010 one was actually a Victoria University initiative which arose from a major tax conference the university had had in 2009, but it attracted the interest of the government and including Sir John Key.
And so he was very supportive of the idea of a university-based working group, but the big advantage that we had relative to those other working groups and also to the 2019 tax we can group is that we were completely independent of the government point one. Point two, we had no terms of reference. It was fascinating. I remember sitting down at our first meeting and we literally had a plain sheet of paper.
Where do we go? Whereas the 2019 group had quite prescriptive and restrictive terms of reference. So we decided that we would focus primarily on. Revenue raising taxes rather than the behavioral taxes and at an early stage and Bob Buckle Professor Bob Buckle, dean of the business school at Victoria University at that time was chair, and did a fantastic job. With the research that we had from the University assisted by Treasury and some input from The Reserve Bank, our group at an early stage reached the view that the system tax system in 2010 was suffering from some of three major problems.
Firstly it very heavily reliant on the most growth distorting taxes being taxes on individuals and companies and there were some dangers ahead with demographic changes etc.
Secondly, we concluded there was a gap in the in the in the taxation of capital.
And thirdly we concluded that there are a number of other distortions caused by different entities been taxed at different rates. And so, you know, if you operated through a company, you paid a much different rate than if you operate it as an individual etc.
So those are the three primary areas and we concluded that the system basically wasn't sustainable. But what unlike some working groups where we took with the viewers taken that you shouldn't get involved in politics. We concluded that to present a package that was saleable, we had to accept that I'd be very hard politically to make major changes in things like GST or capital gains taxes or land taxes. So we had to produce a package that would come up with trade-offs, which is what the 2010 report does. And I think by and large it was a well thought through set of alternative proposals that were put to the government and just before Christmas 2009 and which ultimately found a way through into the 2010 budget.
Bruce: One of those things was the land tax. Perhaps talk through the the land tax proposal.
John: The land tax proposal came as part of the overall discussion round the taxation of capital. So this was the subject where our working group had the most debate and the greatest disparity of views.
And it's interesting if you look at history, that's what's happened to every one of the four tax working groups in the last 40 years. We're all the most recent three: the McLeod one, the Victoria University one, the 2019 one, have all recommended to the government some form of increase in the level of taxation on capital. And ironically in all three cases the government has rejected the recommendation. So you have to sit back and say why is it that we've got these working groups which by and large comprise people got a fair bit of experience come up with these recommendations and governments, successive governments of all colors, are saying no and I think it comes down basically to politics and to the fact that the politicians want to be re-elected and you have to sympathise with that.
If I focus specifically on the land tax proposal, our group could not agree on a capital gains tax. We will split I think it was split something like five-three or five-four against a comprehensive capital gains tax for basically exactly the same reasons as the minority view in the 2019 group were against it. That is in the overall scheme of tax policy if you carve out the family home, which which almost certainly have to do politically then what you're left with is a much narrower base and our view back in 2010, I think it was right, is that the net downside of bringing in a comprehensive capital gains tax in terms of impact on coherent sufficiency fairness those core principles was not outweighed by the upside.
However, we thought there was a gap and because in the taxation of capital and the biggest component of capital by a large margin in New Zealand, biggest component of untaxed capital, relates to land and our view was that unless you are bold enough to bring in land that is underneath people's own houses, you may as well forget it. Which is basically what the current government's decided to do, but back in 2010 we went further and said we think you could bring in a very very low level land tax think we're looking about 0.5% and that would have applied to all land and you may have had some exceptions for and variations for Maori land and some aspect to Farmland.
But certainly a lion's share of land would be caught but the revenue from that was potentially extremely significant it was around a billion dollars at a point five percent rate and we were able to put up a package that had compensating tax reductions and other benefits going up. So the top rate would have been about of tax would have been 23% and most people would have been paying about 12% or 13%. So it was a very powerful package. But the justification for it was that it's a very efficient tax land tax, you can't avoid land tax. We didn't think it was as hard to sell as some people suggest because local authority rates are basically a land tax so there's already a precedent and it's reasonably easy to collect.
So that was the that was the basis for our conclusions. But again, it was a split decision, but the majority recommend it and to this day it surprises me that it didn't receive more profile than it did. There was very little attention paid to it. Sir John Key of course wasn't prepared to go that far. He was prepared to go with the GST.
And it was fascinating I recall we had a really useful debate with the then prime minister just before Christmas in 2009 giving him a heads-up as direction of travel and initially he didn't seem at all comfortable with either a GST increase or the land tax and we basically argued in response if you want to reform the tax system you're going to have to do something that's got real grunt to it and is justified from a policy perspective. And I think he bought that argument but saw the GST as being something he could sell which but he did very well actually, but he thought the land tax was not something that he would either want to sell or could sell and you know, I have to respect his political judgment. Maybe he's right. I don't know but I'd to this day believe that sooner or later New Zealand's going to have to tackle this issue. Ironically. It's been kicked out of the park. Now, the black caps will be proud of the the whack that the Prime Minister gave this one it's it's a 6 and we're not going to have this debate for another 10 years, which I think is unfortunate.
Bruce: I've always wondered whether you have a land tax combined up with the rates. So there is a rate that the central government collects, land tax of course, and then central government hands out money to local government and also put some various restrictions around the quality of spending that local government puts in place but I suspect that is equally difficult in terms of the politics.
John: But I think there's an argument for that kind of reform whether the sharing of land tax revenue, which is basically local authority rates equivalent, between central and local government. Of course in Australia they share the GST is paid to the states and that seems to have caused an enormous amount of stress over there and it perhaps as one precedent you need to look at very carefully, but I think there is a case for reform of the funding of local authorities.
And I think there is a package there that you could look at wrapping it up with an enhanced land tax. But you've got to solve the trade-offs and the trade-offs would be a permanent reduction in personal tax rates. The reason I say permanent and this is a real challenge is that the public will be rightly skeptical that they'll get the tax rate reduction now but sooner or later I subsequent government will increase personal rates again, and you end up with the worst of all worlds. And that is a challenge. And you course Parliament is sovereign you can never bind and future governments. So you need to be conscious of that problem
Bruce: In terms of retired people who don't have high income but own a large as it being their family house. I guess you'd increase their super to make up for the increase in the the rate or the land Tex.
John: Yes. I'm in dealing with transitional provisions like that is important. So retired people you'd need to look after them one way of doing it is increasing super, another would be that this text might only apply to people who buy land after a certain date, another another might be for people who quite rightly say I don't have the cash flow to fund those kind of tax that it be built into effectively a loan from the government and paid at the time that the property is sold. So there are and these are all big challenges now, I don't want to underestimate them. But there is a I'm convinced that a package there, you know, the irony is it'll probably take a financial crisis to actually provide the rocket to put this deal into. Because that's what happened with GST back in '84 '85 and we don't want to predict the future financial crisis for New Zealand, of course, but I think it's not until the going gets really tough that, actually if you don't want to bring in those really substantive reforms, that it's easier to get people on side.
Bruce: This is a podcast about the capital markets and one of the things that keeps coming up as the extent to which people have invested in land residential land rather than into to growth assets such as private businesses and the stock market. I like the idea of a land tax because of the way it and incentivises capital to go towards growth assets rather than what I see as being a consumption, being the family home?
John: I think that's right. I think there's a real real issue here and some very good analysis in the 2019 text working group report, which I would recommend for anyone interested in capital markets around risk capital and the principles of taxing risk capital and the circumstances under which government may not wish to be too active in the taxation of risk capital because by definition of they're doing that they're also picking up their share of the losses that arise from that risk capital. So there is an argument and this is how this risk free rate of return principle that that is now applied to tax overseas investments from a New Zealand portfolio and business perspective. That's where that that mechanism had its genesis and the 2019 working group research makes it very clear that the biggest area of unproductive and undertaxed capital is in that area of land without doubt. And so although you can point to certain other areas. I think you deal with 80% of the problem if you were able to tackle the land issue. That's the easy part.
The hard part is that there's the particularly the issue of farms and Maori land very very hard to deal with that and to what extent should you have exemptions etc, but I say again, I think there is a package there. And the productivity commission's report around productivity in New Zealand and the impact of tax on productivity and the kind of assets that we should be taxing more lightly versus those that we should be taxing more heavily all point to doing something around land.
And we get so emotional over it for some reason that we run away. And again, it's the politicians that have to sell it and I can appreciate how hard it is, but sooner or later it will happen whether it's in a lifetime, I don't know.
Bruce: In terms of the the Maori land I understand there's Treaty of Waitangi negotiations that have gone on and when we don't want to disrupt those. In terms of farming land, how would that be handled?
John: Well, the issue with farming land is clearly. It's part of the business of farms the if you impose the tax on it would result in a significant burden on farming which would further erode profitability of a sector which at the moment at least in many aspects of farming is not generating an acceptable return on capital now. So quite rightly this would cause significant pressure. However, you do have to question why is it, why are why do we have all this these assets tied up and not producing an adequate rate of return. So that's a much broader set of economic questions there. I think though that until until there's transformation on that sector if you were to bring on an tax, you'd have to have some very concessionary provisions around farmland and you could do that. You can justify it. What I've learned from tax policy over the years is that you can be reasonably generous and a transition because the decades quickly take care of it so you can grandfather things. But if you get those principles in place and people know where they're headed going forward they can plan accordingly.
And again the lion share of land in New Zealand is residential land and that's the area where you could make some real progress I think.
Bruce: I suspect the line here is Auckland residential land where the heart of the median voter lies and therefore causes the most political difficulty.
John: Yes, but that again comes back to trade-offs.
Bruce: Right so you said this before, so you increase you have a land tax and you drop your rates your tax your income tax rates down to 23% I think.
John: In 2010 with the modeling we were doing in the 2010 working group at that point I top rate of 23% was feasible. It's interesting. I think if you took an average Auckland household and you went out with a package along the lines of, whether this modeling works today, I'd had that obviously verifed, but went out with a package of a point five percent land tax which might result in a tax burden of say eighteen hundred dollars a year on typical Auckland house.
But the conversation was their top tax rate was going to be lets say 23% and the scale down accordingly as a package. That's something I think people would be pretty interested in having a look at. And again coming back to the impact of taxes on incomes versus taxes on land and consumption.
We know from an economic perspective the taxes on consumption and land are going to be less damaging than the taxes on income.
Bruce: And the land tax is on land, its not on the improvements to the land or the housing on the land. So it's just the the land. That's interesting. Shame that this was lost in the tax political wilderness.
Some good work was done there and then the 2019 tax working group was set up. Perhaps review that and the lessons that came out of that.
John: The 2019 tax working group is a really interesting exercise to look back on and I think they'll be books written about it in the future maybe not best sellers but these books. And the reason I say that is that it was very clear when it was set up that the government had a absolutely genuine desire to improve the fairness of the New Zealand tax system and to obtain advice on how they could better structure the tax system to deal with poverty, housing affordability, environmental issues and social issues. And the terms of reference were very very specific and and gave very clear guidance.
My own view is that they were too restrictive and I think some on that working group share that view that they would have found it easier to have had more room to come up with packages because some of the trade-offs that they may have wanted to offer they couldn't because of the restrictions. We have to bear in mind that it had a very bumpy political birth because initially it was suggested as part of the 2017 election campaign from Labour where they were going to setup this committee after they were elected into government and that resulting people saying we'll hang on I'll be electing a government or a committee. And then the labor committed to well, we'll set up a committee, but we will not legislate but we will not introduce any measures that have effect before the 2020 election.
So that's the way they dealt with that criticism, but it didn't mean that they'd already committed to any significant changes being taken to the electorate. Contrast that with 2010 and back to the Roger Douglas days where they weren't taking these substantive matters out to the electorate.
So the group was chaired by Sir Michael Cullen. I thought that was an inspired choice in the sense that very very able man and someone who I thought would be able to sell very well the arguments for expanding the tax base to include some kind of tax on capital which was clearly one of the government's objectives, and they've been pretty open about that.
With the benefit of hindsight, although I think Sir Michael did a very very good job in terms of the way he did articulate things, I had underestimated though the effect of him being a former obviously very senior politician Deputy Prime Minister Minister of Finance, that I think resulted in some in the public seeing him as an extension of the government.
So caused some skepticism as to the independence of the group. So the lesson I think for me from that is that actually you probably best to keep these groups as independent as possible from government. That in no way is a criticusm of Sir Michael I have enormous respect for him, but I think that the history there is interesting.
The other interesting development there, of course was it was apparent from an early point that with the particular mix on that group which was more diverse than earlier tax working groups, and I can understand the reasons for that, so your people particular expertise in social policy and Maoridom and so on, environmental issues, but the more diverse there was perhaps less focused by some on the economic principles of tax policy. And that resulted in a likelihood that there was going to be a disparity of opinion and indeed that's of course what happened. When you got a minority of three came out with a report which disagreed with the primary recommendation of the group which was to bring in a comprehensive capital gains tax. And I think that was always going to be difficult for the government to handle.
The other really interesting development with the 2019 working group which I think is a lesson for future governments and future working groups is that they produce their final report in I think February of 2019 and then there was quite a delay whilst the government decided what they wanted to do. And the government finally responded in mid-April to the working groups recommendations. And in the meantime that gap was filled by, all manner of well-meaning commentators and perhaps some who are not so well meaning some who are deliberately trying to undermine the process. And particularly around the capital gains tax which completely dominated the whole media debate there was some very very strong criticism. And I could sense of the public was getting unsettled because although they've been told that if a capital gains tax came in it would only impact, remember the Prime Minister saying four percent of New Zealanders and it was going to be in a straightforward ecetera. And the reality was it was it was not straightforward and we began to get examples of what happens if Grandma dies and the house is held for a while and then sold and what about the holiday house and what about all these valuations that will have to occur... And so the public began to get very very edgy and it's interesting history tells you that you underestimate the public at your peril. And I gave a public address in March of 2019 where I said to quite a big group this package doesn't have a bolters show of been accepted by the government or the public. Because it was simply too too scary and and it lacked the trade-offs and that's exactly what has happened.
And it's I think in many respects unfortunate that direction it did but there are many lessons to be taken out at it. However, there's some really good material on their report and there's a number of others. It's interesting. There are 99 recommendations. If you ask the public I dealt with other people would get beyond the capital gains tax one.
So the other 98, of course the kind of wallowing in the sea somewhere. There will be some I think response from government of already committed to researching a number of those ideas and and things like environmental taxation I think we will see some reforms that are based on this working groups work, but unfortunately it will always be known the capital gains tax that didn't ever proceed.
Bruce: So true that dominated the agenda for so long and it was just the CGT the capital gains tax. It's interesting how it was almost more of a PR disaster than a working group disaster.
John: I think it demonstrates the need for and it's hard for a government in receipt of a report to give a prompt response but it demonstrates the need for there to be immediate political leadership which they gave but they gave I think with great respect to the government some weeks too late. And therefore they lost you know, someone else was driving the debate and the results speak for themselves. I think there's a real lesson in
Bruce: As I said before we started recording, I remember hearing the announcement that they were going to put a CGT on the sales of business and and thinking by golly there's going to be a lot of work there for valuing businesses. It's not good for for clients, but boy, is there a revenue stream that I think every lawyer and an accountant, anyone involved with the capital markets saw a huge stream of these in felt and embarrased, bad, that such a fee would be made from what would be such a difficult tax to be applied to to the client base.
John: Yes, the the package was so comprehensive that the consultants would have made a fortune. Again the government said that's not it's not the case it's going to be really simple but it was that was completely contrary to the facts. I think the taxation of business in a capital tax regime is hugely complicated. The big one of the big issues in New Zealand of courses with imputation, you've got one layer of tax and it was easy to demonstrate that a capital gains tax that taxes again on what's basically the discounted cash flow of future profits. There's an element of double tax and how do you eliminate that so immediately you had all these very technical issues which caused people's eyes to glaze, of course the consultants to smile, but the worst aspect I was it caused business uncertainty and you saw the impact on the share price of certain entities that you know, they were beginning to wobble a bit as people were unclear about what almost would mean. So that was unfortunate and I think at the end of the day that the whole regime was far too ambitious. It was much broader to have a non inflation-adjusted capital gains tax, with no grandfathered assets applied basically all business assets with very little in the way of concessions to deal with some of those complex issues we touched on. Very very very very ambitious and as I said earlier, it was never going to sell.
Bruce: And what many business owners probably don't understand is that valuing a business has a wide range an incredibly wide range depending on the assumptions behind that report or that valuation and likewise what could happen is the IRD could choose one number your lawyer can choose the other and the person that will decide would be the Supreme Court. The people that were designed by the Supreme Court in the end it would have been a litigation feast.
John: Yes and that points to violation of one of the fundamental principles of good tax policy is compliance administration costs.
And the cost would have been enormous. Now, you have to trade those off against the benefits but like Minority Report made a very strong cogent argument, it's only nine nine or 10 pages, but the primary driver of that I think was probably Robin Oliver who is, one of, if not, the most respected tax policy people in New Zealand was Deputy Commissioner of Inland Revenue and head of policy for many many years used to be also on tax policy and Treasury.
And Robin Oliver has an uncanny knack of expressing in very clear terms matters that have been troubling the public for a long time. And so I recall on a couple of radio interviews he basically ditched the capital gains tax. I think his his impact was very very significant. He argues and I think I agree with him that you can take the incremental approach on something like this and that we are better off with the under taxed areas in particular residential housing and rental housing, which do appear to be undertaxed you can deal with those in different ways. You don't need to bring in this enormous reform which sort of blows holes in other parts of the tax system and causes lots of business uncertainty and also grief to to private individuals.
So, you know, it's not we shouldn't say this debate is over, it's not, and the Minority Report I think gives a very good framework to move forward on. Although interestingly the government has kind of rejected that and that's what took everybody by surprise the fact that they didn't only say we might go ahead with the immediate proposal just don't come back and talk about it in the foreseeable future, which is a big surprise.
Bruce: So in terms of the future in terms of tax policy in the future, what's going to happen? You know, there's an issue there with bracket creep and an issue there with more and more spending or tax breaks. What's going to happen in the future and how do we avoid another disaster like we had 1984? Though perhaps that was such a disaster will never ever go back to those days.
John: I do think we've got some real challenges ahead on the tax front because the the impact of inflation lowers it is has meant that we now have. The thirty percent tax rate cutting in at an incredibly low level $48,000 and the top rates only 33 percent so it's not really that much different and that comes in at 70,000.
And successive governments have left it at that level and now it means that a very significant number of kiwis are on either the top rate or very very close to it. Now it's expensive to change that. Once you get everyone paying those rates as soon as you move the brackets that obviously cost a lot of money and at the same time we've got what looks to be an economic downturn coming as you would expect driven by global and domestic events and yet we're forecasting a 25% increase in tax over the next four years. I can't see that 25% been collected. I may be wrong, but I hope I am wrong, but I just think if we look at the global trajectory and we mirror that locally to say that we're going to get a an increase in tax of about 4- 5% a year of economic growth being 2.8. I don't quite understand how that can be the case.
So that means I think that we're going to have pressure on for rate increases and also means we're really not in a good position to deal with some of the other anomalies that the tax working group in 2019 identified such as no tax relief on seismic expenditure, which is a major issue, especially in the Wellington area, the inability to depreciate buildings, even in circumstances where clearly they do depreciate that's an expensive problem to fix.
So the number of areas where the tax system requires reform but both officials and politicians seem quite quick a dealing with matters of reform that raise money, but not so quick at dealing with matters of reform that result in a revenue reduction and I understand that but sooner or later that catches up with you.
So I looking ahead would be surprised if we don't face a scenario in say 2023, which is the four year out year period from the 2019 budget where tax rates and GST don't increase. And you know GST increased to say seventeen and a half or eighteen and a half percent or increases in personal tax rates must be a possibility. Again I hope I'm wrong.
But we have to be really careful because we have the tax system has been managed extremely well over the last 30-40 years almost we have to be careful not to lose those gains and yet some of the design features now that are coming through a putting real pressure on.
Bruce: I suspect that if we are forecasting that the tax take will increase to I think it was a hundred and five billion in 2023 the government expenditure will naturally match that 105 billion even if it not forecast right now. And if there's an economic recession even a mild one the government expenditure will be even higher than a hundred five billion unemployment benefit for example, and the tax take will be much lower and we'll start to have an exaggerated and increase in deficits compared to what would happen if we didn't have that.
John: I agree was that I'm Bill English coined the phrase in his valedictory speech "beware the dangerous complacency of good intentions", and there is a risk that you build in well-meaning and many respects justified increases in spending to deal with some of the social problems that the country faces, some of the environmental challenges we face, and you hard bake in that expenditure and then the revenue falls away.
So you got one variable that's highly volatile in one sense and as is quite possible it drops quite significantly. Whereas the other tends once it's baked and it's very hard to roll it back. So I think that that is a challenge. That's not lost on Grant Robertson, you know, he's clearly across these issues but it's a hard hard equation to balance and there are some months there are some clouds out there.
Bruce: Any final thoughts about tax reform and the way forward.
John: I think the key when I look back on what's now about a 45 year career in tax policy, I first thing I'm very proud of what NZ has achieved. That I think when you look at the cot case we were in the early 80s and the position we're in now with the tax system, I think we should be proud of what's been achieved. But I think we need to preserve that. You know sooner or later someone will do something like provide an exemption from GST shouldn't be imposed on bananas or something ludicrous like that and that will be the slippery slope that will begin to unravel one aspect of reforms that have been so successful.
And I think we need to learn from history as we've talked about in there are many really good things things are going well things are not going so well, so let's listen from that.
And I'm really pleased that the current government is committed to the broad-based low-rate as a non-negotiable strategy and I think hopefully that will survive because that's been hugely important to our success.
And the final message does say it history makes it very clear that major reforms will only succeed if the timings absolutely right point one. If you've got a really strong Communicator point two. And point three, if you take the public with you. Politicians underestimate the public at their peril, and the biggest tax reform failures in my term in the game have been driven by politicians who underestimated the public and then did a really poor job trying to explain what they were trying to achieve in the first place.
Bruce: Thank you, John. Much appreciated.
John: Thank you.