Dr Hon Lock wood Smith MP
National Party Revenue Spokesman
26 October 2007
Speech to the NZ Institute of Chartered Accountants
Sky City Hotel, Auckland
There are not many things I would say the Labour Government does particularly well, but collecting taxes has to be one of them. Fiscal drag alone is now netting the Government an extra $1 billion in income taxes each year.
What's staggering is that despite core government spending having increased from $34 billion in 1999 to almost $54 billion in 2007, Dr Cullen has collected sufficient extra tax to still run a cash surplus.
That would all be fine and dandy if raising taxes imposed low or no economic cost. Unfortunately, that's not the case. Research indicates that tax thresholds and marginal tax rates do influence the hours some people choose to work. They certainly influence individuals' decisions about whether or not to stay on welfare rather than take a job involving more hours work.
Those are examples of the deadweight costs of taxation, and in addition to them are the costs of administration, enforcement, avoidance and compliance – not to mention the non-productive rent-seeking activities when some sectors of the economy try to persuade the Government to allow favourable tax treatment for certain activities.
It should, therefore, be of no surprise that a 1990/91 study by Diewert and Lawrence put the cost of raising an additional dollar of tax on labour income at 18 cents. The Treasury since then has used a cost figure of 20 cents on top of each dollar of extra tax collected.
The fact, then, that New Zealand has climbed the OECD league tables for overall tax burden from 21st worst in 1999 to 13th worst in the latest edition of the OECD's Revenue Statistics is not something that augers well for New Zealand's future.
The OECD had already been sounding warnings in its 2005 report on the New Zealand economy when it stated that "higher taxes have a negative impact on economic growth", and it's sobering that in a study of 98 countries published this year, Dr Alex Robson from the Australian National University found that "on average, countries which significantly cut taxes on upper incomes between 1980 and 2000 enjoyed average per capita growth rates of nearly three times those that did not".
It's reported that a KPMG study on corporate tax produces similar findings: lower rates are linked with higher than average economic growth.
Far from cutting taxes on upper incomes, the Government introduced tax increases on incomes above $60,000 a year and has stubbornly refused to counter the effects of fiscal drag and bracket creep. Because of this, a quarter of a million taxpayers are now paying the old top rate of 33c but are earning less than the average wage.
These policy actions are clearly influencing New Zealanders' broader economic decisions, such as how to organise their income for tax purposes and whether or not to work more hours; and may well be influencing the increasing exodus of New Zealand citizens to Australia.
It's possible the significant increase in taxation is part of a clear economic strategy. In that light, the Prime Minister's public comments on 28 July this year are of interest, when she said "it has taken a while to build up the kitty for Working for Families. It has taken time to build up the kitty for interest-free loans and the early childhood programme. So undoubtedly there will be areas we'll build on for next time, which will be new".
"Building up the kitty", I would suggest, is not a sound basis for increasing the Government's tax take when the costs to the economy of collecting that tax are considered, quite apart from a philosophical objection to collecting more tax than is required to a run a sound government.
Finance Minister Michael Cullen's reluctance to cut personal tax rates, and Labour's decision to break its promise made prior to the last election to raise personal tax thresholds, despite significant and persistent cash surpluses, have made personal tax rates a major political issue as we head towards the election next year.
Add to that the fact that the Government has decided to reduce the corporate tax rate to 30 cents, widening still further the gap between the corporate rate and the top personal rate, and the fact that both major Australian political parties are proposing major tax cut packages across the Tasman, and the whole issue of personal tax rates is brought into still sharper focus.
A study published by the New Zealand Institute of Economic Research in the past week shows that since Labour has been in office, between 2000 and 2006, New Zealanders' average gross hourly wage rose by 22.1%. Due to fiscal drag, the net income of someone working 40 hours on this wage increased by only 18.9%.
By contrast, Australians' average gross hourly wage rose by 34.3% and the net income of an Australian working 40 hours per week on this wage increased by 33.6%. They've got to keep more of their share of the gains from growth.
That means that, at the average wage, the rate of growth of net income in New Zealand was just over half of that in Australia. What's more, the study showed that the Government's flagship Working for Families policy did not change that overall story.
This is becoming hugely important as New Zealand bleeds our young citizens to Australia. Our net loss in the 12 months to September was 26,194, up 27% from the 20,598 of the year before. Research shows 79% of these New Zealanders we're losing are less than 40 years of age, and across all skill sets.
It is no longer good enough for Dr Cullen to dismiss tax exiles fleeing to Australia with such sarcasm as claiming they are "functionally innumerate" and "we're probably better off without them".
The Australian Liberal Party's proposals will make the contrast starker. The Howard Government proposes that low income earners should pay no tax on income up to $16,000 a year. If that were implemented, it would mean someone earning that amount in New Zealand would be paying almost $54 a week more in tax than someone on the same income in Australia. That's a huge difference.
The broad political consensus in Australia supporting ongoing reform of income tax is the first issue we have to face up to. Both major parties have signed up to major tax cuts and to a broader programme of reform. It's significant because of the relative ease with which New Zealanders can simply shift across the Tasman.
The second issue is that, because tax thresholds have not been adjusted in New Zealand for so long, the top personal tax rate kicks in at a level of income only 1.5 times the average wage – compared with 2.4 times the average wage across the whole of the OECD.
Teachers, police, nurses, executive assistants, librarians and mechanics are now on our top tax rate – the tax Dr Cullen imposed on the top 5% of rich New Zealanders – those Dr Cullen described at the time as people who can and indeed should make a greater contribution and "who could well afford to pay".
Ironically, at the threshold at which New Zealanders go on to the top personal tax rate, if they have one dependent child they are considered too poor to cope on their own, and can apply for Working for Families tax credits. That is an absurd situation.
It's also a very serious situation economically because the Government is collecting vast amounts of tax, with the high deadweight costs of collecting it, churning it through the bureaucracy, and paying some of what's left back to the very same families it's collected it from.
In fact, if a family has five dependent children, their net tax position at $60,000 of earned income is zero after Working for Families payments, yet they're considered to be wealthy enough to be in the top income tax bracket.
At the heart of the problem, however, is not the absurdity of paying benefits to workers in our top income tax bracket, it is the effective marginal tax rates that those families face.
In its briefing to the incoming Minister of Revenue in 2005, IRD pointed out that a single-earner family with three dependent children, under Labour's existing Family Assistance policies, faced effective marginal tax rates of 52.2% on incomes from approximately $28,000 to $38,000, 64.2% from $38,000 to $60,000 and 70.2% from $60,000 to approximately $70,000.
Labour's most recent changes to their Working for Families policy have changed those effective marginal tax rates, but for that same family with three dependent children, over the income range from $38,000 to $100,000, the effective marginal tax rate is above 50% for that entire income range and above 60% over the income range from $60,000 to $100,000 of earned income.
Add to that the problem of a single parent family with three dependent children trying to work their way off the Domestic Purposes Benefit. At $10,000 of earned income, that's roughly 13 hours a week at $15 an hour, the DPB payments are still very large. At $25,000 of earned income, roughly 33 hours work at $15 an hour, the parent would have almost completely worked their way off the DPB.
The problem is this: at $15 an hour the parent would have to work an extra 20 hours a week to increase their earnings from $10,000 to $25,000 a year. The effective tax on that extra $15,000 of earned income is about $13,300. That means, even though the parent is paid $15 an hour, their take-home pay, after tax, is effectively only about $1.60 an hour. Who would work for that?
In a paper published in June this year, the New Zealand Institute of Economic Research, in analysing New Zealand's current economic conundrum of significant inflationary pressures, despite lowish economic growth, pointed out that a number of Government policies, such as Working for Families and interest-free student loans, were boosting the demand side of the economy while, on the supply side, high effective marginal tax rates were reducing the incentive to work. From the examples I've just given, it's not hard to see why.
With recent data on the collapse of productivity growth in New Zealand since 2000, there is a desperate need to re-examine the regulatory burden as well as the burden of taxation.
In addition, the perverse incentives of the effective marginal tax rates so many working families face need urgent examination. As the NZIER concluded, "if you provide people with inefficient or perverse incentives, you will end up with inefficient and perverse outcomes".
Finally, with respect to our income tax problems, IRD gave further quite pointed advice in its Briefing Paper to the Incoming Minister of Revenue in 2005.
IRD said "there seems to be growing evidence of tax sheltering and income splitting, raising questions about the robustness of New Zealand's tax system. This appears to be at least in part a consequence of New Zealand's company and trustee tax rates being lower than the top marginal tax rate. By itself, any reduction in the company tax rate would add to the possibility of further tax sheltering".
And that advice was given prior to the widening of the corporate/personal tax gap to 9 cents.
So, it can be seen there are a number of significant problems facing New Zealand's current income tax system. If it was just an argument about the fairness of some people paying more or less tax, it wouldn't be so bad.
As I hope I've demonstrated, the issues run far deeper. Not only do they go to the heart of the collapse in New Zealand's productivity growth since 2000, but they also impact directly on New Zealand's ability to compete successfully in a globalising world.
And that challenge has to be central to any efforts to seriously fix the problems I've been outlining. People, capital, and firms are all increasingly mobile. Firms and people have increasing choices about where they locate and for how long. Investors have a myriad of opportunities. In an evermore global and competitive world we're going to see intense competition for workers, for businesses, and for investment.
Add to this the fact that our population is ageing. There will be relatively fewer of our people in the full-time workforce in the future. We'll become even more dependent on attracting skilled people from overseas, more dependent on those who wish to work part-time, and more dependent on those who are currently outside the labour market.
Tax policy, therefore, cannot just be about one-off tax cuts or threshold adjustments. It must be a phased programme to deal with the disincentives and distortions caused by illogical tax changes and high marginal tax rates. It must enable us to compete successfully for business, capital, and skills.
Taxation reform, because of the economic and demographic realities I've outlined, requires a longer-term strategic approach.
That strategy needs to consider the dynamic effects of taxation on the economy. Unless tax reform can help lift New Zealand to higher sustainable levels of non-inflationary growth, cutting taxes will be only a race to the bottom as other countries will be compelled to do the same to remain competitive.
In considering the dynamic impacts on the economy, several issues become important:
1. We know that high effective marginal tax rates are a disincentive to greater work effort. That some New Zealand families face effective marginal tax rates of 101.2%, according to IRD's briefing to the Income Minister in 2005, is plainly bad policy.
2. We know that where tax rates change significantly, we get nodes of employment activity. People work out the hours they need to work to avoid moving up to higher tax levels.
3. Though it can be argued that maintaining the difference between corporate and the top personal rates provides incentives for retaining earnings rather than making distributions, over time it's likely that significant gaps between the corporate rate and personal rates will lead to increased effort to avoid higher personal rates. A key issue here is the impact on the overall credibility of the tax system. Large-scale legitimate avoidance behaviour by higher-income earners will undermine the goodwill of lower-income earners and expand the black economy
4. Where tax breaks are offered, such as the proposed R&D Tax Credits, we know behaviour will be influenced. It can be argued that where the activity is desirable, such as with investment in R & D, that is a good thing. However, we know equally that if significant distortions away from investments of higher economic return are the result of the tax incentives, the wider economic impact can in fact be negative.
These issues will be given full consideration when National brings together its tax policy prior to the next election. We need to find an appropriate balance in the iron triangle of efficiency, or less distortions, equity or fairness, and simplicity.
The line I have often heard from your representatives appearing in front of the Finance and Expenditure Select Committee on the numerous tax bills that come before us is a very good starting point. Your representatives keep reminding us of the value of "broad base, low rate".
It's a sound starting point. The challenge for us politicians, however, is how we move from the current dog's breakfast that is our growing plethora of tax rates, tax credits, and tax rebates to something more cogent, towards a tax system that will serve New Zealand well in an increasingly competitive world.
The liberalisation of trade has often been challenging for politicians over the past 50 years, but it has happened in part and will continue to happen. Technology and the fact that electronic transactions have little respect for national borders have seen less political hand-wringing as financial markets have been liberalised.
One of the new challenges for politicians is the liberalisation of the flow of people. It, too, is inevitable as the need for skills and the value placed on them grows.
The reality of these developments means tax policy cannot be hostage to the prejudices and manipulations of politicians. Nations and their governments that don't understand that will be punished by an unforgiving world.