Closing tac loopholes for famers and business

Closing Tax Loopholes for Business and Farmers

Gareth MorganTax and Welfare14 Comments

A principle of a good income taxation regime is that it is neutral, that all income gets taxed in the same way. Unfortunately ever since New Zealand moved from land and property taxes to income tax an anomaly has been present and the effects of that distortion have built up over time. They are now at the point where inequality between property owners and others has become obscene. This anomaly is starkest with our largest export industries, as they are also our largest landowners.

What loopholes?

In most countries the loopholes in the income tax regime are somewhat imperfectly addressed by the use of wealth taxes, stamp duty, land transfer taxes, and estate duties. None of these alternatives close the loophole efficiently and instead give rise to their own inequities, distortions and inefficiencies.

It is important that all forms of income be taxed in the same way, most notably because it improves economic efficiency – both allocative (where we allocate our investments) and productive (ensuring those investments are used efficiently). An efficient economy is one wherein consumers and investors make the same choices whether they consider the benefits in before-or after-tax terms. If those relative benefits differ because the way that taxes are imposed, then there is a loss of allocative efficiency. If businesses (including farming) make different investment and production decisions because it reduces their tax bill, then people will invest in ways that aren’t ideal for the economy. In other words, the tax regime inhibits productive efficiency.

In our 2011 book, “The Big Kahuna: Turning Tax and Welfare in New Zealand on its head”, Susan Guthrie and myself posited the Comprehensive Capital Income Tax (CCIT) as an overdue reform for the New Zealand income tax regime. We pointed out that until it was introduced our economy would suffer from over-investment in low returning capital assets – and by implication under-investment in high-returning capital assets. The argument was that the current income tax regime fails to tax the full return from investment in some asset-types and as a consequence investors compete to buy those types of assets. This is not because of the pre-tax return being created by the productive use of the asset, but rather because the favourable tax treatment makes these asset types attractive to hoard. The demand for asset types that reap at least some return that lies outside the gambit of the income tax regime becomes excessive as investors clamber to take advantage of the tax break. This results in a pricing of the asset that far outweighs its ability to produce competitive risk-adjusted income.

The CCIT is designed to remove that tax distortion – albeit only partially. It does that by subjecting to the normal income tax rates, a deemed minimum rate of return on the value of all major assets. So let’s say the cyclically-adjusted, risk free rate in the economy (often taken as the long term average of the government bond rate) is 5%. Then under a CCIT-augmented income tax regime, all assets would have to return at least 5% for taxation purposes.

Consider the consequences. It means for instance that owner-occupied dwellings would be deemed to furnish their owners a 5% return, and that return would be taxable. Such a step would remove the anomaly that exists today between the choice an investor has to put their money in the bank and earn interest and pay tax on that interest before they can spend it; versus purchasing a house with that cash and enjoying year after year the rental services that asset provides – tax free. This is a huge distortion in our economy and continues to drive the house price to income ratio up and up, placing that asset type beyond the reach of more and more people. Such an outcome is a nonsense result and totally unnecessary. As Europe’s most successful economy Germany attests, there is no need for the house price to income ratio to rise at all, if you tax the effective return to housing fully.

How the CCIT applies to business & farming

Now turn to business. Why do some businesses persist year after year without even making the risk free rate of return on the assets deployed? Of course any half decent business test by the IRD would determine that they’re not businesses at all – but rather lifestyle choices. And why? Because the owners are able to effectively reap an income from the “business” in a tax efficient (read, “avoiding”) manner. Your friendly corner dairy or workman with a van could well be this type of “pretend” business. The impact of the CCIT on such an activity would compel the business owner to declare at least a 5% return for the purposes of income tax. If the taxable profit from the business is already above 5% of the assets deployed, then the CCIT would have no effect.

So finally we come to farming. It’s just a business like any other so under the CCIT regime it would be subject to a minimum taxable income of 5% of assets deployed, each and every year. If a farm already exceeds that on average, then the CCIT has no impact. If it doesn’t average that then the tax impost on the farm owner would rise.

Now of course farm income is volatile and the concept above is a year-by-year deemed income. That implies that for businesses with a volatile annual income there would need to be a smoothing regime in place for the CCIT liability. This is not of course an option to escape the tax, but merely to smooth the cashflow effects. One would expect use of money interest to apply and there to be a limit to how long tax could be deferred. Remember a business that doesn’t make the risk free return over time isn’t a business at all, so the assets are being either deployed lazily – or as one would expect as more likely – being deployed in order to reap benefits that lie beyond the gambit of the income tax regime (anyone heard of capital gains?).

On a final note the CCIT regime we advocate is a little different to the current income and expenditure regime. Rather than apply the 5% deemed income to the full value of the asset and make interest deductible, because the CCIT only applies to non-financial assets (interest and dividends are already subject to tax), the approach for assessment of the CCIT liability is to apply the 5% deemed income to the value of the productive asset less the liabilities secured against that asset.

Remember the objective here. It is to ensure that all forms of income are subject to income tax to some degree. A CCIT would be a huge improvement on the distortive, inefficient and inequitable income tax regime we currently have. In the household sector alone we estimate that there are $750bn of assets (net of financial liabilities) held that deliver untaxed benefits to their owners. On the principle that not an additional dollar of taxation is to be raised from deploying a CCIT, expansion of the tax base by the 5% of income deemed to come from those assets could provide a 20-25% cut in overall income tax rates.

It would also free up an enormous amount of capital currently sunk into housing and other unproductive assets to be invested in productive assets. We simply can’t get rich as a nation by selling houses and land to each other; we need to sell stuff to the world.


Closing Tax Loopholes for Business and Farmers was last modified: September 6th, 2016 by Gareth Morgan
About the Author

Gareth Morgan

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Gareth Morgan is a New Zealand economist and commentator on public policy who in previous lives has been in business as an economic consultant, funds manager, and professional company director. He is also a motorcycle adventurer and philanthropist. Gareth and his wife Joanne have a charitable foundation, the Morgan Foundation, which has three main stands of philanthropic endeavour – public interest research, conservation and social investment.

14 Comments on “Closing Tax Loopholes for Business and Farmers”

  1. “…so under the CCIT regime it would be subject to a minimum taxable income of 5% of assets deployed, each and every year. If a farm already exceeds that on average, then the CCIT has no impact. If it doesn’t average that then the tax impost on the farm owner would rise.”

    Am I reading this right? If a farmer is doing well and is pretty profitable then the proposed tax change will have “no impact” because they’re already paying tax. But if a farmer is struggling and the farm isn’t very profitable and so they aren’t paying much tax at present then the “tax impost… will rise”?

    Isn’t that 180 degrees wrong? That sounds a hell of a lot like kicking a man when he’s down to me.

    And it all flows from the wrongness of imposing a tax on a “deemed income” rather than an *actual* income. You can only tax a “deemed income” if it actually exists; if there’s real money (as opposed to “deemed” money) to pay the tax with!

    1. You clearly don’t read or just have very negative view on this tax proposal. ‘Smoothing’ is the key word. In a poor year you can defer payment of the tax on your notional 5% return on invested capital to years in which you make much more than 5%. But you cannot defer your tax payments on a minimum 5% return indefinitely – which is what most residential rental ‘investments’ are about – making a loss to reduce tax liability on other income in the hope of capital gain. If you cannot make up the shortfall in a good year, why are you in the business at all?

      1. See my flat tax proposal. No smoothing required. Having a bad year? Pay less tax. Having good a good year? The farmer and the country both win. Sweet as.

    2. As Chris says below ‘Smoothing’ is a key element. The other and to my mind more important idea is that such a tax would mean that assets would be priced on their earning potential not the potential capital gain.

    3. If they are not doing better than 5% return on capital, then it is either, A, a hobby, B, a tax dodge or C, they are simply speculating on capital gains.

  2. “..the approach for assessment of the CCIT liability is to apply the 5% deemed income to the value of the productive asset less the liabilities secured against that asset.”

    For the home owner/occupier – I think that means having a mortgage is beneficial (tax-wise, that is)?

    1. Quite possibly. And this is Gareth’s point. We pour money into property, distorting its value instead of thinking what the best use of this money. If for every dollar I put into paying of my house I’m taxed at 5% notional return on that increasing equity, I might start to ask, “can I get better than 5% somewhere else?”.

  3. Jesus, that was long winded and convoluted. I’m a huge fan of the KISS method. Keep It Simple Stupid.
    How about we decide how much we (the govt) needs to run the country. Add up everyone’s income, (including business profit, ie their income) and divide by the countrys income. That results in a percentage. Not sure what that number would be, probably around 25% as a guess. Then, charge everyone 25% on every cent they earn. Kid with a paper route? Give us your 25%. Multi million dollar bank profit? Thanks for your 25%. Most of the tax dept could be re purposed to productive work. Same for tax accountants. No loopholes, just give us 25%. No gst, no import duties or other govt cash grabs, just everyone coughs up 25%. A bit of work so companies and people dont hide income, but way less work than the current method. Job done. Everyone pays their fair share.

    1. The reason we have a progressive taxation arrangement on income tax is because people benefit enormously from the family they are born into. The majority of us work and save all our lives to have a house (or two), while others inherit vast property portfolios. But over the years, people have lost sight of the fact that once you have large pile of dosh, inherited or earnt, it tends to work for itself. Hence land tax and death taxes were removed in the late 80s if I recall correctly.
      Are you aware that income tax was largely introduced to fund World War I? Having discovered this cash cow, politicians have been very reluctant to let it go. But the problem with income tax is that is very easy to slip that big SUV in as a legitimate expense or to have a golf course or property or farm that… well run at a loss or to use transfer pricing to have your NZ operation make very little money. In effect income is easy to hide, fudge or blur your income. Kiwis that consider themselves honest and reputable are right into this game.
      Hiding property is much much harder to do. We have a whole legal machine dedicated to protecting your rights (and banks right) to it and councils have a very good idea on the relative valuations of the properties.
      And remember Gareth’s proposal is about the equity in the property – you aren’t paying twice, once with the mortgage and again with the tax.

  4. We have a major problem in NZ with the “system” that has developed. I am unsure why Farmers are targeted so much but so be it, lets call the group “asset rich”. That grabs all the landlords and commercial property owners as well as farmers and other entities who place large parts of their investment portfolio’s in appreciating assets such as land and buildings. What is proposed in this article is just way too complex and based on some economics wiz kids dream job. The solution to this issue is clearly some sort of collection method that either captures profits annually through an assessment of valuations or on the sale of property.
    A huge part of our economy is reliant on capital gain to balance the books because the cash returns from the ventures we engage in are so poor. Slapping a tax on the capital gain would nullify that return from that part of an owners portfolio. That theoretically would force them to improve returns from their assets. It is pretty obvious that farming in particular struggles to find alternative products to produce that can deliver those returns. Likewise commercial or rental property owners would attempt to increase rents to compensate with consequences unknown. You can understand the governments reluctance to tackle this issue as it potentially could leave the banking sector, one of the largest tax paying sectors, with serious problems trying to readjust to a state that is so different to what exists now.

  5. You think capital allocation is an issue, look at the mis use of resources, mis allocation of subsidies, the hidden problems that this giant welfare machine creates. The last line is frightening to any hard working NZ, and I suspect most of the wealth to pay these “benefits” is being earned by the people you want to penalise!

    The Government says its tax reforms are benefiting lower
    income households, and it’s got the figures to prove it.

    Acting Finance Minister Steven Joyce has released new Treasury data showing the
    top 10 percent of households will pay 37.2 percent of total income tax this
    financial year, compared with 35.5 percent in 2007/08.

    “This latest data confirms New Zealand’s income tax and support system
    significantly redistributes incomes to households in need,” he said.

    “Higher income households are paying a larger share of income tax than they
    were in 2008, and lower income households are paying less – the 30 percent of
    households with the lowest incomes are forecast to pay just 5.4 percent of
    income tax compared with 6.3 percent in 2007/08.”

    Mr Joyce says Treasury estimates that in the current financial year 42 percent
    of households will pay less in income tax than they receive from welfare
    benefits, Working for Families, superannuation and accommodation subsidies.

    “For the 30 percent
    of households with the lowest incomes, the $1.7 billion of income tax they
    are expected to pay will be more than offset by the $10.6b they will receive in
    income support.”

    1. Yep, welfare for farmers, businesses and National’s cronies is very costly for those of us that actually pay taxes.
      Mostly only real workers on PAYE these days, and the lowest incomes with GST.

  6. There sure is a lot of resistance out there to change. Only a half awake examination of our tax and welfare systems should convince almost anyone (freed from the burden of protecting their own niche of unfair advantage) that massive improvements are possible. I haven’t seen, I think, a single argument against the UBI that isn’t based squarely on “it isn’t affordable” or “someone might get something for nothing that they don’t deserve or need” and yet what we have in so-called targeted welfare system (and universal NZ superannuation) can be criticised in very similar ways and a whole lot more besides.

    Where the CCIT is concerned, most of the arguments against it seem to be either technical objections (around valuations, for example) or based on “winners” and “losers” and that the losers (i.e. the present winners) will get upset. Gee, that sounds like a good argument. Asset rich, income poor people and businesses can certainly arrange their finances to cope well with the CCIT proposed. The measure of these kind of reforms ought to be: will NZ economy and society be better off. Well, how can we possibly not deploy a measure that can go a long way to preventing the disaster of housing bubbles and at the same time expand the tax base and close unfair biases and loopholes?

    One point I’ll make is that these changes don’t need to be introduced in a single hit. It’s certainly possible to phase in progressively measures such as UBI+flat income tax+CCIT. Phasing in CCIT sounds prudent to me, so as to TRY to avoid immediately bursting the housing bubble. Start it off at a much discounted tax rate and then gradually up the rate until the ultimate value is achieved some years later. The same can be done with UBI, as the ultimately necessary components of the welfare system are progressively phased out.

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