Anthony Willy and Anthony De Reeper: A Capital Gains Tax Yes or No

First published 9 September  2014 
  
Taxation is at the heart of the establishment and maintenance of civil society.  The difficulty is in knowing how much to extract from the wealth producing members of society.

Nothing much has changed since the seventeenth century when Jean-Baptiste Colbert the Controller General of Finances to Louis XIV’S remarked that “the art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.” 

A tax on gains from the sale of capital items is merely another potential source of revenue for the state. The New Zealand Labour Party has signalled in the run up to the election that it will if elected introduce a selective tax at the rate of 15% on all gains from the sale of capital assets except the family home. The stated reasons for this are equity between taxpayers and to take the heat out of the Auckland residential property market.

In any debate about whether or not the existing tax regime is effective and equitable it is important to bear in mind two things: first that the tax is currently imposed on some capital receipts and at income tax rates. In most jurisdictions which impose a tax on capital receipts the tax is substantially lower than for income receipts (except the French. They tax capital gains at 60% and have an economy which is among the sickest in Europe). Second in all tax matters the onus of proof is always on the taxpayer. This becomes crucial to the discussion later about the state of a taxpayer's mind and what may or may not have been the intention present at the time of acquisition and disposition of capital property.

Capital and income the distinction

At first glance the distinction between capital and income is obvious beyond debate. The money I have in the bank is capital and the interest I earn from it is income. My farm is a capital item and the returns from my farming activities are income. The building from which I carry on my plumbing business is a capital item, the money I earn from my plumbing business is income. And probably the best example of all my house is a capital item which provides only a roof over my head and no economic return while I own it. The present taxation regime does not tax these capital items because their value is passive adding nothing to the wealth of the owner during the time of ownership (other than an enhanced ability to borrow against the asset, but any such borrowing is a net liability). Indeed capital assets are often a financial burden, involving in the case of land and buildings, the cost of ownership (rates, insurances, maintenance etc.) and of the money usage foregone of owing them. In the case of money in the bank the opportunity cost of how else it may be spent has to be accounted for.

Capital assets currently subject to income tax

Capital assets currently subject to income tax include:

1. Any assets bought with the intention to resale at some future time for example buying a dwelling on a rising property market (whether lived in or not) with the intention of reselling at a profit.

2. Any asset acquired by the taxpayer as part of the stock in trade of a business. For example a builder buying land for future subdivision and the erection of buildings.

3. Any increase in the value of any land held for less than 10 years which results from zoning changes.

4. The profits on sale of any subdivision of land which involves more than minor work to effect the subdivision.

These categories comprise a substantial revenue base, to the extent that the existing law is enforced being as they are taxable at income tax rates.

Taxpayers state of mind

Central to one and two above is the state of mind of the taxpayer at the time of acquiring the asset. The Courts are accustomed to deciding on the state of a persons As one English judge observed a "the state of a man's mind is as much a  question of fact as the state of his digestion" and the  Courts approach such matters by asking what did the taxpayer have in mind as evidenced by his conduct. The business of deciding on a persons state of mind is rather like Pink Elephants; hard to describe in the abstract but unmistakable when encountered.

Increase in value of a capital asset

The debate about of whether or not to tax capital only arises because it has become the norm (except for periods of economic downturn) for some capital assets to increase in value throughout their life time. If the value of those assets remained constant then there would be nothing to tax, and no debate. The question then is why do some capital assets increase in value over their lifetime (of course  not all  do; for example the value of money in a bank account will decrease  unless there is zero inflation, or company shares will loose value for a variety of reasons). That said most land based assets do increase in value over time and, increasingly assets other than realty, such as intellectual property and financial instruments have enjoyed amazing accretions in value in more recent times. Why is that? The answers are disparate and include:

(i) Population increases, often resulting from immigration, driving up the demand for hitherto relatively static commodities such as the supply of housing.

(ii) A perception that ownership of a particular item of property will confer income opportunities above those flowing from other similar property. Thus an office building in a Central Business District, providing the price is thought to be right, will be preferred to owning a shop in a small suburban shopping mall.

(iii) An increase in the number of people wishing to use a given asset. Thus values in the Wellington CBD are driven by the size of the membership of the Public Service employees wishing to use them.

(iv) Natural features attaching to the property the desirability of which may change from time to time. For example water front land in New Zealand. During the period of early colonial development the water front was traditionally a place where basic commercial activities took place; import/export activities, where housing, oil storage, maritime administrative buildings and the like. It was also a convenient place to locate roads and railways. Currently it is seen as a desirable place to live and work.

(v)  The effect of The Resource Management Act on the value of properties. For example the rezoning of rural land for rural residential subdivision or close residential settlement will increase the per square meter value of the land or the zoning out of  historic and undesirable activities such as a fertilizer plant or quarry adjacent to residential land will enhance the value of the remaining residential land.

(vi) The effect of government decisions on the value of a property. Thus if a new school of hospital is to be established in an area, or a central or local government office offering enhanced employment prospect moves into to an area, or road, rail or telecommunications are improved this will tend to add to the value of existing residential and commercial property.

(vii) Changes in the public perception of the standing of a public institution such as a school if it succeeds beyond its competitors in offering what is seen as a desirable standard of education. This will attract people to the area and push up the value of both residential and commercial property (the latter because the customer foot count will increase).

(viii) Changes in behaviour such as the rise of social media, the use of the mobile phones and the internet have contributed to the previously unthinkable increase in the value of the intellectual property attaching to those services and therefore the value of the shares in those companies.

(ix) Changes in land use such as the development of viticulture or dairy farming on what was formerly arable land.

(x) Increases in the value of a share portfolio for reasons beyond the actions of the shareholder such as the discovery of hydro carbons or some valuable mineral on land owned by the company, or the development of some new intellectual property or a service prized by consumers. And contrary if previously valuable attributes of the asset decline or become exhausted the value of the asset will fall.

The list goes on but the important point to recognise about all these drivers is that they have little to do with the input from the owner of the capital asset and nothing to do with the tax system. They mostly result from the operation of external forces over which the owner of the capital asset has little or no control and may arise from changes which the owner not only does not seek but actively opposes. For example in the 1970s pastoral farmers in Marlborough trenchantly opposed the development of viticulture in the province. Had they succeeded in their opposition (and it was a near run thing given the rural background of some of the Councillors) Marlborough would have lost a billion dollar industry.

Capital Gains Taxes And How They Work In Practice                                                                            

There are essentially three options

            (a) CGT on all capital items bought and sold.

            (b) A selective CGT at the point of sale with exemptions.

            (c) A CGT on all assets whether realised or not.

Currently the political talk from the Labour/Greens Parties is for (b). How might that work?

It seems that the primary target of the proposed CGT is to catch the profits on the sale of domestic dwellings (except what is described as the "family home") with the intention of reducing "speculation" in such property. As understood however the proposed tax will also apply to all capital assets although there appears to be no suggestion that the value of commercial or other business property such as; industrial and commercial premises, farms and vineyards etc. are being artificially inflated by any of the drivers said to be at work in the private housing market.

It follows that if the current law were to be properly implemented there will be a net loss of revenue to the government from the imposition of a capital gains tax at a rate lower than the marginal rate for income tax in respect of all those assets currently within the tax net. But more importantly the rational speculator will embrace the new CGT for as long as it is less than the income tax rates because it will give peace of mind and an indemnity against some later tax audit leading to a contested claim for unpaid taxes, interest and penalties on property that the Commissioner retrospectively deems to be taxable. In addition the vendor will attempt to build into the sale price a margin for any CGT payable, something which is difficult to do in the case of income tax.

The Family home exemption

The proposed exemption for the "family home" will create further problems for the policy makers and tax collectors. Clearly it cannot be intended to refer only to the house occupied by the nuclear family. Presumably it applies to any property the buyer calls home.

If this is what is intended it will then be necessary to decide if there is a period of time during which a dwelling must be owned before it becomes a family home. If a finite term is placed on ownership to qualify (say one or two years) then on a rising market the "speculator" may choose to simply live in the house for the prescribed period before selling it. If that rational behaviour became widespread it would then be necessary to impose a restriction ensnaring sales of  any dwelling where the Commissioner asserts retrospectively an intention to resell at the time of purchase. This will raise the question of how many years and over what period of time. But even with such a catchall given the endless ingenuity of taxpayers it will be necessary to have a tax avoidance provision similar to that which currently exists catching any transaction which the Commissioner and the Courts consider is contrary to the spirit and intendment of the legislation, and that would then bring the whole exercise full circle with the intention of the taxpayer as evidenced by conduct being the focus of enquiry.

The question will also arise; are there to be exemptions of sales of a "family home" within the mandated period? Typically these might include such unintended reasons as: a broken marriage or partnership, changes in work related requirements, to upgrade a dwelling, to move into another school zone, financial pressures and the need to free up capital, retirement, ill health, or a wish to down size, to name but a few reasons house owners have for selling. None of these have anything to do with "speculation" and it would seem harsh if sales resulting from such external factors were not excluded from the tax net. If they are then that would not only further erode the proposed tax base and open up the exercise to endless debate about the bona fides of the claimed reason for selling.

Given these difficulties and the prospect of very little taxation being raised from such a narrowly focused CGT it is our view that it is not worth the effort and administrative headaches involved. Which is probably why as far as is known the Inland Revenue Department has never shown much enthusiasm for a comprehensive CGT. Tax review committees which sat in 1966 and 1982, and under the last Labour Government considered the question but none  recommended it. In a thoughtful paper on the subject given by a senior policy analyst of the Inland Revenue Department in 2000 the author examined whether the absence of an CGT has caused any distortions to the New Zealand economy but could find none.  

The entities to be taxed

For a CGT to operate efficiently it needs to be blind to the legal status of the taxpayer. Thus it will apply to all corporates, partnerships and all property held in trust. That includes trusts created by a will as well as those created during the lifetime of a settlor. The latter are widely used by the farming community for preserving succession of rural properties. The problem arises in relation to the otherwise exempt family home and whether it would be caught by the tax on the death of the owner as a reintroduced form of death duty. If it is then residential property gifted during the lifetime of the owner would not be caught but property left by will would be, and the only reason it would be caught is because it is owned by the deceased's trustees at the time of death. That would be anomalous and unfair. This could only be rectified by excluding residential dwellings held as trust property (and that would require valuing every farm house or business residence at the time of death), or by reintroducing gift duty on any transfers of residential properties during the life of the owner.  

Other Jurisdictions

Proponents of a CGT point to the fact that such a tax is widely relied on in most of the developed economies, and that New Zealand is out of step with the rest of the world. There are two responses to this: The introduction of a CGT in 1965 by the United Kingdom was partly to raise money to pay for the lingering economic effects of two ruinous world wars, and partly along with a suit of other measures (wealth taxes, death duties gift duty etc.) as a social engineering measure designed to redistribute inherited wealth. Those considerations no longer apply in New Zealand. Any socialist wish to further redistribute wealth in New Zealand society can be more effectively achieved through the existing tax structures simply by altering the rates and the thresholds of income tax. Secondly there is no evidence anywhere in the developed world that a capital gains tax has achieved the object of lowering property prices. It is instructive to consider the United Kingdom experience. They have a been exposed to CGT for nearly fifty years, and one would expect that by now the tax would be bedded in and achieving its intended purposes, but not a bit of it. In a recent article by Matthew Lynne in "The Telegraph" of 9 July 2014 the author said:

The stock market is getting back to close to its all time highs. House prices are surging upwards and in London they have gone crazy. Companies are rushing to list their shares publically again, minting a new generation of multi millionaire entrepreneurs.....so you might expect the tax collected on all that money to be going up. Capital gains tax .....should be going through the roof. Except you would be wrong. The amount the government collects from capital gains tax is actually going down.

This is so even though the rate was lifted from 18% to 28% on 2010. The decline in revenue is partly because of the effect of the "Kahldun-Laffer Curve" which predicates that above a certain figure the higher the rate a tax is set the less money is collected, and the operation of this principle is graphically illustrated by the recent English CGT experience. In 2008-9 during the recession when the rate was at 18%,, the Treasury collected 7.85 billion pounds in Capital gains taxes. By 2013 when the economy had recovered and the and the rate was at 28%, the CGT receipts fell to 3.9 billion pounds. The author says:

Capital Gains taxes are especially vulnerable to the operation of the Laffer Curve because they are so slippery.

The author points out that a CGT, effective only at the point of sale and accompanied by exemptions, becomes virtually voluntary as people shuffle their assets or simply hold onto them.

This is the real world of taxation of capital assets and it is clear from the United Kingdom experience and also the American experience of the boom in house prices leading up to the Global Financial Crisis, that a capital gains tax has no measurable effect on the value of the housing stock, those values are driven by external factors discussed earlier and unrelated to the tax system. Neither will it do anything to promote equity between taxpayers. At best it will simply be another tax among many serving to extract more feathers from the goose to the detriment of the health of the bird.

A committee of experts

The suggestion that the form and content of a taxation measure will be left to a "committee of experts" before being introduced is novel. When a political party brings legislation to the House it is in its final form subject to select committee review. It is highly unusual and of doubtful constitutional validity for a Party to tell tax payers they are to become subject to a new tax the form and content of which will be decided by an extra Parliamentary body at some time in the future. It is particularly puzzling why this should be necessary given that there a numerous international example of CGT from which to choose.

This article was first published 9 September  2014 and is reproduced here with permission of the authors.