Frank Newman: Labour's capital gains tax proposal

Labour has foreshadowed the introduction of a capital gains tax (CGT), but given no detail of what such a tax could look like if it were to be elected government - as is now a real possibility.

Labour has said it would implement the recommendations of a yet to be formed Tax Working Group. Labour will set the terms of reference and appoint the members of that Group. Given that lack of independence there is every reason to believe the recommendations of the Working Group will reflect the wishes of the Labour Party. 

The one and only thing that has been clarified is that the family home will be exempt from the CGT.

Given Labour's new leader is refusing to talk detail, the best indicator of what Labour's CGT would look like is to see what it has said previously when it was prepared to talk about it.

Experts generally agree that a tax should be simple, have a broad base, and few exemptions and incentives. A “good” tax should:

• Reflect taxpayer’s ability to pay. (For this reason most taxes are levied when income is earned or realised, not on the change in notional values.)

• Generate income for the government much greater than its cost to administer.

• Have a low compliance cost to the taxpayer and be convenient to pay (e.g. income tax and GST).

• Be hard for taxpayers to avoid. In other words, have few exemptions for lawyers and accountants to exploit, and

• Not create distortions in economic behaviour.

When measured against these criteria Labour’s previous CGT proposal was given the thumbs down, not because a capital gains tax as such is necessarily a bad idea in theory, but because of its practical effects. In essence Labour’s CGT as previously proposed would tax:

• Investment property.
• Commercial property.
• Shares.
• Assets in trust, when sold.
• Rural property.
• Inherited assets, when sold.
• Farms, including non-family dwellings, machinery, stock.
• The sale of intellectual property.
• Gifts, other than inheritances.

The assets that would not be taxed are:

• Family homes.
• Collectibles; such as cars, jewellery, art.
• Retirement savings like KiwiSaver.
• Term deposits.
• Small business exemption up to $250,000.
• Lottery and gambling winnings.
• Maori land.

When Labour’s Finance Spokesperson at the time was asked why the family home was exempt he replied that to include it was “politically unacceptable”. In other words, would cost them votes.

It is not surprisingly that Labour does not want to talk about the detail behind their policy – and to date most journalists have allowed them to do so.

It's simply not acceptable for a party, especially one that may be in government, to promise such a fundamental change to our tax system without giving any detail. Instead Ms Ardern expects voters to become believers in the Labour church with "trust me" faith. With tax, detail is important – it’s like the fine print on a contract – it’s the detail that actually matters because that’s where the fish-hooks are.

Here are some of the issues Labour does not want to discuss in detail:

• Exempting the family home will create what is called the “mansion effect”. Money flows into the area of lowest tax – which will be family homes. Less will go into shares and investment property. Someone with a spare $100,000 or so will instead put an extension on their home, knowing that when they retire they can sell their home and buy something smaller and cheaper and make what they expect to be a tidy tax free gain.
  
  Some property investors may do likewise. Instead of pumping cash into their rental properties and putting up with the endless hassles of dealing with tenants, they will sell up and put all of the capital into a mansion so they can enjoy their capital and reap a tax free gain when they sell. Others will become recidivist home buyers and sellers. Buy, live in it for a while, sell and buy something better, sell and buy something better and so on.
  
  As a consequence, a large amount of unproductive money will be invested in oversized homes and less money will be put into investments that benefit others. Rents will rise and the taxpayer will have to provide more state houses instead of private landlords. Art collections would also be exempt so we could expect art to fill the cavernous vacant spaces of these over-sized mansions.

• All assets subject to the CGT would have to be valued as at a specified (“V”) date. Given the subjective nature of valuation and the very significant differences in valuations between valuers, inevitably there will be all sorts of rackets and disputes involving valuations.

• No adjustment will be made for inflation. As a result a portion, perhaps a significant portion, of the taxable gains will be “illusory”. Even if inflation is assumed to average just 2.5% a year, after 10 years there would be a 28% inflationary gain that would be taxed. The more inflation the government creates, the greater the tax it will collect. That’s perverse, and grossly unfair.

• Although all capital gains on the sale of investment property would be taxed, Labour had proposed retaining the existing “intention” test so those who buy with the intention of selling would still be taxed at their marginal rate as though it were income. That would actually add to the confusion that already exists. Most countries with a CGT do not mix income and capital gains in this way. Quite possibly Labour would scrap the intention test, and instead extend their five-year bright line test to include all investment assets, not only residential investment property.

These are just some of the problems with Labour’s CGT and have been widely discussed over many decades by various expert panels. For example, in 2001 the McLeod Committee concluded, “We do not consider that New Zealand should adopt a general realisations-based capital gains tax. We do not believe that such a tax would make our tax system fairer and more efficient, nor do we believe that it would lower tax avoidance or raise substantial revenue that could be used to reduce rates. Instead, such a tax would increase the complexity and costs of our system.”

No doubt, Labour would not be appointing the McLeod panel to undertake its new review!

One of the ironies in the debate is the lack of attention given to the fact that New Zealand already has a capital gains tax regime. Unfortunately its application is far from clear and therefore not widely understood.

Put very simply, a taxpayer is liable for income tax on capital gains if they deal or trade in an asset, or if they bought the investment with the intention of resale at a profit. If, on the other hand, they made the investment with the intention of providing a taxable income stream then capital profits, should any arise, would not be taxed. The problem of course is establishing "intention.

Let’s take a hypothetical example of a young entrepreneur who sees how well ebay has done overseas and decides to replicate the service here in New Zealand. Let’s assume he has also seen how IT entrepreneurs in the US start-up then sell businesses and become fabulously and famously wealthy in the process. “Why not here?”, he thinks and enters into the venture with the intention of building the business and selling a few years down the track. He does so and sets up "TradeIt" with the help of some passive investors, and a few years later they pocket many hundreds of millions of dollars. Given those intentions, the capital gain would be treated as income, and income tax would be payable.

If on the other hand that entrepreneur says they started the business with the intention of holding for the long-term to reap the benefits of the substantial annual income BUT THEY JUST HAPPEND to sell it a few years later for a very large sum to a very willing buyer, then the gain on sale would not be taxed.

The problem of course is that only our young entrepreneur and his backers know what their intentions were when the investment was made and it is up to the IRD to review the facts and make an assessment.

Had the IRD determined that our young and now very wealthy IT entrepreneur intended to sell (perhaps from evidence of their past investment habits, how much equity they had in the business, whether they drew profits, the correspondence surrounding the transaction, and so on) then tax would be payable. Conceivably the founders of TradeIT could say, “It is soooo unfair that I did not pay tax on the gain…so I hereby declare it was my intention to resell at a profit and therefore I would pay tax on my gain”. Usually taxpayers are not that obliging.

Labour has given us no details about it proposed CGT, other than to say we are going to get one, and it will exclude the family home. Fortunately it has previously given us some detail and it has not indicated that its policy position has changed.