Thursday, 13 August 2009

Capital gains tax and distortions

I'm no expert on the Kiwi tax system. But a few things strike me.

First, we're hearing a couple of different stories for a capital gains tax. The first story is that the current tax structure gives investors a disproportionate incentive to invest in housing relative to other assets and that this causes distortion. While I can see the case for a distortion away from interest-bearing assets and towards assets that carry capital gains, I have a much harder time seeing how this necessarily twists investment towards housing. Now, it could be the case that some property investors who improve and resell properties quickly are able to disguise normal income as capital gains by this mechanism, but I'd be surprised if the efficient solution were a broad capital gains tax rather than IRD just watching things a bit more closely.

The second story is that we need to reduce our reliance on income taxation and move towards a broader tax base; reducing income taxes in favour of a higher GST and a capital gains tax could be part of such a move. But at least some of the arguments running this way are that the New Zealand savings rate is too low so we need to encourage savings and discourage consumption. It's rather unclear to me that putting a tax on the fruits of investment is a good way of encouraging savings.

My bigger worry on the latter story is that it's pretty unrealistic to think this will be a revenue-neutral move. During the session on tax at the New Zealand Economic Association Meetings, there was at least as much talk about introducing a capital gains tax as a way of avoiding having to cut entitlement spending going forward as their was about using it to replace other forms of tax. Call me a pessimist, but even if the first move on introducing the new tax is to reduce other taxes at the same time, the odds on income taxes going back up to the status quo ex ante are, well, pretty high. Even if the current government is perfectly sincere about wanting to just broaden the base in a fiscally-neutral way, it's then awfully cheap for some subsequent government to ratchet things back up.

Unless the move to introduce a capital gains tax is coupled with serious spending cuts that hit medium term budget projections - like increasing the retirement age - a current move to introduce the new tax while cutting other taxes just isn't a stable equilibrium. It instead makes it more likely that the medium term budget problems are resolved by overall tax increases rather than by spending cuts. I rather prefer the latter, so I worry about moves that make the former more likely.

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