An odd approach to tax policy

Pattrick Smellie has had about the best summary on the messes in the last round of proposed tax changes.

Earlier this week, the government put up a pile of tweaks to tax policy. This sort of thing is usually pretty bland. But included in the mix was a change to the GST treatment of management fees on Kiwisaver funds. 

Pattrick writes:

A regulatory impact statement, which it’s not clear if most ministers had read or been briefed on before waving this proposal through at a cabinet meeting, warned that maybe $103 billion of KiwiSaver savings would not occur as a result of the changes. 

Stuff’s Rob Stock broke the story yesterday afternoon and all hell broke loose on a policy whose introduction broke every rule in the political book. 

Quite apart from apparently attacking the KiwiSaver scheme's basic premise – to build funds for the future – it was introduced without so much as a press statement. A properly prepared government would at least have tried to control how such a political hand grenade was first reported. 

No such effort was made. 

Cynics will think this was the government sneaking it in and hoping no one would notice. 

Well, maybe, but look what actually happened. 

It is equally likely that somehow, amazingly, this proposal didn’t cause even a momentary flicker on anyone’s political radar.

It's a really strange one because the change looks like it could have been defensible. 

The most recent Tax Working Group laid out the usual case for exempting financial services from GST. There can be huge valuation problems in sorting out what's the value of the service provided and what's the value of the underlying traded thing when it all gets bundled together.

I'm hardly an expert on this stuff, but I know that motivated people sometimes point to the exemption for financial services when they try arguing for exemptions on other stuff. So I'd looked at it at that point, saw that there was darned good "It's just too impracticably difficult to levy GST here so we're not going to" reasons for it, and concluded that the "let's exempt meritorious things" people were being disingenuous in pointing to the financial services exemption. 

So when news broke on a plan to set GST on financial services here, it seemed odd. Hadn't IRD already concluded this stuff is just too hard? I checked back in the papers from the TWG Secretariat and they hadn't foreshadowed any areas that could be pulled from the actually-too-hard basket. 

But those difficulties shouldn't apply when it comes to explicit fees levied in financial services. Whether it leads to other distortions and new structures to try to turn fees into margins, that's beyond me. It's at least possible and possibly even probable that the proposed change had made sense on a basic-tax-principles assessment. 

It seems the kind of thing where, if the RIA on it has, at paragraph 49, $103 billion in reduced Kiwisaver fund balances by 2070, they might have considered better preparation on this one. It's plausibly defensible, but got killed within a day through bad comms. 

The same bundle brought GST changes for platform service providers like Uber, and this one could turn into a right mess. It's very much a what-sucks-least problem, and all options are going to suck. I'm just not convinced they've picked an option that sucks least.

Recall that there's a de minimus regime around GST where if an outfit has less than $60k in revenue it isn't required to file for GST because the time and hassle for everyone involved is greater than the amount of tax that might be collected. Makes sense, right?

So what then happens if a tech innovation means a lot of new small part-time entrants are able to enter a sector, many of which will be under the de minimus threshold because it's a part-time deal for them? IRD might start worrying about base erosion and about distortions favouring the small-time operators. 

But how can you do anything about it that doesn't make things worse? All the options are bad too. 

IRD canvasses some in the RIA, and came up with the following. 

For driver-partners who work with platforms like Uber and who are GST registered, no changes. They charge GST, claim back expenses; Uber pays them a GST-inclusive price from riders and claims back the GST that they've charged. All fine. 

But for drivers below that threshold, the platform will charge GST on the ride. 

Now that's a problem because the drivers will have paid GST on their fuel, oil, maintenance, vehicle - all the inputs where GST would normally be claimed back. Remember that part of why the de minimus threshold works is because minimus is smaller than you might have thought. At the same time as they're not charging GST, they're also not claiming back GST on expenses. So the net is a lot smaller than you might have figured. 

If Uber, or Lyft, or whoever, is charging GST on the full cost of a ride, and the suppliers aren't claiming GST on inputs, then you've double-charged GST. And that's a big problem. 

IRD proposes a workaround. The platform would collect 15% GST on the full cost of the ride. It would submit 6.5% up to IRD and send 8.5% back to driver-partners as a deemed input cost proportion. 

I don't know where the split came from - whether it's some overall average of how this stuff nets out, or one specific to transport, or something else. 

But it will wind up requiring the platforms to implement a pile of new accounting to track things, which might need runway to sort out.

Suppose I drove for a few ride-share companies. Would I be able to set up one GST-registered company where all my driving for one platform gets accounted, have it take more than its fair share of the costs of fuel, maintenance, and everything else, and have my driving for the other platforms come under the deemed cost regime? Possibly isn't worth the hassle to set up, but IRD might need to watch that driver-operators aren't trying it on. 

GST normally avoids this kind of problem; folks claim back GST on expenses while paying GST on sales. But a deemed-expenses kind of set-up would break that. 

Maybe the thing is defensible if it really is less bad than potential base erosion and distortions where platforms change industry structure, but I'd hope that they'd talked with the platforms about practicabilities and implementation. It sounds like it could be tricky. 

Do flat taxes make sense? Depends on your goal.

Stuff's Susan Edmunds got in touch asking whether flat taxes work. I was pretty long-winded, so only some of my comments could possibly be used. Here's what I'd sent through. Enjoy!

People’s views on flat taxes will depend on their views of the desirable overall size and scope of government. It is difficult to finance a large redistributive state on a 17.5% flat tax – the Crown gets a very large proportion of its revenue from income tax payments from high income earners. The flat tax is consistent with ACT’s desire for a more constrained and smaller government, and can be efficient within that setup. Lower effective marginal tax rates can increase labour supply, but we should be cautious not to overstate effects here. Most studies conclude that primary earners are not that responsive to tax rates, or at least not in the shorter term in deciding how many hours to work. The overall tax burden can be important for bigger on/off kinds of decisions though, like whether to migrate to New Zealand in the first place, or whether to shift abroad if you currently live here.

So a flat tax can be consistent with a shift toward a smaller overall government.

ACT proposes funding the reduction in the overall tax take by abolishing the Provincial Growth Fund, raising the age of NZ Super, removing fees-free study, cancelling winter energy payments, capping Working for Families, and ending government contributions to Kiwisaver.

Abolishing the Provincial Growth Fund seems sensible enough, but we should note that that fund will end at the end of the current government. A tax system change is long lasting. So future governments would be constrained against putting in big expensive regional spending programmes to buy the support of whichever party might make that a condition of coalition support.

Raising the age of Super entitlement, so long as it’s done with enough lead-time for people to prepare properly for retirement, is also a generally good idea – whether you want to use the savings then to give more money to younger poorer people, or to fund a reduced overall tax bill. It would be difficult to do this in the short term.

Removing fees-free study makes the overall package less regressive than it might otherwise seem as the benefits of the programme disproportionately accrue to higher-earning families. While many poorer families also benefit from fees-free study, the bulk of the benefit goes to higher earning families who would have gone to further study anyway. That’s one reason that we had opposed fees-free in the first place, and had suggested reinstating interest on student loans while using the savings to boost scholarships for low-income students and to improve preparation for tertiary study at high school.

Winter energy payments are incredibly badly targeted and an ineffective way of supporting those on lower incomes. But the combination of reducing this payment while also increasing income tax paid at the bottom might argue for an offsetting boost to benefits. Similarly, capping Working for Families to two children will be attractive to those on higher incomes who have had fewer children and who might wonder about very large family sizes among those on lower incomes, it would likely have negative effects on material deprivation among those poorer larger families.

Finally, abolishing Crown contributions to Kiwisaver also seems rather sensible. Series of papers produced by Grant Scobie and various co-authors showed that Kiwisaver has had no effect on overall savings rates. The policy then mostly rewards people for savings that they would have undertaken anyway.

Caveat on all of this: I have not double-checked the numbers and am taking them all as given on ACT’s website.

Aligning the flat tax rate with the company tax rate will mostly have effect on companies’ ability to attract foreign capital, and a bit of a reduction in taxes paid by nonresidents. Under the imputation regime, the company tax rate is a bit irrelevant if the company is solely held by Kiwis: the owners of the firm get an imputation tax credit along with any dividend payment, so if the company tax rate were higher than the top marginal tax rate, then IRD would just be writing that off against their income tax due anyway. Where it would have effect is on dividend distributions to foreign owners who aren’t eligible for imputation credits and who would consequently see a tax reduction – and also consequently be more willing to invest in New Zealand. Since New Zealand is generally shallow when it comes to capital and could use a lot more investment, on balance that part seems rather desirable.

I think some of the reporting around the proposed flat tax has been a bit lazy, but some of the problem is that we just don’t have data here that’s available in other places. For example, there’s been a lot of reporting that many earners would see an increase in total taxes paid under a 17.5% flat tax because the higher tax on earnings under $14,000 would outweigh the reduced taxes paid on earnings over $48,000. But many earners that are in that group will be secondary earners in households where a primary earner will enjoy a more substantial tax cut. So if we then consider a household where one person is on >$100k and the second person is on $40k, there would be an increase in the tax paid by the second person but it would be dominated by the tax cut enjoyed by the first person. And, the tax increase on the second person would be ‘inframarginal’ – in other words, the marginal tax rate doesn’t change for that person, but the tax collected on earlier earnings does. So it should not have any effect on the second person’s hours worked (conditional on that person still finding it worthwhile to be in work), but will have some likely minor effect on the higher-earning partner’s labour supply. And if we think about migration decisions as being about how the household as a whole fares, it could have effects on decisions by families with a higher skilled worker to move to New Zealand.

So, I suppose, a few bottom lines:
• If your ideal government includes a lot of redistribution, including programmes like fees-free study that are very poorly targeted if you think redistribution should mostly help poor people, then you shouldn’t be a fan of flat taxes. They simply cannot raise the amount of money necessary for a large redistributive state.

• If you think that government should on the whole be smaller, then financing it via a flat tax can work well. Don’t be overoptimistic about huge consequent growth effects coming out of increased labour supply from the highly skilled who are already here, as the literature suggests primary earners’ wages are not all that responsive to tax rates. But you could see a bump via greater labour supply from high skilled secondary earners, and through changes in migration.

You can’t really say whether a flat tax works without specifying what the goal is. It doesn’t work if you want to have a large and redistributive state as you cannot finance that kind of government on a flat tax. But it does work if you don’t want that kind of government. 

The quoted bits have me more firmly on the pro side. I'd be happy enough with a smaller overall size of government, but figure it's worth laying out the tradeoffs.

Tax wedges

New Zealand fares pretty well in this new OECD report on tax wedges. The OECD measures the average and marginal tax and social security burden on employment income.

The average tax wedge in New Zealand is much lower the OECD average and also below that in Oz. A single person on the average wage has a 16.4% tax burden in NZ; the burden in Oz is 27.2%. A single parent with two kids on 67% of the average wage has a -18.4% tax burden as Working for Families (our EITC, targeted at low to middle income workers with children) makes the average labour tax burden strongly negative: the worker takes home rather more than his or her employer pays out, though he'll then go on to pay 15% GST on all purchases.

Some of our marginal tax wedges are less pretty: abatement rates for Working for Families make a mess of effective marginal tax rates for workers on half the average salary, and fairly high for those in middle-income ranges.

Counting consumption taxes would make New Zealand look worse relative to the US, but much of Europe relies heavily on consumption taxes as well.

 

Scrolling your mouse pointer over other countries should let you compare New Zealand with other OECD countries. If your RSS feed strips out the chart, hit it here.

Don't start by assuming stupidity

Suppose that you want to reduce petrol usage because of global warming.

If you begin from an assumption of consumer rationality, you'll prefer a carbon tax or some form of emission trading. Announce today a schedule of Pigovean carbon taxes and how they will affect petrol prices as they ramp up over time. Then let customers decide how to re-optimise when buying cars. We'd expect an increase in demand for cars with better fuel economy. Cars with worse fuel economy will start having to sell at a discount. Manufacturers adjust their product mix to account for changing demand and aggregate fleet composition changes over the longer term.

If you start from an assumption of consumer stupidity, you'll prefer regulations targeting car manufacturers mandating fuel economy standards. If car buyers are myopic and stupid, they'll fail to account for the higher lifetime cost of a car with worse fuel economy. Because customers are stupid in this way, manufacturers will not adjust their product mix to shift towards cars with better fuel economy - there's no change in demand for more efficient cars even with a well-publicised schedule of future tax increases. And so direct regulation has to be used. There are problems with this and lots of them - all the gaming of US CAFE standards and redefinitions of what constitutes a truck as most obvious example. But it could be a second best if car buyers are really stupid. Or, if they're just really really short-sighted. We'll also have to assume that car buyers do not change their behaviour by a lot when the price of driving a kilometer goes down by a lot.

What happens if we look to the data? Busse et al in the latest American Economic Review find pretty good evidence that car buyers' demand for fuel economy is sensitive to petrol prices. They conclude (ungated versions):

We estimated that a $1 increase in the price of gasoline increases the market share of cars in the highest fuel economy quartile by 21.1 percent and decreases the market share of cars in the lowest fuel economy quartile by 27.1 percent. We also estimated the effect of a $1 increase in gasoline prices on unit sales of new cars and found that sales in the highest fuel economy quartile increased by 10–12 percent, while sales in the lowest fuel economy quartile fell by 27–28 percent. We estimated the effect of gasoline prices on the equilibrium prices of new cars and found that a $1 increase in the price of gasoline is associated with an increase of $354 in the average price of the highest fuel economy quartile of cars relative to that of the lowest fuel economy quartile. For used cars, the estimated relative price difference is $1,945.

We used these estimates to investigate whether the changes in equilibrium prices for new and used cars associated with changes in gasoline prices show evidence that consumers undervalue future gasoline costs of cars with different fuel economies relative to the prices of those cars. This could be thought of as a necessary condition for effective policy: the more car buyers discount future fuel costs, the less effective a gasoline tax or carbon tax will be in influencing vehicle choice. Using several different assumptions about vehicle miles traveled, a range of assumptions about the elasticity of demand, and comparing the relative price differences between different quartiles, we find little evidence of consumer myopia. Many of our implicit discount rates are near zero; most are less than 20 percent.

So the "people aren't stupid and weigh costs over time in a sensible fashion" model seems the better baseline approach.

Now imagine that you set a fuel economy standard instead of a carbon/petrol tax in a world where customers are forward-looking and not idiots. Well, once they've bought the more efficient car, the value they derive from burning another litre of petrol increases substantially: they can drive farther, and they're not charged any more for that litre of petrol. And so a lot of the reductions in carbon emission you might have expected get whittled away by that people drive more. If you'd done it instead with a petrol tax, the marginal cost of another litre of petrol is higher. People still flip to the more efficient vehicle, but petrol usage doesn't rebound as much as consequence because the marginal cost of a litre is higher.