Capital gains tax Labour party policy and its implications for farmers

NZIER report to Federated Farmers

June 2014

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About NZIER

NZIER is a specialist consulting firm that uses applied economic research and analysis to provide a wide range of strategic advice to clients in the public and private sectors, throughout New Zealand and Australia, and further afield.

NZIER is also known for its long-established Quarterly Survey of Business Opinion and Quarterly Predictions.

Our aim is to be the premier centre of applied economic research in New Zealand. We pride ourselves on our reputation for independence and delivering quality analysis in the right form, and at the right time, for our clients. We ensure quality through teamwork on individual projects, critical review at internal seminars, and by peer review at various stages through a project by a senior staff member otherwise not involved in the project.

Each year NZIER devotes resources to undertake and make freely available economic research and thinking aimed at promoting a better understanding of New Zealand’s important economic challenges.

NZIER was established in 1958.

Authorship This paper was prepared at NZIER by John Stephenson.

It was quality approved by John Ballingall.

The assistance of Michael Dunn is gratefully acknowledged.

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Key points The Labour party’s CGT would not be a good addition to New Zealand’s tax mix.

The way that CGT is both promoted and protested in the media it sounds like a game changer. It isn’t.

The CGT would do little to improve the efficiency and effectiveness of New Zealand’s tax system. The main reason for this is that it would be riddled with exceptions and unresolvable design problems and for all this it would raise very little revenue.

In principle, it appears to broaden the tax base. Thus it could make for a more efficient tax system if additional revenue was used to lower other tax rates. However there are no current proposals for such an offset and the tax will not raise much revenue. While the Labour party expects the CGT would bring in over $3.7 billion (or 3% of total tax revenue) in 2026 the real number is likely to be half that amount.

Labour expects to raise at least $1.3 billion from the farm sector. A more realistic estimate is that the tax would raise a nominal $590 million in revenue in 15 years’ time.

Labour’s numbers don’t take account of ‘lock-in’ – that people will choose not to sell to avoid taxable gains.

While the tax would take time to ramp up, it would reduce current farm values. We estimate the loss in value will be between $2.4 billion and $7.6 billion (-1% to -5%).

Other asset owners would not face tax on their capital gains – chief amongst them are people who own their own home. This is politically predictable but economically costly as it retains a key distortion between asset types.

Home affordability is unlikely to improve. Housing costs rise and fall with the relative costs of land, construction and transport (supply-side costs). These would not fall with a CGT.

There is no such thing as a perfect CGT and design choices bring both costs and benefits. Victoria University’s Tax Working Group consider these costs and benefits and concluded that a CGT of the kind proposed by the Labour Party would not be an efficient and effective option going forward.

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Contents 1. Labour’s Capital Gains Tax .............................................................................. 1

1.1. Purpose ................................................................................................... 1

1.2. Sound in principle ................................................................................... 1

1.3. Less sound in practice ............................................................................. 3

2. Not a large revenue spinner ........................................................................... 7

3. Impact on the farming sector ......................................................................... 9

3.1. At first glance tax rates would increase by up to 25%............................ 9

3.2. Lower land prices mean lower tax revenue ........................................... 9

3.3. Falling farm sales further reduce fiscal gain ......................................... 10

4. Not worth the effort ..................................................................................... 12

Tables

Table 1 Impacts of capital gains tax on the farm sector ............................................................ 11

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1. Labour’s Capital Gains Tax The New Zealand Labour party has a policy of introducing a capital gains tax (CGT). The CGT would involve a 15% tax on gains in asset values, paid when the asset is sold.

Gains would be measured from the date the tax is introduced.

The tax would not apply to gains realised on:

family homes

including an allowance for land around a home on a farm

retirement savings

including sale of small business assets if the purpose is to fund retirement income

Capital losses could be used to offset tax on current and future capital gains but not on other types of income.

The policy should be thought of as an extension of the existing tax system. Many capital gains are already taxable in New Zealand.1 Labour’s CGT extends the scope of assets and entities subject to capital gains.

1.1. Purpose The main objectives of the tax are:2

improve the efficiency of current tax system (“removing the tax bias towards investment property”)

raise more revenue (“keep our assets, pay down debt”)

fund transfers or targeted tax reductions (“give hard working families a tax break”).3

1.2. Sound in principle These are sound objectives for any tax system. Ideal tax systems raise enough revenue to pay for spending or benefits while imposing as small a cost as possible.

1 This is true when the purpose of owning assets is to make money from selling rather than holding or using the assets. E.g.

managed funds are generally taxed on realisation of profits from sales of equity investments as this is assumed to be a key part of their business. Capital gains from real estate can similarly be taxed if a seller purchased had purchased a property with intent to profit from selling it.

2 https://www.labour.org.nz/sites/default/files/CGTWebdoct%20July%202011.pdf.

3 In this brief we do not evaluate specific targeted tax reductions or potential increases in transfers because Labour policy on these is not now explicitly linked to revenue from a CGT. When first announced the CGT was to be used to fund cuts to GST and a proposed tax free threshold for income below $5,000. These policies have since been dropped because they are not sufficiently well targeted to those on low incomes (“we believe there are better ways to help struggling Kiwi families”, Dominion Post 22 January 2014). The CGT will nonetheless implicitly be used to fund other policies such as a proposed R&D tax credit.

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1.2.1. Improves efficiency of the tax system

‘Cost’ in this context is not so much about dollars paid in tax but ‘distortions’ which make people worse off.

General principles for minimising costs while raising enough revenue to fund spending include making sure that the tax system is:

broad based

low rate

administratively simple

based on ability to pay.

Broadens the tax base

The broader the tax base the better because people can’t dodge the tax by doing things they otherwise wouldn’t want to do. Consider the costs of excluding people with pony-tails from any income tax. In principle, a CGT contributes to base broadening by extending coverage of the current tax system to include a currently untaxed source of income.

Based on a ‘low’ rate

Low tax rates are also generally more efficient than higher rates. Consider the impacts on investment and unemployment of a 99% corporate tax rate. In this respect, a 15% CGT seems reasonable – on the face of it.

Tends to be progressive

CGT tends by its nature to be a progressive tax.4 Progressivity is a desirable property of tax systems to the extent that it is efficient to tax people based on ability to pay – although the degree of progressivity is a matter of considerable debate in terms of both equity and efficiency.

Gives greater clarity to tax rules

An explicit CGT could, in principle, have the benefit of providing greater clarity over what a capital gain is and when capital gains are taxable or not. Tax law is always open to a degree of interpretation but the tax treatment of capital gains in New Zealand is an area that may benefit from less vague rules.

Reduce tax avoidance

Widening the scope of capital gains could also reduce incentives to shuffle income from taxed income to untaxed gains. This, in principle, would improve the efficiency of the tax system by reducing time and money spent on negotiating the line between income and capital gains. It could also reduce time and money spent on enforcement of rules against evasion.

4 Wealthier and higher income households are more likely to face CGT and thus face higher overall tax rates compared to

households with lower income and wealth.

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1.3. Less sound in practice While sound in principle, problems with CGTs begin to become apparent when practical cost effectiveness and administrative simplicity are considered.

Most OECD countries have a CGT and in all of these of countries the tax comes with complicated calculations and extensive exemptions. For all this complexity the tax raises very little revenue (see the next section).

1.3.1. Imprecise measurement of gains

To introduce a CGT tax a number of pragmatic design choices have to be made which undermine its in-principle appeal. For example, to calculate a gain, an initial or ‘book’ value has to be used. Actual cost of purchase is fine over the long term but this is not a reasonable basis for valuation when the tax is first introduced so an alternative valuation method is needed. This can become very complicated when, for example, assets have not been traded for a very long time. Inevitably, averages of one sort or another are applied. This means some assets will be under-taxed and others over-taxed.

1.3.2. Inevitable exclusions

The family home

The ‘family home’ is commonly excluded from CGT – as it is in Labour’s proposal. This significantly undermines the in-principle value of a CGT.5 Exempting the family home has the effect of:

reducing the revenue that can be raised

introducing distortions in behaviour by tipping prices in favour of e.g.

owning one large house instead of a small house and a small bach

spending on home renovations instead of investing in a small business.

The average tax-payer might think reduced CGT tax is a benefit but it isn’t. Lower tax revenue reduces the efficiency of the tax and limits scope for offsetting changes to other tax rates (e.g. GST). This really matters as the efficiency of taxes falls exponentially as the tax rate increases.6 Thus there are efficiency gains to having low rates of tax on as many tax bases as possible and therefore benefits from using CGT revenue to reduce tax rates elsewhere.

Sizable exceptions also make the tax system more complicated and increase administrative and compliance costs.

5 Exclusion of the family home also means a CGT would be contrary to the principle of “horizontal equity” – the idea that

individuals with similar income or assets pay the same amount in taxes.

6 The rule of thumb is that a doubling of the tax rate quadruples the efficiency cost of the tax system. See Creedy, J. (2003) ‘The Excess Burden of Taxation and Why it (Approximately) Quadruples When the Tax Rate Doubles’, NZ Treasury Working Paper 03/29, http://www.treasury.govt.nz/publications/research-policy/wp/2003/03-29.

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Retirement savings and small business assets

The Labour party policy also includes an exception for retirement savings withdrawals and for sale of ‘small’ business assets – up to a value of $250,000 – if they are being sold for retirement purposes. It is unclear whether this is intended to apply to farmers or not – although the examples provided Labour’s policy documents suggest that farms do not qualify for the proposed $250,000 exemption on ‘small business assets.

Alignment with other policy goals

Exceptions are not exclusively political – although the non-political exceptions are technically the ones which are most (though not always) difficult to know how to deal with (i.e. whether the exceptions will increase or reduce the costs of the tax system). The Labour party has set aside a number of these issues to be considered by an expert panel.

Key issues to be addressed are whether to tax venture capital and whether (and how) to allow for rollover of investment from one asset to another. The issue of rollover is considered important for not discouraging investment in cases where investors use their capital gains to back new business ventures including highly risky start-ups and similar entrepreneurial ventures.

This issue is of particular importance for policy-makers who pursue policies aimed at encouraging R&D and high-growth enterprises. In general, it is unwise to conflate spending and promotional policies with tax policies, but gauging the extent to which a new tax will undermine existing subsidies or similar initiatives – and adjusting them accordingly – is hard to do. This makes exemption an expedient and seemingly cost-effective CGT design choice.

1.3.3. Not as progressive as you’d think

While CGTs are generally progressive, they are less progressive than one might think. This is partly because people with large portfolios of investment can manage the sale of their assets to maximise assessed losses and hold onto assets to reduce assessed (realised) gains. As a rule of thumb, the larger a person’s wealth the greater their ability to manage their investments in this way and the smaller their overall tax rate.7

Modelling of the impacts of CGT on property markets also suggests that capital gains taxes lead to higher rents. This effect would be felt most strongly by people on low incomes.8

1.3.4. Homes won’t become more affordable

CGT on investment property is likely to cause home ownership rates to rise over the long term, principally because the cost of renting will rise relative to the cost of

7 The same can be said for other forms of income tax but it is likely to be more extreme when tax is only assessed on

‘realisation’ of a gain. In principle, tax avoidance could be reduced by taxing gains as they accrue instead of when they are realised but this is generally considered practically and politically infeasible.

8 Coleman, A. (2009) ‘The long term effects of capital gains taxes in New Zealand’, Motu Working Paper 09-13, Motu Economic and Public Policy Research, http://www.victoria.ac.nz/sacl/centres-and-institutes/cagtr/twg/publications/3-long-term-effects-of-cgt-coleman.pdf.

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owning. This does not mean that places to live – i.e. homes – have become more affordable.

There is a perception that the absence of capital gains stimulates speculative investment in the property sector and that this causes prices to rise and homes to become unaffordable. This overlooks the fact that speculative investment is already subject to income tax on capital gains.9 It also overlooks the fact that developers (including builders) are already subject to income tax on capital gains in New Zealand (the law is specific on this point). If anything, the supply of housing is constrained by existing taxes on property development.

Home affordability, in terms of cost relative to income, rises and falls with the relative costs of land, construction and transport (supply-side costs). These would not fall with a CGT. Countries with capital gains taxes have certainly not been immune from rising house prices (see Figure 1)

Land prices would be expected to fall if a CGT caused reduced returns to buyers but returns to development are already taxed according to capital gains.

Figure 1 House price indices

Real prices, base year 2005

Source: OECD

1.3.5. Damned if you do and if you don’t

There is no such thing as a perfect CGT and design choices will bring both cost and benefits. For example:

a low tax rate on CGT encourages people to shelter their savings in assets which accrue capital gains instead of interest income or wage income

9 Whether or not these are being paid is another matter but not an issue that is peculiar to the property sector.

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the ‘progressivity’ of CGT can create distortions by taxing ‘high yield’ investment more than capital in ‘low yield’ investment – in other words reducing the relative returns to good decisions

CGT doesn’t affect risk-taking if taxes are levied on gains as they accrue and losses can be offset against all forms of income, but there is no single ‘correct’ way to value assets which have not been sold in the market

CGT can be levied on ‘realisation’ of gains but this causes ‘lock-in’ where people avoid selling assets in order to avoid taxes

problems with valuing existing assets, when a scheme is introduced, can be avoided by exempting existing assets from CGT but this would increase lock-in

a tax on realised asset gains can unnecessarily force dissolution of family businesses which would otherwise be passed through the family and while this can be solved by ‘rolling over’ the gain this exacerbates ‘lock-in’ and reduces the size of the tax base.

These kinds of issues are some of the reasons why the most recent thorough consideration of New Zealand’s tax options, by Victoria University’s Tax Working Group, concluded that a CGT of the kind proposed by the Labour Party would not an efficient and effective option going forward.

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2. Not a large revenue spinner In 2011 the Labour party estimated that its 15% capital gains tax would raise $17.5 million in its first year rising to $3.7 billion in 2026 as the scope of assets captured by the policy grows over time.10 This is 3% of projected crown tax revenue and 1% of nominal GDP in 2026.11

These estimates are high. The revenue potential of the tax is likely to be half that estimated by Labour – if not smaller.

By way of example, Australia’s CGT averages around 1% of Australia’s GDP. However Australian capital gains tax rates average 25% rather than the 15% proposed by Labour.

Labour’s proposed policy is similar to the CGT applied in Australia. If New Zealand collected CGT from the same sources as the Australian Federal government, but at a lower 15% rate, revenue in 2026 would be $1.7 billion as opposed to the $3.7 billion estimated by Labour.12

It is possible that a CGT in New Zealand would capture proportionately more revenue than in Australia, though this is unlikely.

The estimated components of the revenue captured by a CGT also do not match with a detailed bottom-up assessment of revenue. Individual investment property yielded an estimated $1.7 billion in realised capital gains in 2012, on $7.2 billion of sales. This equates to $253 million in revenue under a 15% CGT and 0.04% of the value of the housing stock. Assuming the value of the housing stock grows at 5.25% p.a. this suggests that CGT from investment property in 2026 would be $541 million – as opposed to the $1.34 billion estimated for the Labour party.13

The estimated revenue gained from property is generally suspect because it:

does not account for negative impacts on the value of properties from introduction of a CGT

assumes monotonically increasing prices, even though, for example:

growth trends in, for example, rural property prices have undergone major step changes with 20 years of flat prices (1980 to 2000) to rapid appreciation (2000 to 2009)

only Auckland and Canterbury have exhibited growth in residential prices since 2007.

overlooks spatial variation in the level of property prices and turnover

overstates the average price of and rate of appreciation for rental properties (lower than for owner-occupied properties).

10 The CGT estimates were produced by the consultancy BERL for the Office of the Leader of the Opposition in 2011.

11 Based on projections of nominal GDP and Core Crown tax revenue in the 2013 version of the Treasury’s Long Term Fiscal Model http://www.treasury.govt.nz/government/longterm/fiscalmodel.

12 This is based on average Australian CGT per dollar of GDP between 2000 and 2009 (the period for which we have data)

multiplied by Treasury’s projected nominal GDP for 2026 and by the ratio of the intended New Zealand CGT tax rate against the average Australian CGT tax rate (15%/25%).

13 Growth in the value of the housing stock of 5.2% is made up of 3.5% price appreciation and 1.75% volume growth as used in the 2011 consultant’s report to the Leader of the Opposition.

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The Labour party’s estimates of CGT revenue were revised up in 2014. We are unsure of the analytical basis for those revisions so our detailed comments above are restricted to the 2011 estimates. Nonetheless, the 2014 estimates are less believable than the 2011 estimates.

Figure 2 Estimated CGT revenue

Source: NZIER, NZ Labour party

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3. Impact on the farming sector A CGT will raise the effective tax rate imposed on the farming sector. Exactly how much it will rise is another matter.

Some of the impact will be factored into land prices – which will fall by as much as 7% in the year the tax is introduced. This would reduce the apparent change in tax rate.

The effective tax rate and change in land value will both depend on whether the rate of farm sales falls.

A large reduction in farm sales would mean a $2.4 billion decline in land values, a 1.4% change in tax rates, for a sum total additional crown revenue of $190 million (0.4%).

3.1. At first glance tax rates would increase by up to 25%

On the face of it, farmers could face a material impact from a CGT with a CGT increasing tax rates from 28% to 34% - once the tax is at full effect and assuming no offsetting change in other tax rates.14 This is an increase in tax rates of close to 25%.

This assessment is based on agricultural land worth an estimated $170 billion dollars in 2011.15 A rate of appreciation of 3.75% p.a. used in Labour’s analysis of a GGT implies this land will be worth $290 billion in 2026. With 1-in-20 farms traded each year and a 15% CGT this implies an additional $940 million in tax – once the tax is at full effect.16 This compares to an estimated $3.8 billion tax paid on projected operating surpluses of $13.6 billion.

This increase in tax rates is larger than is likely to be experienced by other industries because agriculture is capital intensive. Around three-quarters of value added in agriculture is from capital (land and plant and equipment and machinery). This is higher than the economy-wide average of around 50% although smaller than the 79% and 83% shares of value added found in the utilities and mining sectors.

3.2. Lower land prices mean lower tax revenue

The importance of land to the farming sector also means that future capital gains tax liabilities will be factored into prices which people are willing to pay for farms. Sector wide, a 15% CGT would reduce the (present) value of projected cash-flows by $11.5

14 We focus on changes to taxes on capital income and assume farm profits are all taxed at the current corporate tax rate of

28%.

15 This is an estimate for 2011. This is used as the base year for our analysis for comparability with the Labour party’s analysis. Different choices of base year would change the dollar values we use but does not alter the overall findings of our analysis which is best assessed in terms of tax as a share of other numbers such as total tax revenue, land value or sector operating surplus.

16 For sake of comparability we use the same appreciation assumption used in the Labour party’s analysis. We also follow the assumption that the policy reaches full effect in 15 years.

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billion and this value would come off the current value of farm land.17 For those who are looking to exit the industry – e.g. to retire – this cost would be immediate. If nothing else changes, this amounts to a 7% reduction in land values.

This reduction in land values means that the CGT will raise $870 million instead of the $940 million suggested above and considerably less than the $1.3 billion estimated by Labour.

3.3. Falling farm sales further reduce fiscal gain

Farm sales are likely to fall in response to the CGT. In the short term, some farmers who are faced with a fall in land prices would hold onto their farms for longer – if they can. Longer term, those who are faced with the prospect of capital gains tax will be able to structure their affairs so as to reduce or delay tax liability.

International research suggests asset turnover can fall by more than 10% for every 10% increase in changes to capital gains taxes. Most of these studies focus on equity investment and changes in existing tax rates – meaning that the precise magnitude of changes to farm sales is difficult to estimate with much precision. Table 1 provides a range of possible impacts based on international estimates. The range is from no change, which provides an upper estimate on the magnitude of impact of a CGT, to reduction in sales of 79%, which we deem to be an upper bound on likely impacts. The responsiveness of taxable sales to the introduction of the tax is referred to as ‘elasticity of realisation’ – in the last row of Table 1.

Aside from simply delaying sale, there would be significant opportunities to avoid taxable ‘realisation’ events by keeping assets in the family. The CGT tax proposed by labour would not treat transfers to family members as events where capital gains are assessed.

Note that as turnover falls tax payments fall. This means the tax impact on cashflow gets smaller. This then reduces the impact of the tax on land values which further reduces tax revenue. In the case of the lower bound impact land values fall by only 1%, effective tax rates increase by only 1.4% and crown tax revenues rise by only 0.2%.18

17 The present valued reduction in cashflow is the discounted sum of tax as it rises over time towards a notional $940 million in

2015 – not adjusted for changes in turnover and lower land prices.

18 There would be limited wider or indirect effects of a capital gains tax on the farming sector. The CGT tax would principally

affect personal asset holdings and small business sectors. Moreover, if the farming sector can reduce its exposure to the CGT tax we would expect similar adaptation in other sectors. This means that the overall size and impact on the economy and on sectors supplying farms will be limited. The only potentially material impacts are from reduced returns to R&D. Capital gains on patents and other intellectual property is within scope of the Labour party’s CGT. This means that, other things being equal, rates of return to R&D will fa ll and supply of new technical knowledge could fall. This is more a risk than an impact as changes in the supply of new knowledge will depend crucially on other policies, such as subsidies to R&D.

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Table 1 Impacts of capital gains tax on the farm sector

Nominal $ millions (unless otherwise stated), base year calibrated to 2011 values, PV = present value

No tax

Upper bound

Large impact

Small impact

Lower bound

Property sales (turnover p.a.) 5.0% 5.0% 4.1% 3.3% 1.1%

Change in future cashflow (PV) -11,500 -9,400 -7,600 -2,400

Land value in base year 167,900 156,400 158,500 160,300 165,500

Change in land value in base year -11,500 -9,400 -7,600 -2,400

% change -7% -6% -5% -1%

~ change per farm ($) -115,927 -94,758 -76,613 -24,194

Land value in 15 years 291,700 271,700 275,300 278,500 287,500

Capital gain in 15 years 123,800 115,300 116,800 118,200 122,000

Realised gain 6,200 5,800 4,800 3,900 1,300

Tax rate 15.0% 15.0% 15.0% 15.0%

CGT revenue (t+15) 870 720 590 190

Total tax revenue 111,000 111,870 111,720 111,590 111,190

Long term change in tax revenue 0.8% 0.7% 0.5% 0.2%

Projected effective tax rate 28.0% 34.0% 33.3% 32.3% 29.4%

Elasticity of realisation19

-18% -34% -79%

19 Low-end response value is inferred from Burman and Randolph (1994), ‘Measuring Permanent Responses to Capital-Gains

Tax Changes in Panel Data’, American Economic Review, vol. 84, No.4, pp. 794-809. Mid-range is inferred from Auerbach, Alan J. and Jonathan M. Siegel (2000), ‘Capital Gains Realizations of the Rich and Sophisticated,’ American Economic Review, vol. 90, no.2, pp. 276–282. High-end is from Dowd, T., R. McLelland and A. Muthitacharoen (2012), ‘New Evidence on the Tax Elasticity of Capital Gains’, Congressional Budget Office, CBO Working paper, June 2012, http://www.cbo.gov/sites/default/files/cbofiles/attachments/43334-TaxElasticityCapGains.pdf

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4. Not worth the effort Labour’s proposed CGT would not be a good addition to New Zealand’s tax mix. While the policy has some in-principle appeal, in practice it adds a degree of complication to the tax system for which it is hard to see much in the way of benefit.

The way that CGT is both promoted and protested in the media it sounds like a game change. It isn’t.

The CGT would do little to improve the efficiency and effectiveness of New Zealand’s tax system. The main reason for this is that it would be riddled with exceptions, unresolvable design problems and for all this it would raise very little revenue.

New Zealand could do with innovation and improvement in its tax system and enlarging the tax base to include more capital income is an option but only if it raises sufficient revenue to lower other tax rates.

A CGT as proposed by labour would raise very little revenue so it cannot be used to materially improve the efficiency of the tax system. There is also currently no explicit policy to use the revenue to reduce other tax rates.20

The CGT would have much less impact on the farm sector than might appear at first glance. While the direct tax impact might look large – according to Labour party estimates – the tax reduces sales of farms. This reduces taxable gains and lowers the impact of the tax. This reduces revenue from the CGT – although current farm owners will still see a decline in the value of their farms. The most likely outcome in our view is the tax would raise a nominal $590 million in revenue (+0.5%) in 15 years’ time and reduce current land values by $7.6 billion (-5%).

20 In 2011 the Labour party said it would use revenue from a CGT to offset lower tax revenue from removing GST on fruit and

vegetables. This policy was dropped this year. This change of policy is good as it amounts to broadening the tax base with one hand while narrowing it on another.