Thursday, April 13, 2006

Brian Fallow: Own-goal risk with new tax plan

There was a whiff of political tribalism in the air on Tuesday when the Government unveiled its long-awaited overhaul of the investment taxation regime.

The upshot is liable to be an economic own-goal: turning what you might call expatriate Kiwi capital into the permanently exiled variety.

As always in such an exercise there would be winners and losers, said Finance Minister Michael Cullen.

"The winners will be thousands of ordinary, hard-working New Zealanders the Government is helping achieve long-term financial security," he said.

"The losers will tend to be sophisticated direct-investors who have enjoyed considerable tax advantages under the old regime and who have the ability to easily adjust their investment arrangements."

The Government deserves some credit for trying to tidy up an area of the tax laws that has long been riddled with anomalies.

The tax rules are different depending on whether investment is direct or through an intermediary vehicle, active or passive, in New Zealand or offshore, and if offshore in a "grey list" country or somewhere else.

Addressing the long-standing absurdity of taxing the return on savings of people in the low-to-middle income bracket at 33c in the dollar, when their other income is taxed at 19.5c, has become urgent with the advent of the KiwiSaver workplace superannuation scheme next April.

It would be hard to encourage people to save through vehicles that are taxed harder than the savers' other income.

And it makes sense to address the equally long-standing complaint of the managed funds industry that capital gains they make on their investors' behalf from local shares are taxed while the same profits the same investors would make if they held the shares directly or through a passive fund are not.

There is even a case in the spirit of CER for exempting investment into Australia from the rules applying to more remote and distant investment destinations.

But it is hard to discern any principled reason for setting a de minimis threshold of $50,000 as the cut-off point between gentle and harsh tax treatment of equity investment elsewhere in the world.

It is a political number. It is a number which says: "Who cares about the 10,000 to 20,000 people on the wrong side of that line; they don't vote for us anyway."

It is hard to justify these days the arbitrary division of the rest of the world into grey list and non-grey list countries.

The grey list consists of Australia, Britain, Canada, Germany, Japan, Norway, Spain and the United States. They are exempted from the tough foreign investment fund (FIF) regime which was adopted in the wake of Winebox-like rorts involving tax havens.

The assumption was that the countries on the list taxed businesses at a similar rate to New Zealand and it was, therefore, reasonable to treat investors putting money into those countries roughly the same as those investing at home.

The arbitrary line left most of Asia and Europe out.

The task of levelling that playing field, without leaving the door wide open to wholesale tax avoidance, would be daunting indeed.

But what the Government has come up with, even after taking aboard a lot of the points made in the hailstorm of criticism its original proposal engendered, still amounts to a capital gains tax on investment into countries that did not formerly attract it.

True, the impact is mitigated in a timing sense by the 5 per cent cap and rollover provisions.

A particularly good year for the Dow or the Footsie, or a big fall in the kiwi dollar like that now under way, could easily push the value of an investors' offshore equity holdings up by much more than the annual cap of 5 per cent of the value at the start of the year.

The rollover provisions allow a degree of smoothing through periods of relative market strength and weakness and the gyrations of the exchange rate cycle.

But the bottom line is that if an investor wants to sell up and bring the money home he or she may well be deterred from doing so by the prospect of a hefty tax bill.

Capital gains taxes are commonly criticised for locking investors into an asset they might otherwise want to quit. Such rigidities are not economically efficient.

This case would be less one of locking in than locking out. The new rules give investors an incentive to keep capital out of the country, turning expatriate dollars into exiled ones.

The investors involved are likely to have less reason than the rest of us to bring their money home and perhaps more opportunity in the way of overseas travel, children on their OE and so on, to use the funds offshore.

Death also puts the money out of the taxman's reach.

The temptation for outright evasion - what the taxman doesn't know won't hurt him - will be increased if the tax is seen as an excessive new impost.

At the very least, it will be an enforcement challenge for Inland Revenue and tend to undermine the voluntary compliance which is the foundation of the present approach to tax administration.

The flipside of the locking-out effect is a ghettoising effect, with the tax regime encouraging investors to keep their money in New Zealand or Australia.

More likely Australia, because the New Zealand equities market has already been pretty comprehensively hollowed out.

The stock exchange has long resembled nothing so much as a rather low-rent motel on the road from state ownership to foreign ownership.

Removing a couple of disincentives to invest by way of managed funds in New Zealand listed companies may at the margin increase the uptake of KiwiSaver schemes and thereby the pool of capital available locally.

But that effect will be offset by less chance of attracting back capital which has already left the country.

The same sort of mindset was evident in last month's announcement that new immigrants are to be exempt from New Zealand tax on most foreign income for four years, but returning expatriates will need to have been away for 10 years to qualify for the same relief.

Why not four years, to match the period of the (limited) tax holiday?

Whether it is a matter of attracting back expatriate talent and enterprise, or expatriate capital, we cannot afford to be as cavalier as this.

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