A fair capital gains tax would adjust for inflation
Indexation is important for wages, but it’s even more crucial if we’re to avoid hugely distorted capital gains bills, writes Norman Gemmell.
As we wait for the final report from the Tax Working Group (TWG), a new debate was kicked off by National last week over whether the Government should be taxing wage increases to compensate for the effects of price inflation eroding our real incomes.
Tax economists have long advocated that keeping income tax thresholds constant in real terms (by adjusting them upwards as prices rise) should be the norm. But this indexation is much less important for tax on wages than it is for tax on capital gains – a crucial point in the current climate.
To see why, suppose your salary is $1000 a week, annual inflation is 2 per cent and your employer agrees an extra $20 a week over the coming year. Surely you shouldn’t have to pay extra tax on the $20, since your real income won’t change? Actually, not necessarily.
Consider someone paying a 30 per cent average tax rate on their $1000 weekly wage – a bit more than the current New Zealand income tax. They pay $300 in income tax and keep $700. Now the 2 per cent inflation award raises their wage to $1020 a week, so they now pay $306 in tax and keep $714. So, their take-home pay has gone up by 2 per cent, and so has their weekly tax payment. No ‘‘stealth tax’’ here, even though some of the extra $20 has gone in extra tax.
Of course, with New Zealand’s progressive income tax, any wage increase raises your average tax rate. If you don’t move into a higher tax bracket (known as bracket creep), this only generates a tiny increase in your average tax rate. This is the amount of extra tax that is due to inflation.
For people who do move into a higher tax bracket, there will be a slightly bigger increase in their average tax rate, but it is still not very large. Importantly, it can be removed simply by regularly increasing tax brackets in line with general inflation, known as indexation.
But a much bigger immediate design issue lies in wait for the current Government’s response to the Tax Working Group’s recommendations on a capital gains tax (CGT). Capital income, such as capital gains from house sales or interest payments on bank accounts, are much more vulnerable to this ‘‘indexation problem’’.
Consider a simple capital gain example. If house prices rise by 5 per cent but ‘‘general’’ inflation is 2 per cent, the real capital gain for homeowners is 3 per cent, not 5 per cent. Now suppose that a 33 per cent tax-rate payer buys a bach for $100,000 and sells it one year later for $105,000. The CGT liability on the sale is $660, due to the general inflation of 2 per cent, plus $990 for the additional house price increase (the ‘‘real’’ gain).
So the extra tax levied on the inflation component is a whopping two-thirds as big as the ‘‘real’’ tax liability (or 40 per cent of the total). In other words, with a CGT, failing to allow for general inflation means a huge additional tax bill.
This is why CGT regimes in other countries often allow general inflationary increases to be deducted from the value of the CGT base before the tax is calculated. This is in order to avoid the ‘‘effective’’ tax rate on this kind of income being much higher than when the same amount of income is earned from wages.
Some regimes such as Australia’s set the tax rate on capital gains at a lower rate. But this is inevitably approximate and doesn’t adequately deal with the inflation issue, partly because inflation rates vary from year to year.
What does this all mean for the TWG advice and a Government concerned with ‘‘fairness’’? First, adopting National’s indexing of income tax thresholds would be a good idea, and not just for transparency reasons. It is the fair thing to do for taxpayers right across the income scale, who otherwise pay more tax simply because prices have risen.
Also, if the Government decides to go ahead with a CGT, designing out the ‘‘inflation problem’’ is much more important, due to the size of the tax distortion it creates.
It is also important for fairness. Otherwise, what superficially looks like the same tax rate being applied to all income actually means that the effective tax rate on capital gains (and interest income) is much higher than the same rate on income earned as wages.
Surely that’s not fair?
Professor Norman Gemmell is chair in public finance at Victoria University of Wellington’s School of Accounting and Commercial Law.