Capital gains tax – how fair is it really?
There are big flaws in Labour’s capital gains tax, writes Geof Nightingale.
A CAPITAL gains tax is one of Labour’s proposed elements for a good tax system and at its core is the intention of delivering equity and fairness for all New Zealanders.
Yet, if implemented as it is currently promised, would it really deliver fairness?
Well, no, not completely. Labour’s capital gains tax would capture some capital gains that are currently not taxed but it’s certainly not perfect, and fairly big holes in its design loom large.
For instance, if we look at someone who sells their family home and earns $100,000 on its sale. The family home is excluded from the proposed capital gains tax and the homeowner therefore would pay no tax on these earnings. We then compare this with someone who works fulltime all year on a salary of $100,000 and is fully taxed through the PAYE system. Why would these same amounts, acquired through two different means of earnings, not be taxed at the same rate? Many people would even view the worker as more deserving of a lower tax rate, having worked over 2000 hours, rather than the person that sells their house at a profit.
This is where our view of a ‘fair’ world turns opaque. Should tax gains from labour therefore be the same as tax gains from capital – and would this principle then apply to other investments?
If we look at another example, two couples invest the same total amount into property for their own personal use. Mike and Annette buy a family home for $1m and Charlotte and James purchase their family home for $500,000, and also decide to purchase a house at the beach for $500,000. Each couple now has $1m invested in property.
Fast forward three years, Charlotte and James decide to sell their beach house for $600,000, $100,000 more than they paid for it. Under Labour’s capital gains tax, they would be taxed at a rate of 15 per cent on this gain. In contrast, Mike and Annette also decide to sell their family home for $1.2m, making $200,000 from the price they paid for it, and pay no tax on this gain because of the proposed family home exemption. It’s hard to see how that’s a fair outcome in contrast to Charlotte’s and James’.
With Mike’s and Annette’s situation compounded throughout the economy, a capital gains tax with a family home exemption has a ‘‘mansion effect’’ – an unintended consequence of its design. It incentivises people to invest more in their family home rather than diversify into other property investments such as a secondary home, rental property or other alternative investment options like shares.
Coupled with a rising property market, and a policy that incentivises maximising investment in family homes, this embeds property tax preferences in some, but not all, property. Indeed, it unwittingly encourages excessive investment in the family home.
A founding pillar of a good tax system is how it’s designed and, in principle, a capital gains tax is a good design feature. A comprehensive capital gains tax improves the fairness of the tax system, and reduces tax distortions to the type of investment undertaken. However, the less-than-comprehensive type of capital gains tax that people vote for, and which Labour has proposed, doesn’t achieve its objectives.
It might enable a slightly fairer tax system in some cases, although this is dependent on how people organise their tax affairs. It might also decrease the inherent tax unfairness in the system to some extent, but as Charlotte and James found out, it wouldn’t solve all of our problems. Geof Nightingale is PwC’s Tax and Private Business Leader.