Taxation as political football ends in own goals

Raising top tax rates is unlikely to have a good outcome , Thomas Pippos reports.

‘‘I SEE you and raise you’’ seems to be the order of events for the left-leaning opposition parties when it comes to the highest marginal tax rate and the associated trust tax rate – both currently set at 33 per cent.

Labour has previously signalled its plan to lift those rates to 36 per cent. More recently the Greens have stated that they would look to increase them even further to 40 per cent. Emotive language is also being used around those taxpayers having to pay ‘‘their fair share’’, implying that they aren’t already.

Where these rates would finally end up under a centre-left Government is anyone’s guess. The smart money would suggest somewhere between 36 per cent and 40 per cent as the Greens are unlikely to be brushed off in a coalition. That could also be just the beginning of a journey rather than the destination. Once you start raising taxes in such a discriminative manner, or believe that you can raise some taxes relatively easily, there is no real logical limit or upper threshold you can’t breach, particularly if the changes are targeted at a progressively smaller group.

The policy is therefore as much about politics as raising revenue. The impacted group represent 2 per cent of the population that already pay 22 per cent of personal income tax – the most tax per capita in absolute and relative terms. Ironically, they are also not the wealthiest New Zealanders, just those who can’t fall outside of the rules – a segment of the upper middle class.

Raising taxes in this manner is also not without its challenges. At one level it raises revenue, never as much as anticipated, but it also creates a regulatory arbitrage between those higher rates and, in this case, the company rate, which is proposed to stay at 28 per cent.

The taxpayers who will be primarily impacted will be those who can’t divert, or haven’t already diverted, their income into a company structure. The clearest example of this is highly paid employees. After this group, the number of impacted taxpayers will fall away materially as income from businesses, investments and certain income from work can easily and naturally be earned through, and retained in, a corporate vehicle.

In response to this point, it’s been argued that company taxation is merely an interim tax, with the final tax, and level of tax payable on company profits, actually determined by the tax rate applicable to shareholders. Put simply, dividends paid out of companies will always be subject to tax at the shareholder’s marginal tax rate which, if they are an individual or a trust, would still expose that income to the proposed new higher rates upon its distribution.

A problem with this response is that dividend distributions can generally be controlled by the impacted shareholders. If they can’t, say in a widely held company, for example, they can certainly be trapped in a corporate vehicle by interposing another corporate to hold those investments. The upshot is avoiding the new rates can be quite straightforward and natural for many taxpayers. The proposed rules would simply incentivise companies to not distribute earnings.

A separate and opposite issue arises with the trust tax rate proposal. As all of its income would be taxed at the higher rate irrespective of the amount earned, a considerably lower tax rate would likely apply if it were distributed to a beneficiary. This creates an opposite tax incentive for trusts, to distribute income rather than accumulate it.

These are just two simple examples of how what is proposed will provide added focus for taxpayers and their advisers to optimise their tax position – the response to which could easily be a myriad of complicated rules to try to prevent that from happening.

It’s not like we haven’t been there before and, subject to the election outcome, it seems we could be there again. Tax policy’s own Groundhog Day, albeit without a ‘‘happy ever after’’ ending, as there never is when a single tax rate becomes a political football.