Treating Capital Gains Fairly and Efficiently

How might a non-ideological capital gains tax look like?

Someone once told me that a test of being a socialist was whether you supported capital gains taxes. I pointed out that the New Zealand Treasury, the Reserve Bank of New Zealand the IMF and the OECD all supported them.

Not explicitly – perhaps they are implicit socialists – but they all share the standard economic advice that taxation on the return on capital should be neutral, that it should be the same irrespective of where the investment is made. What they are concerned with is that a tax system should not distort investment behaviour by privileging entirely for tax reasons one investment over another. To do so results in inefficient investment and wasted savings.

I am with them. I support a capital gains tax as a way of improving our investment performance. So much so, that I would support using any additional receipts to reduce taxation on savings; I think it pernicious (and unjust to small savers) that the part of an interest payment which is to cover rising prices is taxed, so the government benefits from inflation. (Incidentally it is a view I formed during the Muldoon years of high inflation.) While I am not opposed to improving the tax base, if the government wants to spend more it should raise tax rates.

Taxing the real component of interest rates means we should tax only the real component of capital gains too. But we should not tax them retrospectively. If the tax is imposed from, say, 1 April 2015, then only the gains since that date would be taxed, and gains from the past left untaxed. The purpose of the tax is to influence investment behaviour. Before the date the investment has already occurred so it cannot be influenced. Not incidentally, a retrospective capital gains tax is a very erratic wealth tax; if one favours a wealth tax, then design it properly.

It is difficult to know the precise impact of a capital gain tax. It would discourage purchases of farm land and housing by foreigners, who find New Zealand attractive because capital gains are not taxed. As far as I can, see this does nothing for the performance of the New Zealand economy other than employ real estate agents, lawyers, valuers and the like. (I see no reason why the government should be subsidising them, which is the effect of not having a capital gains tax.)

It would also reduce speculation in the housing market with investors deploying their savings in more productive areas than oversized and under-utilised houses. However, the hard logic of a capital gains tax is that one’s first home should not be subject to capital gains tax; when you sell your home you make a capital gain but when you go on to buy another one you make a capital loss and they roughly cancel out. One could evolve a very complicated regime to deal with anomalies, but nobody would understand it – even the accountants and lawyers who made a mint out of exploiting it. A simple, commonsense and comprehensible approach is what is needed. (You would not levy a capital gains tax retrospectively on a house owned by a dead person. But as it became part of an estate the tax would start to be levied.)

You might wonder if homeowners were not taxed whether there would be any dampening of capital gains in housing. Multiple house owners and speculators would be taxed and would shift their investing elsewhere rather than the practice of tax avoidance that the erratic tax regime on investment generates. That would reduce nominal capital gains in the housing market, making it easier for those without first homes to buy in. That is what is meant by ‘knocking the top off the market’.

What about farmers? Sadly, far too many of them farm for capital gains rather than for a return from farm production. That would be discouraged. (It would make more sense then to get the real exchange rate down so that the extra profitability went into farm investment and production, rather than higher farm prices.)

The list of ‘socialist’ institutions favouring a capital gains tax did not did not include the Inland Revenue Department. They are very aware of the complexities of introducing such a tax. Earlier I illustrated a principle by suggesting what would happen if it was introduced on 1 April 2015. That is far too early. We need a working party to nut out the details (in which the devil lies). The 2010 Tax Working Group muffed the challenge. Sadly, there is no independent centre of expertise which could prepare a report. Unprepared, we will muddle on, wasting savings on inefficient speculative investment and wondering why the performance of New Zealand’s investment remains disappointing.