With the Tax Working Group (TWG) likely to release its final report in late January – a month early – media coverage and public reaction to the polarising tax is heating up. In my view, the consequences of a CGT are far-reaching and potentially massively distortionary.

The Tax Working Group’s interim report released in September stopped short of making a recommendation to the government one way or the other on whether a capital gains tax (CGT) should be introduced.

Instead, it focused on the issues and considerations that would need to be addressed if a CGT was introduced. Its final report in January will contain its recommendation.

New Zealand’s tax system already taxes capital gains in a number of instances.

Taxpayers who purchase assets with the intention to later sell them are technically subject to tax – this applies to all asset classes without exception.

The current taxation of land is another area with specific rules targeting the taxation of capital gains. Over time there has been a move to extend the reach of these rules.

One example is the current five year Brightline rule, which seeks to tax residential investment property bought and disposed of within five years.

The government has asked the TWG to consider the feasibility of a comprehensive CGT that would apply broadly to most asset classes, including all property (except for the family home) shares, and the sale of business assets and goodwill.

Former governments have steered well clear of a CGT, not because it doesn’t have merits (a lot of countries have one), but more than likely because any attempt to introduce one would be political suicide.

The Labour-led coalition is understood to believe the time is right to consider the tax.

They have perhaps come to believe that public sentiment has changed, and been emboldened by surveys that show there is majority support for the introduction of some form of tax on capital.

But there is no doubt bringing in a CGT would be highly polarising and politically charged.

Opposition leader Simon Bridges has already announced that a National government would repeal any CGT if it was introduced, because it believes New Zealanders are currently taxed more than enough.

CGT detractors believe it will be complex to administer and costly for taxpayers to comply with. They may be right.

Rather than exempt assets acquired by taxpayers before the date of application, which would remove the need for costly asset valuations (the Australian approach), the TWG’s preferred approach is to bring all assets into the CGT net from a certain day and require them to be valued at that day.

Conscious of valuation costs, the TWG is unlikely to mandate all assets be professionally valued and is looking at rules of thumb, whereby values could be determined based on rateable or accounting values.

This may placate a lot of taxpayers, but not all. Faced with the prospect of a large tax bill when assets are sold, many taxpayers will want to obtain an optimum valuation, so will inevitably fork out for professional valuations.

In practical terms, valuation costs are likely to pale in comparison with the ongoing costs required to interpret and apply any CGT rules.

While the government may attempt to try and keep the rules as simple as possible, given the varying circumstances and situations, the rules will need to be extensive.

As with the tax rules now, there will be instances where the legislation is not clear or does not cover all situations.

A larger issue will be the potential distortionary effects a CGT will have on taxpayer behaviour.

In an ideal New Zealand, all types of investments would be taxed in the same way and so investors, all things being considered equal, would seek investments that returned the highest pre-tax profit.

Scarce resources would be allocated to their highest and most productive use, markets would function efficiently – and the sun would always shine.

This is not the case currently across assets classes and is unlikely to be the case under any CGT. This is not because there is no appetite to treat investments the same way, but given the nature and nuances of different classes of investments, it is not always practicable to do so.

New Zealand’s housing market is often used as an example of how investment decisions can be distorted by the tax system.

And a CGT is seen by many supporters as a magic elixir that will fix the country’s housing affordability woes.

However, the TWG has already expressed as its view that tax has “not played a large role in the state of NZ’s housing market, and will be unlikely to play a role in fixing it.”

It would be interesting to know how just how many of the oft publicised “majority” of New Zealanders who support a CGT would still be supporters if they knew it was unlikely to fix the housing market.

There have already been grumblings from the New Zealand Stock Exchange, which has urged the TWG to recommend the government keeps NZ shares exempt from a CGT.

Its concern is that collectively owned portfolio investment entities (PIEs) may be exempted, given the difficultly in applying a CGT.

But this would create an uneven playing field between direct investors who invest indirectly through PIEs and could potentially damage New Zealand’s capital markets.

Further, a letter from the Ministers of Revenue and Finance to the TWG invited the group to consider whether a tax-free threshold for the application of CGT on the sale of businesses would be
appropriate.

Estimates put the current amount of untaxed gains in SMEs to be approximately 20 percent of accounting profits, so the impact of a CGT on SMEs could in fact be considerable.

The government would look better if it exempted the small business owner’s capital profits from CGT.

So already further potential exemptions and exceptions are creeping in. The more exemptions and exceptions a tax, has the more it is prone to distorting tax payer behaviour.

In a small economy such as NZ’s the potential effects a CGT will be of a greater magnitude than the additional amount of tax revenue it is likely to generate, or the perceived inequity between the haves and the have-nots it will attempt to address.

TWG chairman, Sir Michael Cullen, believes it’s now or never if a capital gains tax is to be introduced, as such a move would become more politically unpalatable as New Zealand’s population ages.

One thing is certain, if a CGT is introduced Kiwis will pay more tax and have greater compliance costs than they currently do.

The comments in this article are of a general nature and should not be relied on for specific cases, where readers should seek professional advice.

Grant Neagle