Report to the Treasurer and Minister of revenue - by a committee of experts on tax compliance: Report to the Treasurer and Minis

Bill Birch Treasurer

Report to the Treasurer and Minister of revenue

By a committee of experts on tax compliance

Chapter 1 -
Simplicity and Coherence

Introduction

1.1 New Zealand first enacted an income
tax law in 1891. Since that time, the legislation has become increasingly
complex. For many years, people have entertained hopes that tax law can be made
simpler, only to have those hopes disappointed as reforms have added more and
more pages of legislation. Many taxpayers and their advisers feel let down by
the process of tax reform. Why do things seem to get worse rather than better?
Why can governments not make a better job of reform?

1.2 These are good questions. With all the resources that have been poured
into decades of tax reform, both in New Zealand and in other countries,
taxpayers may come to believe that a measure of scepticism is justified on their
part: surely, reformers could do better if only they tried harder. On the face
of it, this is a reasonable conclusion. But it fails to take into account a
pervasive and ultimately unresolvable factor: the paradox of tax policy, which
may be called for convenience "the fiscal paradox".

The fiscal paradox, neutrality and complexity

1.3 The fiscal paradox is that the more
neutral and more equitable a government makes its income tax system, the more
complex that system becomes. This paradox shapes the results of modern tax
reform, because most governments rightly regard neutrality and equity as key
goals of tax policy.

1.4 The policy of neutrality stipulates that the tax system should be neutral
between taxpayers: as far as possible all income should be taxed in the same
manner, whoever the taxpayers, whatever the form of the transaction, and
whatever the structure of the business or investment. To put it another way, the
tax system should not influence people's economic decisions, and income should
be taxed according to a "comprehensive" definition. During the late 1980s, the
pursuit of neutrality led New Zealand to eliminate many of the provisions of the
Income Tax Act 1976 that preferred one type of business activity, or one type of
investment structure over others.

1.5 The policy of equity stipulates that people similarly situated should be
taxed in the same way at the same rate.

Economic costs of taxation

  1.6 Taxation imposes economic costs on
society arising from the costs of compliance and administration, and the effects
on taxpayer behaviour. These costs are different from the revenue cost of the
tax itself, which is a transfer of wealth from the taxpayer to the government,
and so is not itself a net cost to society. Compliance, administration, and
behavioural costs of taxation are, however, costs to society. Called deadweight
costs these are the costs incurred as a result of the tax system which are not
expended directly for consumption or wealth-generating activities. Reducing
these costs, which is a goal of the committee, is therefore beneficial to
society.

1.7 For every dollar of tax collected, the Inland Revenue Department's
administration costs are on average, 1.2 cents. Thus for every dollar of tax
collected, the government expends 98.8 cents on goods and services other than
revenue collection. Taxpayers and others also incur costs in meeting their
obligations under the tax laws. These compliance costs can be quite significant.
Borne in the first instance by the person incurring the costs, they are
ultimately a cost to society.

1.8 The effect of taxation on behaviour is a far larger deadweight cost than
compliance and administrative costs. Taxation affects individuals' decisions to
improve their skills, participate in the labour force, work, save, invest and
take risks. Of particular concern is the way in which taxation affects
investment decisions.

1.9 Without tax, investors generally will invest in sectors where they expect
to earn the highest return commensurate with risk. This pattern of investment
maximises the wealth of the investor and of society. If the tax system imposes a
different rate of tax on different investments, it distorts investment
decisions, with the result that society's wealth is not maximised. This effect
is known as allocative inefficiency.

1.10 For example, assume an investment opportunity is expected to earn a 10
per cent pre-tax return, and will be subject to 33 per cent tax. The investment
will return 6.7 per cent to the investor (the post-tax return), but 10 per cent
to society (since society would earn the total 10 per cent return, divided
between the investor and the government). An alternative investment may earn an
8 per cent return but, due to tax concessions, it is taxed at an effective rate
of 10 per cent. This investment earns the investor an after-tax return of 7.2
per cent, so this is the investment that the investor will choose. However, the
investment earns society a total return of only 8 per cent. The tax system
would, therefore, be encouraging private investors to make investments which do
not earn society as high a return as it would earn if the tax system were not
distorting investment decisions.

1.11 These allocative costs have generally been recognised
as by far the greatest costs of the tax system. A conservative estimate1 of the allocative or deadweight costs
relating to taxing employment income in New Zealand in 1991 was 18 cents per
dollar collected. The deadweight costs of taxes on income from capital, for
example, interest, dividends and rent, would be considerably higher.

1.12 Ideally, all income should be taxed at as even a rate as possible.
Pursuing horizontal equity, however, brings disadvantages in terms of simplicity
and compliance costs. For example, the accrual rules in subpart HF of the Income
Tax Act 1994 are intended to measure the actual (economic) income from financial
arrangements in which the legal entitlement to income is deferred beyond the
period in which the income arises. While it is clear that compliance costs would
be reduced by repealing the accrual rules, the economic costs in terms of
increasing tax distortions and the resulting allocative efficiency costs may
well be far greater.

1.13 Treating different forms of income differently not only
offends horizontal equity and increases deadweight costs, it also creates
boundaries, which create opportunities for tax arbitrage and, therefore, tax
avoidance2. It also
increases the complexity and reduces the coherence of the tax system, especially
when accompanied by anti-avoidance rules designed to prevent the unintended
exploitation of the comparatively favourable tax regime.

1.14 Designing a tax system requires an appreciation of certain trade-offs.
On the one hand, the system should be simple and should minimise compliance
costs, administrative costs and economic efficiency costs. On the other hand,
the system should also pursue horizontal and vertical equity objectives, and
whatever social and economic policy objectives the government wishes to further
through the tax system.

Complexity in drafting

1.15 To the question, "Why does the Income
Tax Act 1994 not contain one simple provision that taxes people on their income
from year to year?", the answer is that first, the Act does contain such a
provision, it is currently numbered as section CD 5; and secondly, most of the
other charging, deductions, and timing provisions in part C to part N of the
Act, and the definition provisions in part O, have a different, though closely
related, function to promote neutrality and horizontal equity. Part J, repealed
from the start of the 1998-99 income year, and part K are exceptions.

1.16 Together, parts C to O, without parts J and K, make up well over 90 per
cent of the Act. Broadly speaking, these provisions prevent taxpayers converting
gains from revenue to capital. The provisions also prevent taxpayers creating or
accelerating expenses that can be deducted in calculating net income, and also
deferring the recognition of income and, therefore, its taxation, from one year
to the next. If taxpayers engage in this last practice, they get an economic
benefit from the time value of money.

1.17 If allowed, each of these activities erodes the revenue base, affects
the Act's neutrality, and reduces horizontal equity. A few provisions have the
opposite effect, that is, they prevent people being taxed twice on the same
income, or being taxed at a rate that is too high in their personal
circumstances.

Political and social policies

1.18 Two factors that add complexity
appear to be tax policies but are more correctly categorised as political or
social policies. These factors are the lack of a comprehensive tax on capital
gains and the progressive income tax scale.

1.19 As noted above, the Income Tax Act 1994 contains provisions to prevent
people converting revenue gains to capital gains, or capital expenditure to
deductible revenue expenditure.

1.20 The second factor is a function of a policy sometimes called vertical
equity, which stipulates that richer people should pay a bigger fraction of
their income in tax than poorer people. An income tax system achieves vertical
equity by having a progressive average scale of tax rates. That is, lower slices
of an individual's income are taxed at lower rates than higher slices. From 1
July 1998, taking into account the low income rebate, New Zealand's marginal tax
scale is as follows:



Income Tax

Rate

$0 - $9,500

15%
$9,501 - $38,000 21%
above $38,000

33%

1.21 Neither the absence of a
comprehensive tax on capital gains nor a progressive scale is an essential
feature of an income tax regime. But for historical, social and political
reasons, New Zealand embraces both. Consideration of these features is outside
the committee's terms of reference. Generally speaking, the exemption for
capital gains favours richer people over poorer people, because the former are
more often in a position to derive economic gains as capital rather than as
revenue. On the other hand, a progressive scale favours poorer people, because
it causes them to pay a smaller fraction of their income in tax.

1.22 Importantly for the committee's terms of reference, a progressive scale
entails greater complexity than a single flat tax rate, because there must be
rules to ensure that the Crown taxes income at the different rates that are
appropriate for the individuals who derive the economic benefit of the income.

1.23 The fact that New Zealand does not have a comprehensive capital gains
tax in itself creates complexity. From this fact, it may be inferred that if
there were such a tax, this would solve the issue of complexity. But that does
not necessarily follow. Introducing some models might make the situation more
complex, although equity would be enhanced. The capital gains tax envisaged in
the 1989 government discussion document is simpler than some models. On balance,
in terms of complexity, the lack of a comprehensive tax on capital gains may be
beneficial.

1.24 The last paragraph does not express an opinion on whether New Zealand
should tax capital gains. The reason for taxing these gains would be to
eliminate the current tax preference in favour of gains that occur in a capital
form. The committee merely points out that taxing capital gains, like almost
anything else that a tax system does to promote economic neutrality, entails
complexity and costs of compliance.

Examples of the fiscal paradox in action

1.25 Examples of policies that promote
neutrality and that lead to complexity are not hard to find. The committee takes
one case in which Parliament's object is to prevent taxpayers exploiting a
potential absence of neutrality; a second case in which the government tried to
prevent people being taxed at an inappropriately high rate; and a third case, in
which the overall policy is to relieve the taxpayer from unduly high rates, but
where Parliament was required to incorporate additional rules to frustrate
taxpayers who might otherwise exploit elements of the regime favourable to them.
These examples illustrate the problems of both a progressive scale and the lack
of a comprehensive tax on capital gains. The examples are the accrual rules, the
still-born tax credit system for superannuation funds and life offices, and the
imputation system for company and shareholder taxation.

The accrual rules

1.26 Properly called the "qualified accruals rules", these rules are found in
subpart EH of the Income Tax Act 1994. They are generally regarded as the most
complex regime in the Act. Their function is to prevent taxpayers exploiting the
time value of money. Take a taxpayer who lends $1,000 for, say, five years, for
a single payment of $1,645 that is payable at the end of the five years. The
amount of $645 represents interest at 10 per cent per annum, compounding
monthly, and is the compensation to the taxpayer for not being able to use the
$1,000 over the five-year period. But in the absence of the accrual rules or
similar provisions no tax is payable until the end of year five. Conversely,
taxpayers can achieve an effect that is similarly beneficial from an economic
point of view, by borrowing for a term and incurring and deducting all interest
on day one. This technique was fundamental to many tax-saving schemes of the
early 1980s in which interest was payable to parties who were based in the Cook
Islands and were associated with the taxpayer.

1.27 The accrual rules oblige taxpayers to spread interest on a loan or debt
over the duration of the contract. But to operate effectively, the rules must
cover not only loans, but also other financial arrangements that can have
similar economic effects, such as, credit sales, bonds, transactions involving
foreign exchange, and so on. The upshot is that the methods of calculation and
of application of the rules are very complex. Indeed, it is doubtful whether the
rules could have operated at all before the ready availability of programmable
calculators. On the other hand, the rules have the benefit of taxing people who
are parties to financial arrangements and whose gains arise from year to year in
the same way in which wage and salary earners are taxed. In short, the rules
promote neutrality and horizontal equity between the two groups.

The tax credit system

1.28 New Zealand tries to tax all forms of
savings at the same rate through rules known as "TTE", that is, taxed, taxed,
exempt. Contributions to savings, or to bank accounts are from taxed
income; accretions of income earned by savings, or by bank balances are
taxed as they are added to savings; and when savings are paid out on
retirement or otherwise, the payments are exempt in the hands of the
recipient.

1.29 When a superannuation fund earns money on principal that its members
have contributed, the fund pays tax on the accretion. The tax is levied at a
flat 33 per cent, the same rate as the tax on money held in other investment
vehicles, such as companies, life insurance funds, and so on.

1.30 On the other hand, individuals are taxed on a progressive scale. What
happens to income in a savings institution that belongs to an individual whose
marginal tax rate is less than 33 per cent? One way or another, New Zealand
tries to ensure that such income is taxed at the individual's rate, not at the
rate of 33 per cent that applies to the institution.

1.31 When the savings vehicle is a bank account and the income is interest,
this objective is relatively easy to attain. The bank deducts withholding tax
from interest that it credits to depositors" accounts. It pays the tax to the
Inland Revenue Department. As taxpayers, depositors file individual returns of
income, and pay extra tax or receive a refund, according to whether tax was
withheld from their interest at the appropriate rate.

1.32 When the vehicle is a company, the imputation system has a similar
effect. The company pays tax at 33 per cent, but attaches a credit for the tax
to dividends paid to shareholders. If the tax that the company paid was at a
rate higher than a shareholder's personal marginal rate, the shareholder
receives a credit for the excess.

1.33 It is very hard to apply machinery of this sort to superannuation funds.
Superannuation funds pool the savings of members, so cannot easily identify
interest. Superannuation funds do not pay dividends on a regular basis, so
cannot impute credits to members as companies impute credits to shareholders.
The result is that, but for specific legislative initiatives, taxpayers with a
marginal tax rate of, say, 21 per cent will pay tax at 21 per cent on interest
on bank deposits, but will incur tax at the rate of 33 per cent on accretions to
their interests in superannuation funds.

1.34 The government sought to address this anomaly in 1998 by proposing a
system of tax credits. The government was unable to secure the passage of these
rules through Parliament. These rules would have allowed superannuation funds
and life offices to credit tax paid at the fund level to the individual savers.
Excess tax paid on behalf of low-rate fund members would have been credited to
their account. This proposal would have had the effect of taxing members at
their individual tax rate.

1.35 The mechanism required to achieve this result, however, was necessarily
complex, and would have imposed compliance costs. When this mechanism was framed
in legislation, that legislation could not help but be complicated. The
mechanism compounds in one set of rules three requirements that are complex even
when they are found individually. These requirements are rules that provide for
one taxpayer's circumstances to influence the tax rate enjoyed by another
taxpayer, rules about apportionment, and rules that keep benefits isolated and
identified over a number of tax years.

The imputation system for company and
shareholder taxation

1.36 The Income Tax Act 1994 contains different rules for taxing income
earned through different legal entities, required by virtue of the different
legal relationships and different entitlements to income. In principle, the Act
should tax the income earned by or on behalf of an individual at the time it is
earned.

1.37 To achieve the goals of equity and efficiency, the person who should be
taxed, or who should bear the tax, is the person entitled to the income earned
on his or her behalf. Equity is measured by the relative tax burdens of people,
not of legal entities.

1.38 Efficiency is also achieved by measuring and regulating the tax impact
on the people who control investments and who make decisions on how much they
work, save and invest. These people may act through companies, but individuals
make the decisions, and they do so, by and large, in their self-interest. It may
appear, then, that the way to achieve the goal of taxing the income of
individuals is to tax them on income received, imposing tax when a shareholder
receives a dividend, without imposing any company tax.

1.39 Such an approach would be simple, and would reduce compliance costs. But
it would not achieve the goal of taxing income earned at the individual level,
because the income may not be received until some years after it is earned by
the company. The longer the period of deferral between the time of earning and
the time of receipt, the greater the reduction in the effective tax rate. Taxing
company income on the basis of distributions alone, therefore, would violate
objectives of horizontal equity and efficiency, because shareholder income
earned through different companies could be subject to different effective tax
rates, depending on the distribution policies of the companies.

1.40 A way around this difficulty would be to attribute company income
directly to shareholders. The shareholders could then be taxed directly on the
income attributed to them through the company. This solution, however,
introduces its own complexities. The shareholders would have to know their share
of the taxable income of the company. Requiring the company to notify
shareholders of their income would address the problem, but would carry
compliance costs. The taxable income would need to be allocated across the
shareholders according to their participant rights at particular times of the
year. The shareholders would still have to pay tax, and they might have cash
flow difficulties if the company had not paid them a dividend. Addressing the
problem in this way would also negate some of the savings expected to be
achieved through the proposed reforms to eliminate the filing of tax returns, as
shareholders would have to file tax returns to pay their tax on attributed
company earnings.

1.41 The method actually used to pay tax on company earnings is the
imputation system, by which the company calculates and pays tax on its earnings
on behalf of its shareholders. Its shareholders are taxed on dividends, but are
entitled to a credit for tax paid by the company on their behalf. This method
achieves the compliance cost savings of having the company calculate and pay the
tax, but the tax burden is imposed as proxy for the shareholders being charged
tax on their share of the company's taxable income for the current year.

1.42 The imputation system works well for companies. However, different rules
are necessary for different legal entities because of the legal relationships
created by different entities, and because of the difficulties of determining
who is entitled to income earned through them. For example, people working in
partnerships are taxed directly on income earned through the partnership. The
partners are co-owners of the underlying assets of the partnership and legally
own their share of the income earned by the partnership. Trust income has its
own regime. Broadly speaking, income that is distributed is taxed to
beneficiaries who receive it, and income that is retained is taxed to the
trustee.

1.43 While the policy goal is the same, namely that the cost of the tax
should be borne by the person entitled to the income, and should be determined
at the time the income is earned, different legal mechanisms are used because of
the different legal relationships that arise.

1.44 An irony of the full imputation regime is that, although its purpose is
to liberate taxpayers from the non-neutrality of the former system of taxing
both companies and shareholders, most of its provisions are designed to prevent
taxpayers creating other non-neutral entities, by converting revenue into
capital or by exploiting rate differentials between different taxpayers. Take,
for example, the 10 or 12 pages of rules in subpart ME of the Income Tax Act
1994, which govern the operation of imputation credit accounts.

1.45 Though framed as rules that govern this particular kind of memorandum
account, the provisions are, in fact, substantive rules that determine how and
when companies are permitted to attach tax credits to dividends. Broadly
speaking, the principal objective of the rules is to ensure that the people, who
as shareholders indirectly bear tax that is paid by a company are, first, the
same people who derive the benefit of that tax when it is distributed as a
credit, and secondly, when they derive that benefit, they do so in shares that
are proportionate to their shares in the company. That is, shareholders who
enjoy a low tax rate cannot transfer the benefit of tax credits to shareholders
who have a higher rate. This objective is pursued within an overall framework
that, for reasons of practicality, treats company profits and tax as the
fungible sums that they undoubtedly are, and does not require companies to make
an artificial link between an identified dollar of profit and a particular 33
cents of tax levied on that dollar.

Summary

1.46 These days, people generally regard
taxes as a cost that they bear in order to maintain the kind of society that
they hope to enjoy. There is, of course, disagreement on the level of tax that
is most efficient for this purpose. But people are less willing to bear the
compliance and administrative costs of taxation, because they are aware that
these imposts are mere transaction costs that, in themselves, have no direct
value to society or to the individual. As the committee explained earlier, the
behavioural costs of taxation are an even more serious burden on society than
compliance and administration costs.

1.47 While it is generally agreed that there should be some taxation, people,
especially those in business, are dissatisfied by levels of compliance and
administrative costs, and entertain hopes that these costs can be significantly
reduced. These hopes are not entirely misplaced. Throughout this report, the
committee recommends improvements that can be made to the tax system, many of
which are already under way. But at the same time, the committee emphasises that
income tax, for all its virtues as a source of public funds, is a system that by
its very nature results in rather heavy compliance and administrative costs.
These costs must fall more heavily on businesses than on employees, because of
the greater complexity of the affairs of businesses. In the wider interest of
containing overall deadweight costs, businesses and in particular employers are
convenient vehicles for achieving administrative goals. This consideration
raises important issues of whether, when businesses are used in this way, they
should be compensated by the government for net costs borne in the wider
interest of the taxpaying community. This matter is outside the committee's
terms of reference.

1.48 The costs just mentioned are necessarily increased in jurisdictions
employing progressive tax rate scales. However, while there are many reasons for
complexity in income tax law, the most pervasive is the policy of making the tax
system as neutral and as equitable as possible.

1.49 The committee has gone into some detail in its discussion of what it has
called "the fiscal paradox" because it believes that the operation of this
influence is not well understood. Many people have heard that the major values
of tax policy are neutrality, horizontal equity and simplicity (being shorthand
for minimised costs of compliance and administration). What they have not heard
is that these values are in conflict. Even many tax professionals have a less
than perfect understanding of the problem. The committee hopes that its
explanation and the examples that it has chosen will shed light on the subject.


Footnotes

1 Diewert and Lawrence, 1994, The Marginal Costs of Taxation in
New Zealand, Swan Consultants Ltd. Back

2 See discussion in paras 6.18 to 6.34. Back