Capital gains tax – the effects

The capital gains tax (CGT) debate is heating up. Opposition politicians claim in the absence of a CGT “speculators” are getting away without paying tax and contributing to the high cost of housing. The government on the other hand says speculators are already taxed, and affordability issues are more to do with supply than demand; which it is dealing with by requiring councils to make more land available and changing regulations to make it easier to build.

Here is a fairly quick summary of some key points regarding CGT as proposed by Labour.

Most economists and tax experts think it is impractical, not because they think a capital gains tax as such is necessarily a bad idea, but because a long-history of CGTs in other parts of the world suggests that if a CGT is to work it needs to be simple and universal – in other words it needs to be “pure”. They also generally believe if it is introduced it should replace other taxes rather than add to the tax burden (income tax generally because it is a disincentive for people to work).

Here are some of the issues that arise from Labour’s proposal:

  1. The family home will be exempt (as will Maori land as it happens). Experience overseas has shown this creates what is called the “mansion effect”. Money flows into the area of lowest tax – which will be family homes. Less will go into shares and property for rent. Someone with a spare $50,000 or so will instead put an extension on their home, knowing that when they retire they can sell their home and buy something smaller and cheaper and make what they expect to be a tidy tax free gain. Some property investors may do likewise. Instead of pumping cash into their rental properties and putting up with the endless hassles of dealing with tenants, they will sell their rentals and put all of the cash into a mansion (swimming pool, tennis court, etc) knowing that they may as well enjoy their capital and reap a tax free gain when they sell. Others will of course simply become recidivist home buyers and sellers. Buy, live in it for a while, sell and buy something better, sell and buy something better and so on. The result will be a large amount of unproductive money invested in oversize homes. Less money will be put in rental properties so rents will rise and the taxpayer will have to provide more state houses instead of private landlords.
  2. Art collections will be exempt. So we will have mansions with lots of art on the walls and filling vacant spaces.
  3. All assets subject to the CGT would have to be valued as at a specified (“V”) date. How practical is that? There will be all sorts of rackets and disputes coming out of that requirement.
  4. No adjustment will be taken for inflation. As a result most of the gains that will be taxed will be “illusory”, especially in provincial areas. For example, this year the inflation rate is expected to be about 3%. Let’s say that results in the value of your investment property rising from say $300,000 to $309,000. You sell after one year and will be taxed at 15% of the $9,000 inflationary gain ($1,350) even those the “real” inflation adjusted value of the property has not changed. What’s fair about that? The more inflation the government creates, the greater the tax it will collect. That’s perverse.
  5.  Although all capital gains on the sale of investment property would be taxed (at 15%) the existing “intention” test would be retained so those who buy with the intention of selling would still be taxed at their marginal rate as though it were income. That would actually add to the confusion that already exists. Most countries with a CGT do not mix income and capital gains in this way.

 

These are just some of the problems with a CGT. Those problems have been widely discussed over many decades by various expert panels. For example, in 2001 the McLeod Committee concluded, “We do not consider that New Zealand should adopt a general realisations-based capital gains tax. We do not believe that such a tax would make our tax system fairer and more efficient, nor do we believe that it would lower tax avoidance or raise substantial revenue that could be used to reduce rates. Instead, such a tax would increase the complexity and costs of our system.”

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