Taxing capital incomes – are we doing it the right way?

About fifteen years ago, the new Secretary of the Treasury, Dr Caroline McLeish, was part of a World Bank team that put together a dataset measuring the regulations and taxes that small businesses face in different countries. In conjunction with Price Waterhouse, this group (including an extremely famous Harvard economist) worked out the taxes paid by a standardised 20-person business in its first two years of operation, as well as the taxes its employees pay. 

The authors then used this data to ascertain if there was a consistent relationship between the taxes and regulations that businesses in each country face and the amount of investment taking place in each country. There was: the countries with lower tax rates and less onerous regulations tended to have more investment and more foreign investment. The data were considered so useful that the exercise is now repeated annually. One of the original papers by this group of authors, “The effect of corporate taxes on investment and entrepreneurship” (published in 2010) has been cited more than 750 times. 

New Zealand has low levels of capital for a country of its income level and quite high corporate taxes. 

‘Quite high’ is actually an understatement: in 2004 (that year the data used in the 2010 paper were collected) New Zealand was third highest in the OECD (if social security tax payments made on behalf of workers are excluded), and in 2016 it was the highest. At the same time taxes paid by average workers were the second or third lowest in the OECD, slightly higher than Chile but lower than just about everywhere else. 

The basic reason why New Zealand has relatively high taxes on capital incomes and relatively low taxes on labour incomes is that New Zealand has much smaller social security taxes than almost all other OECD countries, and does not have a compulsory contributory superannuation system. Social Security taxes are only levied on labour income, not capital income, and this forces a wedge between the average tax rates on these two forms of income. On average, OECD countries raise about 9 percent of GDP in these social security taxes. New Zealand raises about 2 percent of GDP, from ACC contributions. 

I have discussed the potential consequences of this in more detail here.  There are at least three theoretical reasons to think that social security taxes – or a compulsory saving scheme – may be a good idea. 

1. First, social security taxes should create fewer disincentives than other taxes, for in most countries the more money a person pays in taxes the larger the pension they receive. (This does not have to be the case, however: Ireland has a social security tax system, but pension entitlement depends on time in the country not the amount a person has paid in taxes.) 
2. Secondly, a compulsory saving scheme may reduce long run wealth inequality. 
3. And thirdly, social security taxes are a very easy way of letting the tax rates on labour incomes and capital incomes diverge.

The argument that there is no good reason for the tax rates on capital and labour income to be the same was formalised by the Nobel Prize winning economists James Mirrlees and Peter Diamond in the early 1970s (in two articles: on the non-taxation of intermediate goods and on an optimal linear income tax). There has been almost universal acceptance of the basic principle by tax economists ever since (see the discussion in Chapter 6 here or here). 

They argued an optimal tax system should result in a trade-off between redistributive equity objectives and production-enhancing efficiency objectives. Since capital incomes are unevenly distributed, the former motive suggests higher taxes on capital incomes. Since capital is supplied more elastically than labour (meaning the supply of labour does not change much when taxes change, but the supply of capital can change a lot or can be directed to sectors with low tax rates), this provides a reason for low taxes on capital incomes. 

This trade-off suggests labour income taxes could be higher or lower than capital income taxes, depending on both preferences for redistribution and the technical responsiveness of labour and capital to tax rates. 

Most countries have decided that tax rates on capital incomes should be lower than tax rates on labour incomes. These countries include Norway, Sweden, Finland and Denmark, – countries famous for their low income inequality and redistributive policies – which have invented the Nordic tax system (the Nordic model). 

The Nordic model has the same initial basic tax rate for capital and labour incomes, but labour incomes are subject to steeply rising marginal tax rates whereas capital incomes are not. The reason: the Scandinavian countries do not want to jeopardise the high levels of capital investment that help generate high incomes in their countries, fearing that high taxes on capital incomes would generate capital flight. 

Furthermore, wages are likely to decline if capital stocks decline in response to taxes, so that the burden of capital income taxation partially falls on workers as lower wages. (This is a widely accepted result, and there is recent empirical evidence from Germany and the United States supporting this idea.) The appropriate tax on capital incomes is not zero, as some theorists have argued, but there are few who argue it should be higher than the tax on labour incomes either. 

So why has New Zealand adopted a tax system that is significantly different from those in most OECD countries? Do these differences create incentives that lead to a low capital, low productivity economy? I suspect that they do, and it is a conversation – with evidence – that New Zealand needs to have.

At least two possibilities, and the assumptions that they require, come to mind.

The first is that there may be fundamental technical reasons why it is efficient for New Zealand to have low taxes on labour incomes and high taxes on capital incomes. The responsiveness of labour to tax rates could be much higher in New Zealand than in other countries, or the responsiveness of capital to tax could be much lower. This could mean it is not optimal to have higher taxes on labour incomes than capital incomes.

Secondly, it could be that New Zealand has a higher preference for income redistribution than other countries, so New Zealanders are prepared to have inefficiently high taxes on capital incomes because of equity considerations. (There is not much evidence that this is true, as our tax system is not particularly redistributive – New Zealand has a low top marginal tax rate, for example).

Either way, it would be useful to understand why New Zealand’s tax system looks so different from those in the rest of the world. We can hope the new Secretary is just the person to ensure the analysis takes place.