Speech to Institute of Chartered Accountants
Rotorua Convention Centre, 1170 Fenton Street, Rotorua
I am sure I do not need to remind you that we have just had a general election, and a new government is in the process of being formed as a result. My remarks today need to be seen in the context of the conventions of a caretaker government. That is, I will not be announcing any initiatives that have not already been canvassed, although I will be discussing progress on the tax policy programme that was in place prior to the election.
Tax was an important election issue, and if I could venture one comment on the election result it would be that it showed a broad level of comfort with the current balance of taxation and expenditure, in light of the outlook for the economy. The most recent economic data tends to support a conservative fiscal stance.
The Pre-Election Update painted a picture of real economic growth slowing to around 2¼ per cent over the coming year, after averaging in excess of 3½ per cent growth over the past five March years. The drivers of this anticipated slowdown are well known - lagged impact of increases in the exchange rate and interest rates, declining net migration, a fall in house price inflation, and expected declines in New Zealand's terms of trade from record highs.
At the same time, the PREFU highlighted some growing macroeconomic imbalances in the economy, and forecast that these would unwind in a fairly benign manner.
Recent current account data show that the imbalance is widening further, and other partial data to date show no signs that this will narrow in the very near term. We cannot rule out the possibility that the current account deficit will rise above 9 per cent of GDP in the next 12 months. The increases in oil prices due to Hurricanes Katrina and Rita have not helped, though prices have retreated from their peak of US$70 per barrel. Although the benign adjustment as painted in the Pre-Election Update is still a possible scenario, we must also consider other scenarios that involve more disruptive paths.
It is not possible to be definitive about the factors that could "tip" the economy over onto a less benign/more disruptive adjustment path. However, the risks of a rapid and disruptive adjustment have increased. This is evidenced by the economic imbalance demonstrated by the increasing current account deficit, and the prospect that oil prices and continuing strong domestic demand could push annual CPI inflation towards 4 per cent. These developments, particularly if they are sustained and become built into expectations, increase the risk of sustained below trend growth and rising unemployment.
From a fiscal perspective the PREFU story remains unchanged. There is nothing to date which suggests any on-going change in tax revenue or expenses.
The PREFU forecasts operating balances of around 3 per cent by 2009, which are used to pre-fund future fiscal costs associated with an ageing population and to invest in capital assets. The result is a nominal borrowing requirement of around $1 billion over the forecast horizon to 2009.
Gross debt is forecast to fall as a percentage of GDP to 19.1 per cent by 2009 and to remain relatively flat out to 2015.
This economic picture highlights the importance of the integrity and sustainability of the New Zealand tax base and the need to keep abreast of the challenges that face us. I will touch on both those challenges and the tax policy decisions awaiting the new government in the remainder of this speech.
Turning first to the important policy decisions awaiting the government, what is decided over the next few weeks will shape much of our policy and legislative work in the tax area over the next six months or so. Those immediate decisions will probably involve matters that were in train when Parliament rose for the general election, as well as commitments made in the lead-up to the election.
Historically, tax was fundamental to the development of our democratic institutions. Parliament rightly guards closely its hard won right to approve taxation. Taxation obviously funds the various spending policies that governments are elected to deliver, and tax is itself about the allocation of society's resources – who pays for what.
All this means that a well functioning and reliable tax system is a great asset for a democracy. A system that is regarded as unfair or inefficient undermines a democracy by thwarting a government's ability to deliver on the policy platforms chosen by the electorate.
In New Zealand we are fortunate in having an excellent tax system on which to base our democracy. This has been achieved over a number of years with the active support of many of you.
The tax system does face challenges, as one would expect in a dynamic economy and a changing demography. Both tax policy and tax administration resources are being stretched to deliver all the things that are wanted. This is not a major problem, but still a challenge. It means that the government will need to focus on its priorities to ensure that they are smoothly delivered. This may mean some other issues, perhaps issues of priority to tax practitioners, may have to take a temporary back seat. But with the normal cooperation I am sure that we can work things through to the reasonable satisfaction of all.
An important early step for any new government is the development of a tax policy work programme that gives effect to its revenue strategy. For the last few years the work programme has covered a period of 18 months or so. Once approved, the work programme is usually released publicly, as part of the generic tax policy process.
Tax policy officials report on a recommended work programme, and once approved – and amended by the government in accordance with its priorities, the work programme becomes a detailed tax policy agreement between the government, Inland Revenue and the Treasury. It is possible that we will have an agreed work programme by the end of the year, or we may have to wait until next year – it all depends on the priorities that are set over the next few weeks.
For those reasons there is not a lot of detailed tax policy that I can discuss with you today. What I can do, however, is broadly update you on what I see as emerging issues over the next three years and some of the early priority decisions the government will face.
About 43 per cent of our tax base comes from the income tax paid by individuals. GST makes up a further 19 per cent, and company income tax about 17 per cent. That is about 80 per cent of our tax base. In all three areas there are risks that need to be managed.
New Zealand collects relatively more revenue at the company tax level than many countries do. In 2002, New Zealand's ratio of company tax as a proportion of GDP was just over 4 per cent, the sixth highest in the OECD. By March of this year the percentage of company tax to GDP had risen even higher, to an estimated 5.1 per cent.
Another prominent feature of our company tax base is the extent to which large companies operating in New Zealand are foreign-owned, mostly by Australian companies. This leaves us vulnerable to some risks in relation to source taxation.
Under current tax rules there are incentives for non-resident companies not to pay tax on income generated in New Zealand. There are many ways they can do this, such as borrowing in New Zealand to finance overseas expenditure, and selling back to New Zealand branches the intellectual property that is developed here. The recent introduction of new thin capitalisation rules for foreign-owned banks operating in New Zealand is an example of a policy response to what the government saw as rapid erosion of the tax base.
One cannot, of course, consider the company tax system without also considering imputation. The imputation system integrates company tax and personal taxation so that company tax is, in economic substance, a withholding tax, since company tax is a down payment on the ultimate shareholder tax levied on dividends. One of the strengths of imputation is that it encourages New Zealand companies with New Zealand shareholders to pay tax, since company tax paid is a benefit to shareholders.
Protecting the corporate tax base will undoubtedly remain a key aspect of the government's tax policy work programme. The revenue the government collects at the company level is about equivalent to what we spend on health care. If companies push too hard to reduce their tax costs, governments will react to protect that revenue base. This is something companies and tax practitioners do need to take into account.
A recent article in "Tax Notes International" stated that "in this post-Enron, post-Worldcom, post-Parmalat world, there is a new dimension of risk associated with overambitious efforts to lower taxes. Now the actions of the tax department can tarnish a company's public image."
In the United States, the article continues, "PricewaterhouseCoopers has asked corporate tax directors: "How will your CEO react to seeing your tax affairs splashed all over the front page of a national newspaper (or even the inside pages)?"
Tax management is not, therefore, just a matter of lowering tax costs. Society expects corporates to invest back into the society in which they do business by way of taxes.
I think we in New Zealand have developed good practices that enable us to work together to manage our tax system. The recent banking legislation was a good example of that.
As you are aware, a critical feature of the imputation system is that imputation credits have no value to non-resident shareholders. This is a critical design feature of the system. Since New Zealand tax on dividends flowing to non-residents is normally limited to 15 per cent under tax treaties, if we refunded to non-resident shareholders the value of imputation credits, our source-based taxation on non-resident owned companies would be limited to 15 per cent. This is why the government has been concerned about arrangements that might allow non-residents to stream or sell off imputation credits.
In the previous administration the government took or announced three measures to protect the imputation system. They relate to imputation credit shopping, securities lending and trans-Tasman redeemable preference shares.
Each was seen as necessary to ensure that we do not directly or indirectly allow imputation credits on tax that is economically or, in substance, attributable to non-residents to flow to residents who can use them. It is accepted that a more coherent policy framework for this issue is desirable and likely to be a priority on the tax policy work programme.
There are also some emerging pressures in the personal income tax system – namely, incentives to split income and to shelter it in companies and trusts, both of which appear to be on the increase. Inland Revenue has stated its concern about this activity. The government needs to consider whether this issue can be handled by administrative actions by Inland Revenue or whether changes in the law are necessary.
Our GST system is much lauded by the rest of the world for its comprehensiveness and simplicity. It deserves its reputation as a model for a pure GST / VAT system. It is, nevertheless, not without its problems.
I am aware of schemes whose central feature is that one person gets a GST refund, but there is no offsetting output tax.
First, there are schemes whereby input tax refunds are claimed by a purchaser registered on an invoice basis, whereas the offsetting output tax is owed by a vendor registered on a cash basis. The output tax liability is deferred to the never-never.
Second, there are schemes whereby the output tax liability is located in insolvent companies that appear and disappear like phoenixes. Hence they are internationally known as "phoenix schemes", I am told. These problems with GST and VAT systems are worldwide. We are following international developments closely and Inland Revenue is active in challenging them. Again, the issue is whether Inland Revenue's administrative response needs to be backed up with legislative change.
To turn briefly to the international scene, New Zealand tax policy cannot be developed in isolation from the rest of the world. Trade and capital flows are increasing, so what were once largely domestic tax issues are increasingly becoming international issues. The large accounting firms have international connections, as is now increasingly the case with law firms. Just as the private sector is ready to change in this way, so must tax policy makers and administrators.
This is why New Zealand has, over recent years, considerably increased its involvement in the OECD's Committee on Fiscal Affairs. While the OECD is limited to thirty members, its outreach programme involves most of the world. The Committee on Fiscal Affairs is, therefore, as close as we have to an international tax forum. New Zealand's influence in that body is something of considerable national value.
The OECD's tax committee is working on a number of areas of real importance to New Zealand. First, there is the continuing review of the OECD model treaty upon which New Zealand's network of 29 tax treaties with other countries is largely based,
The OECD is looking at significant issues relating to the ability of countries like New Zealand to protect their rights to tax income at source.
New Zealand is working closely on the OECD's proposals regarding the taxation of permanent establishments. Proposals to apply transfer pricing rules effectively to allocate asset ownership between a parent and its offshore branch would significantly change traditional practice in calculating branch profit taxation. For example, it would allow the branch to deduct notional interest and royalty payments with no offsetting non-resident withholding tax.
New Zealand sees this as creating considerable risk to source-based taxation, and in line with my earlier comments on the importance of this to our tax base, we are working actively with other OECD countries on this issue.
Another issue is thin capitalisation rules. To protect our tax base we have such rules, but their place in tax treaties is uncertain. New Zealand is working to see if greater clarity on the consistency of such rules can be obtained.
The committee is also looking at the tax treatment of funds known as collective investment vehicles. These vehicles do not fit easily into orthodox tax treaties because of their trust-like structure. Determining when the benefits of tax treaties should or should not apply is under critical considered by the OECD. Should it depend on where a vehicle or fund is resident or where its beneficiaries reside? The committee is also looking at whether the current OECD model gives source countries adequate taxing rights for services.
The OECD is also creating a facility to share knowledge about tax avoidance schemes between tax administrations. It is well known that international firms share such ideas, and it seems valuable for the revenue authorities to do likewise.
Finally, New Zealand continues to participate actively in the OECD's harmful tax practices project. In this area we are working especially closely with Australia, which is hosting a Global Forum on harmful tax practices in Melbourne in November which New Zealand will be attending.
Officials have been working very closely with Australia on harmful tax issues, negotiating jointly with them on eight tax information exchange agreements. We are also cooperating with Australia in the Pacific region – encouraging jurisdictions in the area to adopt the standards for international cooperation on tax matters that were advanced in the previous Berlin Global Forum.
The OECD is one example of New Zealand and Australia developing close cooperation on tax matters. This relationship is very important to New Zealand.
On the tax side we want to develop it as far as we can, in a manner that is mutually beneficial. Officials from both countries have discussed the possibility of a revision of the current double tax agreement. It was recognised that since the current Australia–New Zealand DTA was agreed to in 1995, Australia has altered its policy on non-resident withholding tax on interest dividends and royalties. New Zealand agreed to review its policy on non-resident withholding tax to see whether we believe a move along the same lines would be in our national interest.
This review is likely to be a priority, reflecting the seriousness with which New Zealand takes the trans-Tasman relationship.
When Parliament was dissolved in the lead-up to the election, two revenue-related bills were before the House: the May tax bill – the Taxation (Depreciation, Payment Dates Alignment, FBT and Miscellaneous Provisions) Bill and the Child Support Amendment Bill.
The tax bill had its first reading and was referred to the Finance and Expenditure Committee, which called for submissions by 12 August. The Child Support Amendment Bill was introduced in July and was awaiting its first reading when Parliament rose. Both bills lapsed on dissolution
The Child Support Amendment Bill contained important measures to help deal with debt accumulated by liable parents. It is important that the legislation strikes a correct balance so that liable parents do meet their obligations. I envisage legislation along these lines proceeding in the new Parliament.
The tax bill included a number of measures announced in the 2005 Budget. Overall these were business-friendly measures that would reduce compliance costs, reduce tax and increase business efficiency. On that basis it could be expected that, at least in broad terms, the proposed measures will have reasonably wide support in Parliament.
It therefore seems likely that the tax bill will be reinstated. However, there could be some time before such a bill could be enacted. Parliament needs to meet, by law, no later than 18 November.
Every effort will be made to pass the bill by the end of March 2006. If it is not, it is appreciated that this creates some problems with effective dates of:
- April / May 2005 for depreciation;
- 1 April 2006 for provisional tax and GST date alignment;
- 1 April 2006 for the payroll subsidy; and
- 1 April 2006 for fringe benefit tax – and so on.
All these dates would need to be reviewed in terms of their viability. That means not only their feasibility for taxpayers, but also for Inland Revenue, which has to implement them. The government will be seeking clarity on these matters as early as possible.
The period to the end of this year will be a very busy one. During the election campaign commitments were made to changes to Family Assistance and the Student Loan Scheme, to come into effect on 1 April 2006. For this timetable to be met, policy decisions and legislation will be required quickly. That means the government will need to consider its priorities and what is feasible from a delivery point of view.
If the carbon tax is to come into effect on 1 April 2007, as previously announced, that will require legislation in 2006.
A number of other priority policies will also have to be advanced for announced for timetables to be met. These include KiwiSaver and associated reforms to the taxation of savings entities, which were announced to come into effect on 1 April 2007. This may seem a long way away, but the savings industry requires time to implement any changes, making legislation in 2006 a necessity.
A discussion document on savings entities was released for public comment before the election. Numerous submissions have been received. The most controversial aspect has undoubtedly been the proposed change to the taxation of offshore investment. Commentary and submissions have expressed significant opposition to the proposed changes. They also contain too little acknowledgement of what most who are familiar with this industry publicly or privately admit: that the current rules are not working.
Before the election the government made it clear that it was open to reasonable solutions. The option that submissions seem to favour is taxation limited to dividends. With no capital gains tax and low dividend yields, the result would provide too much incentive to invest offshore. That does not seem to be reasonable.
A priority for the government will be continuing the dialogue that has been started with the private sector to determine whether there is a reasonable and workable solution to what is a difficult and important issue.
All in all this is a very full schedule of issues and legislation. Undoubtedly, the changes that are made will provide plenty of material for your next conference.