Taxing To The Hilt: The Failed Socialist Experiment

The great mistake that Socialists make about the world is that individuals behaviour does not change by altering the tax system. This is their justification for not cutting taxes when tax cuts are affordable: that they refuse to acknowledge the overwhelming evidence that tax changes influence individual economic activities, which have a massive cumulative effect on the overall economy.

The most startling case in point is the current state of the property market. The principal reason that that the Auckland residential property market has been running so hot over the last few years has nothing to do with sound macroeconomics; even the most basic economist will tell you that housing is not a productive investment. It does not, of itself, create wealth. But it is a sensible individual choice, based in large part to the peculiarities of the tax system that Michael Cullen governs.

The reality is that while it is nonsensical that investment property attracts so much individual investment, compared to productive assets, it is very sensible at the individual level. The reason it makes sense is that for small, individual investors, capital gains on investment properties are not taxed.

Personal income is taxed. At sixty thousand dollars, an investor is paying twice the marginal tax than somebody earning thirty-eight thousand dollars a year. The Socialist mantra claims, for some reason, that this is a fair arrangement. The individual taxpayer, who is by no means wealthy, but is striving hard to earn sixty thousand a year, does not feel that same degree of fairness. Unfairness soon leads to resentment. And resentment leads to people looking at ways of behaving differently.

There are various, widely-known mechanisms and financial products in the market to deliver tax-free capital gains to off-set personal income tax. And there are many individual investors—principally those who are earning over $60,000 per year—who are taking advantage of their legal entitlements.

Gone are the days when investment in residential property was a time-consuming affair, associated with the pitfalls of finding a good tenant to a property. There are several companies in the market that provide an end-to-end property investment service, from development of the property, financing, provision of legal advice, valuation of the property, tenancy and maintenance management, and guarantees of rental returns. An ordinary investor can enter the residential property market, having expended no greater energy than he would if he had simply gone down to the bank and made a deposit.

These are not the rich fat cats of society. This is not a scandal of winebox proportions. This is not a story of a handful of high net-worth individuals exploiting cunningly-devised, and little-known tax legislation, to rip the tax base of a few million dollars here and there. Rather, it is a matter of ordinary, mum-and-dad investors making the use of basic investment vehicles to reduce their tax liabilities, to the tune of hundreds of millions, if not billions, of dollars a year. They are not even small business owners who can take advantage of this situation, but ordinary, average, middle-income salary and wage earners.

The average income for a university-educated, full-time worker in paid employment is morme than $60,000 per year. In Auckland, that person earns more. Consequently, there is a massive market for property-based financial products that are designed to reduce tax.

The property market in New Zealand is effectively a state-sanctioned, and profitable grand pyramid scheme. Demand for residential property investment, propelled by high marginal tax rates, is largely immune to incremental interest rate rises, as the higher the finance cost of a property, the greater that property losses can be attributed against personal income tax. High marginal tax rates at low threshholds, through the property market, have created a degree of structural inflation.

Michael Cullen argues that reducing tax across the board has inflationary effects. Roger Kerr has written extensively on this, pointing out that in an open, competitive, trading economy, the effect of increasing the money supply is less inflationary than in a protected market. The reason for this is that the price of most goods and services in New Zealand is directly related to international commodity prices: New Zealand is too small a market to effect an increase in international commodity prices.

And what Cullen's argument doesn't address is that high marginal tax rates are a key component in both structural inflation, and high interest rates: housing investment is normally financed by fixed-term interest rates that are immune to increases in the Reserve Bank's OCR. House price inflation, driven by increased demand for investment property, to off-set personal income tax, is the key player in the structural inflationary mix.

This, of course, constitutes on its own, a massive potential threat to the tax base. It is guided, for no other reason, than that individual investors feel resentful towards the Government for the amount of money they are paying in tax, for little service.

The result is four-fold: that the Socialists’ attempt to punish the well-off doesn’t actually work, that the tax base is reduced, and that economic activity is distorted: that individuals will cumulatively invest in non-productive assets, rather than productive businesses. Further, low-income New Zealanders are priced out of owning their own homes, as structural inflation locks them out.

That is entirely the situation in the New Zealand economy today.

The Reserve Bank has responded that it is looking at the arrangements of Loss Attributing Qualifying Companies. Again, these are not intricate devices reserved only for the very wealthy who can afford complex legal advice; they can be set up by any one of many mortgage-brokers in New Zealand. They are the prime instrument for reducing an individual’s tax liability. These products are easily accessible, and inexpensive to set up.

Tens of thousands of LAQCs function to fuel and maintain the value of the property market. The effect of any changes to the tax system relating to LAQCs would have an immediate and catastrophic effect on the Auckland housing market, in particular. The consequence of that is a potential threat to the banking system as a whole. But before the Socialists suggest that such a correction would be a good thing, consider this: the working capital of most small businesses in New Zealand is financed by equity in residential property. Start pinging the housing market, and small companies--and therefore jobs--go down the drain.

The only means to safely amend this situation is not to look at a capital gains tax on property. Capital gains have come about because of the distortionary nature of the tax system, which is driving investors into property ahead of other asset classes.

A far more practical approach to encourage investors to move into productive assets is to reduce high marginal tax rates. It’s not something Michael Cullen would like to tell his voters—who believe that middle-income New Zealanders are actually being punished for working hard and earning more. The reality for many of them is that the punishment doesn’t exist. Instead, the tax system fuels higher housing prices, making it unaffordable for low-income New Zealanders to live in places like Auckland and Wellington. Yet again, the Socialist formula cheats low-income New Zealanders who aren’t paying sufficient tax to benefit from tax write-offs in order to leverage them into the property market.

By reducing marginal tax rates and increasing the threshholds to which those rates apply, the Government would remove this perverse incentive to over-invest in the property market. Residential property would still be a viable investment option, but it would no longer be the only investment option for many New Zealanders. House prices would rise at a slower rate, and the structural inflation, and higher interest rates to attempt to counter those price rises, would disappear.

This morning I was having breakfast with a mate, who earns around a hundred grand a year. He’s not wealthy, except in the eyes of the non-working poor, but he is comfortable. I asked him about his property investments. He responded that he had none. I said to him: “Are you fucking mad? Why not?”

He answers: “Because I’m not sure about where the market’s at, right now.”

So I give him a three-minute spiel around the fact the Auckland property market has doubled in value, every seven years, for the last hundred years. That a very simply-devised mechanism would provide him with an additional income stream of twenty thousand dollars a year, plus capital gains over the medium-term.

By the time we got to our second coffee, I had made a call to another mate to see him at lunchtime. By dinner this evening, my breakfast companion was the proud investor in two residential properties, and Dr Cullen was some twenty thousand dollars a year poorer.

New Zealanders don’t have to go off-shore to pay lower taxes. They can do that right here. Of course, it doesn’t make our economy as a whole more robust, and low-income New Zealanders don’t share in that wealth—but that is the necessary consequence of Socialism and rampant taxation.

The Labour Government has slowly, but surely, created this situation due to their dogmatic insistence that it is right and fair to punish middle-income New Zealanders. Over the last six years wage rises have pushed middle New Zealand into high marginal tax brackets. This has encouraged New Zealanders to seek alternative investment options to reduce that tax liability.