Tax Reform in New Zealand
Delivered at Canadian Tax Foundation Annual Conference, Vancouver, on 29 November 1988
Thank you for inviting me to speak to you tonight.
When the fourth labour government took office in 1984, New Zealand had been living in what could be described as a fortress economy for 50 years. A mentality bent on protecting us from the rest of the world reigned supreme.
Symptoms of poor economic performance were largely overlooked. Successive governments failed to tackle the underlying malaise. Even in the supposedly halcyon days of the 1960s, our growth rate was well below that of similar countries.
In the 10 years to 1983, New Zealand's real GDP grew by less than half the average for all OECD countries. In terms of GDP per capita, our ranking in the OECD standard of living tables fell from third in 1953 to 19th in 1975 and by 1982 we were languishing in 32nd place.
In 1953 New Zealand had a standard of living the equivalent of Switzerland's. But while Switzerland has progressed to the point where it now has the highest per capita standard of living in the world, our position has steadily eroded. Our GNP per head is now less than half that of Switzerland's.
In addition, New Zealand has had large and increasing fiscal and balance of payment deficits over the past two decades. There has been a corresponding growth in internal and external debt, a stagnant and often declining productivity, despite investment levels that were quite respectable by international standards and inflation rates generally double those of our trading partners. Taken at face value, this record of mounting economic problems is surprising.
As many of you here tonight will know, New Zealand is a country with substantial natural resources and a well-educated and innovative workforce. In fact, the fault for this poor performance was of our own making.
For years we encouraged a "cotton wool" society where producers were protected from market reality by a raft of price, interest rate and other regulations, and a highly inefficient and complex system of import controls. Risk was shifted from the private sector to the taxpayer. You could say that we socialised losses and privatised gains.
Past administrations responded to the country's economic malaise by shoring up failed regulation with more and more regulation. It became a self-perpetuating exercise. The system grew increasingly extreme. In some areas the degree of regulation equalled or exceeded that of many Eastern Bloc countries.
The weight of such policies was unsustainable. A modern mixed economy cannot be run like a feudal estate. Ultimately there had to be a major shift of emphasis away from day-to-day economic control to a wider vision that respected both economic principles and social goals. This is the path that economic policy has taken since the 1984 election.
Our strategy is clear, rational and simple. It is based on three fundamental principles.
First and foremost is the quality of Government decision-making. We have looked beyond the short-term pressures and factors that can cause governments to lose sight of their goals.
We considered it vital to identify the basic problems facing the economy, and then to deal with their root causes. The medium-term orientation of our policies reflects this. We have followed policies where the best results were not immediate: Rather than ones that might help us politically over the next six months.
The second important principle is that economic policy should help resources flow to where the return is highest, rather than impeding that adjustment. Flexibility is the key to a healthy economy and this means a greater role for prices to reflect the changes in supply and demand.
The third and final principle revolves around equity. Equity objectives and the spreading of the burden of economic adjustment are prominent in our programme of economic reform. Therefore those objectives must be pursued in the most efficient way possible.
This has meant more targeted assistance, including the careful use of direct tax and welfare benefits.
It also required a review of the many ad hoc interventions that had evolved in New Zealand. Here we often found that there was no conflict between equity and efficiency, and reform allowed us to pursue both of these objectives.
In many cases social equity was clearly improved when bad interventions were removed. Tonight I would like to take one aspect of our policy that has interesting Canadian parallels and demonstrate how it fits into our overall economic strategy.
It is a topic that I understand is of considerable interest in Canada at the moment, the thorny issue of tax reform. Taxation reform has played an integral part in the New Zealand Government's economic policy.
There are few more pervasive sets of regulations than the tax system. As a consequence, the potential efficiency and equity gains from tax reform are large. The reverse is also true.
Moves to abolish unwarranted regulations elsewhere in the economy can have implications for the tax system and can make it more difficult to justify tax concessions.
Over the last two decades New Zealand, in common with most OECD countries, has placed increased demands for revenue on its tax system. Total tax revenue as a percentage of nominal GDP rose from 25% in 1970/71 to 31% in 1985/86. This year it is expected to amount to 36%. The period to 1985/86 was also marked by a change in the composition of New Zealand's tax revenue.
Personal income tax increased from 45% of the total tax revenue in 1970/71, to 65% in 1985/86. The brunt of this share was borne by salary and wage earners. Moreover, this increase came from a base narrowed by specific concessions, such as deductions for superannuation and life insurance payments, and a raft of other deductions and rebates.
In addition, some non-cash remuneration - for example, low interest rate loans and the provision of a motor vehicle - fell outside the income tax system. Certain elements of economic income were also not formally included in the tax base. The most notable was capital gains.
The increased reliance on personal income tax was accompanied by a significant reduction in the importance of company tax. This fell from 19% of total central Government tax receipts in 1970/71 to 9% in 1985/86. The decline suggests that the corporate base was being eroded at a significant rate.
Numerous business tax preferences were introduced. However, there was no reason to believe that corporate profitability had fallen substantially in relation to wages and salaries and the income of unincorporated firms.
Moreover, the returns from specific activities, assets and instruments, were effectively taxed on a spectrum ranging across expenditure, real income, historical cost, or nominal income tax bases.
The rise in personal income tax was also accompanied by a decline in the proportion of tax contributed by indirect taxes. The main tax on expenditure was a single-stage, wholesale sales tax which in 1984 covered only about one-third of personal consumption.
Your Finance Minister, Mr Wilson, has described the Canadian manufacturers' sales tax as "the worst tax that a politician could ever devise". That description could have been applied equally to our wholesale sales tax. Numerous exemptions were granted on the basis of classes, uses and users of goods. There were 12 specific and 7 ad valorem rates, ranging from 10% to 60% of wholesale value.
We also levied minor indirect taxes on a narrow range of goods - for example, film hire tax and domestic air travel tax. This narrowness of the income and expenditure tax bases was not by design, but something that had evolved as the result of a continuing series of ad hoc decisions by successive Governments, and a period of sustained inflation.
By 1984 there was an urgent need for tax reform. The system was unfair, and was seen to be unfair. High marginal tax rates discouraged innovation, efficiency, hard work and savings. Investment decisions were based more and more on minimising tax instead of maximising economic returns.
The objectives of the government's major tax reform programme were set out in my 1984 budget. They were:
To introduce a greater degree of equity into the tax and benefit systems;
To minimise the distortionary impact of the tax system on resource allocation by reducing anomalies and concessions, widening the tax base and lowering marginal tax rates; and
To make the tax system more certain and simple.
But before looking at the nature of the tax reforms we have instituted, it is worth discussing briefly the reforms initiated in the public sector. In order to achieve our tax objectives, it was necessary to reduce the high growth rate of Government expenditure. After all, this represents the true tax burden.
We have moved on a number of fronts to control spending. There has been constant emphasis on the quality of spending as well as its volume. A key element was to implement measures that encourage the best use of available skills.
Improving the value that taxpayers get from public expenditure is a fundamental part of our economic strategy.
Our main objectives were :
First, to get better value and greater productivity from the resources that go into the public sector.
Secondly to better control expenditure.
And thirdly, to ensure the pressures and disciplines being applied elsewhere in the economy also apply to the public sector.
Our reforms concentrated first on State business activities, commonly known as SOEs, or State Owned Enterprises. This policy has been a resounding success. We have corporatised and breathed life into moribund State businesses, some of them huge in scale.
This has created a vigorous competitive environment that is generating new opportunities for investment and jobs. In their first year of operation, many of the new State Owned enterprises have achieved remarkable results compared with their departmental predecessors.
New Zealand Post recorded an after tax profit of $72 million in 1987/88 after a loss of $78 million in 1986/87. The Coal Corporation has increased output but operates with only half the staff it once had. It now sells to customers like New Zealand Steel and Electricorp for about half the price: and it is making a profit instead of a loss.
Today the Forestry Corporation has less than a third of the salaried staff its departmental predecessor had. It has turned an annual loss of $70 million into a $40 million profit.
The second part of our reform concerned the core public sector. The introduction of the State Sector Act this year set the climate for new and more disciplined public spending and management.
Up until now, budgeted expenditure levels tended to be set by up-dating the costs of the previous year's programmes, adding the costs of new programmes, and applying full compensation for inflation. Expenditure was then controlled by imposing rules and attempting to limit the inputs available to departments.
The new system focuses on three important questions.
Do programmes represent value for money?
Do they contribute to the Government's objectives?
What services does the Government want a department to provide?
We expect improvements in the quality of our spending. 'Permanent' heads of departments have become chief executives subject to a performance contract negotiated with the Minister. Accountability will be greatly enhanced.
Virtually all input controls will be abolished and chief executives will be directly responsible for the staff and other resources they employ. Ministers and departments will be better able to apply the funds available to the high priority areas. There will be savings through greater efficiencies and, in some cases, through reduction or elimination of lower-value programmes.
Although expenditure and other policy moves provided the Government with some room to manoeuvre in the income tax area, most expenditure control had to be used to reduce the deficit.
The real opportunity to make fundamental improvements in the tax system was provided by the introduction of a goods and services tax GST. Some of you may already be familiar with the basic elements of the tax.
Earlier this year, I met and talked to Mr Don Blenkarn, when the Canadian House of Commons' Standing Committee on Finance and Economic Affairs visited New Zealand to study GST. Its design and implementation were also discussed by Professor John Due in a recent issue of the Canadian Tax Journal.
In that article, he described GST as "the world's most broadly based value-added tax".
It is applied at a single rate of 10% with minimal exceptions. Thus it spreads a wide net with a thin mesh through the economy.
In 1984 we had concluded that the bulk of taxation is best spread over two broad bases. Having introduced the Goods and Services Tax on 1 October 1986, the question now is the balance between company and income tax and GST, rather than the choice between them.
In New Zealand we found that the constraints on introducing a broadly-based single-rate consumption tax were not as great as previously imagined. We had recognised from the outset that these two features were critical in minimising the efficiency costs of GST, including compliance and administrative costs.
Public debate tended to centre on whether Items such as food and clothing and the activities of charities and central and local government should be exempt from the tax in order to assist low-income families and desirable causes.
However, our studies showed that in absolute terms higher income people would gain most from exemptions for food, clothing and other 'necessities'. This came through clearly in surveys of household spending. For example, had food been exempted from GST, the bottom 20% of households would have received only 15% of the aggregate benefit of the exemption. The other 80% of households, which were not considered to be poor, would get 85% of the relief. To my mind that would not represent social equity.
Such spending patterns do not apply just to food. The well-off spend more money on everything: therefore they pay the most GST, revenue that can then be used to fund our income support programmes.
It was suggested that we should tax luxury goods at a higher rate. Everyone has views about what constitutes the necessities of life and what might be considered inessential or a luxury. This view changes as society evolves and prevailing tastes and ideas alter.
The wholesale sales tax, which I referred to earlier, was introduced in the 1930s. When it was abolished in 1986 it still reflected the spending patterns and ideas of that time. Things like refrigerators and washing machines that were considered luxuries 56 years earlier but are now standard household fittings were subject to sales tax.
Selective taxes can also have undesired effects.
A New Zealand example was the imposition of high sales taxes on boats as luxury items. The result was lost jobs for local boat builders, most of whom were probably not well off, while the truly wealthy bought their yachts in Australia.
In my opinion, the problems of low-income people caused by the relative burden of a broad-based consumption tax are best handled by redistribution via the income tax and benefit system.
The same day GST was introduced, substantial cuts in income tax rates were implemented.
Restructured social benefit payments were increased by 5% - the estimated net price impact of the new tax after the removal of existing sales taxes.
The benefits are fully indexed.
Public acceptance of the tax, and its smooth introduction 23 months after it was first announced in the 1984 budget, was largely the result of a comprehensive publicity and education campaign.
There had also been extensive discussion between the Government and the private sector to iron out potential problems before GST was implemented.
There was, however, one major area where problems at the design stage of the tax were not resolved. As a result, financial services are currently exempt from GST. I believe your Finance Department's tax reform group is examining ways to include this component in Canada's proposed federal sales tax.
New Zealand will be very interested in the results, especially if you find an effective way to bring financial services into the added-value tax net.
The introduction of GST not only enabled us to abolish wholesale sales tax and certain minor indirect taxes, it also provided the key to reduced income tax rates. Income tax rates have been reduced significantly. The company tax rate is 28%, down from 45% in 1984; and our top personal income tax rate is 33%, compared with 66% under the previous administration.
At the same time we have continued to reduce the scope for individual and corporate taxpayers to pay less than their share of tax.
Those measures include:
The imposition of a fringe benefit tax, levied on the employer.
The introduction of more neutral tax regimes for the agriculture, forestry and bloodstock industries.
Phased abolition of export incentives and all accelerated depreciation provisions.
The development of an accruals based taxation system.
Changes to the timing of provisional and terminal tax payments to reduce the extent of tax deferrals on non-source-deducted income.
A full imputation system to determine tax liability on distributed corporate income, implemented from 1 April 1988. (Shareholders' dividends will be taxed at their personal marginal tax rate, with an imputation credit for company tax already paid.)
The phased introduction of a tax on superannuation and life insurance. (Contributions and fund earnings will be taxed, and emerging benefits exempt.)
A regime to combat international tax avoidance through tax havens and trusts; and a move against 'double-dipping' of tax losses by dual resident companies.
The abolition of stamp duties on financial instruments, and conveyance and lease duties on residential properties.
In addition, we propose to introduce a withholding tax on domestic interest and dividend income.
We are also examining a capital gains and/or assets taxes, to further lower tax rates and widen the income net.
As a result of our reform programme, tax avoidance has become more difficult and less worthwhile.
The government's consultative committee on the taxation of superannuation and life insurance, recently commented that "higher marginal tax rates are increasingly becoming effective rates for the upper income bracket and those deriving capital income".
We are replacing a tax system that appeared to be progressive with one which is progressive.
That system is now much fairer and more secure. The tax base is broader. Distortions that discourage people from working and earning, or which favour one form of investment over another, have been reduced.
In short, in the past four years we have transformed New Zealand's taxation system from one of the most burdensome, inefficient and unfair systems, to one of the best.
Four years ago my Government embarked on a strategy to change the conditioning of decades and create in its place an environment that encouraged a revitalised and dynamic economy. Above all, we wanted to create a climate of opportunity where every individual was free to achieve their full potential.
I would like to conclude with a brief summary of some of the benefits that are emerging as a result of our policies.
Inflation is now running at an annual rate of 3 to 4%. Interest rates are coming down. The balance of payments has improved markedly. We have just had the best current account out-turn on record.
There has been new investment in a number of industries. New Zealand firms have been expanding into overseas markets. Consumers now enjoy an increasing diversity of goods and services.
We are seeing new attitudes, new business approaches, and a new and growing ability to compete internationally.
Last year, for the first time in 35 years, we had a budget surplus. For the first time in 35 years we reduced our overseas public debt.
This year we continued this progress with a budget surplus of more than $2,000m or 3.6% of GDP.
In four years we have achieved a spectacular turn-around in the Government's financial position.
A turn-around in today's terms of more than $7,000 million or 11% of GDP.
I am confident that the 1990s will see New Zealand returning once again to rank amongst the countries with high standards of living. The steady decline in our relative standard of living that marked the last three decades will be well and truly reversed.
Thank you.