What ‘Jack and Jill’ can teach us about the (un)fairness of capital gains taxes

In New Zealand, capital gains tax debates spring up like zombies. Each time they get killed off, back to life they come.

New Zealand already has some types of capital gains taxes – such as the bright-line test (which taxes residential land bought and sold within two years) and taxes on other various activities. So the debate is more about expanding taxes on capital gains, rather than introducing a new tax.

ANZ’s chief executive Antonia Watson triggered the latest furore this week when she argued since people invest in housing for the purpose of realising capital gains, those gains should be taxed.

This earned a sharp rebuke from the government. But there was also muted support from the Labour Party, which sees capital gains taxes as a potential issue for New Zealand’s next general election.

Despite the government’s position, Inland Revenue is consulting the public and experts on how to address long-term challenges like superannuation and healthcare funding. Capital gains taxes has been put forward as one option.

Supporters of capital gains taxes also argue it is needed to create a more fair tax system, rather than relying on taxing income and consumption via the goods and services tax (GST).

Taxing Jack and Jill

So is it more fair to tax income from all sources, including capital gains? Superficially the answer is a clear “yes”.

But mapping out the future for notional taxpayers – Jack and Jill – shows how it could be anything but.

Imagine Jack and Jill are each 21 years old, with the same qualifications, the same job and the same expected lifetime salary. They both plan to retire at age 65, and to simplify things, suppose neither has any existing savings and won’t have Kiwisaver accounts.

For whatever reason, neither of them marry or have children and they both rent the same type of apartment, with the same rent, all their lives.

What separates them is that Jack is a party animal, who spends every dollar he can, and saves nothing. Jill, by contrast, saves a quarter of her post-tax income, foregoing current consumption so she can consume more when she retires.

Some of her savings generate taxable cash returns such as interest, non-imputed dividends and rents. But they also accrue capital gains, which are treated as either being fully taxed like any other income (at Jill’s marginal tax rate), or not at all.

Assume Jack and Jill each have a pre-tax annual salary of NZ$50,000, which will stay constant in inflation-adjusted terms. Allowing for inflation only strengthens the contrasts discussed below.

For this illustration, New Zealand’s current personal tax brackets and rates apply for each year until Jack and Jill retire at age 65.

Jill’s savings are assumed to generate a taxable 2% annual cash income (distributed each year), and annual 4% capital gain (reinvested each year, taxable or not).

With these assumptions, Jill accumulates a retirement nest-egg of $1.5 million, while Jack has nothing to show for his working life when he retires.

Since Jill earns income from savings as well as her salary, she pays more lifetime income tax than Jack. It would work out to be over a third more even without capital gains taxes, but more than double with capital gains taxed.

Jill pays less lifetime GST than Jack, mainly due to her higher savings rate, but she still pays much more total tax than Jack over their working lives.

While many other scenarios and assumptions are possible, this simple illustration shows that even without a capital gains tax, Jill’s thrift is rewarded by her paying more overall tax than Jack while they are still working – and much more so if capital gains are taxed.

Plus Jill accumulates more savings to be used to pay for aged care if she needs it, whereas under current rules Jack qualifies for taxpayer subsidised aged care as soon as he needs it. Jack benefits despite paying less lifetime tax and having lived it up a lot more than Jill before retiring.

A question of fairness

This shows that taxing capital gains is not obviously fairer than leaving them untaxed. Different lifestyle and savings choices result in differing lifetime contributions to the tax system (Jill contributing more) and differing burdens on aged care subsidies (Jack imposing more).

So if we are going to have a debate about capital gains taxes, we might need a broader definition of “fair”. We also need to take a broader view of how we incentivise – or not – desirable activities like saving for retirement.

New Zealand might be out of step with other developed countries in terms of not more widely taxing capital gains. But we are also out of step in terms of how poorly our tax system incentivises retirement savings.

That many New Zealanders take the route of saving for their retirement through tax-free capital gains on residential property is no mistake, even if it is an accident of policy.

If we shut that route down by extending the reach of capital gains taxes, how else do we comparably encourage people to save for retirement and reduce any future burdens they might place on the tax system?