The productivity gap: A taxing question

The Productivity Commission’s draft report, New Zealand Firms: Reaching for the frontier, is well worth a summer read.

It highlights New Zealand’s ongoing struggle with productivity and restates the view that the main contributor to economic growth has been from more hours worked rather than more output per hour (‘working harder, not smarter’). We are said to lag behind comparable small advanced economies. The sources of New Zealand’s poor productivity performance are varied and includes capital shallowness, low investment in research and development (R&D), innovation and the knowledge economy, an unsophisticated export mix, small market size, and geographic distance.  

The draft report concludes that not enough New Zealand businesses are operating at the global economic frontier. In short, we don’t have enough globally competitive firms that operate at the high end of the global value chain, compared to peer economies. It suggests that our collective efforts should be focussed on increasing the number of innovative “frontier firms”, to enable high value exporting at scale and to help lift up firms operating below the frontier through better diffusion of knowledge and technologies.

Government support, both indirect and direct, should be focussed in areas of the economy with rich possibilities for innovation. The aim is not to pick individual winners, but to back winners by supporting sectors that are promising. This includes taking a more proactive approach to attracting foreign multinationals that have expertise and capability in high-value exports and whose presence will result in spill over benefits for the economy and New Zealand firms. Regulatory settings (such as immigration, competition and innovation policy) should also be calibrated to support frontier firms.

The report does not look at the role of tax policy settings, other than finding that the spill over benefits of innovation provide a rationale for policies like R&D tax credits (see F6.3 of the draft report). Tax is otherwise outside the scope of the Commission’s report. 

We often hear arguments for the tax system being used to achieve specific social objectives. From sugar taxes and removing GST on fruit and vegetables to encourage healthy eating to a wealth or capital gains tax to address rising house prices and wealth inequality.

The arguments against using the tax system in this way are usually framed in terms of the impact on the integrity and coherence of our tax system, particularly our GST which is world leading because it applies broadly and with few exceptions. The overriding concern is to stop our tax system ending up looking like a block of swiss cheese. This is a valid concern in a tax context (and not to be confused with epidemiologists using swiss cheese positively to describe the system of layering defensive measures against COVID-19).  

But the tax system is not easily divorced from social and economic challenges and realities: the effects of global pandemics, climate change, rising housing and wealth inequality, and calls for businesses to pay their “fair share” (to name a few). All pose the question: what is the role of tax, if in any, as part of the solution?

Those perspectives may make it unrealistic for the tax system’s design to simply ignore these wider issues. Tax may not be a silver bullet but its effects, and the options for its use, should be considered in the design of an overall solution.

Back to the Productivity Commission’s findings - is there a bigger role for the tax system in supporting New Zealand businesses to reach their productivity frontier?

A tax policy purist would say that should not be the role of tax policy. The tax system should be agnostic to the type of economic activity, industry or sector – it should collect revenue at least economic cost (i.e. distortion) in general terms. If you work in tax, the mantra “broad base low rate” or BBLR may well be familiar. That largely gives effect to the purist’s view.

Its evolution reflects compromises over time, many of which are difficult to now unwind.

Some examples to illustrate this are:

Much of the focus in the previous Parliamentary term was on whether New Zealand should implement a general capital gains tax. The political response was, ultimately, no - even though this was the Tax Working Group’s recommendation. The reality is that New Zealand already taxes some capital gains as income, but in an ad hoc and incoherent manner. New Zealand shares and most residential property benefit from this “capital/revenue” distinction while debt investments do not, and offshore shares face a hybrid dividend/capital gains tax. The continuing strength of the housing market is seeing calls for the tax response to be reconsidered or additional arbitrary measures (such as increasing the residential bright-line period).   

As noted in the Commission’s report, the tax system delivers support to New Zealand firms undertaking innovation, through a refundable 15% R&D tax credit. Its scope is narrow – it applies to firms developing a new type of widget rather than mass producing widgets – creating differences. Similarly, increasing the threshold for immediately expensing business assets, or accelerated depreciation, favours capital intensive firms more than labour intensive ones. These might be examples of the tax system already picking winners, albeit at an aggregate rather than individual firm level?

New Zealand and others already use their tax systems to change behaviour, which is outside the BBLR framework. Excise on cigarettes and tobacco has a clear public health policy driver. Fuel excise (and regional fuel levies), unlike other taxes, are hypothecated to fund the cost of infrastructure. General environmental taxation is an area in which New Zealand lags behind other OECD countries. These reflect deliberate policy choices that go beyond pure tax policy considerations.

For non-residents looking to invest in New Zealand, the tax rate is generally the headline.  However, look deeper and the choice of debt or equity can give very different tax outcomes. New Zealand’s approved issuer levy regime, for example, imposes a low rate of tax on foreign lenders due to the cost of capital considerations for New Zealand firms. Because of this there are additional rules to stop misuse, such as transfer pricing and interest restrictions, which add to the complexity. Some countries have adopted more neutral approaches, such as an allowance for corporate equity, to better align the tax treatment of debt and equity by allowing a deduction for equity. On the other hand, our imputation system anchors firms in New Zealand to the extent of their domestic shareholders to avoid double taxation (or at least that’s the logic).

An area where tax policy could have wide ranging economic impact is in the response to the “fair share” debate. This has tended to focus on multinationals selling “into” a country who do not pay tax because it is not operating “in” country. This is not only a New Zealand concern. It is a global issue and one which the OECD is trying to forge international consensus to fix. The risk is that real change may be a bridge too far, leaving frustrated countries to adopt unilateral measures. The New Zealand Government has a digital services tax (effectively a tariff on sales to New Zealand consumers) as a back up to the OECD process. The proliferation of individual measures poses risks not only of double taxation and trade retaliation but how and where multinationals will choose to invest.

So, while New Zealand tax practitioners and Tax Policy Officials may preach the virtues of a pure tax system, the reality does not necessarily match what’s on the packaging.

The tax system may not be the answer, but its impact certainly does need to be considered in designing the solution.