Funding resilience

How New Zealand funds not just the immediate rebuild of flood and cyclone damaged roads, bridges, and other infrastructure but also builds our financial resilience to adverse climate events is a multi- (potentially hundred) billion-dollar question.

In the lead up to the 2020 election, KPMG released Repairing Government Finances: Some tax options?  The context for that document was to generate discussion around whether, and how, tax settings should be used to repair the Government’s balance sheet following its fiscal response to Covid-19.

While for many Covid-19 may be in the rear-view mirror, there is still the debt hangover from the fiscal response and now, these new challenges to fund. So, a similar question remains, but the funding ask is likely an order of magnitude greater.

And bubbling in away in the background are other tax system tensions, including questions about the “fairness” of the current rules. The recent release of Inland Revenue’s research into effective tax rates of the wealthiest New Zealand households has surfaced these concerns (you can read our analysis of the research here.)

That has implications not just for the funding model – if one assumes the primary role of the tax system is to fund government expenditure – but from whom that funding should be raised. Questions around fairness are inevitably grounded on who pays and how much. Reasonable people can, and do, disagree on this. 

To set the scene, Treasury’s 2021 Long Term Insights Briefing (LTIB) provides a good summary of New Zealand’s long term-fiscal challenges and range of potential policy responses.  

A key focus of the LTIB is the pressure on long-term public finances from changes in demographics – namely an ageing population and the accompanying increases in demand for health services and retirement benefits. There is an accompanying warning. Treasury’s long-term modelling suggests that “net [government] debt is likely to be on an unsustainable trajectory if expenditure and revenue follows historical trends.”  

The economic and fiscal impacts of climate change are also mentioned. The LTIB notes that “more frequent and severe extreme weather events and the gradual increase in temperature and sea levels will have economic and fiscal impacts in the future, which adaptation policy today could reduce. Governments will also face trade-offs when choosing the pace of emissions reduction and the policy levers to achieve.”

While a clear fiscal risk there is no estimate of the likely cost of climate change responses, including building more resilient infrastructure. But the LTIB warns that “New Zealand will face shocks and natural disasters in the future. Incurring an unsustainable level or trajectory of debt today could prevent the populations at the time from managing those shocks as effectively as possible, imposing additional costs on them at what would already be a challenging time.”

In a nutshell, demographic and societal changes, along with climate events are likely to be significant fiscal events. The timing and frequency of these events is only likely to accelerate. The LTIB notes that a package of measures is likely to be required and that “New Zealand needs to start thinking about these changes now. Small and gradual changes in the nearer term would help to minimise the cost of fiscal pressures across generations, preventing higher debt and a larger adjustment in the future.”

The question is what that response should comprise. 

So, how can Government fund both its current and future expenditure needs?  

Government can (continue to) borrow. Government can also refinance rather than pay down existing debt, as they have the luxury of taking a longer-term view. (While our net Government debt, at around 20% of GDP, is relatively low by world standards, as noted in Treasury’s LTIB, this may not be sustainable as the only response.)

Alternatively, Government operating deficits and debt may be reduced by:

• Reducing expenditure.
• A growing economy increasing tax revenue.
• Changing tax policy settings.

When considering tax policy settings, and changes to them, it’s important to ask the following questions:  

Who is in the tax base? The current tax system makes choices about who tax is collected from. New Zealand taxes on a “residence” basis and non-residents on income sourced here.  Additional persons can be included as taxpayers (for example, some countries tax on a citizenship basis).

What is in the tax base? New Zealand’s income tax is generally considered to be “broad” based. Further broadening the tax base, for example, by including current non-taxed amounts will raise tax revenue. The release of Inland Revenue’s high-wealth individuals research has prompted renewed discussion about whether New Zealand should have a comprehensive capital gains tax.

What are the different tax bases? New tax bases may be identified, such as wealth taxes or activity-based or behavioural taxes (or incentives). These may have both revenue raising and other objectives, such as discouraging (or encouraging) certain behaviours (e.g., excise tax on cigarettes/tobacco) or making the cost of the activity more transparent. New Zealand’s most efficient tax is the GST, which applies on most forms of consumption. There have been calls to both narrow (e.g., by exempting items such as fruits and vegetables) and increase (e.g., by applying GST more fully to financial services) the scope of the GST.    

How much tax is paid and by whom? Increasing (or decreasing) tax rates will have both fiscal and fairness implications. Fairness, in the tax context, tends to focus on concepts of “horizontal” equity – those on the same income should pay the same amount of tax, and “vertical equity” – those earning higher incomes should pay proportionately more tax. As noted earlier, fairness can be subjective and raises wider issues, such as how “income” is (and should be) defined, which is a tax base question.

What is the impact on system coherence? Choices around different tax settings (such as personal and entity tax rates or providing exemptions) can have whole of system impacts. There may be good policy reasons for taxing, or not taxing, certain things. For example, Inland Revenue’s own LTIB on Tax, foreign investment and productivity notes that high tax rates on inbound investment increase the cost of capital for New Zealand firms. However, lowering these rates can present other structural challenges (e.g., misalignment with personal tax rates or incentivising certain types of assets or investments over others). Policy choices may decrease or increase system integrity, which may then require other (undesirable) responses. For example, the bright line rule extension and interest limitation rules were introduced in response to concerns that residential rental properties were “undertaxed”.   

In 2020’s Repairing Government Finances: Some tax options? we listed some different taxing options, and their pros and cons, to inform the debate around tax policy choices in that year’s election lead up. We are not going to repeat those here. The taxing options have, largely, not changed. Importantly, these are not recommendations. Our aim is that this document provides some food for thought.

The challenges around funding resilience are not short-term ones. Changes, including to tax policy settings (if any), need to be viewed in that longer-term context. There will be trade-offs, including the impact of policies across current and future generations.

Expectations need to be moderated about what can be achieved in a single Budget or even multiple Budgets, particularly when there is also a recovery effort to fund.   

It is the direction of travel and sign-posting that is important. That is what we are hoping to see, if not in the Budget, in the upcoming election campaign as the different parties’ outline their vision for New Zealand. 

However, all of this relies on policy makers taking a longer-term view when the politics reward short-term decision making.  

Darshana and Rachel each have over 20 years’ tax experience and jointly lead KPMG’s Tax Policy team, where they work closely with Inland Revenue and Government on tax policy and tax technical matters. Darshana specialises in financial services and international tax advisory and tax governance. Rachel has a particular focus on the financial services, real estate and the forestry sectors. Both Darshana and Rachel are also members of the New Zealand Tax Advisory Group of Chartered Accountants Australia and New Zealand.