Too Near a Third Rail?

Traditionally Capital Gains Tax (CGT) has been politically untouchable. What does the handling of the issue tell us about the government’s political skills?

The focus of this column is what we can learn from the government’s handling of the capital gains tax issue. However, let me first say something about the case for it.

I have always favoured a CGT in principle because without it, investment is distorted towards returns from speculative capital gains and away from production (which is easier to tax directly). This has particularly applied to the housing market, where the lack of an appropriate CGT has encouraged people to build and occupy larger houses than they need for homes.

A particular issue is the Minsky cycle, which describes financial instability. People reinvest their speculative capital gains, fuelling further price rises. Of course the cycle has to come to a (frequently abrupt) halt, typically with price crashes and a lot of consequential heartache. (This may not happen in the housing market, which may suffer a very long price stagnation which has its downsides too – but that is for another column.)

These issues were not covered by the Tax Working Group (TWG), which focused on the equity case for capital gains. Since those in the productive sector pay taxes on their income, surely it is reasonable that investors, particularly speculators, should pay taxes on their income too. ‘It’s only fair.’ Unfortunately the TWG gave little attention to the ‘efficiency’ arguments for a CGT.

(An aside, one of the issues with which the government seems concerned is how to increase the labour income share relative to the investment-income share; a CGT would do that after-tax.)

So the pro-CGT advocates went into battle with one hand tied behind their backs. Consider the pro-CGT Taxjustice campaign arguing for a ‘fair’ taxation system. Think of the greater impact if its billboards had shouted ‘speculators should pay income taxes too’.

A second strategic mistake was to let the argument be dominated by the ferocity of the anti-CGT campaign who argued the tax was not fair on them. (‘Fair’ is a weasel word in political discourse.) The pro-CGT campaign never got across that the TWG also recommended substantial cuts in the income tax rates for those in the productive sector, so tying the other hand behind its back too. The government was on a hiding to nothing.

Could they ever have won? In my view a comprehensive CGT instituted with a one-off introduction was too late. Were I advising Governor Hobson or Prime Minister John Balance, who first introduced income taxes in New Zealand, I would say ‘go for it’. (The Australians introduced theirs in 1985; it was not a priority for our Rogernomes who were more concerned about reducing taxes on the rich.)

Today capital gains are now too integral a part of the economy for them to be dealt with in the way TWG proposed. Keith Woodford gives a good explanation of what has happened in the farm sector here:

A useful parallel is cars. So much of our urban and rural configurations and our living arrangements are built around cars that a doubling of tax on cars would be extremely disruptive. (There are – perhaps exaggerated – estimates that a CGT would, in effect, double the tax rate on farms.) Suppose that such a tax was imposed (unlikely, given the uproar over quite small rises in petrol tax, including most areas rejecting the opportunity and then grizzling about the lack of local roadworks). There would be chaos and hardship as people tried to adjust to the home, recreation, schooling, work and transport implications. Eventually things would settle down. The same chaos followed eventually by a settling down would have happen with the CGT.

What we are doing instead is steadily developing the infrastructure – public transport and bike paths – to enable people to adjust to a car-expensive or car-less life style. (Ideally, people’s home choices would be reconfigured but unfortunately, our house building program is working in the opposite direction as it extends the urban fringe.) I was surprised that the TWG did not consider more explicitly a similarly incremental approach.

Say, first by increasing the period of the brightline test on second and non-residents’ housing so they would have to hold onto them even longer to avoid a capital gains tax. (No one could accuse this of being a capital gains tax since it was introduced by a National Government; of course, it is.)

It does not seem this option has been ruled out, while the government is also thinking about taxing urban landbankers.

The next step would be to apply a similar tax regime to high-valued first-owned houses, say all capital gains on the value of houses over the first $1.5m. It is hard to think of a home being worth more than that figure.

These measures are aimed at reducing the Minsky bubble in housing markets, thereby making homes more affordable, while reallocating house construction resources to better-sized homes and releasing the land for housing on which some large houses are built.

Then we might think about extending the capital gains tax on shares (which are likely to receive a boost as investors divert from the housing market to the sharemarket).

I’m getting outside my expertise at this stage. What I would be trying to do though, is, step by step, to align our CGT with Australian practices. It would be a long-haul strategy.

Instead the TWG went for the big bang which left the public with a ‘yes’ or ‘no’ choice. The noise was for ‘no’, although who knows what the majority would have thought had a balanced option been offered to them?

The government could not have implemented the scheme until after the next election. There was a real possibility that National, campaigning against the tax, would have won it, so there would have been no CGT anyway. One of the few politicians who have done well out of the kerfuffle has been Simon Bridges. Who would have thought when the Government established the TWG that it would strengthen the position of the Leader of the Opposition?

The other politician to have done well was Winston Peters, who is said to have vetoed the CGT introduction. My bet is that had there been no Peters in the cabinet room, the government would have decided not to proceed anyway. Peters was a good excuse to justify the decision to the government’s leftish supporters. It strengthens his party’s prospects, presenting itself as practical commonsense to those in the centre. Peters knows a lot about third rails.

Jacinda Ardern showed political leadership in the way she announced the decision to reject the introduction of CGT. She can be superb at connecting well with the public.

My query is where was her political instinct when the government established the TWG? As they prepared the terms of reference, was there nobody who thought there would be an uproar, who really understood the third rail nature of the CGT? Whatever you may think of the government’s short-term tactical abilities, the episode must raise doubts about its skills with political strategy.

An interesting contribution from Bill Rosenberg who was on the TWG will be found here.