Sharebroking and investments: What Cullen's wealth tax means for investors

By Nick Stride

Friday 22nd March 2002

MICHAEL CULLEN: His 'interest' in a switch to the 'risk-free return method' set off speculation

Ever since Finance Minister Michael Cullen dropped his "wealth tax" comments into an obscure speech on February 22, sharebrokers and accountants have been bombarded by calls from their clients asking what it all means and what they should do.

Their anxiety might prove premature. After all, Dr Cullen said only that he was "interested" in a switch to taxing holdings of overseas shares and unit trusts by the "risk-free return method."

On the other hand, finance ministers don't normally announce they are "interested in" radical changes unless the underlying policy work is some way down the track.

The proximity of his speech to Budget day also raised eyebrows. The modern convention is for "no surprises" budgets, so ministers leak out all the significant changes well beforehand.

Dr Cullen said he hoped to be able to set out in the Budget "in some detail" the likely direction the government would take on taxing foreign holdings so investors will have to wait until May 23 for definite news.

In the meantime tax practitioners and investment advisers are alarmed by the mooted change in its present form if not in principle.

The principle of RFRM taxation is that assets are taxed each year by applying a "risk-free rate," in this case proposed as the one-year government bond rate adjusted for inflation, to their capital value. So the tax payable each year on shares in, say, Telstra would be calculated as the value of the holding at the beginning of the tax year multiplied by the RFRM, multiplied by the investor's tax rate.

Tax practitioners agree this method doesn't amount to a capital gains tax.

"Essentially it's a wealth tax but it doesn't attempt to tax your capital gains," says Stephen Titter, a tax partner at Ernst & Young.

"It just taxes the value of the asset you have as a proxy for taxing income from the asset."

And many agree with Dr Cullen that it "has the potential to make the relevant tax rules simpler, fairer and more effective" - but only if it is applied across all asset classes both domestic and foreign.

But when the McLeod report was released last year the media immediately picked up on the potential for the RFRM to be applied to people's homes.

Dr Cullen and Prime Minister Helen Clark almost fell over themselves in their rush to assure voters it would not be.

That, says Campbell Miller, a strategist at sharebroker JB Were, is "the ultimate absurdity."

"The scheme they've come up with is a great scheme if you apply it equally to everything," Mr Miller says.

"But by immediately saying you're not going to apply it to (residential) property you start to introduce distortions."

"New Zealand's number one economic problem is the vast degree of private sector borrowing in order to buy houses. Under this proposal that's only going to get worse."

Macquarie Equities senior adviser Arthur Lim agrees.

"The impact will be all kinds of anomalies in the tax system," he says. "It will only aggravate property investment."

Mr Lim reports clients have already declared that, if the RFRM is applied to overseas shares, they will simply sell up and put the money into local property.

The proposal, if adopted, will sweep away a central tenet of tax- system reform over the past 15 years - that the government raises revenue in a way that doesn't distort investment decisions.

Mr Miller says Dr Cullen's interest shows the government is looking at tax-system reform from its own perspective only, ignoring wide-ranging distortionary effects on investment behaviour.

The proposal to set the RFRM at the one-year bond rate "is making the assumption, for example, that a New Zealand investor would never want to invest at a rate lower than they could get from the New Zealand government."

But investors can and do want to invest in far less risky, and therefore lower-returning assets - for example, US or Swiss government bonds.

If they did so under RFRM they would still get taxed as though they were earning the New Zealand government one-year rate.

"What the government is saying is, we're going to tax you as though you can't do anything better than lending money to us, even if you can," Mr Miller says.

Investors would be forced to invest in things that are always more risky than New Zealand government stock.

Setting the tax at the one-year bond rate would also mean taxpayers would be penalised for the fact New Zealand has a higher risk premium than many other countries.

One reason for that is that we're a small country whose economy can suffer major damage from a single event - an earthquake, for instance, or a cattle disease.

Also affecting the risk premium is government policy itself.

"So it's a strange, circular thing," Mr Miller says.

"The more silly things the government does in terms of policy, the more the risk premium you pay goes up."

RFRM would also affect the type of foreign shares investors choose, Mr Miller says.

If an investor owns shares in an overseas company that pays dividends they will be double-taxed - once by the overseas government on the dividend income and again in New Zealand by the risk-free method.

But there will also be a disincentive to invest in high-growth companies that don't pay dividends, because the investor will pay RFRM cash tax but will have no income from the investment with which to do so.

But, says Mr Miller, "most great companies in the world don't pay dividends. They retain their money to grow."

The net effect, he says, would be to give investors tax incentives to allocate their portfolios in ways no sound investment advisor would recommend.

Apart from the emphasis on property investors would be encouraged to allocate their money to domestic shares, which make up only one fifth of 1% of the global equity market.

"For a government that's trying to tell people they must save for their retirement, giving them a reason to invest more in New Zealand, and more in risky things in New Zealand, is not a very good policy," Mr Miller says.

One way of avoiding the distortionary effects on the onshore/offshore investment decision would be to introduce RFRM on a broad-brush basis, as the Business Roundtable recommended in its submission to the McLeod review.

For obvious political reasons residential property could never be included.

McLeod recommended the regime apply only to foreign shares and unit trusts and Dr Cullen has given no reason to think extending the regime to domestic investments is even under consideration.

Nonetheless tax and investment practitioners suspect the offshore proposal could be "the thin end of the wedge."

If that happened it would bring with it an entirely new set of distortions.

Mr Miller points to the potential effect on New Zealand companies' dividend policies.

Listed companies are frequently criticised for contributing to poor economic performance by paying out too much of their earnings rather than reinvesting for growth.

Taxing share investments at a flat rate, Mr Miller says, would mean investors would have an incentive to invest in companies paying out enough cash to meet the RFRM tax bill.

They would therefore "reward" companies with high dividends and "punish" those with no or low payouts.

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