What is income for tax?
I’ve now read the IRD and Treasury effective tax rate reports, and they’re good. I’ll read them a few more times before writing anything on them in a couple of weeks – but the authors of all these reports were really careful to provide rationale and scenarios to explain what all the different numbers meant. It’s pretty awesome to see things so carefully described and released in public like this – and it would be great to see even more of it.
For this reason I initially found the discussion I’ve seen publicly – and via people contacting me – a bit perplexing. That was until I read the release from the minister – David Parker. Although I thought it was quite a polite release, it did take a particular view about how we should consider measures of progressivity – for both consumption and income taxes – as if it was a matter of fact.
And, in truth, these things can be a bit contensious – a reason why it appears both reports spent a lot of time discussing how the estimated tax rate would change depending on what we view as income. So let’s have a yarn about what income is shall we 😉
What is income?
At first brush this question seems really easy – you know what income is when you see it. When your boss pops your wages in your account, when you receive interest on your savings – these are income.
But it can start to get tricky. Is it income when your mate gives you $20 to go buy a pizza? Is it income if your mate purchased a pizza off you?
Or what about some more tricky stuff – is it income if your boss pays some money towards your rent? Is it income when you stay in your own house and prevent yourself from having to pay rent?
These lines get blurry because we haven’t really defined what we mean by income.
The Treasury report cites the intention of what we wish to measure with income in the following way:
Analysis of progressivity is more broadly based on the underlying principles of ability to pay,
https://www.treasury.govt.nz/sites/default/files/2023-04/an23-02.pdf
natural rights and equal sacrifice: ‘these concepts are that those with the greatest ability to
pay should pay more, that individuals have a natural right over the income they earn, and
that the burden of taxation on individuals should be spread equally in terms of utility
sacrificed’.
I like this definition – not because they quoted me in it – but because it collapses down a bunch of important motives that much smarter people than me have written about a lot in the past. When measuring income for tax purposes, we are trying to create a measure about someones capacity to contribute.
There are objective and subjective elements to this. The purpose of good analysis is to then make clear how assumptions about what constitutes income can influence our view about the tax burden of differing individuals – which appears to be exactly what these reports were doing. [Note: I’m also not an entirely random person reading it this way – I have done a little thinking about measuring equity and redistribution in New Zealand in the past – and advised on these projects at a much earlier stage of their life but have been uninvolved for some time.]
And hence this leads to the very debates people are having in public!
We have taxable income which people are compliant with – and taxable income was, in some sense, determined on the basis of assumptions and debate about ability to pay. However, different assumptions can help us understand the tax system in different ways.
Get to the point – what is income
Ok ok. I’m going to leave out the idea of whether we consider government transfers as income – because we already chatted about this here. Cliff notes – if we are talking about the “progressivity of the tax system” they are, if we are talking about the “fairness of redistribution in New Zealand” they are not.
Commentators in news articles need to stop confusing progressivity and fairness – I don’t give a crap if you’re “simplifying for a public audience” or “this is the common definition”, these are technical terms and you are speaking with ideology. If you don’t understand the distinctions then that is on you, and maybe reflect on that and then give this awesome book a read.
But I digress – what are the key income bits people are a bit weird about:
- Unrealised capital gains: The increase in the value of owned assets that haven’t been sold.
- Imputed rent: The value of living in your own house.
To make sense of these we need to introduce an idea called economic income or Haig-Simons income. The definition is pretty simple:
Income in a period = Consumption in a period + Net Wealth at the end of the Period – Net Wealth at the start of the period.
Your “income” is simply the potential amount you could have consumed in the period, without reducing the wealth available for future spending.
As we will discuss below, unrealised capital gains and imputed rent both fit into this definition of income – but understanding the definition makes us understand a bit more about why this makes us nervous.
This general flow of expenditure on consumption goods and savings (which are then goods you’ll purchase in the future) tells us the current capacity someone has to consume. This current capacity to consume can then be viewed as reflecting their ability to pay to contribute to public spending.
Other matters can jump in though which make this difficult:
- Are there minimum expenses that should not be considered as income as they are necessary to survive.
- Do those with higher income, or in different circumstances, have greater necessities. In this case their equivalent income may be lower.
- How do we consider “net wealth”? Given how hard it is the value and how much less tangible gains on this wealth may be?
The ideal income we want to measure is one that is consistent between all people, and represents what we see as the sum they “could” contribute from during that period. For measurement reasons we may keep some elements (what we will term expenses) in income to keep the measure consistent – but we would want to then be clear that a reasonable system may not expect individuals to be “net contributors” from that part of income.
On expenses
Every day I need to consume calories. If I don’t I would die. Similarily I need basic shelter. I use my wage income to pay for this. However, someone who owns their own farm may well be able to cover these same costs without “measured income” by spending some of their own time working on the farm and living in the little farm house.
Given this we want an income measure that will treat these expenses consistently – either excluding any time this expense shows up in income, or including it in every circumstance when it shows up.
Take rent. If you earn wages and pay rent the wage income you use to do this is counted as income. However, if you own a house the opportunity cost of using your wealth to live in your own house (the imputed rent) is not counted.
To make things like for like, we could subtract housing costs from all individuals – or we could add imputed rent as income for those who have their own house.
The ETRs will look different in both circumstances, so we will want to be careful with how we judge them – but in both cases the treatment will be consistent.
In terms of a definition of “income” the flow use of the property is real consumption – so net imputed rent (subtracting the cost of maintaining the property) is indeed part of this income concept.
Net wealth and unrealised gains
A big part of Haig-Simons income is the definition of what net wealth is. By definition this flow of income is counted “as it accrues” not as it is realised – as it could be realised, so the individual has the capacity to contribute.
We want to value the asset on the basis of the price it could be realised for in order to understand what an individual potentially has access to. However, not every asset has a market price. In this case it is necessary to guess, or impute, the value of wealth – this process may differ a lot from the real value, and is why the reports spend so much time discussing and looking at alternative assumptions about this.
However, there is a more fundamental issue than the valuation of wealth – unequal sacrifice due to forced liquidation of assets.
The rationale for any measure of income as a tax base is “equal sacrifice”. However, the sale of an asset now in order to pay tax may force the individual to sacrifice substantial income in the future – if they have to sell in an illiquid way. The example often given here is a “fire sale” for a retired individual who owns their own house in Auckland.
This issue is clearly important for genuine tax policy around the world – as capital gains are taxed on a realised basis (when the person has cash on hand) rather than an accrued basis.
A less extreme way to think about this is that a lack of cash on hand (liquidity) means an individual may be forced to take a haircut on any asset sale in order to meet the tax liability – so i) looking at the full value may exaggerate income as there true “net worth” will drop with the sale ii) switching the timing of the time away to realisation will make sense.
So if we are going to tax realised gains should we count the income on realisation or when accrued? Contrary to the fire in public – most economists would say accrued. This is because the increase in wealth does give the individual great capacity to consume and thereby contribute. By definition this will reduce ETRs most of the time – but will lead to situations where individuals have wildly high ETRs … if the realised gain is taxed.
However, before we start getting too up on our high horse about this – don’t forget that New Zealand does not tax most capital gains. So if we do want to view things in terms of a comprehensive income base, noting that there are significant accruing gains that will largely never be taxed is quite relevant – and getting caught up on the fact that they are measured “at accrual” feels a bit like a deflection.
If the realised gain was taxed you would want to include the present value of that future liability when looking at accruing gains – as there is an accuring tax liability – otherwise the ETRs would risk being misleading. But that largely is not the case in New Zealand.
As a result, this concern is still relevant when saying that an “accrual tax” has issues. But it isn’t particularly relevant when investigating the average tax liability of individuals that earn a lot of income from capital gains – again remember, these are not taxed in New Zealand unlike most other countries.
Personally I find the income base weird to start with – and would look towards international recommendations for a progressive consumption tax and potential tax on inheritance.
But if you are happy with taxing an income base, I don’t see why you’d get wound up looking at accruing capital gains to understand ETRs when the realised gain is itself untaxed.
On inflation
A bunch of economists and commentators went wild about inflation not being included in the analysis, stating it makes everything junk. This is both an interesting point – which relates to my preference towards consumption taxes above – but it is also not nearly as important as is being stated.
Why does inflation matter here? Well income that is just “compensation for inflation” isn’t really income – it is a required return to maintain the true value of the asset. Haig-Simon income is in real terms, not nominal. As a result, not accounting for inflation does increase the income base.
However, the current tax system is based on the taxation of nominal returns to capital – as a result, we tax the entire nominal interest you earn from savings, or the entire nominal share price gain on foreign shares. In this way, a system that compares capital income items on a “like-for-like basis” is the version without inflation.
This is a larger issue for long-lived assets. And it points to a deeper issue about what is income from capital gains – namely if the risk-free rate of return declined during the period (it did) and this explains part of the increase in asset prices (it did) this is largely not income – unless it generates age based redistribution (Kaldor 1955, Fagereng etal 2022).
And the overall taxation of inflation is a big issue – Andrew Coleman has a fascinating paper about this.
But what is this:
The IRD paper does not, but is clear that it is doing so to make sure the related bases are treated consistently – and due to the complication of dealing with the life of the asset. My guess would be that such assumptions were probably forced on them in order to avoid making the questionaire too invasive about individual assets.
If we just took a rule of thumb where we substracted the inflation target from the reported nominal gains in the report (equivalent to increasing the cost base by inflation), the ETR rises to around 11-12%. If they had reported this would people be talking about how the report was a smoking gun about something?
No, because the real reason they disagree is that they don’t believe this is the correct tax base overall. That’s fine, but actually say what it is then instead of weirdly bagging people who explicitly and repeatedly told you what they were doing – and you missed it because you didn’t read their report.
You used to work at IRD, so you are biased
I did – more than that I worked with the team who was kicking this off while I was there, but have been over in Australia for a while now.
I do think highly of the people who worked on both these reports from my personal knowledge of the types of people they are. But deep in my heart I am an economist. If I had read these and thought they were political documents that purposefully ignored important shortcomings – at the behest of an activist minister/government/staffers – I would have no qualms saying it how it is. Hell, I’ve upset enough people I respect on this blog in the past because I can’t keep my mouth shut.
In fact, as I’m now in the private sector causing some mayhem by trying to pick at the report would be in my own interest. I don’t do this because the reports themselves are fine.
If you don’t trust the discussion above, I couldn’t really care much less – you do you. If you think I’ve missed important elements, or you want clarifications on things then drop me a comment down below or flick me an email – as I’d love to chat.
Can I give a preview to my thoughts on the reports results? They seem accurate and descriptive which has value.
- The real lifetime ETRs (relating to redistribution) are probably a bit higher than this for the high wealth group and lower for the general income earner due to the period analysed and the definitions,
- The comments around the media about the NZ tax system being regressive (i.e. with GST) are reading too much into this (and into how it reflects about fairness).
My hope is that the upcoming tax principles work is also careful about how it interprets these types of metrics. But these views may change on further reading, so we’ll see 😉