TCS Daily

Economic Kiwi Fruit

By Veronique de Rugy - February 18, 2005 12:00 AM

In 2001, Congress cut income tax rates for the first time since 1986. However, it did little to reduce the extreme complexity of the tax system -- and may have made it even more complicated. And things have gone downhill ever since. The tax code and regulations are now 46,000 pages long, up from 26,000 in the mid-1980s. The number of different IRS tax forms jumped from 400 to 500 in the past 10 years.

Congress is now considering proposed reforms to decrease this complexity. Before embarking on a new path, and potentially repeating some of the mistakes that undermined the 1986 reform, US policy makers may want to learn from reforms in other nations. The New Zealand's tax code overhaul in the 1980s and 90s led to incredible economic growth. This experience provides a good role model for the US to follow.

NZ has one of the simplest income tax systems in the world. It was not always the case. At the beginning of the 1980s, New Zealand had an old-fashioned system with high tax rates and lots of loopholes. Not surprisingly, the economy was suffering from years of stagnation, high unemployment and fiscal disarray. The widespread view was that the tax system was failing. It was not raising sufficient revenue to finance the nation's bloated welfare state in spite of extremely high marginal tax rates. The tax complexity and the huge amount of loopholes gave great incentives to tax avoidance and evasion. Consequently it was commonly described as unfair and corrupt.

In 1982, the independent McCaw Committee was appointed to review the New Zealand tax system. The main conclusions outlined in the Committee were that the New Zealand's loophole-ridden, high-rate tax system needed a major overhaul. The Review then made a series of recommendations that, together, constituted a call for a very Reaganesque tax reform. The driving idea was to create a simple and transparent tax system, where tax rates are lower and apply more consistently in practice. The aim was a more efficient tax system that would lead to decisions made on their economic merits rather than on the pursuit of tax advantages.

Surprisingly, later governments, especially the 1984 elected labor government, adopted most of the review's recommendations. As a result, New Zealand's tax system was dramatic transformed. Combined with other reforms such as trade liberalization and elimination of agricultural subsidies, the New Zealand economy boomed.

Reviewing the tax reform, NZ shifted its income tax towards a simpler and flatter structure using a broad-base, low-rate principle. The top marginal personal income tax rate was reduced from 66 percent to 33 percent. The tax base was extended and most loopholes removed to reduce complexity and compliance costs to a minimum. In that spirit, many innovations were introduced such as the low rate Fringe Benefit Tax applied to non-cash income.

The NZ tax base is broad by international standards but avoids double-taxing certain types of income. There is, for instance, no second layer of tax on capital gains. The absence of capital gains tax is consistent with New Zealand's move towards a consumption-type tax, like the flat tax, which doesn't tax capital gains at all.

New Zealand also lowered the top corporate marginal tax rate from 45 percent to 33 percent. The alignment of the corporate and individual tax rate along with the full integration of dividend income meant a simple tax system with no double-taxation of corporate income.

New Zeeland also introduced a type of value-added tax in 1986. Called the GST, this consumption tax has a flat tax of 12.5% and drastically reduced the reliance on the income tax. With no exemption from the tax base, this system is almost unique in the world. This is the result of the fact that for over two decades now New Zealand tax designers have placed an important focus on compliance costs. And the result seems rather good.

However, New Zealanders must keep in mind that the GST on top of an income tax creates a long-run danger of bigger government. So they might want to put pressure on the government to get rid of either the VAT or the income tax.

On the budget side, New Zealand also made impressive progress in the battle to control the size of government. According to OECD data, the level of government spending has fallen from about 53 percent of GDP in 1987 to 39 percent of GDP in 2005. The current level of government spending is still too high but the decline is nevertheless impressive. Finally, the country got rid of inflation, and privatized large public companies. The results were astonishing. Unemployment dropped and the deficit disappeared.

In recent years, some small countries with stable political and monetary arrangements have become quite wealthy by offering a business-friendly environment and low tax rates to individuals and corporations: Switzerland, Luxembourg, and Iceland, to name a few. Clearly, New Zealand has joined their rank with great success.

Unfortunately, the current labor government is not as wise as its 1980s predecessor. Spending is going back up along with regulatory costs. In 2000, the top personal income tax increased from 33% to 39% for nothing other than ideological fealty to class-warfare policy. While many countries have drastically cut their corporate income tax rates under 20 percent in the last 10 years, New Zealand's 33 percent rate is now uncompetitively high. Indeed, by OECD standards, NZ has now the 8th highest top corporate income tax rate.

Faced with increasingly steep progressive tax rates on their income, the rich and enterprising who today make lives better for everyone else start fleeing to lower tax jurisdictions. It is particularly relevant to a small country like New Zealand, which should worry about tax havens like Singapore, Estonia or elsewhere. The labor government should worry about tax competition and cut taxes again.

Notwithstanding a bit of back-sliding, New Zealand remains a great success story. New Zealanders have again proved that simplification of the tax code and large rate cuts trigger strong economic growth. More importantly, it proves that if the political will to cut rates is not quite there yet, having a clean tax system can compensate and help sustain economic growth. For the sake on economic prosperity and good tax policy, the US should give tax reform a chance.

Veronique de Rugy is Research fellow at the American Enterprise Institute.


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