Bad tax law can be defined by two simple characteristics.
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It produces different tax outcomes for different sectors / different taxpayers, even when they’re seemingly doing the same thing. This creates winners and losers within the system.
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It’s designed to engineer a social outcome, rather than gather revenue fairly and equitably.
A case in point is the government’s law removing the deductibility of interest on existing residential investments.
This law was unashamedly passed to make residential property investment less appealing, and to drive down the value of residential property in an attempt to give first home buyers an easier road to home ownership.
To enact the law, the government was forced to abandon a cornerstone of fairness in our tax system for one specific group of taxpayers: residential investors. This fundamental fairness principal is that interest should be deductible when debt is taken on to fund income earning assets.
Why is bad tax law dangerous?
Generally, taxpayers respect laws that are fundamentally fair to all – regardless of whether they personally like them or not.
When this fairness is removed and taxpayers see unfair outcomes, they become resentful, angry and non-compliant. Non-compliance due to unfairness in a tax system can be compared to the impact of inflation on an economy.
It undermines it. And the more it’s undermined, the harder it is to win back compliance.
The second (and more subtle) danger is that bad tax law needs to be constantly modified and altered to ensure the social outcomes it was designed to achieve continue to be met – particularly as economic circumstances change. This means adding more and more layers of complexity to an already very big onion.
Such complexity drives costs up and further increases taxpayer resentment and non-compliance.
Again, the move to a 10-year Brightline and the removal of interest deductibility on residential investment property are classic cases in point.
Would you believe that the IRD’s document explaining how we might interpret and apply the government’s new bad tax law (known as “Special Report on interest limitation and additional Brightline rules Public Act 2022 # 10”) is two hundred and fifteen pages long!
This sort of complexity is why taxpayers now need to pay for a full-blown tax opinion in order to answer a simple question like “will I need to pay tax when I sell this house?” or “will I be able to claim interest on my mortgage to buy this two-year-old rental property?”.
The need to constantly update and add complexity to keep bad tax law in check was further evident this month. The government announced (in response to outcries from the corporate build-to-rent sector) that it would provide an exemption to the interest deductibility rules for projects that are 20 units or larger, where the units are offered with 10-year tenancies.
The clue that this is more bad tax law to modify existing bad tax law is that, again, it creates an environment of winners and losers. Why should someone building a 19-unit development have a different tax outcome than someone building a 20-unit development – especially when it comes to something as fundamental as interest deductibility?
There’s also the social agenda around the requirement to offer a 10-year tenancy in order to gain a tax exemption. While we have no problem with a 10-year tenancy being offered, dangling a tax carrot to achieve it moves the focus away from fair revenue gathering towards a social agenda.
This sort of law creates distortions and impacts the market in ways that are often not necessary nor intended.
Consider this. Recent hikes in interest rates (required to curb the inflation that the government’s own policies created) has been enough to turn the residential housing market downward. It makes you wonder whether it was necessary to introduce the bad tax law that robbed residential investors of the fairness they were entitled to rely on in the tax system; especially when that same law change has resulted in spiralling rents for tenants and made it harder for them to buy a first home.
We’re currently working with a client who developed a brand new block of units, having carefully calculated the project’s viability relative to interest costs and cashflow outcomes. However, because the code of compliance certificate was issued prior to the government-imposed cut-off date, and because he developed less than 20 units, he is now denied an interest deduction – even though he created new-build units. The economic viability of his entire project has been compromised by having to pay tax on income that simply doesn’t exist.
It’s easy to understand why a taxpayer experiencing this outcome could become resentful and angry, especially when they’ve done what the government itself failed to do with KiwiBuild: creating much needed new dwellings.
Our hope is that we recognise bad tax law for what it is and push to repeal it. We need to move the system back to one that is fair to all and focuses on gathering the revenue the country needs in an equitable way.