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The Danger Of Bad Tax Laws

Taxpayers respect laws that are fundamentally fair, but when that is removed they become resentful, angry and non-compliant, argues Mark Withers.

By: Mark Withers

31 August 2022

What is bad tax law? It can be defined by two simple characteristics. 1. It will create different tax outcomes between different sectors and different taxpayers who are ostensibly doing the same thing. This creates winners and losers. 2. It is designed to engineer a social outcome rather than gather revenue fairly and equitably.

A case in point is the government’s law that removes the deductibility of interest on existing stock residential investments.

This law was unashamedly enacted to deter residential property investment and drive down the value of residential property to theoretically enable first home buyers an easier road to home ownership.

To enact the law the government abandoned a cornerstone of fairness in our tax system for one specific group of taxpayers, residential investors. That fundamental fairness principal was that interest is deductible when debt is taken on to fund income-earning assets.

Why is bad tax law dangerous?

People generally, and taxpayers specifically, respect laws that are fundamentally fair to all regardless of whether they like them or not. When this fairness is removed and taxpayers bear witness to unfair outcomes, they become resentful, angry and non-compliant.

Non-compliance due to unfairness in a tax system is akin to the cancer inflation is to an economy. It undermines it. And the more it’s undermined, the harder it is to win back compliance.

Very Big Onion

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. This means adding more and more layers of complexity to an already very big onion. This complexity drives compliance costs up and further increases taxpayer resentment and non-compliance. Again, the move to a 10-year bright-line and the removal of interest deductibility on residential investment property is a classic case in point.

Would you believe that the document issued by IRD known as “Special report on interest limitation and additional bright-line rules Public Act 2022 10”, which seeks to explain how we must interpret and apply the government’s new bad tax law, is 216 pages long.

This sort of complexity is why taxpayers now need to buy a full-blown tax opinion to answer a simple question like “will I need to pay tax when I sell this house?”

The need to constantly update and add complexity to keep bad tax law in check was further evident this month when 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 and the units are offered with 10-year tenancies.

This creates more winners and losers. Why should someone building a 19- unit development have a different tax outcome than someone building a 20- unit development?

Social Agenda

And there again is the social agenda with the requirement to offer a 10-year tenancy to gain the tax exemption. I have no problem with a 10-year tenancy being offered as such, but to dangle a tax carrot to achieve it moves the focus away from fair revenue gathering and towards a social agenda.

This sort of law creates distortions and impacts the market in ways that were often not necessary or not intended.

When you consider that the hikes in interest rates that have been necessary to curb the inflation that the government’s own policies have created has been enough to turn the residential housing market downward, you wonder whether it was really necessary to introduce 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.

I have a case at present where a client developed a brand-new block of units having carefully calculated the project’s viability relative to interest costs and cash flow outcomes. But 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 and has had the economic viability of his entire project compromised by having to pay tax on income that simply doesn’t exist.

It’s easy to understand why those experiencing this outcome will become angry, especially when they have done what the government itself failed to do, and managed to create new dwellings. I hope we push to repeal this law and move the system back to a fair one

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