Here's how the New Zealand tax system really works

Thursday, 6 June 2019

Do you understand how our tax system works?

This article was first published in June 2019.

If you're employed, you probably get regular pay slips that show a chunk of tax going from your salary or wages to the Inland Revenue Department.

But do you really know how our tax system works?

First things first – what's taxed?

Good news and bad news. The good – it's pretty simple. The bad – the answer is 'almost everything'.

No matter how much income you earn, a tax liability will arise on every dollar. That includes money from your employer, from self-employed activities, from interest payments in the bank, from rent you earn, or even money you have derived from investments outside New Zealand.

* Capital gains tax: Tax Working Group announces support for capital gains tax, cuts to income tax

* Who shoulders the burden of New Zealand's tax bill?**

Some countries allow you to earn up to a certain amount before you start paying tax but New Zealand doesn't have that.

What are our tax rates?

If you earn up to $14,000 a year, you'll pay 10.5 per cent in tax. Income between $14,000 and $48,000 is taxed at a rate of 17.5 per cent. Between $48,000 and $70,000 it's 30 per cent and over $70,000 it's 33 per cent.

But if you are earning $72,000 that doesn't mean that every dollar you earn is taxed at a rate of 33 per cent.

New Zealand taxes income on a progressive basis.

That is, the more you earn, the more tax you will pay on the extra bits. That is why our tax rates are described as marginal tax rates.

The more you earn, the more tax you pay - and if you get support such as Working for Families, there's even more disincentive.

The first $14,000 you earn is taxed at 10.5 per cent, then the next bit at 17.5 per cent and so on. Only the bit you earn over $70,000 is taxed at 33 per cent.

This means someone earning $75,000 pays $15,670 a year in tax.

The thing with marginal tax rates, though, is that when you get near a higher tax bracket, there's not a lot of incentive to move up.

If you earn $69,000, your take-home pay is $1044.63 a week. At $72,000 it's $1083.

Only $40 different in the hand per week or $2000-odd a year, for a $3000 pay rise.

This effect can be compounded if you're also getting Government support through income-related tax credits such as Working for Families.

Under the Working for Families rules, the tax credit entitlement is reduced by 25 per cent for every dollar earned over $42,700. This clawback can mean there's very little real benefit of getting a pay rise at some levels.

A couple earning $40,000 each a year with two children would end up with $1305 in the hand combined every week plus $97 in Working for Families, or a total of $1402.

If they increased their income to $45,000, each, they would get $1456.50 a week but only $49 from Working for Families.

That means, despite earning $10,000 more a year, they would only end up with about $5000 more in their bank accounts.

Hold on… if everyone pays tax on every dollar they earn, but what about those tax-free capital gains we keep hearing about?

Capital gains are generally not taxed (unless you're a property investor selling a house within five years) or otherwise involved in buying and selling properties.

Thus, if you buy a house and rent it out, it's the income from the rent that is seen as the taxable activity, and provided the house is owned for more than five years the capital gains are just a happy coincidence.

But if you buy and sell with the intention of making money from those deals, you pay tax.

If you are a member of a KiwiSaver fund you don't pay tax on capital gains.

However, the income in your KiwiSaver is taxed in the scheme, and not to you personally, at your prescribed investor rate (PIR). Your PIR is the tax rate you notified the KiwiSaver provider and is based on your previous two years' income.

As a general rule if your taxable income was $14,000 or less in the past two years and your total income income less than $48,000 then your PIR is 10.5 per cent, if your taxable income was $48,000 or less and total income less than $70,000 your PIR is 17.5 per cent, otherwise your PIR is 28 per cent. However, if you do not get your PIR correct, the income can be taxable to you personally. As the recent KiwiSaver tax problems show.

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