Alignment of the top marginal rate and company tax

The classic statement of this doctrine is provided with all the easy authoritativeness of a harangue at the pub by Alex Sanchez, a former Mark Latham staffer.

In today’s world, paying more than the company tax rate of 30 per cent is optional. After you’ve gone beyond that threshold, you merely incorporate and be done with it.

As I’ve explained in columns before this, and as Jerome Faher of Allen Consulting explained at a presentation recently this is (almost) complete bollocks.

ACCI want to . . . cut the top marginal rate to the corporate tax rate of 30%. But, despite the ubiquity and respectability of the case for ‘alignment’, I think it’s based on a simple misunderstanding. People ask “if you can ‘choose’ to pay tax at a 30% rather than 48.5% why wouldn’t you?” But the money in a company is hermetically sealed from its owners. That’s the point of it. So you can’t use any profits in your company until you pay them to yourself as dividends. Get it? When you pay yourself dividends that’s income on which you pay personal tax whereupon the tax advantage of the company disappears.

People also think that somehow owning a company enables you to ‘write off’ more expenditure in the company. But the company is a red herring in this story. Tax avoiders and evaders (oops I nearly wrote ‘We’) will claim personal expenses as business expenses irrespective of the corporate structure. Indeed the immediate benefits of doing so within a company are less because of the lower rate.

The one remaining lurk is the way in which a company’s ‘undistributed profits’ provide its owners with free loan from the tax man. Personal tax is not payable on company profits until they’re distributed as dividends. But, as Bob Hawke’s Finance Minister Peter Walsh used to point out in response to Paul Keating’s agitation for alignment, that problem can be addressed directly by re-introducing the surtax on undistributed profits that we abolished in 1985 when we aligned the personal and company rates it turned only briefly. (The additional revenue this generated could be used to lower company tax further and/or offset any additional tax burden a surcharge imposed on new investment).

I’m writing next week’s column and arguing that far from aligning the company rate, we should continue to move the company and top personal rates further apart, but cutting company tax and leaving the top personal rate where it is. It occured to me as I did some reading that there’s a reason this argument comes most forcefully from people like Sanchez and Bill Shorten. (I presume) they haven’t got much experience with company tax structures. Malcolm Turnbull [pdf] likes to throw in the idea of alignment where it suits his argument, but he’s more circumspect about the argument for alignment and mentions those who don’t support alignment or at least tolerate the idea that transactions costs mute the case for alignment. Malcolmn Turnbull knows about running companies.

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Ken Parish
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Ken Parish(@ken-parish)
15 years ago

Nicholas

I agree with the main thrust of your post, but I think it somewhat understates the extent of potential advantages that a company/trust structure can deliver to the self-employed (and executives of compliant larger private sector corporations). Those advantages are by no means confined to falsely passing off personal expenses as business overheads.

They also include, as Faher mentions but understresses, the benefit of utilising undistributed company profits as effectively a loan that can be used to gain further accretions of tax-deferred wealth. That is especially so for people who make use of the private superannuation scheme vehicle to underpin low tax investment strategies yielding longer term capital gains. I’m sure that private super schemes drove the recent property price bubble in south eastern Australia to almost as great an extent as the Howardian CGT regime itself.

Secondly, a company/trust structure also permits income splitting with spouses and adult children to an extent and with a flexibility that simply isn’t available to PAYG taxpayers. if you’re a professional, you have to create the additonal complication of a service trust entity, because you can’t split professional income directly with non-professional immediate family members, but the end result is the same.

None of this provides a compelling or even persuasive case for lowering the top marginal personal tax rate to 30 % (or perhaps even at all), but it does indicate that most self-employed people (at least those earning (say) 100K or more) would be mugs not to have a company/trust structure and a private super scheme. If I was a betting man, I’d wager you’ve got both Nicholas!

Ken Parish
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Ken Parish(@ken-parish)
15 years ago

I should also have made the point that non-alignment of the company and top personal rates enhances incentives for high income earners to save and invest their tax-deferred retained company profits, which must surely be at least potentially a good thing in a country with generally poor national savings performance like Australia. I assume this is part of your argument in favour of preserving and even increasing the gap between company and top personal rates.

The problem at present appears to be that these savings mostly flow into negatively geared residential rental investments, which are not only not terribly productive but also that the negative gearing borrowings largely negate the economic benefits that would otherwise flow from the savings effect of the tax rate gap. Quarantining negative gearing losses on residential rental properties would fix most of this undesirable spin-off.

Ken Parish
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Ken Parish(@ken-parish)
15 years ago

Perhaps I’m actually saying almost the opposite of your argument on deferral. It’s a good thing as long as the pool of tax avoidance-generated savings is well invested. And your (apparent) proposal proposal to widen the rate gap by reducing the company tax rate but not the top marginal rate would further increase the incentive towards retined company earnings. Why would one then attempt to undo it by charging a margin on that deferral benefit?

Surely it would be preferable to attempt to make an unqualified virtue of it by:

(a) quarantining residential rental negative gearing losses so as to reduce the attractiveness of this rather non-productive form of investment (while not eliminating it entirely as Keating briefly and disastrously attempted in the 1980s); and

(b) providing enhanced tax incentives for more productive forms of investment e.g. R & D and capital investment in high tech or elaborately transformed manufactures generally (where Australia has begun lagging badly over the Howard decade).

I mean, life’s a heap of shit when you look at it, but we might as well look on the bright side of tax and get our happy little tax avoiders doing something useful with their money.

Bill
Bill
15 years ago

Okay Brian

err.. I mean Ken

What exactly are “residential rental negative gearing losses”.

You’ve lost me there.

Paul Watson
15 years ago

Ken’s spot-on, re the massive tax-benefits of income-splitting, via companies (if you’re blue collar and self-employed), and service trusts (if you’re white collar and have “property” in another’s labour).

That the “personal exertion” amendments of a few years ago – aimed at reducing income-splitting – have only hit a small rump of white collar ontractors/quasi-employees reinforces the Howard government’s clever demographic targetting.

The already very rich are (obviously) well-cared for, but more importantly when it comes to getting key marginal seat votes, Cronulla’s (at al) white-trash tradesfolk are also given what amounts to preferred tax treatment.

Sam Bolbot
Sam Bolbot
15 years ago

I don’t pretend to understand the ins and outs of taxation.

However, in a former life I worked as an assessor in old AUSTUDY [DEET days – not to be confused with Austudy Payment as administed by Centrelink]

In those days, eligibility for AUSTUDY depended on the parents’ TAXABLE income.

We had students who were eligible for the full-rate of AUSTUDY despite living in the most expensive suburbs, and attending to the most expensive private schools.

Their parents had miniscule taxable incomes, as shown on their Notice of Tax Assessment – and no assets. In some cases, the school fees with were greater than the parents’ taxable income.

The government has changed the rules, and now if parents are in business, they have to complete the Family Assets test, and are assessed on which ever is the greater – income or expenditure.

So there is obviously plenty of room in the tax system for people to have the benefit of a large income without paying tax on it.

spog
spog
15 years ago

I presume it’s because company profits are split among the shareholders without having to go through any lark about whether they are particpating in the business.

observa
observa
15 years ago

Nicholas,
In a partnership the split is predefined and the ATO will want to be sure this is a reasonable ‘arms length’ transaction. Now this should also be the case for companies in terms of shareholders, but in practice the income of the company can be paid out as dividends, directors fees and salaries/wages. Notice also that a private company nowadays need only have one director/secretary which can be the sole shareholder (my case). The rub is I can then employ anyone I like for whatever remuneration I like, so long as I pay Workcover(state requirement) and PAYG tax and super. This may entail having the wife and kids on the payroll from time to time, which the ATO will be unlikely to query(unlike partnerships and trusts), but if they do want to query some outrageous nepotism, they are going to have to challenge the likes of the Packers and Murdochs in the courts. Clearly the ATO never have. You get the picture?

One of the most beneficial returns for family type companies is to pay the offspring enough to qualify for independent student status at uni.

Cliff
Cliff
15 years ago

So could you say the current disparity between the personal and company tax rates is actually quite good, in that, as money is kept in the company to avoid a higher tax rate (which locks it away from personal use), it encourages reinvestment in business and industry?

Bruce Bradbury
Bruce Bradbury
15 years ago

If the gap in tax rates is considered a problem, another policy option might be a regressive tax on company profits. That is, align the company tax rate to the top personal tax rate for the first $500,000 or so and then have a lower tax rate if desired. This will remove some of the incentive for incorporation without affecting international competitiveness. (I suspect that franking credits might still provide to some incentive for income splitting – but this issue is essentially an orthogonal one to the question of the company tax rate)

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