Another column on tax reform


I’ve written previously about how lifting marginal rate thresholds is a preferable alternative to lowering tax rates (essentially because of the inequity and the inefficiency of lowering tax at the very top).

This week’s column explores an idea I’ve had since I did some research for the BCA [pdf] which showed how little imputation credits figure in our corporate decision makers’ minds when they make decisions. The issue at hand was the dramatic response of the Australian business community to the Howard Government’s reduction of the R&D tax concession. It seemed amazing to me how big the reaction was when for most shareholders, the reduction of the concession only affected the timing of when they paid tax – not the ultimate payment of the tax. Why? Because since imputation, company tax is just withholding tax for local shareholders. They get it all back as franking credits on dividends.

So why did R&D drop off so sharply? It seemed to me to be very clear evidence that franking credits are a very poor way to lower the cost of capital. There’s a lot of evidence of various kinds of ‘money illusion’ going on within the money market in any event – the very fact that companies pay dividends is a bit of a mystery since it’s so much less tax efficient for their shareholders than investing the cash in further assets (and gives them the choice of when to liquidate their asset rather than have it made for them by the company).

If we wanted to lower business tax to lower the cost of capital it seemed a much better optiont to spend the money on lower company tax than dividend imputation which seems to be enjoyed as a windfall as much as it lowers the cost of capital. As I did the research for the column this was corroborated. One set of researchers said this “It is common in commercial practice to ignore the value of imputation credits both when valuing real assets and when conducting capital budgeting analyses.” In other words, the franking credits – at precious cost to the revenue are not factored into the cost of capital within firms.

And what about outside firms? The econometric research suggests that the implicit value of the imputation credits in shares is discounted by 50% or more in share purchases. So it’s not that shareholders ignore them – they don’t. But they don’t fully value them. So it’s pretty hard to justify dividend imputation on efficiency grounds.

As I was writing the column – which also features discussion about foreign investment, I was also thinking about parallels with some work I did on manufactured exports (particularly automotive exports) in the 1980s and 90s. I’ll try to write a little more on this soon, but the idea is simple. It makes sense to lean in the direction of exporting because the world market is a very, very big place. If you find a few things you can do well, you can expand them to your heart’s (and wallet’s) content. If we could capture a percent or two of the world market in cars, we’d have solved our competitiveness problem for the industry.

Now while I’m broadly supportive of free trade, and certainly of reducing high levels of protection the evidence seems to suggest that what really matters is export orientation. In other words, if you can turn the mercantilism that turns up in tariffs and quotas outward, then it might be as messy, as politically corrupt as tariffs and quotas turn out to be, but it may not matter much. What matters is getting your firms tasting the international market and learning to be part of it. Only a few have to cotton on and things start running very smoothly.

Jagdish Bhagwhati put it this way in 1973 conceding the implausibility of shoehorning the (then) NICs (Newly Industrialising Countries) into a standard ‘free trade’ explanation of their success.

Instead of the chaotic selectivity of the incentive policies for ‘import substitution’ which seems to be the main focus of our trade-theoretic analysis, a more important inhibition on growth may in practice be the speed with which import substituting industrialisation is geared toward ‘export promotion’. . . . [T]he key to success is not the absence of detailed, selective and target-oriented export promotion . . . . The distinguishing feature of superior export performance seems to be the pursuit of ‘indiscriminate’ and ‘chaotic’ but energetic policies to promote exports from industries which have been nurtured under protection in the first place.

I suggest the same principles apply to foreign direct investment and the column suggests this.

Anyway, so much for the introduction, on with the column. (Oh and by the way, I didn’t write this intro to lure you into the column. The intro is a memo to myself of the things I had on my mind – one of the things I was trying to prove and something else that occured to me as I wrote it. The column (over the fold) is more engaging – promise!

We Australians think of ourselves as practical people. But in tax reform we’re often seduced by elegance instead of practicality.

Take the GST. On paper it’s simple even elegant. But as John Howard argued, rejecting it in 1981, tracking tax through each stage of production is an administrative nightmare for companies.

Likewise Paul Keating’s adventures in tax reform aligned the top marginal personal tax rate and the company rate. Isn’t that neat? But then he cut company tax further and now the two rates are wide apart again.

Keating also introduced ‘dividend imputation’ to prevent tax being paid twice on company profits, once when firms pay company tax and again when shareholders pay tax on dividends. Imputation tracks tax through a chain of transactions (just like the GST!). It gives companies’ ‘imputation credits’ for the company tax they’ve paid which they then pass to their shareholders with dividends.

Like the GST this was marketed as a ‘Rolls Royce’ reform. But with tax, there are always problems. We should be minimising them pragmatically not firing off one ‘silver bullet’ after another.

If we wanted to increase investment in our companies, or what is the same thing – if we want to lower the cost of capital for our companies, the evidence suggests more cost effective ways of doing so like just cutting company tax.

And dividend imputation discriminates against foreign shareholders. (Because they don’t pay Australian personal tax, they get no benefit). If that sounds OK to you, you might be acting local, but you’re not thinking global. There’s a vast pool of international capital out there. Because we’re a small country, a small increase in the share of foreign investment we attract would be a torrent for us.

That’s why studies suggest that, particularly for small countries, cutting company tax produces substantial economic gains. (That’s just what they’ve done in some of the most successful European countries of recent years like Norway, Sweden and Holland.)

The same studies reveal that cutting top personal tax rates a subject of endless reform discussion and speculation in Australia doesn’t help growth.

One country illustrates the issues with a vengeance. In 1987 when Australia and New Zealand were crowing that we’d aligned the company and top personal tax rate (at relatively high rates), Ireland ignored alignment just slashed tax on foreign investors.

The result? Ireland has laughed all the way to the Bank for International Settlements.

Even in its glory days the Australian economic miracle (now fast fading with faltering productivity growth) pales into insignificance next to Ireland’s. Since 1987 the growth in Irish workers’ productivity per hour has nearly tripled ours. The result? Irish workers have gone from producing around a fifth less per hour to a fifth more!

Could we do as well by copying those policies? I doubt it. Ireland was poorer than us when it started (those were the days), and it got some free kicks from European subsidies. But it also had free access to four hundred odd million rich Europeans.

But Ireland’s experience shows that aligning company and top personal tax rates is no silver bullet. While we’re banging heads together trying to figure out how we can reduce the gap of 18.5 percentage points gap between the two rates, the Irish are still streaking ahead of the field with a gap of 26 percentage points (16 per cent against 42 per cent).

How do they afford it? Well, economic growth keeps the coffers full. But they also abolished their dividend imputation system! With company tax at just 16 per cent who needs it?

In Australia abolishing dividend imputation could probably fund a reduction in our own 30 per cent company rate to around 19 per cent or lower if we attracted lots more investment.

It looks like a worthwhile, revenue neutral reform to me. But it’s scarcely on the agenda. That’s partly because of our fondness for alignment.

The loudmouths in the pub will tell you that what I’ve proposed would allow everyone to incorporate to reduce their personal tax to 19 per cent? But most of them haven’t run companies. You see, whether you own a company that runs your small business or a few shares in BHP Billiton, the issues are the same. You can’t spend its money until it pays you that money.

And if it does that you pay personal tax on it. Get it? A company can help you run but you can’t hide. You can delay tax payments by keeping money in a company but you’ll eventually have to cough up.

With savings rates like ours, incentives to leave your money in companies might be no bad thing. If it was, specific anti-avoidance arrangements could address the problem as they did in 1985 before Paul Keating abolished them with a flourish as he aligned company and personal rates (ever so briefly).

So it’s worth a try. Company tax rates near Hong Kong’s without massive tax cuts to the rich that’s what I call thinking globally and acting locally.

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15 years ago

Can I suggest the overarching problem here Nicholas is essentially income tax. You know- defining what is income and then what is the definition of the entity that will be made to cough up and by how much.
As you so rightly point out-
“That’s why studies suggest that, particularly for small countries, cutting company tax produces substantial economic gains.”
What if we gave them zero company income tax? If it has such beneficial effects for companies, why not individuals, partnerships, cooperativess, profit and non-profit organisations? Hell, why tax human exertion, thrift and endeavour at all, when we could tax the consumption side of it only? Why would you continue to tax labour at all, when you so badly want it to substitute for damaging fossil fuel use?

Why not simply tax fossil fuel and resource use at the source of its extraction/utilisation in the environment? Easy to tax and unavoidable (mine,quarry, farm, river, lake, land use, etc) and equitable via fossil fuel use. The latter could be kicked along with an annual nett wealth tax for high wealth individuals, with relief if you invest(hold wealth) in existing or creating pristine/natural environments. eg you can have your capital gains to your hearts content driving up the prices of wilderness, to the point where capitalists are the environment’s best friend. Everything must be owned or it belongs to the govt(us). That means churches and private schools must be owned by their ‘shareholders’ and add to their nett wealth. You don’t just get to enjoy that wealth by paying private school fees for a while and free-riding.

Now the question is-How to get from the deplorable muddle we all have now, to a new market green economy. The prize for our national leadership in this race is- The headquartering of many international companies, a massive green economic engine propelling us in the right direction, with no tax on thrift or entrepreneurship and no economic distortion between private, business or charitable use of resources. Also a society that taxes resource use only, will not only have the incentive to conserve and recycle, but also concentrate on quality rather than quantity, a prerequisite for long term sustainability. Basically Nicholas you need to give up on the science of muddling through and start to think in revolutionary ways dear boy! The question now is how to get where we so obviously need to be and pronto.

15 years ago

You may have gathered by now I have no faith whatsoever in the taxation of income in this country. For far too long, too much of our best legal and accounting brainpower has been absorbed OTOH by the Herculean task of defining/identifying and taxing income and OTO by quarantining and avoiding same. We should give it up as a bad joke, but to do that, means leftist thinkers have to give up one of their most sacred, but rotten cows. However, if there is one thing the introduction of the GST taught me- is that this nation and its people have an enormous appetite and capacity for well thought out tax reform.

derrida derider
derrida derider
15 years ago

Good luck trying to sell a return to the classical system of company taxation, Nic. You may even be right that we’d all gain from a revenue-neutral reversion to it, but I can’t see you selling it to either left (whattya mean, you’re gonna cut tax on foreign multinationals?) or right (whattya mean, you’re gonna take my franking credits away?) wing punters.

And I’m sorry, but its true that some people get lots of advantages from incorporating. The bulk of these, though, arise from how easy it makes it to hide revenue illegally and to disguise personal expenditure as business expenditure. So you’re right that the “need” to align the personal and company rates is indeed a bit of a furphy.

And twenty years of studying the empirics of tax and benefit leaves me deeply sceptical of arguments about massive deadweight costs of a high top marginal rate.

Richard C
Richard C
15 years ago

Standard actuarial practice values franking credits at 70% of face value. This has been the value derived from observations of stocks going ex-dividend. There were a couple of papers on this a few years ago.

At least in the financial services industry imputation credits are usually modelled for business cases and such. Companies are very aware of imputation credits and their value.

15 years ago

“And I’m sorry, but its true that some people get lots of advantages from incorporating.”
Derrida, the advantages you speak of may not be due to incorporation, but probably that incorporation is often a sign of more mature entrepreneurship (ie income and assets and the trappings and expertise that ensue) Most startups (read scratchers and hopefuls) are sole traders or partners. Certainly many of us with accumulated assets eventually choose incorporation for its better limited liability protection in an increasingly voracious legal system. Be wary of the trap of at the same time therefore because of.

“And twenty years of studying the empirics of tax and benefit leaves me deeply sceptical of arguments about massive deadweight costs of a high top marginal rate.”
Well presumably you have every reason to be skeptical if as you say, we incorporated types are largely avoiding the deadweight costs

derrida derider
derrida derider
15 years ago

Thinking about it, I was wrong (goodness me, that’s never happened before!). It is of course working on own’s own account that gives the major advantages if you seek to either evade or avoid tax.

And Observa has an interesting point. Say somebody avoids tax. Where’s the cost?
– From the viewpoint of equity its obviously bad. Some other sucker has to pay extra.
– From the viewpoint of the taxman, its real bad. Not only does he have to chase the other sucker, that other sucker is gonna try and avoid it because he sees the unfairness.
– But from the viewpoint of economic efficiency, the tax avoider is gonna work or save as hard as if the tax wasn’t there.

Given the widespread evasion and avoidance at the top end, its just another reason to be sceptical of claims that cutting the de jure rate of tax achieves great things for the economy.