Improving capital taxation in Australia

A paper done for CEDA is coming out of embargo tomorrow – Wednesday. Here is the ‘op ed’ of the paper which is appearing in the AFR. I’m told the paper will be downloadable from the CEDA website, but it’s not as I write this and I’ll be out of range for most of tomorrow. If you cant get it, email troppo and I’ll send it by return email.

The paper further develops a theme Troppodillians will be familiar with – that we get mislead into taking quite wrong intellectual shortcuts by the seductive term ‘real reform’ and seems to have generated some interest in the press.

Postscript: another paper on personal tax is here.
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Taxing Australia’s companies. What is real reform?

How often have you heard that aligning personal and company tax rates is some touchstone of ‘real reform’? Of course it would be nice to do, but at what cost?

Not only does cutting the top personal tax rate focus tax reform where it gives us the least growth dividend. (If we’re cutting personal tax, money spent lower down the income scale generates more growth by getting more people to work.) Alignment also keeps our eyes off a bigger prize.

Economic theory suggests lowering company tax generates more growth than lowering personal tax. So does a bit of empiricism whether it’s from casual observation or a careful look through the trusty econometriscope.

Economic theory says taxes on investment returns discourage saving and investing and that this effect compounds hugely over time that it depresses productivity, wages and growth.

That’s why a plausible economic model suggests that cutting company tax eventually generates more than twice as much growth as personal tax cuts returning nearly 50 per cent of its revenue cost back to government as increased growth swells tax receipts.

And that’s before you count the way company tax cuts would increase foreign investment. The econometrics agrees with the theory. Two scholars from the free market American Enterprise Institute investigated the correlation between income and company taxation and wage rates. It turned out lower that company rates increased wages confirming their expectations. But something else confounded their expectations lower personal taxes don’t correlate with higher wages.

Another academic study found that lower company tax strongly increased growth suggesting that that a ten percentage point cut in company tax would increase per capita growth by at least half a per cent per annum. They found virtually no relationship between top marginal personal tax rates and growth.

Now add this example to the econometrics for an overwhelming case against alignment. Ireland’s company tax rate is 12.5% around 30 percentage points below top personal rates. And Ireland has doubled the next best developed country’s growth our own.

Alignment is always sold as an anti-avoidance measure. “Who’d pay 45 per cent tax when they could pay 30 per cent?”. But you can’t enjoy a company’s money without it being paid to you as dividends and when it is guess what? You pay tax on it.

If we’re concerned about the remaining tax deferral opportunities non-alignment creates we should deal with them specifically with anti avoidance measures like those we abolished in 1987 when we (fleetingly) managed alignment. But tackling avoidance by foregoing the huge benefits of company tax cuts is using a sledge hammer to crack a nut.

We also hear that cutting company tax advantages the rich. In fact to the extent that company taxes reduce our wages we all pay them. But even ignoring this, company tax doesn’t tax the wealthy these days because dividend imputation credits shareholders with the company tax paid by their company.

Back in 1987 the introduction of dividend imputation certainly looked like ‘real reform’. It was big and bold with those ‘long clean lines’ that Paul Keating liked in his policies and his decor. It neutralised the tax treatment given to buying shares compared with lending a company money.

But after two decades of experience we now know that the revenue we forgo (around $20 billion) actually increases the supply of capital to Australia’s companies very little.

If you want to know why start by asking a project analyst for an Australian company how much they value the imputation credits for the company’s shareholders. They usually count the value of credits at zero.

And on the sharemarket, the best econometric estimates find credits valued at between zero and 50 cents in the dollar. You see foreigners in our sharemarket are the ‘marginal investors’. It’s their demand for our equities that does most to set their price. And franking credits only help you pay tax in Australia. So foreigners don’t value them.

If we did what the Irish did and abolished dividend imputation, and then used the revenue to cut the company rate, we could lower it by around 10 points or perhaps more down to 19%. All without touching a cent of the surplus. Of course some will object. But if they’re enjoying franking credits now, they’ll get generous compensation for their removal as share prices jump in response to lower company tax rates.

It’s hard to think of a change that would generate so much gain for so little pain.

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Bruce Bradbury
Bruce Bradbury
15 years ago

A simple way to address the personal tax avoidance issue would be to have a regressive company tax. Tax the first $200,000 or so of company tax profits at the same rate as the top personal rate.

Gaby
Gaby
15 years ago

Very fine article Nicholas. Far, far from any taint of “piffle”. Look forward to reading the whole paper.

The anti-avoidance measures would have to be seriously and specifically tackled as you say.

As part of your package, do you see any need to adjust capital gains tax rates? Either on general grounds, or to forestall many and various (“multi-nefarious”) obvious avoidance or even minimization schemes.

timboy
15 years ago

Nic

Why don’t foreign companies like dividend imputation?

They get the 30% franking rebate to apply against their Australian sourced income don’t they?

If franking didn’t apply I guess they would get away with (for a tax treaty country) paying 15% or so withholding tax on their Australian dividend income.

I haven’t read the paper, and just heard a few comments on AM; but are you in favor of avoidance for foreign companies to encourage greater foreign investment?

How do you respond to Paul Keatings criticism?

Bring BAck EP at LP
Bring BAck EP at LP
15 years ago

Nick saw you on the ABC at noon.
look like your dad!

In political terms companies don’t vote shareholders do despite the economics

Andrew Reynolds
15 years ago

Nicholas,
To me, company tax is merely personal tax brought forward – but also with the effect of penalising investment as you showed. Why not simply abolish it? The increased revenue from personal taxes would partially offset the immediate drop in company tax revenue, with a long term effect of being at least revenue neutral from the increased growth over time.
I believe the reason it is popular with the tax collectors is the efficiency argument – it is a lot cheaper to tax a corporate entity than to it is to tax an individual.

Bring Back EP at LP
Bring Back EP at LP
15 years ago

You would need to do it in the first term of office to ensure people gain the benefits over time otherwise you open yourself to being seen as ‘penalising’ shareholders

D.W. Griffiths
D.W. Griffiths
15 years ago

The CEDA paper is here.

TV footage is here.

Radio coverage is here, including Keating’s “piffle” comment.

Jc
Jc
15 years ago

Interesting concept. If cutting company tax down to zero is not doable I guess it wouldn’t be a bad thing. However we have what seems to be a core surplus of around 12 bill a year so it would be possible to have your cake and it too in this context.
Ireland made it to the top of the economic tree in 20 odd years by essentially cutting the corp tax, so we have good enough evidence that such a move accelerates economic growth.

Point is I don’t think investors would be happy campers if imputation credits were eliminated even if stock prices rose. Don’t forget elimination would cause most of this raw income to be (possibly) taxed at a higher marginal rate than before. The other point is that I think investors look at dividends and share price growth as two different things that are going on. It’s silly and not very logical but we’re human after all. There is also the effect of CGT to contend with so people are reluctant sellers if the stock prices are going higher and they have no need to sell, which they may do if dividends are taxed at the marginal rate again. Let’s not forget that dividends are double taxed anyway so we would be going back to that old game.

Moreover some of us think that corporate tax is essentially a double taxation when you consider income derived from working for corporations is assessed as personal income. We’re wealthy enough to lower the corporate tax rate and possibly sail an Irish boom of sorts amd keep our imputation credits while we figure a less complex way of taxing ourselves.

Gaby
Gaby
15 years ago

Thanks Nicholas. But I suppose the point I was trying to make is a little wider.

It seems that the outcome would be a large disparity between top marginal rate, company tax rate and CGT rate and no imputation. A bit like the ’80’s before the intro of CGT and other “Rolls Royce” reforms, but for the “26A’s”.

This gave lots of oportunities for “minimization”. Are things different now to forestall this happening again?

Andrew Reynolds
15 years ago

Nicholas,
Surely the $40b figure is the revenue under the current arrangement. Cutting it altogether would result in higher profits and therefore higher dividends – immediately increasing personal taxation even in year zero and so costing nothing like that figure. Year one results would be a change in dividend policy, further increasing payouts.
The efficiency benefits alone would be huge – investment decisions would then be taken on the basis of things like returns and cashflows, rather than tax effects.