It’s a good question which the Investment and Financial Services Association (IFSA) had the good sense to ask Lateral Economics. You can take in our answer to the question in under 700 words as they appear in the Fin Review today, or at much greater length in the report we did for IFSA. The report – Other People’s Money was released today. It is in two parts and this is the second part. The first part was released about a month ago.
I think there’s an interesting story in the part released today. As we did the report it occurred to me that there was a strong parallel between what happened with manufacturing in the 1960s and what’s happened so far with finance. In each case, assisted by domestic policies we developed a large and relatively competitive industry. In each case we tended not to focus on exports – why bother when supplying the domestic market was going so well? Of course an important difference between the two situations is that the assistance the industry got from tariffs was itself a direct part of the problem of why we didn’t export more, whereas the policy of compulsory super does not directly impede exports.
The similarity is more a kind of cultural complaisance – an idea that exports are nice to have but not something that it’s worth making a great effort to achieve. Of course in one sense this is true. There’s nothing special about exports. So if firms find exporting hard, then it’s not clear that there’s any problem. (I’m not sure there’s a particularly strong case but there are positive externalities in one Australian firm being the first into an export market so at least in principle one can argue for some export marketing assistance). If exporting is hard the exchange rate will fall as far as it needs to to make it sufficiently easy for us to do as much exporting as we need to to finance the imports we want.
But what if the sector you’re in is so influenced by tax and regulatory systems – both in your own country and elsewhere – that it makes better sense to think of the sector, at least when it exports as a joint product between firms and regulatory and tax systems. If that’s the case then we may be foregoing substantial profitable export opportunities by regulating in a way that’s insufficiently cognizant of the needs of exporters.
The report comes to the conclusion that to succeed we need tax and regulatory systems that are more responsive to the needs of exporters.
I expect it won’t be believed by some readers (I could write their slogans here myself) that this is not a plea for some special favours – special tax breaks etc. In fact the in principle issue is broadly conceded – namely that just as GST is not levied on exports so we should not tax foreigners who happen to have money managed out of Australia. We should on the other hand levy company tax on the profits of the Australian based firms that manage the money. But as a matter of fact, despite substantial efforts to remove what is essentially inadvertent taxation of foreigners’ investment in Australian managed funds, when global firms investigate the situation with a view to domiciling substantial export activity here they discover a range of problems or uncertainties about the way in which our regulatory and tax systems will interact with what they plan. The result is that they do it out of Ireland where these things have been ironed out – or at least ironed out better and with less uncertainty than here.
The column is over the fold.
Thanks to compulsory super, Australias is the fourth largest funds management industry in the world. It manages a trillion dollars. Its sophisticated, capable and cost competitive.
Yet under three per cent of its revenue comes from exports that is, foreigners paying us to manage their money. Why?
Exporting isnt easy.
A global fund is domiciled in one country, holds assets in other countries, and may have investors from several other countries as well. Throw in the network of bilateral tax treaties and the complexities are enormous.
This complexity means that global funds management is best thought of as a co-product between funds management firms and the tax and regulatory systems to which they are subject.
The regulators of the most successful financial exporters pay assiduous attention to their global fund managers tax and regulatory needs. That doesnt mean theyre a light touch. Unlike firms in other industries, global financiers actually demand strong regulation to protect market integrity.
Nor is this a rationalisation for tax avoidance. You see, just as we exempt exports from GST (like other countries) so most countries accept that that global funds should be tax transparent.
In other words, while an Australian based manager should of course pay company tax on their profits on managing a global fund, the investments in the fund should not themselves be directly taxed. After all, income from many of those investments has already borne company tax at source and bears income tax when distributed to investors in their home countries. Taxing the investments in the fund a third time as opposed to the profits on managing the fund simply sends them elsewhere.
Recognising this, our Government has spent the last few years trying to extricate investments in Australian domiciled global funds from inadvertent taxation. But the devils in the detail, with difficult tradeoffs sometimes necessary between tax neutrality for global funds and preventing avoidance elsewhere in the tax system.
Meanwhile were up against small countries like Luxembourg and Ireland hosting huge global funds, whose regulators have specialised in this game for decades. If theres a tension between their financial exporters needs and domestic considerations, guess whose interests win out?
Starting with virtually no funds management sectors of their own, these financial entrepôts offered generous tax breaks to attract global funds. This gave them the incentive and the information necessary to build tax and regulatory regimes that were highly responsive to those funds needs.
For example, when a European court struck down a special holding company structure within Luxembourg for breaching the EU constitution, a new regime was re-introduced within just four months!
Ireland worked with global funds to produce an innovative regime which is more tax transparent than companies and trusts for pooling super funds so called Common Contractual Funds (CCFs). Some firms tell us that with a similar regime wed manage billions more in pension assets right now. But its a chicken and egg problem.
Our industry is chock full of global funds often run by global companies, but theyre busy managing Australias money. The complex regulatory problems faced by global funds are solved first and faster in Ireland and other financial entrepôts.
Were still beavering away on tax transparency. But changes must run the gauntlet of lengthy reviews. The delay and uncertainty is often a show stopper.
Doing due diligence on establishing a global fund, firms get advice on whether some transaction attracts a particular tax. Here theyre often told probably not. Meanwhile Irelands regulators answer no, with precedents to back them up. Guess where the fund ends up domiciled?
Still, at a time of labour shortage more jobs in finance will mostly mean fewer jobs elsewhere. Whats so special about finance? How about the fact that finance employees get paid far more than average wages even allowing for their higher skill levels.
That helps explain why, from about the time Luxembourg and Ireland became financial centres, their economic growth surged. Its never looked back. Ireland the poor man of Europe is now Europes second wealthiest economy. The wealthiest? Luxembourg by a country mile.