How Australia can afford to cut company tax

Three options for fiscally sustainable reform

David Ingles, Chris Murphy, Miranda Stewart

Economics and finance, Government and governance | Australia

17 November 2017

With countries around the world moving to cut corporate tax rates, similar reform in Australia will be increasingly necessary. David Ingles, Chris Murphy and Miranda Stewart suggest three ways to do this without blowing a hole in the budget.

The Government’s Enterprise Tax Plan proposes to reduce the corporate tax rate from 30 per cent to 25 per cent. It is clear that corporate tax rates are coming down around the world. The United States has the highest corporate tax rate globally, at 35 per cent, but all US tax reform plans aim to cut that rate to as low as 20 per cent. Meanwhile, we see significant base erosion and profit shifting by large corporations to minimise company tax.

A cut in the company tax rate should stimulate foreign investment and increases in productivity and real wages. But a sticking point is the budget cost. The tax cut is estimated to cost the budget about $8 billion per year. The dynamic effect of increased investment could improve tax collections and reduce this to about $4 billion per year according to modelling. But in an era of fiscal deficits, that may still be too expensive.

Default government policy is to finance the corporate tax cut relying on bracket creep in the personal income tax and on arbitrary and inefficient ad hoc taxes on banks and foreigners. A small (1 percentage point) increase in the GST rate could finance the tax cut and lead to a net gain in consumer welfare of $1.7 billion. But it lacks public support and raises issues about more comprehensive tax reform.

The government does have other options, which have been largely ignored in the present debate. This is likely because different stakeholders in the business and investment community are affected by these changes.

More on this: Would raising the GST solve Australia's budget challenges?

We show in two just-released research papers that the government can finance the rate cut in the company tax system itself by broadening the base or reforming the corporate-shareholder tax system. We consider base-broadening measures that eliminate interest deductibility and the replacement of the imputation credit system with a dividend discount. A supplementary economic rent tax on financial services could be efficient and raise revenue. Modelling shows that the reform options we consider are revenue-neutral and welfare enhancing.

The first option is to broaden the base by moving to a comprehensive business income tax (CBIT) that would abolish interest deductibility.

The approach of broadening the base and lowering the rate has long been useful in producing efficiency gains and sufficient revenue. One way we can do this in the company tax is by eliminating deductions for interest costs, called a comprehensive business income tax (CBIT). We would exempt or provide a discount for dividend and interest income (like capital gains) at the personal level.

While this appears a radical change, limits on interest deductions are increasingly prevalent around the world. This could raise enough revenue to finance a corporate tax rate cut to 25 per cent, with an increase in consumer welfare of $1.7 billion. We would need to include the financial sector in the CBIT base with adjustments, or tax it separately on the net interest margin (as modelled in our paper).

The second option is to replace the dividend imputation system with a discount for dividends.

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Dividend imputation was designed on a ‘closed economy’ assumption about investment. Today, it is more appropriate to consider Australian corporate-shareholder tax policy in a ‘small open economy’ context, in which the rate of return to investors and the cost of corporate capital is set globally. About one-third of Australian equity is foreign owned.

Domestic investors including superannuation funds that primarily benefit higher earners are effectively being subsidised through the refundable dividend imputation system. It is likely that dividend imputation leads to excessive home-country bias in share portfolios by eroding the risk/reward benefits of portfolio diversification.

The imputation system also generates a bias towards debt for investment by non-residents in Australian companies. This leads to tax planning using that erodes the base with interest deductions, as was seen in the recent Chevron case.

We model replacing full imputation with a partial dividend discount, similar to the CGT discount and find that this can fund the company tax rate cut. This has a net gain in consumer welfare of $2.3 billion.

The third option is a supplementary economic rent tax on financial services.

Taxing economic rents by providing companies with an Allowance for Corporate Capital for both equity and debt finance is efficient and its close cousin, the ACE, was considered seriously by the Henry Tax Review. A downside is its substantial budget cost because it narrows the corporate tax base.

However, a tax on economic rents in the financial sector (and perhaps resources) on top of a lower tax rate across the corporate sector can be revenue-neutral. We model an 8 per cent financial services rent tax which produces a net gain to consumer welfare of $3.6 billion and is revenue-neutral at a general company tax rate of 25 per cent. This is much more efficient than the Major Bank Levy introduced in July.

These three alternative options are all plausible for government, to finance an increasingly necessary corporate tax rate cut. They could produce positive fiscal and economic effects and have potential to be combined in designing Australia’s company tax for the next decade. Indeed, if two of the three options are adopted together, we could afford a 20 per cent rate in the longer term, which may be needed given international trends.

This piece was first published in the Australian Financial Review. It is published here in partnership with the Austaxpolicy blog, Australia’s leading site for the analysis of tax and transfer policy, based at Crawford School of Public Policy.

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