A lost opportunity for business tax reform

The Business Tax Working Group failed to reach a consensus on how to fund a lower corporate tax rate. Image from www.shutterstock.com

The release by the Business Tax Working Group of the Draft Final Report represents a lost opportunity for business tax reform. The Group dumped its original broader base, lower rate, revenue neutral approach. Instead, it called for a reduction in the corporate tax rate by 2 to 3 percentage points without identifying the programs that would have to be cut or the taxes that would have to be increased to fund such cuts. In Australia’s current economic and political environment, it is very unlikely that such an agenda will be pursued.

Although the Group looked at a wide range of more or less dubious concessions, every one of them found a section of the business lobby willing to fight for its continuation. The alternative, not seriously considered, is to look at a more fundamental reform of the tax base.

The Group further impairs its argument for reform by failing to fully articulate what distortions a lower tax rate would address beyond the need to compete for mobile international capital. This is a mistake as it leads the Group to dismiss the introduction of an Allowance for Corporate Equity (ACE), which allows firms to deduct an imputed cost of equity from their accounting profits.

An ACE would address two crucial features of the business tax system that require more than cosmetic tax reform.

Firstly, there is a divide between the tax treatment of debt and equity in Australia. While interest is a tax deduction, dividend payments are not directly deductible. The dividend imputation system provides tax relief only for domestic investors. This distorts international investors’ investment decisions, resulting in heavier reliance on debt financing. While the efficiency losses of the tax-induced distortion of the debt-equity ratio are difficult to estimate, they will be high if it leads to more bankruptcies as firms become more vulnerable to adverse shocks.

Secondly, the current tax regime distorts marginal investments. An investment that should be undertaken in the absence of taxes does not go ahead under the current corporate tax regime. An investor needs to secure a post-tax return to compensate for the tax paid on return on equity, which is treated as accounting profit. This leads to lower investment, lower productivity and, in turn, lower wages.

An ACE would address this discriminatory treatment of equity financing and at the same time eliminate the taxation of marginal investments. The introduction of an ACE has the potential to unleash a substantial amount of new investment.

There are other properties of an ACE that might make it particularly relevant for Australia. By construction, an ACE eliminates the taxation of normal returns on equity, while still taxing economic rents. A normal return is the investor’s opportunity cost of capital. Economic rents are returns in excess of the normal return and are usually either firm or location-specific. The former emerge, for example, because of a particular technology, know-how, or entrepreneurship skills. The latter are associated with the business’ location in Australia, such as in the case of mineral resources or oligopolistic industries.

Importantly, an ACE at the existing tax rate would benefit all firms but the benefit would be greater for lower return firms over higher return firms. That is, firms struggling because of the high Australian dollar would benefit more from an ACE than firms that are enjoying high returns. The ultimate question, however, ought to be whether an ACE at the existing rate is likely to deliver more benefits than a lower corporate tax rate (with or without a broader base). The answer to that question will depend on whether location-specific rents are more important than firm-specific rents. Although this question needs to be addressed by quantitative, empirical analysis, a casual look at the Australian economy suggests the prevalence of location-specific rents.

Distinguishing between normal returns and rents is essential for tax reform. A tax on normal returns on equity is immediately passed on to more immobile factors such as labour. Whether rents are firm or location specific determines if a tax on economic rents is passed on to more immobile factors. Whereas taxes on location-specific rents are borne by and large by the firms, taxes on firm-specific rents create the incentives for these firms to locate at lower rate jurisdictions. These incentives already exist under the current regime and an ACE at the existing tax rate would mitigate them. Indeed, this provides a strong argument against raising the tax rate to finance the introduction of an ACE. Instead, an ACE could be financed from future tax revenue created by the positive impact of its introduction on investment, productivity and long-run growth. It is disappointing that the Group has chosen not to seek to model the impact of an ACE in the economy.