Reduce the corporate tax rate? Not so fast

Scripted beforehand: Tax Forum discussion about a lower corporate tax rate followed predictable lines. AAP

As former Treasury Secretary Ken Henry observed, much of the national conversation that took place at the first session on business taxation at the National Tax Forum could have been scripted beforehand.

While business representatives argued for a lower corporate tax rate, along the lines suggested in the Henry Review, union leaders questioned the need for such a reduction and for the preferential treatment of capital income.

Who actually pays?

The central issue of dispute was over what economists call “tax incidence”, that is the question of who ultimately bears the burden of corporate taxes.

The Henry Review was partly based on the proposition that, in a small, open economy such as Australia, the fact that the legal obligation to pay corporate taxes falls on shareholders is irrelevant, and that the ultimate burden of corporate tax falls mainly on labour.

Ken Henry addresses the recent tax forum. AAP
The simple theory behind the tax incidence proposition can be described this way. In a small, open economy, capital is very mobile and eventually shifts overseas as a result with the lower returns associated with a corporate tax rate.

On this analysis, the retention of corporate taxes results in less investment in the economy, and a smaller capital stock. This in turn leads to lower labour productivity of labour and, therefore, lower wages.

Reduce with caution

There are, however, several reasons why this simple theory should be used with caution to support any further reductions in the corporate tax rate.

For example, capital markets are not perfect and for a variety of reasons domestic investors have a preference to invest domestically.

Estimates of the impact of corporate tax on wages vary widely. Some suggesting that the burden of corporate tax passed on to workers might be small.

For example, in a 2009 National Bureau of Economic Research working paper, economists Alison Felix and James Hines Jr examine the effect of US states’ corporate taxes on union wage premiums, which measure the difference between union wages and wages of non-unionised workers.

These authors show that a 1% lower corporate tax rate is associated with a 0.36% increase in union wages; average effects, given that firms are mostly not fully unionised, are smaller than this.

Further, reductions in corporate taxes may take some time to flow through workers in the form of extra capital, higher productivity and wages.

Moreover, the corporate tax is a tax on both normal returns to capital and rents. Rents are “pure profits” in excess of the risk adjusted market rate of return.

Corporate taxes falling on location-specific rents (such as the extraction of mineral resources) are non-distortionary – investment in mining will continue to flow in to Australia.

The flip side of this is that reducing the corporate tax rate would reduce the tax on economic rents during a mining boom.

Dealing with a “patchwork” economy

This is particularly important as we come to grips with what the Prime Minister Julia Gillard has referred to as a “patchwork” economy, where many sectors of the economy are struggling to adapt to the higher Australian dollar and to record terms of trade.

Importantly, the current international environment means that the pressure to reduce rates resulting from international tax competition has been substantially reduced.

How best to deal with a patchwork economy? AAP

Finally, further reducing the corporate tax rate will create a wider wedge between the maximum personal rate and the corporate rate. This increased wedge might create incentives for firms to inefficiently retain capital rather than distribute it to shareholders.

This wedge might be particularly relevant for small businesses for which the distinction between labour and capital income might not be that transparent.

“Unwise”

It is unwise to consider further reductions in the corporate tax rate in isolation from changes in the personal tax income.

Some of these issues were flagged in the Henry Review itself but are lacking in the discussion between business representatives and union leaders.

The Henry Review was circumspect – overall it considered that there was a good case to lower corporate taxes. However, the case for further reducing the corporate rate tax in the short run is no longer clear.

Instead, tax reform should look at opportunities to efficiently reduce the tax burden faced by corporations that are not benefitting from the higher returns associated with the mining boom.

These opportunities include the introduction of an allowance for corporate equity, which reduces the marginal tax rate on investments that attract a normal return to a larger extent than it reduces the marginal rate faced by investments that attract a higher return.

Changing the tax treatment of business losses to allow firms to offset current losses against income previously taxed is another option to be explored.

Sensible reform

A sensible business tax reform that takes into account the challenges and opportunities brought about by the mining boom has the potential to influence in a positive way the society that our children will live in, the jobs they will have, and their ability to live fulfilling lives.

Such reform will also eliminate the temptation to return to the old and very inefficient ways of providing direct support to industries that are struggling.