Yesterday, the government’s business tax working group released its discussion paper on possibilities for tax reform. The paper makes a case for a broader base and lower tax rate (the corporate tax is currently a flat rate of 30%), and notes that any cut could be funded by a variety of options: by reducing debt deductions for multinational companies; cutting depreciation write-offs for oil, gas, transport and agriculture; ending up-front deductions for mining exploration; and cutting back on the tax offset for R&D investment.
Special exemptions and deductions from taxation for some but not other businesses expenses are a form of subsidy. Removal of the special exemptions leads to a more neutral tax treatment of alternative investment options, resulting in a more productive mix of alternative investment options. An exception is if the special tax deduction or exemption provides offsetting compensation for external benefits to other firms of particular investments. In an approximate aggregate revenue neutral tax reform package, the revenue gain from a larger and more comprehensive business tax base can be used to fund a lower tax rate.
In the context of Australia as a small open economy, a lower tax rate will encourage a higher level of aggregate investment, less distortions to the mix of debt and equity financing of investment, and a reduced incentive for multinational companies to shift their taxable income from Australia to countries with lower statutory tax rates. In time, most of the benefits of a larger and more productive capital stock will be passed on into higher market wages and real take-home pay for Australian workers.
The Treasury Tax Expenditure Statement lists 112 special exemptions or deductions for selected businesses expenses relative to the norm of a comprehensive business income tax base. One set of items are accelerated depreciation for selected equipment, including statutory life caps less than the economic life for much transport equipment, and some investments in oil and gas (item B95), concessional depreciation deductions for buildings (B97), immediate write-off for small business investments less than $6000 (B108), and accelerated depreciation for some but far from all expenditures by primary producers on water, horticulture and utility connections (B82, B85, B86).
Accelerated depreciation brings forward the time at which investment expenses are claimed. In effect, the concession is a subsidy to the favoured investments not available to alternative investment options. For example, investment by a mining company is subsidised if it is placed in oil or gas rather than in coal and iron ore; investment by a small business is favoured if the item is valued at less than $6000 relative to a larger and more expensive piece of machinery. There is no logical reason to subsidise these forms of investment relative to alternative uses of limited investment funds. From the perspective of society wellbeing and national productivity, accelerated depreciation as a form of subsidy shifts investment from more valuable to less valuable projects.
The provision of special tax exemptions and deductions for investment options where a market failure can be argued is a different story. This case is illustrated by the 40% extra allowance for expenditure on R&D (items B105 and B106). Much R&D by the investing firm provides spillover benefits to other firms, but other firms do not pay the investing firm for these benefits.
The tax concession or subsidy is a crude way of providing compensation for the spillover benefits, and it encourages firms to increase investment in R&D to a level consistent with the best use of national resources. But one might argue whether other policy interventions such as direct subsidies – or a different tax concession rate – are more appropriate.
A more comprehensive tax base with less special exemptions and deductions provides a second set of benefits through the lower tax rate that it will fund. In the context of Australia as a net importer of international capital in a small open economy, a lower tax rate on business investment in Australia initially increases the after-tax return to overseas investors. Seeking the best after-tax return across the globe, international investors shift more funds to Australia until the extra investment drives down the pre-tax return to restore the initial after-tax return. The increase in capital means more and better machines, buildings and technology per Australian worker, and higher labour productivity.
But the reality is that multinational companies have opportunities to shift their taxable revenues to lower tax rate countries and to shift many of their debt, overhead and intellectual property expenses to higher tax rate countries. Further, tax authorities are always playing a catch-up game to minimise these profit-shifting strategies. A lower Australian business tax rate increases the incentive of multinationals to record their profits in Australia, and to shift their tax payments from overseas to Australia.
A lower Australian business tax rate has additional gains for the Australian economy. The lower rate reduces the current tax favoured treatment of debt investment over equity investment by international investors. In turn, the lower gearing ratio would increase the ability of firms to ride cyclical, seasonal and other business shocks.
Ultimately, as argued by Australia’s Future Tax System report of 2010 and the Mirrlees Report of 2010 in the UK, with supporting econometric evidence, most of the benefits of a lower Australian business tax rate are passed on to employees as higher wages. But this will take some years of decision changes and adjustment.