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Corporate tax cuts at risk - but are they really required?

As the government scrambles to balance the books, the business community has voiced its fears that Treasurer Wayne Swan will renege on his promise of a 1% reduction in the corporate tax rate. AAP

In the last 24 hours, we have heard mutterings about the possibility that an earlier commitment to cuts in the corporate tax rate may not go ahead in the budget. Some in the business community have, unsurprisingly, raised alarm at this possibility.

It is worthwhile, however, considering the justification for such cuts, since the economic imperative is not altogether crystal clear. And this is even more so for a budget where the goal of a surplus poses risks in terms of cuts to the social wage.

One argument raised both in political debate and within the media is that the cuts in the corporate rate are a compensation for the mining tax.

However, for those who thought the latter had something to do with equity and with a broadening of the tax base, particularly for longer-term fiscal sustainability, this is a somewhat strange argument. It seems to be suggesting that there should be some compensation in terms of tax cuts for entities which were taxed in the first place because of their ability to pay. Strange!

The other, more economic, argument that is often put in favour of cuts to the corporate tax rate is that such cuts would stimulate business investment and economic growth.

On closer reflection, it is not at all clear what the mechanism at work is supposed to be by which a cut in the corporate tax rate would stimulate business investment.

If you think about business investment in terms of the fact that it’s generating extra productive capacity, then the critical element is an expectation of growth in sales. If growth in sales is not expected to change, it is unclear why businesses would speed up the rate at which they are expanding their productive capacity and thus the rate at which their investment expenditures are growing, even with an increase in current and near-term after-tax profits.

In this case, one is left asking why businesses would not simply “pocket” the tax cuts without any significant change in their investment activity.

Of course there may be some investment projects where, at the current tax rate, the projected after-tax rate of return is just on below the minimum required to warrant undertaking the investment. In this case, a corporate tax cut could make the difference, pushing the after-tax rate of return just above that minimum.

In this case, the tax cut could conceivably make the difference between investment and no investment.

But one wonders whether or not this would be the general case and whether, as suggested above, it is more sluggish demand which is the constraining factor on business investment.

The only other possibility is that improved net after-tax profits resulting from any change to corporate tax are earmarked for investment in R & D and new technologies which boost productivity, leading in turn to downward pressure on costs and prices.

But here too the story is not as simple as it looks. Even if the corporate tax rate has some downward pressure on prices and the rate of inflation, it is by no means clear that this would stimulate household expenditure and in turn aggregate demand. One producer’s lower costs is another producer’s lower revenue.

In any case, the channelling of greater funds into innovation and new technologies is not automatic. It requires sufficient competitive pressure for a start. And moreover, improvements in technology and productivity are themselves typically bound up with the process of business investment.

So, we are back to where we started - wondering how precisely a cut in corporate tax may by itself spur business to greater heights in terms of faster growth in investment.

To the extent that it does, it would be a useful result in an economy with sluggish activity in a number of sectors, such as manufacturing.

The real question is how likely this is and whether other measures (for eaxmple, stimulating expenditures by low-income level households) in a budget designed to tighten fiscal policy would be better in order to prevent a further softening in the economy, not to mention having an equity-dividend.

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