Achieving revenue neutrality in the corporate tax rate will be a tricky business

In summing up a business summit in Brisbane on June 13, the Prime Minister floated her intention to lower the company tax rate – but as part of a business tax revenue neutral package. This intention raises two questions: what is the pay-off of a lower company tax rate; and, what are the other offsetting revenue raising measures and their comparative effects?

The case for a lower company tax rate was articulated in the Henry Review: A Future Tax System for Australia. In the context of Australia as a open economy as part of a much larger global capital market, the supply savings for investment in Australian mines, manufacturing plants, hotels and tourist ventures, and other business investments is very responsive to the after Australian tax return on the investments. Relative tax rates in Australia and alternative country investment locations influence the location of investments in Australia or elsewhere. Also, multinational companies have some discretion to shift their taxable income from one country to another via transfer pricing of outputs and by shifting expenses of debt interest, research and development and intellectual property, and overhead administrative and marketing costs.

A lower corporate tax rate increases the after Australian tax return on investments in Australia, increases the attraction of locating investments in Australia, and increases the incentive for multinationals to record their profits in Australia. The extra investment increases the stock of machines, buildings and intellectual property per Australian worker. At the same time, the extra investment on lower priority investment options drive down the before tax return on Australian investments at the margin. After some years, the extra capital per worker means higher labour productivity and in turn higher real wages. That is, in time, most of the benefits of a lower corporate tax rate are passed onto workers as higher wages.

Also, a lower corporate tax rate leads to a larger economy, and one with larger business tax and wages tax bases. The larger economy helps generate additional tax revenue. But only under unlikely assumptions will the extra revenue offset the first round loss of a lower corporate tax rate.

One option for funding the revenue loss with a lower corporate tax rate is to remove special tax exemptions and deductions in what is called a broader base and lower rate approximate revenue neutral package. This strategy would complete the proposals made by the Ralph Review of business income tax in 1999. In its recent report of Trade and Assistance Review 2010-11, the Productivity Commission estimated that tax concessions amount to $5.4 billion in 2010-11. These concessions include accelerated depreciation for oil and gas, some transport equipment, and the immediate expensing by small business for capital items valued at less than $6000.

Shifting to an economic life for all depreciation would provide for neutrality of tax treatment of all investment choices and a more productive economy. There is no market failure reason to subsidise investment in, for example, oil and gas verses iron ore, or of small business verses large business.

The case for removing current tax concessions for expenditure on R&D is less compelling. In part, the concession recognises – albeit in a crude way – the spillover or external benefits of R&D by one business to other businesses.

Another option, and one proposed by the Henry Review, was to increase the effective tax rate and the tax collected on economic rents earned on geographically immobile inputs, including land, minerals and energy, and some monopoly rents. These are largely state and/or local government-based taxes. As illustrated by the poor outcomes with the mining tax reforms, desirable reforms of these taxes has to address challenging issues, including those of Commonwealth-state financial relations.

An area deserving further analysis is the system of withholding taxes on the income earned by non-residents on their investments in Australia. The current treatment is non-neutral, ad hoc at best, potentially only transferring tax revenue from the Australian treasury to home country treasuries, and a hostage to international tax treaties designed by, and for the benefit of, net capital exporting countries.

Interest on debt funded investment is a deduction in measuring corporate income, and faces a withholding tax of from zero to ten per cent depending on country and treaty. Dividends earned on equity investments if franked involve no further Australian tax above the 30% corporate tax, but if unfranked with zero corporate tax face a withholding tax of zero to 15% depending on country and treaty. Capital gains face no Australian tax. Neutrality of tax treatment, with some efficiency gains, requires the same effective tax rate on all forms of income earned by non-resident investors. To the extent that overseas countries give a tax credit for Australian tax paid, collecting a standard withholding tax on all types of non-resident income at a rate less than the overseas rate would not reduce the incentive to invest in Australia, and it would transfer revenue from the treasuries of capital exporting countries to the Australian treasury.

A revenue neutral business tax reform package involving a lower corporate tax rate will not be easy. The package is likely to require negotiations with the states and renegotiation of international tax treaties. It needs to explain the longer-term gains of a larger economy and higher wages. In the short run there will be some losers.

This article first appeared on The Conversation.