Why subsidies stand in the way of corporate tax reform

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.