Budget Forum 2018: The Future of Corporate Taxation

In the 2018-19 Budget, the Government re-affirmed its policy to reduce the corporate tax rate over 10 years from 30 to 25 per cent for all corporations. Already enacted for smaller companies (and held up by the Senate for larger companies), this policy is consistent with global trends. But the question of what to do with Australia’s corporation tax remains a live issue.

Corporation tax is a relatively large source of revenue in Australia. It raises $77 billion or 19% of Commonwealth revenues, or 5% of GDP compared to the OECD average of just under 3% (Treasury 2015 Chart 5.3 p76). But this revenue may be overstated thanks to imputation.

The Australian dividend imputation system

Under Australia’s shareholder-credit imputation system, corporation tax is essentially converted into a withholding tax that is creditable when the shareholder pays tax on dividends. The ultimate tax burden is the same as if the shareholders had earned the business income directly.

Franking credits are only available for corporate tax paid in Australia, not for tax on corporate profits earned offshore. Nor are they available for foreign investors. Over the 4 years to 2013-14, franking credits claimed by domestic investors averaged 36.3 per cent of total corporate tax revenue (Minifie 2017 p59).

If individuals get a cash refund for corporate tax paid, no effective tax burden results. The more relevant tax for domestic investors is the individual income tax (including the capital gains tax). This implies that we are over-counting corporate tax revenue, and a third and up to half should really be attributable to individual income tax.

This adjustment takes corporation tax revenue from being well over to being around the OECD average.

Australia’s corporate tax is therefore mainly a pre-payment of personal income tax and a tax on foreign corporations and foreign investment in domestic corporations. This sounds good, but it may not be. It is now recognised that there is limited utility in taxing foreign investors, who make investment decisions in a global market. Given elastic supply curves for foreign investment, the incidence of the corporate tax may well fall – at least in part – on domestic wage earners.

Marginal excess burden of corporate tax

Corporate tax has a high marginal excess burden (MEB, or economic cost) because of its relatively high rate of 30 per cent in Australia, combined with the high level of mobility of the underlying tax base (Treasury 2015 p24) – i.e. international capital. The MEB of the company tax is shown as 132 per cent in Murphy 2018 (p20).

On the face of it, this implies that company tax should be reduced. The revenue would be made up by, say, raising the GST (with a much lower MEB of 24 per cent) and this would produce a substantial net economic benefit.

Australian studies have suggested that up to half the cost of abolishing the corporate tax might be recouped as a result of additional economic growth.

Why do we tax corporations?

Corporation tax is eventually passed on to individuals. This raises the question why we bother to tax corporations at all.

In an income tax system, it is convenient to tax corporations as a form of source withholding. If we were to shift to a different personal tax system, such as a consumption tax, this might not be necessary.

The second reason for corporate tax is that there is a lot of foreign ownership of corporations in Australia (and other places). We might not receive much direct financial benefit from their operations here if they were not taxed.

But this argument is a two-edged sword. On the MEB analysis noted earlier, the effort to extract fiscal benefits contradicts the policy needed for an economically efficient outcome. In the small open economy view of corporate tax, the tax drives up the interest rate demanded by the marginal investor, who is foreign, and reduces investment.

A final argument for corporate tax is that it taxes location-specific economic rents, like the abnormal profits earned in the banking industry or, at times, the resource sector. However, there are other ways to deal with these issues, like specific rent taxes.

Source-based tax

Australia, like most countries, levies tax on a ‘source-country’ basis, taxing the profits of all firms operating in the domestic economy regardless of their ownership.

Adam et al (2013 p3) argue of the UK source basis:

The source basis is a problematic – arguably even incoherent – basis for taxation of multinational companies. Conceptually, there is often no right answer to the question of what shares of profits are generated by activities in different countries.

Sorenson and Johnson (2010 p190) conclude that a source-based company income tax creates an incentive to shift taxable profits towards low-taxed foreign jurisdictions by manipulating transfer prices, royalties and internal interest costs.

An alternative to taxing corporations using the source principle is taxing resident individuals on the dividends and gains they receive from corporate sources.

However, such a tax is not administratively feasible in a global economy, unless information sharing by national tax authorities becomes more prevalent. Otherwise, tax can be evaded using tax havens and secret accounts. But these difficulties in taxing capital income on a residence basis are now being addressed, and may be less than the difficulties encountered with the source basis for the corporate tax.

Another issue is that residence taxes on individuals are not that useful to countries with high proportions of foreign ownership. This has historically been the case in Australia, although it is becoming less so since Australian corporations are more frequently investing overseas, reducing the net foreign investment share.

Alternatives to corporate tax

Capital income taxation at the personal level includes, by definition, income received via corporate structures. Edwards (2003 p30) notes that under Haig-Simons, “business would not need to be taxed if all capital income were taxed on an accrual basis at the individual level. But that is extremely impractical. Instead the current income tax system settled on using corporations as ‘pre-collectors’ of income tax.”

Other US researchers have proposed reducing or abolishing the corporate tax, financing this in part by accrual taxation of capital gains.

It may be preferable to address the issues in a non-income tax framework. Some experts do not believe that capital income should be taxed at all, and prefer consumption taxation. Because a consumption tax allows indefinite deferral of tax, there is no need for a corporation tax to buttress the tax base on an accruing basis.

The corporate income tax could be converted to a cash-flow corporate tax. If based on the destination principle, one option is a higher Goods and Services Tax at the personal level, combined with a reduction in wage tax (Auerbach et al 2017). This is because the GST is both a tax on consumption and a tax on corporate rents (as well as consumption out of ‘old’ capital).

This has the advantage of building on an existing tax, and also of creating fewer problems for international tax treaties than the conventional cash flow corporate tax. However, it would be highly desirable that exemptions and zero ratings in the GST be abolished so as to generate a broad-based tax on consumption.

Capital gains tax reform

Dividend and interest income are already taxable under the individual income tax. How to tax capital gains is a more serious issue. The opportunity exists for income to be re-invested in the company and emerge, years down the track, not only as higher dividends but as capital gain. The current corporate income tax mitigates this difficultly by acting as a ‘pre-collector’ of tax.

Capital gains are lightly taxed in Australia, as in most other countries:

1. The capital gains tax is levied on only half the gain if the asset is held over 12 months (the CGT 50% discount). As it is not levied until realisation, the tax is deferred until sale at the choice (largely) of the investor.

2. The tax is deferred. This lowers the effective tax rate on capital income, more so the longer the period of deferral. However, this sort of hybrid income-expenditure tax may be more efficient than a conventional income tax as it addresses, in part, the discrimination against deferred consumption inherent in an income tax (Ingles 2015).

3. There is no deemed realisation on death; assets are passed on to inheritors with an uplifted valuation base.

It is possible but difficult to fix these problems within an income tax framework. One approach would be to tax gain on an accrual basis each year, but this is challenging in practice. Another approach is to use deeming or an annual wealth tax. These options amount to a presumptive taxation of capital income (Ingles 2016).

Ingles 2015 rejects the view that the individual tax should be based on consumption, mainly because it fails to tax most economic rents. But a hybrid income-consumption tax might make sense.

The Z-tax

In Ingles 2015, I advocate a modified cash-flow personal consumption tax called the ‘Z-tax’. This tax treats all capital incomes as if they were capital gains, so tax is only applied on drawdowns from the Z-tax ‘box’.

Deferring tax within the Z-tax box moves the tax system closer to an expenditure or consumption tax the longer the investment is held. That addresses the income tax’s discrimination against saving.

Because the Z-tax explicitly allows deferral, when applied to individuals it need not involve corporate tax at all. It simply does not matter if earnings are retained tax-free within the corporation as they will ultimately be consumed, and taxed.

The future of corporate taxation

The corporate income tax may be gradually going out of evolution. In the long run, we can replace source-based corporate taxation, with all the difficulties that entails, with either an expanded GST (which implicitly taxes corporate rents on a destination basis) or reformed residence-based personal income taxation, or both. A corporate rent tax could however be imposed under the personal (residence) tax approach.

Ultimately, Australia will need to ratchet down the headline corporate rate in order to maintain relative competitiveness.

If the corporate income tax were to be reduced or removed, the tax system may need to rely on capital income taxation of individuals to a greater extent. This might not be a bad place – at least for a rich country like Australia – to end up.

 

More from our Budget Forum 2018 series:

Budget Forum 2018: This is not a Genuine or Equitable Way to Simplify the Personal Income Tax System by Andrew Podger

Budget Forum 2018: A Missed Opportunity for Enhancing Australia’s Budget Transparency on Distributional Information by Teck Chi Wong

Budget Forum 2018: Targeting the Black Economy by Joel Emery

Budget Forum 2018: Tax Caps and Tax Cuts: Good for Australia? by Miranda Stewart

Budget Forum 2018: Risks Greater Than I Can Recall in My Working Life by John Hewson

Budget Forum 2018: Should Australia Produce a Citizen’s Climate Budget? by Usman W Chohan

Budget Forum 2018: Cuts to Personal Income Tax – A Mixed Bag by Robert Breunig

Budget Forum 2018: A Political Budget Unlikely to Work Politically by John Hewson

Budget Forum 2018: The Government Could Be Boosting the Budget Bottom Line with a Change to How It Taxes Gas by Diane Kraal