In Australia, it appears that every newly elected government grapples with how best to tax small businesses. The small business sector is often seen as requiring special tax needs, with lobbying made on its behalf for special concessions to compensate for disadvantages due to size and/or inherent characteristics. However, these concessions may lead to adverse consequences, particularly increased complexity. This means that any reform proposals need careful analysis.
One proposal requiring greater analysis concern the implications of the introduction of a dual income tax (DIT) system for small businesses. In an earlier article, and a subsequent blog post based on it, we highlighted that, while a DIT system could have some possible benefits, concerns were raised by experts about required integrity provisions that could adversely drive up complexity and compliance costs, and create the need for extensive education programs for both advisors and small business operators.
In this post, we will consider whether a DIT would achieve greater tax neutrality in relation to the choice of business structures.
Tax Neutrality
The concept of ‘tax neutrality’ refers to a tax system that does not influence personal and financial choices and does not create a bias for taxpayers in choosing one investment over another. The idea of tax neutrality is that in perfectly competitive economics, government should not skew private investment decisions. In general, the tax system should strive to be neutral, but in some circumstances, it is impossible to achieve this goal without certain levels of distortion influencing taxpayer decisions.
In theory, tax neutrality is a broadly accepted concept, and a foundation for any canonical aim of tax reform. However, in practice, trade-offs amongst tax neutrality and different goals may not be easily resolved. For example, the notion of equity can be a stronger policy motivator than neutrality when it comes to a tax system being politically acceptable.
Of course, neutrality needs to be balanced with other objectives of tax policy such as: equity, fairness, efficiency, simplicity, revenue raising capacity, reduction in compliance costs and promoting domestic investments.
Non-neutrality in the tax system can lead individuals and business practitioners to structure the substance of their activities in a manner that minimise tax liabilities. Tax neutrality focuses on the notion that, if a tax system has a potential to distort economic decisions, then tax may adversely affect investment decisions and result in inefficient economic decisions.
In Australia, the legal structure implemented by a business can have significant effects on the business tax liabilities and the tax concession eligibilities. Taking this into consideration, the Australian tax system does not achieve tax neutrality. The choice of business structure with different tax implications may influence complexity, and thereby increase tax compliance costs. It has been argued that the cost of complying with tax obligations for small businesses can be high and regressive, as the burden disproportionately falls on smaller businesses. Is it possible that a DIT would improve tax neutrality between the different business structures in Australia?
Tax Neutrality and the Nordic DIT
The dual income tax system (also known as a Nordic tax system) splits business income into two components: capital and labour income. The capital income amount is taxed at a lower rate (equal to the corporate and the lowest individual tax rates); labour income is taxed at the progressive marginal tax rates.
To split business income, the rule is to first calculate the return on business assets, which is regarded as capital income, and the balance of the business profit is labour income. The imputed rate of return is set in accordance to the applicable interest rate on average government bond plus the risk premium.
The original case for a dual income tax system was to address tax non-neutralities. One of the main features of the DIT is having a separate flat tax for capital income. The theoretical arguments for such a tax are the adjustment for inflation and that the present value of returns on investment is not affected by a tax that uniformly applies to all types of capital income, thus ensuring neutrality in investment. The rationale that founded this theory is the equality between tax and economic depreciation and the deduction of debt interest.
Generally, the key principle of a DIT is aligning the capital tax rate with the corporate tax rate. This is seen as important to eliminate the incentives for choosing between corporate and non-corporate business structures. To address this, for example, a revision of the 1992 Norwegian tax reform was made in 2006, to provide an equal tax treatment for business owners who have chosen different business structures in carrying out their business activities. This saw the introduction of the shareholder income tax in 2006, which aimed to reduce the incentives for business owners when choosing business structures for tax purposes. These reforms are said to have improved horizontal equity.
One of the major issues associated with the DIT is that while having a low uniform tax rate on all capital incomes could reduce tax arbitrage, it also opens possibilities for exploiting the system by taxpayers shifting income from high-taxed labour income into low-taxed capital income.
The analysis suggested that while the Nordic DIT Model could step towards improved tax neutrality, it is incorrect that a DIT removes all the possibilities of tax influencing taxpayers’ decisions. For example, clearly the different tax rates applying to capital and labour income are a breach of tax neutrality and require integrity rules to ensure that they are not abused. However, the lower tax rate on capital was seen as having the potential to decrease tax arbitrages and planning.
Tax Neutrality and the Pitcher Partners DIT Model
Pitcher Partners, an Australian accounting firm, advocated for the introduction of a DIT system in Australia, particularly for closely held companies, to reduce the tax rate and structural biases that exist under the current tax system. However, could the DIT Model of Pitcher Partners achieve greater tax neutrality for the taxation of Australian small businesses?
Pitcher Partners DIT Model has a unique feature that differs from the Nordic DIT, that is, the alignment of the top personal tax rate with the corporate tax rate (up to approx. $312,500). The purpose of this tax rate equality is to mitigate the distortions of income shifting between labour income and capital income that occur under the Nordic system. The large gap between the top marginal tax rates on labour income and the capital income tax rate, that exists under the Nordic system, can create strong incentives for tax-minimising behaviour.
The case for greater alignment of tax rates is found in New Zealand which has a closer alignment between the corporate tax rate (28%) and the top personal tax rate (33%). New Zealand also has no general capital gains tax, and currently, the tax on consumption (the GST) is a flat rate of 15% applicable to almost all purchases, excluding financial services and residential rents.
Overall, there is a possibility that the Pitcher Partners Model could achieve greater tax neutrality between different business structures in Australia with the consistent allocation between capital and labour income. Such potential tax neutrality is due to the equality between the tax rates, but only up to a taxable income of $312,500 in their proposed model.
It is argued that lowering and broadening the capital tax rate under a DIT system is the preferred approach to achieve a more neutral tax system. This is due to efficiencies in tax collections, with a likely reduction in the distortions associated with capital allocation, investment, financial decisions and structural choice.
Recommendations
An option for tax reform in Australia is to maintain the principles of comprehensive income taxation and to strengthen the objective of tax neutrality by broadening the capital tax base, while lowering the marginal tax rates, that is, aligning the top marginal personal tax rates with the current top corporate tax rate of 30%. To compensate for the loss of tax revenue, the GST rate should be increased to 15%.
Lowering marginal tax rates is consistent with Henry Ergas’s argument that very high marginal tax rates can be very distorting for taxpayers’ decisions concerning their incentive to work, investments, and savings. He also argued that an ideal neutral tax system is where no one pays more than one-third of any marginal dollar in tax, and suggested that a taxpayer who earns more for extra effort put in, should not be taxed more.
Overall, a DIT does have the potential to improve tax neutrality and may remove structural biases that exist in Australia – but more work is needed to develop a comprehensive proposal. In terms of the taxation of businesses, tax neutrality is a design feature that should be strived for, however achieving it is a difficult task (quite aside from the tax imposed), especially when faced with an array of possible business structures that have a variety of legal implications.
For the full article see: https://www.jausttax.com/2018/09/28/volume20-issue01-trad-and-freudenberg
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