I'd like to start by thanking the organisers for the invitation to talk to you about tax policy. My Treasury career started in September 1984 when I joined the, then, Tax Policy Division from academia. A large part of my 25-year career in the Treasury has been devoted to tax policy. Tax is, for me, something of a passion. But the fact that I have spent so much of my career on tax policy issues also reflects a sober, dispassionate, assessment of its importance. And it is just as important today as at any time in the last quarter century.
So let me extend my thanks to the conveners of this colloquium, the University of New South Wales and Monash University, for the opportunity to speak to you tonight about tax policy.
The Tax Review Panel, established by the Government at last year's Budget, is part way through a review that the Treasurer has described as the most comprehensive review of the Australian taxation and transfer system, including state taxes, for at least the last 50 years. In fact, it is potentially the most comprehensive policy review ever undertaken in Australia.
The tax treatment of businesses, and of investments and savings, is clearly an important part of the review. As for other areas that the review is considering, in looking ahead over the next 20 to 30 years, the Panel will need to consider whether it makes sense to retain the essential features of the current system and fine tune them, or whether more dramatic, far‑reaching changes are required.
In thinking about these choices, between fine tuning and system reform, there are two standout challenges that we face.
Challenges confronting business and capital taxation
The first challenge is system complexity. I discussed the complexity and uncertainties surrounding the tax system at some length in my speech to the National Press Club on 12 November last year, so I won't spend a lot of time on this topic tonight.
The second challenge is the not‑so‑small matter of global integration. Perhaps there was a time when it was sensible to conceive of the representative firm as a vehicle that raises domestic capital and produces goods domestically. For some businesses, this stylised model remains relevant; and I'll have more to say about these businesses later. However, for an increasingly large proportion of Australian businesses, operations, financing and profit flows are globalised.
Now, the way one thinks about tax policy choices, and their implications for efficiency and equity, can be quite different, depending upon whether one adopts a closed economy or open economy setting. For the Review Panel, then, understanding Australia's place in the global economy is critical to our deliberations. For the most part, we are adopting an open economy perspective — one of a relatively small domestic economy with few restrictions on cross-border financial flows, in which capital is therefore highly elastic.
Reflections on previous tax reform exercises
Tonight, I am going to focus on the taxation of businesses and capital in an open economy setting. But, in order to get some perspective, I'd like first to go back in time and reflect upon some past reviews of Australia's business tax system.
In my 25‑year career, all of the tax policy reforms I've have been involved with have been either directly or indirectly influenced by the Asprey Review — which was commissioned by Treasurer Snedden in 1972 and later tabled by Treasurer Hayden in 1975. The Tax Review Committee was chaired by the Honourable Mr Justice K. W. Asprey, a Judge of Appeal of the Supreme Court of New South Wales.
Asprey was the seminal work on the Australian tax system — considered by many to be the first attempt to investigate and rationalise the Australian tax system more or less in its entirety.
Based on its terms of reference, Asprey discussed and applied three high level principles for thinking about tax policy reform. These principles, coined by Asprey as 'the big three', were fairness, efficiency and simplicity. The big three point to trade-offs that policymakers come up against repeatedly when thinking about tax: the choices between simplicity and efficiency, fairness and simplicity, and fairness and efficiency.
The fairness-efficiency-simplicity framework, in its simple elegance, has been used in almost every subsequent reform exercise and is, with good reason, still widely used to this day.
Asprey, in broadly applying 'the big three', proposed some key approaches towards reforming Australia's tax system. Among the major recommendations of Asprey on the income tax side were proposals to broaden the tax base by generally taxing capital gains and fringe benefits. But Asprey also included proposals for a general foreign tax credit system and a partial imputation system.
Prior to 1987, significant amounts of foreign source income subject to tax in a foreign jurisdiction were exempt from Australian tax to avoid double taxation. The exemption from Australian tax applied regardless of how little foreign tax was paid.
Asprey's fairness argument supporting the introduction of a foreign tax credit regime went something like this: the tax system can result in markedly different outcomes for two resident taxpayers, one with Australian source interest and dividends (which were fully taxed), the other with foreign source income and capital gains (which were not taxed). Incidentally, the fairness argument was tightly linked with an efficiency argument — that the tax system should not distort savings choices by, for example, taxing a resident's foreign income less than other forms of income.
Likewise, the argument for imputation was born out of an equity argument which was almost identical to its efficiency argument. The argument was that the interaction between the classical company tax system, progressive personal tax rates and the non-taxation of capital gains at the personal level meant that resident taxpayers faced markedly different after‑tax outcomes. Asprey wasn't against the double taxation of dividends per se but rather concerned by the variability in the overall tax borne by the shareholder and the bias in favour of retaining profits and raising finance from corporate debt.
The proposed imputation system was seen as a possible solution which addressed the bias against the raising of corporate equity from Australian investors while retaining the ability to tax foreigners' income at source at the company level, ensuring that Australians continued to take a share of the profits generated domestically by foreign investors.
While these capital income tax proposals were not implemented immediately, the broad vision that Asprey signalled was clear: first, tax income from the savings of residents on a worldwide basis; second, achieve broad neutrality for the savings choices of residents; and third, maintain the taxation of the Australian source income of non-residents.
This Asprey vision was well established in tax policy circles by the time I joined the Treasury and, along with a small number of highly motivated and obviously energetic colleagues, I had the opportunity to work on Treasurer Paul Keating's 1985 draft White Paper on Tax Reform.
While the centre-piece of the draft White Paper – a modest proposal to levy a broad‑based consumption tax to replace the wholesale sales tax and fund personal income tax cuts – was defeated at an extraordinary summit in mid 1985, a suite of income tax base broadening measures was implemented by the Hawke Government: capital gains tax in 1985, fringe benefits tax in 1986 and the foreign tax credit system in 1987. The draft White Paper endorsed Asprey's criticisms of the classical company tax system, and, much to the astonishment of Australia's business community, following the tax summit Treasurer Keating unveiled a full imputation system and the alignment of the
company and top personal tax rates.
Reflecting back on those events, I'd like to make two broad observations pertinent to thinking about where we might have to take our business income tax system in an open economy context.
Complexity and globalised business
The first thing to say is that the business tax system has become much more complex, partly due to the affairs of international business becoming more sophisticated. In 1975, Asprey was able to conclude that '[In terms of] simplicity, it [that is the company tax system] will rate higher than personal income tax'. Imagine stepping up to the podium at a colloquium such as this, 34 years later, and suggesting that the business tax system in Australia is 'relatively simple'. Reducing the complexity of the tax-transfer system is a major issue for the review, and I will have more to say on that on another occasion.
The second thing to note is that the draft White Paper was written at a time in which we were only just beginning to come to terms with the economy opening up — as high levels of border protection and capital controls were being dismantled and labour market deregulation and macroeconomic reforms, such as the floating of the exchange rate, were beginning to take effect. In the subsequent quarter century, as the Australian economy has become truly globalised, almost everything relevant to our thinking about the business tax system has changed.
Since Asprey and the draft White Paper, our understanding of the implications of globalisation, and especially of the openness of our economy to capital flows, has deepened. Yet it is probably fair to say that policymakers have struggled to come to terms with this international dimension of business and capital taxation. So my second observation is that the Tax Review Panel has to take this opportunity to reflect deeply on the implications of globalisation for the efficiency and equity of business and capital tax choices, and question the merits of complex provisions to achieve outcomes that may only make sense in a closed economy.
I should note that these two observations are related. While there are numerous factors other than globalisation that have contributed to tax system complexity, the diversity of international business and financial structures, and their interactions with the myriad of tax treatments applied by different jurisdictions, has become so complex that it can, at times, defy understanding.
The implications of being a small, open economy
One of the proposals implemented following the draft White Paper was the alignment of the company and top personal tax rates at 49 per cent, undertaken in concert with the introduction of full dividend imputation. The rate alignment involved a substantial cut in the top marginal tax rate from 60 per cent and a small increase in the company tax rate from 46 per cent. However, soon after the company tax rate was reduced to 39 per cent for international competitiveness reasons.
Since that time, company tax rates in Australia and abroad have continued to decline, for the most part only partially funded by corporate tax base broadening measures.
Among policy advisers there has also been increasing recognition that the incidence of Australian company income tax most probably falls in the long run, on the immobile factors of production — in particular labour — rather than being fully borne by the owners of capital.
Where capital is perfectly mobile, the supply of capital from abroad is perfectly elastic. In these circumstances, the burden of taxes on capital (such as company income tax) are shifted onto immobile factors such as workers and land via an outflow of capital which lifts its marginal product to the pre-tax return demanded by offshore investors. This same process drives down the productivity of domestic immobile factors due to a lower capital intensity of production – capital shallowing.
In contrast, and again assuming a perfectly elastic supply of capital from abroad, the taxation of domestic savings in equity (which occurs primarily through the taxation of dividends and capital gains at the personal level) does not affect the aggregate level of capital invested in Australia as any reduction in Australian‑owned capital invested domestically is offset by an increase in imported capital.
Thus, in a relatively small, globally integrated, capital‑importing country like Australia, the company tax probably has the effect of lowering real wages. And it also has the effect of increasing pre‑tax returns per unit of shareholder capital invested in Australian companies. If domestic shareholders have access to full company tax imputation, the company tax actually increases their dividend income – both in pre‑tax and post‑tax terms. Indeed, taken together, the company tax and full dividend imputation are, under certain simplifying assumptions, equivalent to a subsidy on domestic savings invested in domestic companies. It is not surprising then that Australian investors have a portfolio bias for franked dividends. Moreover, while a cut in the company tax rate would increase gross domestic product, it would also attract more foreign investment, increase real wages and reduce the rate of return to domestic shareholders, including superannuation funds, as share prices increase due to the improved returns for non‑resident investors.
Even in this highly simplified small, open economy model, policy choices are not straight forward.
Having a small, open economy framework can also inform how we approach the taxation of foreign income. Both Asprey and the draft White Paper recommended, on equity grounds, the world‑wide taxation of residents, accompanied by a foreign tax credit system.
Both reviews had rather stylised international tax models. In particular, they did not factor in the implications of Australian companies having foreign investors and, hence, that to tax an Australian company in respect of its foreign earnings would increase the cost to Australian managers of accessing world‑wide capital to finance offshore operations.
The reviews proposed taxing all foreign income on an accruals basis. This idea was abandoned even prior to implementation when it was recognised that such a system would have high compliance costs and inhibit the international competitiveness of Australian companies that were seeking to expand offshore. Instead, income from foreign operations was taxed when received by the Australian company, with a credit for foreign taxes paid. Concerns that taxpayers would defer repatriation of income in order to obtain tax benefits from deferral led to the introduction of the anti‑tax‑deferral rules in the 1990s.
Over the past ten years, there has been substantial progress in our understanding of how taxation impacts on the international competitiveness of Australian business. This recognition has resulted in our company income tax shifting, broadly, from a residence to a source basis. Today, most income of resident companies from direct investments overseas is exempt from tax.
The income of resident savers is still largely taxed on a world‑wide basis, with income from offshore equity investments being taxed as an unfranked dividend. From an open economy perspective, this represents a tax on domestic savings and does not distort the level of investment or affect the cost of capital for those Australian firms that have access to foreign capital.
A related observation: in a closed economy, a full imputation system addresses tax neutrality between debt and equity – pretty much. But in an open economy model, where foreign shareholders are not entitled to imputation credits and interest income is largely taxed on a residence basis, there is a tax bias favouring debt. Factoring foreign tax systems into the equation muddies this result of course.
So an open economy model affects the way one should think
about our company tax arrangements, including dividend imputation.
But I don't want to be interpreted as arguing the case for doing away with imputation. Our system has some distinct advantages. For one thing as imputation credits are only provided for Australian tax paid, Australian multinationals have fewer incentives to shift profits offshore. If ending imputation means an increase in incentives to artificially shift profits offshore or otherwise avoid company tax, the reduction in the company tax base could have ongoing revenue consequences.
There are also some limitations of the open economy framework that should be noted. Capital flows are not fully mobile between countries, with home biases still evident. This point could not have been illustrated more starkly than in the present global financial crisis. But there have been numerous other occasions on which small, open economies have learned, the hard way, just how fickle global capital markets can be. And even in very stable times, there are segments of the Australian economy for which the small, open economy framework is simply not appropriate. For example, small and medium enterprises in Australia do not generally have access to foreign equity. For these firms, the imputation system, which is accepted and well understood, probably does serve a role in attracting domestic savings.
Moreover, for small businesses, the company income tax combined with the imputation system ensures that business owners face much the same tax consequences irrespective of the form in which they receive income from the company; whether it be as dividends, wages or interest.
It should also not be assumed that governments of small, open economies should not impose any taxes on capital (including business taxes). This would be a misreading of the optimal tax literature. The absence of perfect capital mobility and the presence of location specific rents mean there is a case for taxing investment in Australia. That some countries, including the United States, provide a credit to their companies for tax paid in Australia may also be relevant.
However, we may wish to rethink how we design capital income taxes; and, in particular, whether we build upon the existing income tax framework, or pursue more far‑reaching change. International tax literature advocates changes to the business tax base; by either narrowing it (as would be the case with a business level expenditure tax) or radically broadening it (by moving to a comprehensive business income tax). We may even wish to consider shifting to a destination basis (similar to a GST where exports are exempt and imports taxed) rather than the current source basis. These decisions will, in turn, have implications for how we tax foreign source income and integrate the taxation of shareholders and firms.
While this review offers an unprecedented opportunity to closely examine all aspects of our tax and transfer systems, we shouldn't ignore the significant challenges and transition costs of change. But sometimes change is necessary. And though this is proving to be challenging, understanding and acknowledging the implications of an evolving globalisation of the Australian economy is essential if we are to position our tax system for the future.
I understand some of these issues have been touched upon already in the conference and I expect you will spend more time on them tomorrow. I look forward very much to the outcomes of your discussions.
This speech was originally posted on the Australia's Future Tax System website.