It gives me great pleasure to speak with you today on the progress of the Australia's Future Tax System review. This review has been described as the most comprehensive of the Australian tax‑transfer system for at least the past 50 years. We are now approaching the final stages of the review, with the Panel's report to Government due in little over four months.
Today, I would like to provide you with an insight into some of the Panel's thinking on Australia's company tax arrangements, including the imputation system, which I think will be of interest to you.
The impact of globalisation on tax policy development
Many submissions to the review identified globalisation and the need for an internationally competitive tax‑transfer system as one of the more pressing challenges facing Australia.
Globalisation has important implications for what makes an efficient and fair tax system.
The most obvious manifestation of this has been the stark international trend of declining company tax rates. Among OECD countries, the unweighted average company tax rate fell from around 47 per cent in 1982 to under 27 per cent in 2008. Small economies, in particular, have sought to maximise their share of the world's capital, or savings, invested domestically.
In light of the competition between countries to increase their share of global capital flows that have become increasingly mobile, there has been a trend towards reducing company tax rates and, among academics, an increased interest in company level expenditure taxes. The authors of the international capital tax chapter of the Mirrlees Review being undertaken by the United Kingdom's Institute of Fiscal Studies — Rachel Griffith, James Hines and Peter Birch Sørensen — advocate an allowance for corporate equity, which is a source‑based business level expenditure tax.
Some academics believe that countries will, one day, need to relinquish source‑based company taxes in favour of taxes that do not encourage companies to shift production offshore. In the same review, the authors of the corporate tax chapter — Alan Auerbach, Michael Devereux and Helen Simpson — advocate a shift from company income tax to what they term a 'destination‑based cash flow tax'. This business expenditure tax would only tax the economic rents of a business consumed domestically. The advantages of such a tax over a source‑based tax are that it would not distort firms' production location decisions and would not be at risk from transfer pricing, and so could provide a buffer against international tax competition.
However, replacing the company income tax with a destination‑based business cash flow tax would give rise to significant transitional and other issues, which should not be underestimated.
For this reason perhaps, business submissions to the review have overwhelmingly focused on the merits of cutting the company tax rate and, to a lesser extent, selectively narrowing the base (through more generous write‑off arrangements) rather than seeking more radical reform. And the Panel does need to seriously consider the merits of a reduction in the company tax rate. After all, Australia has moved from having the ninth lowest company tax rate in the OECD in 2001 to having the twenty‑second lowest today.
However, there are other factors that need to be considered in setting the appropriate tax rate.
The two roles of company tax
In evaluating the appropriateness of Australia's company tax rate, the Panel must have regard to the two roles performed by the company tax. First, it is the primary means of taxing foreign investment in Australia, including in respect of location‑specific rents such as resources.
Submissions that focus on this function generally advocate a reduction in the company tax rate to attract additional foreign investment. Secondly, the company tax also has a role in supporting the integrity of the personal tax system — what is known as its 'backstop function'.
Without a company tax and, in the absence of an accrual‑based personal income tax, individuals could defer tax through retaining profits in companies. There would also be incentives for labour‑capital conversion — where individuals reduce their tax liabilities by, in effect, characterising income relating to their personal skills and efforts as company profits.
The integrity function of the company tax has been particularly influential in New Zealand tax policy thinking. Rate alignment — aligning the top personal and company tax rates — was described as the 'cornerstone' of the New Zealand tax system. That alignment ended in the 2000‑01 income year, although I understand it remains a medium‑term objective of the New Zealand Government.
Today, New Zealand's company tax rate is 30 per cent and its top personal tax rate 38 per cent, though this is due to fall to 37 per cent in 2010‑11. Australia only briefly achieved rate alignment at 49 per cent in 1987‑88. Today, the gap between the top personal and company tax rates stands at 16.5 percentage points, more than double that in New Zealand.
In Australia's case, rate alignment could be achieved through an increase in the company tax rate, with the risk of a significant reduction in investment in Australia, or a deep cut in personal tax rates.
The merits of the latter approach will depend on a number of factors, including the mobility of labour. Indeed one explanation for the differences in the income tax rates between Australia and New Zealand may be that Australia's workforce is far less mobile than New Zealand's. In 2000, the OECD estimated less than 4 per cent of Australia's highly skilled individuals lived outside Australia. For New Zealand, that number was 24 per cent.
So, it is clear there are a number of competing considerations the Panel must take into account when evaluating the appropriateness of Australia's company tax rate.
The importance of the company tax base
At least as important as the company tax rate is the company tax base. As firms typically look to effective, rather than statutory, rates when making production location decisions, the base can affect cross‑country allocations of investment. But it also has important implications for the quality of investment.
Where there are inter‑asset or inter‑sectoral distortions in the company tax base, there can be sub‑optimal resource allocation. Providing a deduction for debt but not equity can also distort financing choices and encourage overleveraging. Finally, where the tax system treats gains and losses asymmetrically, it can create a bias against risk‑taking and entrepreneurship.
Company base broadening efforts have been directed towards reducing such distortions. To a significant degree, they have also funded the reductions in statutory company tax rates. As a consequence, the decline in effective tax rates has been less than the decline in statutory tax rates which I mentioned earlier. A question for the Panel has been whether to continue such base broadening efforts, noting opportunities to do so may be limited, or whether to move in the other direction and change the company tax base, possibly through a business expenditure tax.
A business expenditure tax, such as an allowance for corporate equity, could correct inter‑asset and inter‑sectoral distortions; provide greater financing neutrality; and overcome difficulties in measuring income and losses. However, as countries' experiences with business level expenditure taxes are very limited, a cautionary approach is warranted.
Integrating the treatment of companies and shareholders
Another aspect of the company tax system that merits attention is how the taxation of companies and shareholders is integrated. Australia and New Zealand are now the only two countries in the OECD that maintain d
ividend imputation systems, though most OECD countries provide some form of shareholder relief, such as through a lower tax rate on dividends or a uniform credit.
In my address to a business tax colloquium in February this year, I discussed how the dividend imputation system could become less relevant as Australia becomes more integrated with the global economy. For a small, open economy, the cost of capital is set in part by the international capital markets. To the extent the cost of capital is set overseas, imputation improves the after‑tax return to residents' savings and changes the pattern of equity ownership from foreign to domestic investors, but does little to reduce the cost of capital for Australian firms.
I do not think, however, the time has yet come for dividend imputation to be abandoned. The imputation system assists small and medium size firms in accessing equity capital. It ensures that the labour income of owner‑managers paid out as dividends is appropriately taxed, albeit with some potential deferral, and it encourages Australian companies to pay Australian tax. These benefits are significant.
That said, the time has perhaps come to consider whether, in the medium to longer term, there are alternative means of accessing the benefits of imputation that are better attuned to the needs of a global economy. A business expenditure tax is one alternative, though probably not the only one, that will merit public discussion in coming years.
Submissions have been overwhelmingly in support of retaining imputation, but also propose modifications to the existing system. One proposal — raised in several submissions, including one from the New Zealand Treasury and Inland Revenue Department — is to allow mutual recognition of imputation credits between Australia and New Zealand.
Mutual recognition of imputation credits
At issue here is that imputation credits in Australia and New Zealand are available only for domestic company tax not foreign taxes. This potentially creates a bias against offshore investment — the reason why some submissions propose that Australia unilaterally provide some credit for foreign company taxes, whether by way of an explicit credit or dividend streaming.
The New Zealand submission sets out a number of benefits that could flow from bilateral mutual recognition. It is said to increase the productivity of investment and product market competition between Australia and New Zealand. Other benefits are said to be reductions in tax operating costs for small to medium firms in structuring their trans‑Tasman investments and reduced incentives to engage in profit shifting between Australia and New Zealand, which would result in a more productive use of resources.
There is something in all of these points. New Zealand would, of course, also reap some of these benefits from any unilateral action by Australia.
However, there are arguments against recognition that the Panel needs to consider. For two small open economies where the cost of capital is largely set by the international capital markets, it is less likely that credits for foreign taxes will affect the cost of capital and production location decisions of firms — particularly those that are internationally focused.
Even if mutual recognition could improve the efficiency of trans‑Tasman investment, it would also risk distorting investment decisions where the choice is between investing in Australia and New Zealand, or investing in a third country.
These are some tax policy perspectives on mutual recognition. Needless to say, different considerations arise when this issue is viewed from the objective of developing a Single Economic Market, which has the potential to further align the two economies.
It is clear, just from this brief discussion of a few select company tax issues that the tax review as a whole will bring up a number of competing considerations that the Panel will need to work through as it approaches its final report. I, like you, will be very interested in seeing where we end up.
This speech was originally posted on the Australia's Future Tax System website.