Can we use company tax policy to enhance Australian living standards?
The Treasurer thinks so, using the 2016-17 budget to announce a Ten Year Enterprise Tax Plan, essentially cuts to the company tax rate which will be phased in over the next decade.
The premise put forward by Treasury and its advisors that a cut to company tax will attract capital, leading to growth in GDP and wages, is uncontroversial. In itself, this is not a justification for cutting company tax. To correctly assess the impact of the policy on the Australian people, we need to understand its impact on gross national income (GNI). While Treasury finds that GNI will also increase, the case for this is less certain.
Unsurprisingly, economists frame the question of choosing the appropriate rate of company tax as an optimisation problem. We could have a low company tax rate, attract lots of capital from foreign investors, and collect little revenue through the tax system; or we could have a high company tax rate, attract less capital, but collect lots of revenue on what we have. This optimisation problem can be stated as “Choose X, the cut to the rate of company tax, to maximise ΔI, the change in gross national income.”
For this problem, our starting point is the status quo; where the company tax rate is 30 per cent, and foreign ownership of capital is estimated to be 20 per cent. From this starting point, there are both gains and losses to GNI from a cut to company tax.
Losses from a cut to the company tax rate stem from a fall in taxation revenue, principally the revenue collected on the 20 per cent of capital that is foreign owned, and willingly installed under the present tax regime. This loss of revenue collected from non-residents is a loss to gross national income. Importantly, any taxation revenue lost on domestically owned capital is a gain to the domestic owners of capital, so it remains under the umbrella of national income.
As a nation, we gain income when foreign investors respond positively to the increase in their post-tax rate of return on investment in Australia. For every additional dollar earned by foreign investors, the nation receives a proportion, equivalent to the new (reduced) rate of company tax.
Additional capital will need to attract workers. This will be achieved by bidding up wages. To retain workers, the incumbent businesses will also have to pay higher wages. An increase in wages has two effects. It reduces the post-tax rate of return to all investors, because the cost of labour in Australia increases; it is this mechanism that will limit the foreign investment response to the company tax cut. It also provides a boost to national income.
The boost to national income derived from stronger wages should not be oversold. It is only the marginal wage increase paid on the new, foreign-owned capital that adds to national income. Across the rest of the economy, an increase in the wage amounts to a transfer between employers (including government) and employees, with no net impact on national income. Furthermore, the benefit to workers should not be exaggerated. If the company tax cut is to be revenue neutral, the burden of replacing the revenue lost from company tax will fall on workers in some form: an increase in personal income tax or GST are possible policy measures that have been mentioned, while a recent Treasury report used a non-distortionary lump-sum tax to finance a company tax cut. These details are yet to be decided upon.
Our optimisation problem provides a simple framework in which it can be shown that the net impact on national income following from a company tax cut may be positive or negative. It depends on the elasticity of demand for capital (this is closely related to the elasticity of substitution between capital and factors that are fixed in the long run, such as labour and natural resources). If the elasticity is high, we attract enough capital to make a cut to company tax worthwhile. But if the elasticity is low, it is possible that national income would increase if we increase the rate of company tax. That is, X in our optimisation problem could be negative.
The crucial value for the elasticity of demand for capital is two-thirds, or 20/30, derived directly from the share of foreign ownership (20%) and the current rate of company tax (30%) (this translates to a labour-capital substitution elasticity of around 0.4). For gross national income to increase, for every percentage point cut in the rate of company tax, we need the aggregate capital stock to grow by at least two-thirds of a percent.
So, if the elasticity of demand for capital is greater than two-thirds, cut company tax to increase income. If it is less than two-thirds, raise company tax. If it is equal to two-thirds, then company tax is already set at the rate that optimises national income.
Economists will disagree over the appropriate value for this elasticity, but it is fair to say that there is uncertainty over whether it is less than or greater than two-thirds, with a comprehensive review supporting a great range of elasticities. While Treasury modelling has assumed higher values for this elasticity, those who think it is relatively low would argue that the economy, within the constraints of its population, natural resources and infrastructure, cannot absorb significant quantities of new capital above a normal rate of growth. Wages would be bid up quickly, driving down returns to capital. This limits the amount of additional capital growth that might be derived from a cut to company tax.
The case for a cut to company tax is tenuous at best, and the policy is not without risks. We need to do better than break-even to make this policy worthwhile, for several reasons.
1. Transition costs need to be considered. The losses to national income will be felt immediately, while gains are only realised over many years, as capital stock is installed and becomes productive. There is also the cost of compositional change, with some industries expanding and others contracting. This may mean that workers are obliged to retrain or relocate.
2. With more foreign-owned capital, trade surpluses will be larger (or deficits will be smaller) than they otherwise would have been. To achieve this we will require the terms of trade to fall. This reduces the purchasing power of the domestic population and reduces the potency of any gain to gross national income.
3. The wage gain associated with a cut to company tax may be subdued if, instead of attracting labour from the existing workforce, the policy attracts inward migration. In this case, GDP growth will be stronger, but the positive impact of wage growth on per capita income will be reduced.
4. Foreign owners of capital might not react by as much as our optimisation framework suggests, because the price transmission mechanism is muted by taxation treaties, including some which give investors credit in their home country for withholding tax paid in Australia. When we cut the Australian company tax rate (and in turn, cut the rate of withholding tax charged by Australia on unfranked dividends paid to foreign investors), the benefits to our economy rely on foreign investors responding to an increase in their post-tax rate of return. However, if a proportion of tax paid in Australia is credited back to the investing agent in its home country, the change in the agent’s post-tax rate of return is smaller, and the investment response will also be smaller. As The Australia Institute points out, American firms operating in Australia will not invest more, employ more or be any more competitive after Australia cuts the company tax – they will simply pay less tax here and more tax in the US.
5. There are risks associated with higher levels of debt. With a higher stock of capital in the long run, the economy may arrive at a higher, albeit stable debt-to-GDP ratio. Depending on how (and whether) the government chooses to fund the company tax cut, this debt may be held by the public or private sector. High debt increases the nation’s exposure to international interest rate movements, and makes our AAA credit rating less secure.
In Ireland during the Celtic Tiger years, economists were very aware of the difference between GDP and GNI. With the company tax rate at just 12.5 per cent, the Irish economy was awash with foreign capital, enjoying high wages and low unemployment. On the downside, accommodation costs were eye-watering, the Guinness was not cheap and one could wait hours in the rain for a taxi.
Ireland’s heavy reliance on foreign capital left it exposed in the Global Financial Crisis. With a legacy of high wages and low taxation, Ireland went into recession, experiencing a period of crisis-driven adjustment characterised by high unemployment and austerity measures.
The current Australian rate of company tax at 30 per cent is almost certainly close to its optimal rate. Unless a cut to company tax can bring in a significant amount of additional investment, it’s probably not worth the risk.
Janine Dixon and Jason Nassios recently published a report about the impact of a company tax cut on living standards in Australia.