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Often, the effects of a lower company income tax on investment, national income, government revenue and so forth are assessed as if company tax was the only tax affecting the decisions of companies to invest, and of savers to provide the funds. Instead, company income tax is only one link in the chain of capital income tax, which separates the pre-tax return earned by the company investor and the after-tax return received by the shareholder providing the funds.

For resident shareholders in the imputation system, company income tax is a withholding tax, and the actual tax burden on dividends is the progressive personal income tax—for individuals—and a flat 15 per cent—for superannuation funds. The tax burden on retained earnings is however different, as explained further below.

For non-resident shareholders, a system of withholding taxes on company income repatriated overseas interacts with the company income tax in different ways to determine the capital income tax burden.

Assessment of the effects of a lower corporate income tax rate on the incentives for and rewards from investment, and on government revenue, should consider the interaction of the company tax with the taxes imposed on capital income received by the resident and non-resident providers of funds.

The economics of capital income taxation

An important aspect of the different capital income taxes on shareholders is that the company tax is imposed on the demand or investor side of the market, while the personal income, superannuation and withholding taxes on capital income are imposed on the supply or saver side. But, in long run equilibrium, the effects of taxation on quantities invested and saved, market prices setting pre-tax investment returns and after-tax saver returns, and government revenues are the same for demand and supply side taxes.

The company income tax base is the residual return to shareholder equity funds. It includes the normal rate of return plus ‘above normal’ returns that may be derived including for monopoly power, economic rents on limited in-supply natural resources, and quasi-rents on intellectual property and managerial expertise. The ‘above normal’ return also includes the consumer surplus on inframarginal investments, which are namely investments that earn more than the minimum rate of return.

Lower company tax –for whom?

For resident shareholders who represent about 70 per cent of shareholders, and for company income distributed as dividends, the imputation system means the company tax is a pure withholding tax. That is, for a fully franked dividend bearing the 30 per cent corporate income tax, a high-income taxpayer with a marginal rate of, say, 47 per cent would pay an additional 17 per cent for a tax burden of 47 per cent; by contrast, a low-income taxpayer with a marginal rate of, say, 19 per cent would receive a refund of 11 per cent for a tax burden of 19 per cent.

A different tax burden applies for resident shareholders for retained earnings (about 30 per cent of corporate income on average) used by the company to fund additional investment. For investors with shares that are held for many years, franking credits may be carried forward and used to offset personal tax on future dividends. But, franking credits are carried forward only in nominal terms, and so lose value over time. This produces a higher effective tax rate on the shareholder than the personal income statutory rate, even if profits are distributed in the future. Alternatively, if the shares are sold, the tax burden for the investor includes the corporate tax paid plus capital gains tax (albeit usually with the CGT 50% discount) paid on the higher share price driven by the extra investment.

For resident shareholders, especially small family-owned companies, a lower corporate tax rate has a very limited effect on the tax burden. Consequently, it does little to change the incentives and rewards for investment or government tax revenue. For franked dividends, the lower corporate rate is fully offset by a higher personal income tax and lower refund for superannuation funds. For retained earnings, much of the initial gain of the lower company rate is recaptured with higher income tax on future dividends and additional capital gains tax. Also, a lower corporate income tax has no effect on the tax burden on debt provided funds, some 40 per cent of the average company investment.

Is there a lower company tax burden on non-residents?

What about non-resident shareholders, who might be considered the key marginal providers of funds for investment by multinational and large public companies operating in Australia?

The interaction of the Australian company income tax and the system of withholding taxes means that most of a reduction of the company tax rate is passed on to the non-resident shareholder. Franked dividends are exempt from withholding tax; and all of a lower corporate tax rate is passed on. For unfranked dividends (about 10 per cent of all dividends), a constant low withholding tax rate applies. A lower corporate tax rate on retained earnings produces a dollar for dollar lower tax burden, and additional available funds for investment. Capital gains tax normally do not apply to non-residents. So, a lower corporate tax rate improves the incentives and rewards for non-residents to reallocate global mobile funds to investment by Australian companies. As for residents, a lower corporate tax rate has no effect on the tax burden on debt; in fact, it reduces the value of the deduction for debt, making debt a little more costly relative to equity.

For income received by non-resident investors on the existing non-resident owned shares, the lower Australian corporate tax rate provides a transfer of taxation revenue from Australia to non-resident shareholders. This transfer is unlike a lower personal income tax rate, which transfers government funds to resident Australian tax payers.

The transfer of funds from Australian tax to non-residents, plus the additional after-tax income on additional non-resident funded investment, mean that the Gross National Income (GNI) response to a lower corporate income tax rate is less than the Gross Domestic Product (GDP) response and, possibly, GNI decreases. The income measure is of more relevance to Australian wellbeing.

In summary, the tax burden between the company investor pre-tax return and the after-tax return received by the saver providing funds requires consideration of other forms of capital income taxation as well as the corporate income tax. The tax burden and the effects of a lower corporate tax rate on the burden varies across debt and equity funds, resident and non-resident shareholders, and company income distributed and retained.

 

Further reading

Freebairn, John, “Effective Tax Rates on Different Corporate Investments”, Working Paper, Department of Economics, University of Melbourne, June 2018.

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This article has 4 comments

  1. John, I agree with most of your analysis, but am not sure the picture for non-resident shareholders is complete. As I understand it, foreign shareholders are still subject to their own income and capital gains tax rules in their country of tax residence. Of course the applicable rules might be very generous, but for the most part (and I am thinking of US and UK foreign investors particularly) they are well above zero, even if below the Australian company tax rate. For countries where we have an income tax treaty and where the principle of taxing only the difference between the Australian and foreign rates applies, surely the advantage is nil (as long as the provisions of the treaty are upheld.)? There will be I am sure some outright avoidance of all company and income tax by some individuals, but how large a group this is I cannot estimate. But in their case changes to our rates can have no impact at all.

  2. Actually, on my last point, a correction. If companies increase their dividends paid that increase in the dividend will benefit foreign shareholders who pay no tax, and retained earnings should increase the company value which ultimately represent additional capital gains on which the avoider pays no tax. But the main point remains: for law-abiding foreign investors subject to a foreign tax treaty, what is the real gain?

  3. My understanding is that all countries except the US now have a territorial system meaning no home country tax is imposed. While the US does impose home country tax as you note, it is contended that most investors delay the income repatriation and use other means to defer any US tax. Trump has proposed a form of amnesty to speed-up the return of income from off-shore investments.

  4. Excellent article John which should alert all tax practitioners before giving investment advice, The complexities with tax and investment can be confusing. Assuming that automatic reduction in taxes will increase DFI or domestic investment, without knowing the context is dangerous. Equity and debt financing for investment will always play a role.

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