The 2020-21 Commonwealth Budget allows most corporations to carry back losses incurred over the next two years against taxes paid in 2018-19. This short-term measure, which applies only to corporations and not other taxpayers, brings to life the policy issue of asymmetric treatment of recorded profits and losses for income taxation.
Normal practice: profits are taxed as you earn, but losses only can be offset in future
Under Australia’s usual corporate income tax rules, to which we will return in the future after the 2021-22 year, recorded profits of corporations are taxed in each year. Corporate losses can be carried forward only in nominal terms as an offset against future year recorded profits. The carryforward of losses is subject to restrictions on continuity of business ownership and similar business activity.
The present value of future deductions is thus less than the current period nominal value, and some losses will not be offset (although shareholders in a loss-making corporation may register a capital loss on the decline in value of their shares).
As a result, corporations with recorded losses that are carried forward pay a higher effective tax rate than the statutory tax rate over the multi-year life of the investment.
Neutrality of income taxation of different investment choices, and equity, would imply developing a more symmetrical treatment of business profits and losses as a desirable long-term structural tax reform.
While almost all business investments involve outlays in the early years and then delayed returns for many years into the future, income tax liability is assessed on a year by year outcome.
Many businesses record losses in the early years of an investment and profits in later years.
Another measure in the 2020-21 Commonwealth Budget will replace depreciation allowances for capital assets with immediate expensing, for businesses with aggregated turnover of up to $5 billion. This will likely increase the numbers of businesses with recorded losses and will also increase the magnitudes of recorded losses.
Some business investments, which are very sensitive to general economy fluctuations such as the COVID-19 recession, may record losses in some years while recording a profit over the entire investment life. However, not all investment projects return a net profit over the investment life cycle. Businesses adopt a portfolio of projects for risk management, but they may still have some years of recorded losses from the portfolio.
Why do we need symmetric treatment of tax losses?
Symmetrical income taxation of different investments by different businesses would require a tax refund on recorded annual losses at the same statutory tax rate applied to recorded profits. If a corporate tax rate of 30 per cent is applicable to annual recorded profit (for large corporations in Australia), this would require a tax refund of 30 per cent of annual loss.
Asymmetric tax treatment of recorded annual business profits and losses produces variation of effective tax rates across different businesses and their investment choices.
More frequent and larger recorded tax losses, which implicitly produce higher effective tax rates over the whole investment, are more likely for some kinds of business investment:
- Investments with large up-front outlays and several years before returns are generated (relative to investments with smaller up-front outlays and shorter lives, relative to future returns);
- smaller businesses with a few, or only one, high-risk business investment (relative to larger businesses with more and diversified investment project portfolios);
- investment projects more sensitive to fluctuations in the business cycle and other market fluctuations (relative to investments with more stable returns).
This distorts after-tax returns across different options for no market failure or other logical reasons. This has the consequence of distorting the choice of investments, with a loss of national productivity and living standards.
The higher average effective tax rate associated with the asymmetric treatment of business profits and losses reduces the aggregate level of investment in the same way as a higher statutory tax rate.
Reform options to address asymmetric loss treatment
There are different reform options to remove or reduce the adverse effects of the current asymmetric income tax treatment of business profits and losses.
A benchmark or ideal symmetrical treatment would have government pay a statutory tax rate share of the losses to balance the statutory charge on profits. Governments resist such payments for income tax. However, the refund of input credits in the supply chain means that they make similar payments for the GST.
A second option is to allow businesses to trade losses. This is currently restricted by rules requiring continuity of ownership and a similar business activity, for the use of losses. Allowing corporations to trade losses would remove most of the asymmetry effects, but with additional transaction costs. It would produce similar revenue losses to the benchmark symmetrical treatment.
The law could be changed to index losses that are carried forward. This offers a partial solution, and is done in the Petroleum Resource Rent Tax. In practice, it leads to debates about the carry-forward indexation rate for losses, and would likely produce different rates for different businesses types and investments.
Allowing the carry-back of losses, as has been temporarily legislated in the Commonwealth 2020-21 budget, provides another avenue for refund of some losses. This is a feature of the tax law in some other countries, although it is usually subject to restrictions. This option has limited applicability for start-up businesses, which will not have profits in prior years against which the loss can be absorbed.
Other Budget Forum 2020 articles
Blink and You’ll Miss It: What the Budget Did for Working Mums, by Miranda Stewart.
Economic Stimulus through a Gender Lens: Why the Budget Did Not Deliver, by Helen Hodgson.
Progressivity and the Personal Income Tax Plan, by Sonali Walpola and Yuan Ping.
Training Subsidies and Market Failures, by John Freebairn.
Getting Coherence into the Equity Debate – Part 3, by Andrew Podger.
Getting Coherence into the Equity Debate – Part 2, by Andrew Podger.
Getting Coherence into the Equity Debate – Part 1, by Andrew Podger.
What Has Volunteering Got to Do With the Budget? By Sue Regan.
Talk of Aspiration Is Not Borne Out in Federal Budget Papers, by John Hewson.
Economic Security for Older Partnered Women and Widows: Fixing Gaps in Australia’s Superannuation System, by Monica Costa, Helen Hodgson, Siobhan Austen and Rhonda Sharp.
Heroic Assumptions in Budget Omit One Major Threat: A Global Debt Crunch, by John Hewson.
Dream Budget or Not? by Shumi Akhtar.
Will Instant Asset Write-Offs Boost Jobs? by Michael Coelli.
It’s Not the Size of the Budget Deficit That Counts; It’s How You Use It, by Steven Hamilton.
Looking for Bold Reform? Get Rid of Payroll Taxes, by Robert Breunig.
It’s Time to Meet Key Social Policy Challenges in COVID Recovery, by John Hewson.
Meet the Liveable Income Guarantee, a Budget-Ready Proposal That Would Prevent Unemployment Benefits Falling off a Cliff, by John Quiggin, Elise Klein and Troy Henderson.
COVID-19 Strengthens Australians’ Belief in the Fair Go, Government Should Support the Vulnerable, by Emma Dawson.
Thanks to Prof. Freebairn for this contribution. An interesting suggestion, but one which raises questions.
Is ‘symmetrical’ treatment of tax-law profit and loss of corporations really a desirable goal? I will suggest a few reasons for doubting the proposition. Some of them relate to the correctness of assumptions about the operation of markets and the practical translation of economic theory into legal and administrative reality.
• It is one thing to say that individuals and corporations should share their net gains with the community at large as a contribution to government’s ability to provide common goods. It is another to say that the community should partly underwrite corporate net losses and do so on a current basis. The issue was thrashed out a few years back in the context of responses to the resource rent tax proposals of the Henry Report.
• The proposed distinction between corporations and individuals has not been explained.
• The tax system already includes deliberate concessional measures which take effect as tax deductions and suppress taxable income relative to accounting income (R&D concessions, accelerated depreciation and write-offs, etc). This creates differences between tax and accounting income. ‘Symmetrical’ treatment of tax losses by allowing a refund at the corporate tax rate would convert these concessions into subsidies. It is difficult to justify a situation in which such concessions operate at the same time as tax loss refunds.
• To convert a tax reduction into a tax refund creates significant integrity risks. We see this already in the context of GST, where input tax credits can be used to generate net payments from government. These are legitimate in theory and in honest practice — there are many projects that involve a development phase in which little or no sales income is generated — but there is a real risk of abuse, including a risk of phoenixing. Correspondingly, tax authorities have to scrutinise such claims with particular care. The risk of introducing tax loss refunds is significant, particularly in an environment of corporate self-assessment.
• The position of the ATO as a creditor in corporate insolvencies has shifted over time. Originally, tax and other debts to the Crown were privileged relative to ordinary unsecured debts. That is no longer the case. While the ATO has some mechanisms that are not available to ordinary unsecured trade creditors, these tend to be labour-intensive and to require prior identification of the taxpayer as an integrity or recovery risk. The present position is part of a policy balance which would be disturbed by allowing tax loss refunds.