Image by Bernard Spragg. NZ CC 2.0 via Flickr

The Budget proposal to cut the company tax cut rate from 30 to 25 per cent has entered the political debate.  For that debate to be well informed, the likely economic effects of the company tax cut need to be understood.  At the request of The Department of the Treasury, I prepared a consultancy report on that topic, which was released by The Treasury on Budget night.

The report used CGETAX, a large-scale Computable General Equilibrium (CGE) model designed for tax policy analysis, to provide detailed numerical estimates of the effects of the company tax cut, in the long run.  CGETAX has 278 industries, nine types of produced capital, eight types of labour, as well as land and minerals as fixed factors.  It uses the latest ABS input-output tables, which refer to 2012-13.  While perfect competition is assumed in many industries, there is a Cournot-Nash oligopoly in sectors with persistently high rates of return: finance; telecommunications; and beverages.

The model allows for many of the important features of the Australian company tax system: franking credits; interest deductibility; investments allowances (for R&D and mining exploration expenditure); depreciation at historic cost; and the availability for a limited range of foreign investors of foreign tax credits in their home country for Australian company tax.

Assuming perfect international capital mobility, in the long run the incidence of company tax is passed on from capital to labour.  On this assumption, the company tax cut leads to an increase in consumer real wages of 1.0 per cent.

It also leads to a gain in annual consumer welfare valued at $4.1 billion to $5.2 billion, depending on the method of funding.  This welfare gain from cutting company tax occurs through three channels: (1) a reduced disincentive to invest in capital; (2) a reduced disincentive to supply labour; and (3) a reduced incentive to incur tax avoidance costs through profit shifting to low-tax jurisdictions.  The associated gain in real GDP is from 0.7 to 0.9 per cent.

Underlying these estimates are a capital stock response driven by an assumed elasticity of substitution between capital and labour of around 0.8 (Gunning, Diamond and Zodrow, 2008, report values in CGE models of between 0.4 and 1.0), a labour supply response determined by a compensated elasticity of the labour supply with respect to the marginal, post-tax real wage of 0.4 (as in the widely-cited study of Gruber and Saez, 2002); and reduced profit shifting via an assumed semi-elasticity of the company tax base with respect to the company tax rate of -0.73 (de Mooij and Devereux, 2009).

Interestingly, the company tax cut is self-funding to a substantial degree.  On a 2015-16 basis, the direct annual cost to the Budget of the company tax cut from 30 per cent to 25 per cent (after allowing for the reduced value of franking credits) is modelled at around $8.2 billion.  But in the long run 55 per cent of this is estimated to be self-funded, reducing the net cost to $3.7 billion.  Self-funding occurs through several channels: higher real wages generate higher personal income tax collections; an enlarged capital stock lifts company tax collections; and higher economic activity leads to widespread gains in other tax collections, including of GST and payroll tax.  This self-funding percentage of 55 per cent is in line with other studies: see the recent study by the UK Treasury (2013) of that country’s company tax cuts and the other studies cited therein.

A recent official estimate puts the total, direct budget cost of the company tax cut at $48 billion over the phase in period from 2016/17 to 2026/27.  This cost would be substantially lower after allowing for self-funding.  While the magnitude of the company tax cut is well judged, the proposed pace of phasing it in is slow.

Treasury (2016) undertook parallel modelling of the company tax cut using an earlier and simpler version of CGETAX, known as the Independent Economics CGE model.  Their main results, also published on Budget night, were similiar.

Surprisingly, Dixon and Nassios from the Centre of Policy Studies at Victoria University recently published a Working Paper reporting that the impact of a company tax cut on living standards would be negative, perhaps because they do not assume perfect international capital mobility.  The Treasury report based on the Independent Economics CGE model demonstrates that assuming a plausible degree of imperfect capital mobility makes little difference to the positive results obtained under perfect mobility, raising the question of whether Dixon and Nassios have assumed that capital mobility is implausibly low.  They could address this issue by making their numerical assumption about mobility explicit and presenting alternative results under perfect capital mobility.

Further, Dixon and Nassios allow for just one out of the three channels through which a company tax cut would raise economic welfare.  That channel, the capital response, is assumed to be weak: the assumed elasticity of substitution between capital and labour is 0.4, which is at the bottom of the usual range of 0.4 to 1.0 referenced earlier.  Regarding the other two channels, the labour supply is assumed by Dixon and Nassios to be rigid and profit shifting is not taken into account.  There are also conceptual issues in their treatment of saving behaviour and external balance.

Finally, Dixon and Nassios do not appear to allow for the important features of the Australian company tax system that are listed above, with the exception of franking credits.  However, they assume the level of franking credits utilised by Australian shareholders matches the company tax attributable to them, whereas ATO data for individuals and superannuation funds shows the utilisation is less than half that amount, after retained earnings and other leakages are taken into account.  This leads Dixon and Nassios to overstate by a factor of more than two the loss in the value of franking credits from the company tax cut, together with the associated negative local investor response.

The Centre of Policy Studies do excellent work in many areas, especially industry policy.  But in CGE modelling of tax reform, CGETAX and its predecessors offer a more comprehensive and detailed analysis.

Coming up soon will be a wide-ranging report on the efficiency of the Australian tax system using CGETAX.  It will show that the single most important tax reform for improving living standards is to reduce our reliance on company tax, in line with the Budget proposal.

The Independent Economics paper and Treasury analysis estimating the economic effects of a company tax cut are available here.

Chris Murphy will be presenting a seminar to provide more information on the modelling of the company tax cut at the Arndt-Corden Department of Economics, Crawford School of Public Policy, 2pm on Tuesday 10 May.  For more information, see here.

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  1. Pingback: Budget Forum 2016: The Connection Between Company Tax and Living Standards - Austaxpolicy: The Tax and Transfer Policy Blog

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