Home > media > Company tax cuts aren’t the only growth tool in the box

Company tax cuts aren’t the only growth tool in the box

August 10, 2017

Company tax cuts aren’t the only growth tool in the box

Janine Dixon and Jason Nassios, The Australian Financial Review, 6 August 2017

With the company tax cut debate back on the agenda, the battle lines are drawn and the usual suspects have taken up their positions for and against. Critics have been quick to point out perceived hypocrisy, particularly in relation to prominent Labor figures. Meanwhile, at Victoria University’s Centre of Policy Studies we have been running detailed, dynamic computable general equilibrium model simulations of the impact of a cut to company tax in Australia. The modelling paints a complex tale but we think we have the answers to the main questions.

Will a company tax stimulate or impede growth?

It depends what you mean by “growth”. A cut to company tax will stimulate investment and wages, as the coalition government and the BCA have been keen to point out. These effects will be modest, derived from investments that are profitable at a 25 per cent tax rate but not at a 30 per cent tax rate. New investments will need workers. To attract these workers away from their existing jobs, wages will grow. Wage growth is great for workers, obviously, but it will also quickly curtail any sought-after investment boom. An investment that looks profitable at 25 per cent tax under today’s wages will not necessarily be profitable as wages go up. Our estimation is that the potential new investment opportunities that open up under the lower tax rate are quite limited, facilitating a small positive stimulus to economic growth.

But here’s the catch. Even though economic growth is stimulated, domestic incomes are reduced, because foreign investors will contribute less to the nation’s income through taxation. Immediately when taxes are cut, as a nation we will lose a chunk of tax revenue from foreign investors. Over time some but not all of this loss to the nation will be offset by higher wages.
So when Bill Shorten says a tax cut “impedes growth”, while his meaning is somewhat ambiguous, he is not wrong. The BCA were quick to deride the statement as “patently untrue”, appealing to the argument that the tax cut would “grow the economy”. Shorten, however, must have been referring to growth in domestic income, which will indeed be impeded by a company tax cut. Domestic income is the more suitable measure of material welfare, and the measure with which governments ought to be concerned.

What about national debt?

Does it matter? Shorten is also correct that the tax cut will accelerate national debt. We anticipate that 10 years after a company tax cut from 30 per cent to 25 per cent, the nation’s foreign debt would be at least 2 per cent higher as a percentage of GDP than it would have been had the company tax rate remained at 30 per cent. This is not necessarily a problem, but what it means is that Australians will be able to consume slightly less of their annual output than they otherwise would have. Again, the gap between “economic growth” and “income growth” is apparent.

Does the tax cut pay for itself?

The stimulus to economic activity will not be enough to enable this policy to self-fund. In other words, the tax base won’t grow enough to enable the recovery of the government revenue lost under the tax cut. Domestic taxpayers will cover the revenue loss in one way or another – a higher rate of income tax or GST, or a reduction in government services are the obvious candidates.
Why is dividend imputation important?

Perhaps the divisive nature of this policy change derives from the fact that the distributional consequences of a company tax cut are uneven. As Paul Keating has often said, local investors, in particular the owners of small and medium enterprises, are not directly impacted by a change to the rate of company tax because of dividend imputation. However, if company tax is cut, higher wage costs will need to be borne by these businesses. To some extent we will see foreign ownership crowding out domestic ownership.

At the big end of town, dividend payout ratios are much lower. Apart from a small cohort of New Zealand residents, non-resident shareholders are unable to claim Australian franking credits. From their point of view, an Australian franking credit carries no value. Taking into account the needs of both its foreign and domestic shareholders, the management of a company with a significant proportion of foreign ownership (such as BHP or Rio Tinto) will pay out a smaller share of its operating cash flows as dividends. With lower payout ratios, domestic investors in these companies receive fewer franking credits and effectively pay some company tax. These are the domestic investors who stand to gain from a cut to company tax. Under a lower company tax rate, these investors will enjoy higher capital gains and contribute to investment growth.

Do we need action?

Our modelling shows that the starting point is crucial. We calculate that the upfront loss of government revenue is too large to justify the later benefits in terms of investment and wage growth. From a different starting point, the story may have been quite different. With less foreign-owned capital to start with, the loss of tax revenue from existing foreign investment may have been justified. Ironically, if we hadn’t already been so successful in attracting foreign capital at the existing 30 per cent tax rate, the case for a tax cut would be a lot stronger.
Australia is fortunate to have the well-deserved confidence of the world’s investors, who have made a significant contribution to our economic landscape and relatively high standards of living. While business investment goes through a weak patch, action may appear warranted. However, a company tax cut is not the “only lever” we have left in the toolbox, nor is it even a suitable lever at this point in time.