Australia's Future Tax System

Final Report: Detailed Analysis

Chapter B: Investment and entity taxation

B1. Company and other investment taxes

B1–1 Costs and benefits of company and other investment taxes

Increased capital mobility over recent decades has focused attention on the effects of taxation on investment decisions. This trend is likely to continue, and while tax is only one of several factors that affect investment decisions, it is likely to be increasingly important.

Despite the increasing cross-border flows of capital, Australia will continue to exhibit some characteristics of a closed economy. Thus, the impact of investment taxes on economic outcomes in both open and closed economies needs to be carefully considered in the development of tax policy.

This section outlines broad principles that should be considered in relation to the taxation of investment and recommends some specific reforms and future directions. The related issue of the taxation of the savings of Australian residents is dealt with in Section A1 Personal income tax. How the taxation of companies and other business entities interacts with the personal income tax system, including the role of Australia's dividend imputation system, is dealt with in Section B2 The treatment of business entities and their owners.

The role of company and other investment taxes

Australia's main investment tax is company income tax, which applies to the return to equity (retained earnings and capital contributed by shareholders) in companies. Company income tax can be seen as taxing the normal return to equity, as well as any above normal returns (or economic rents) generated by an investment.

Through dividend imputation, company income tax effectively acts as a withholding tax on company profits that represent a return to either the savings of Australian investors or the labour of owner-operators of businesses that operate through companies. Equity investments undertaken by unincorporated enterprises or individuals are typically financed from domestic savings, and taxed through the personal income tax system.

In the absence of a company income tax of some form, Australian residents who are shareholders in or owner-operators of companies could significantly reduce the personal income tax they pay by retaining income in companies. Company income tax therefore operates as an integrity (or backstop) measure for the personal income tax system to limit the deferral or avoidance of income tax.

For foreign equity investors in Australia, company income tax generally acts as a final tax, supplemented by dividend withholding tax on distributions paid to non-residents. In limited circumstances tax is also paid on capital gains, in the case of non-portfolio holdings in a 'land rich' company or on Australian sourced 'ordinary income'. Company level taxes are therefore the primary means of taxing foreign equity investments.

By contrast, the returns to debt in the form of interest are a deductible expense for a company or unincorporated business. Interest received by the lender is, however, taxed as income for Australian resident investors or by means of interest withholding tax for foreign investors.

Principle

Company income tax is needed to raise revenue on the normal return, as well as economic rents, earned by foreign capital invested in Australia and to maintain the integrity of income tax as it applies to Australian residents.

The economic impact of investment taxes

While the impact of the overall level of taxation on economic growth remains the subject of debate, there is reasonable evidence that the composition of taxes does affect growth. In particular, there is growing evidence that a shift away from company income tax towards greater reliance on taxing other less mobile factors of production, or on consumption, has the greatest potential to increase GDP and growth (see Part 1).

Income taxes on investment, specifically source-based taxes, can lead to lower domestic productivity by increasing the required pre-tax return from an investment (the cost of capital) and reducing the incentive to invest. This can result in a smaller domestic capital stock, which often leads to lower productivity and lower wages.

The impact of company income tax on capital accumulation depends on the openness of the economy. The more open the economy the more of an impact company income tax has on potential capital accumulation, as the level of capital investment is no longer constrained by the level of domestic savings.

Simulation analysis by Johansson et al. (2008) found that reducing the statutory company income tax rate from 35 per cent to 30 per cent would lead to an increase in the investment to capital ratio of around 1.9 per cent. The study found that the effect of company income taxes is strongest on industries that are older and more profitable (and so have larger tax bases). Younger and smaller businesses (such as start-ups) were found to be less affected, possibly because they are less profitable or because they benefit from concessional tax arrangements.

Johansson et al. (2008) also found that the positive impact of reductions in the company income tax rate diminishes as the tax rate is lowered. Countries with a relatively high company income tax rate are therefore likely to experience a larger positive effect from a given percentage point reduction in the tax rate than other countries.

In addition, where the income tax base differs from economic income, investment decisions may be biased towards less productive assets where concessions apply, or people may be discouraged from entrepreneurial activity. These distortions to the composition of investment can lower productivity.

Company income tax can affect productivity in a number of ways (Johansson et al. 2008).

  • Where effective tax rates vary across assets, investment can be directed towards less productive uses.
  • Through its effect in discouraging foreign direct investment, taxes on investment can adversely affect technology transfers and knowledge spillovers.
  • Taxes on investment may also reduce investment in innovative activities, by reducing the after tax return.1
  • Complexity of the tax system can also reduce productivity by absorbing resources that could be reallocated to more productive uses. In addition, tax system complexity may also deter foreign direct investment.
  • Company income tax can also distort financing decisions. This can affect productivity by distorting the allocation of investment across industries, favouring those sectors that can more easily access debt, relative to those that have to rely more on equity, such as those that invest more in intangibles.

Using firm level data, Johansson et al. (2008) found that over 10 years the effect of a reduction of the corporate tax rate from 35 per cent to 30 per cent would lead to an increase in the average yearly total factor productivity rate of 0.4 percentage points for firms in industries with median profitability. The analysis suggests that the negative effect of company taxes is uniform across firms of different size and age, except for firms that were both small and young.2

How source-based taxes reduce investment

A small open economy, like Australia, does not have any noticeable impact on the international interest rate or the rate of return required by international investors. If the government imposes a source-based income tax, the pre-tax return to domestic investment will have to increase in order to generate the same post-tax return that could be earned by investing in another country with a lower tax rate.

As a result, some investments with a lower rate of return will not be undertaken, domestic investment will fall and less capital will flow into the country. This will continue until the pre-tax return has risen sufficiently to compensate investors for the effect of the source-based tax.

There is substantial econometric evidence that company income taxes affect foreign direct investment. A review of a wide range of empirical estimates concluded that a one percentage point increase in the marginal effective tax rate causes a 4 per cent fall in the stock of inbound foreign direct investment (de Mooij & Ederveen 2008).

Other studies have also suggested that foreign direct investment may be more responsive to changes in the tax rate as the gap between a country's tax rate and those of other countries increases. For example, foreign investment may be more sensitive to tax where the country's tax rate is significantly above average (Bénassy-Quéré et al. 2003).

Who carries the burden of company income tax?

At first it may appear that the burden of company income tax effectively falls on shareholders, who receive a lower post-tax return on their investment. But this view ignores the possibility that the tax could be shifted to consumers through higher prices, workers through lower wages, or other types of capital through lower returns as capital shifts out of the corporate sector in response to the lower post-tax return from corporate equity.

In a small open economy with perfect capital mobility, the burden or incidence of a source-based tax is shifted onto labour and land. As the source-based tax applies only to domestic investment, foreign investors can avoid the tax by moving their capital offshore. If a source-based tax is imposed or increased, capital flows out of the country until the pre-tax return increases by the full amount of the extra tax. This leads to less capital in the economy, less machinery, plant and research and development per worker and per hectare and therefore lower productivity of labour and land. In turn this means lower wages for workers and lower rents for the owners of land. In this simple model the burden of the source-based tax is fully shifted onto less mobile local factors of production.

Furthermore, because productivity is reduced, the tax burden on less mobile factors may be greater than the tax revenue collected. The obvious conclusion of this is that, given certain stringent assumptions, a small open economy should not levy source-based capital income taxes because they reduce national income (Gordon 1986).

While there is general agreement that at least some of the burden of company income tax is shifted onto labour, the extent of this is less clear. Economies are not fully open and capital is not perfectly mobile. Hence, the short-run and long-run effects are likely to differ. The US Congressional Budget Office (1996) has drawn some general conclusions from a survey of the literature:

  • In the short-term, the burden of company income tax probably falls on shareholders or investors in general, but because investments are taxed differently, it may fall on some more than others.
  • In the long-term, the burden of company income tax is unlikely to fall fully on corporate equity. This is because the company income tax is likely to affect investment decisions.
  • In the very long-term, the burden of company income tax is likely to be shifted in part to labour, if the corporate tax dampens capital accumulation.

Hassett and Mathur (2006) find that a 1 per cent increase in the corporate tax rate is associated with a close to one per cent drop in wage rates. Felix (2007) estimates that a 10 percentage point increase in the corporate tax rate reduces annual gross wages by 7 per cent. Arulampalam, Devereux and Maffini (2009) estimate that around 75 per cent of any increase in source-based taxes on corporate income is passed onto workers in lower wages in the long run.

While these econometric findings are not without their limitations, they are broadly in line with the estimates derived from the use of computable general equilibrium models.3

Principle

In setting the company income tax rate and base, consideration should be given to its real incidence on shareholders, workers, land owners and other capital owners.

There is no 'fair' share of company income tax in isolation of these effects on individuals.

The taxation of economic rents

The analysis of where the incidence of company income tax falls is based on investments earning the normal return, or the going market return on capital. But many investments earn economic rents; that is, profits in excess of a market return. For debt, the normal return is the market rate of interest on debt for the relevant risk class. For equity, the normal return is the required market rate of return on stocks with the relevant risk characteristics.

In a closed economy, taxing the normal return will reduce the level of saving and therefore investment; however, a tax on economic rents would not normally bias investment decisions.

In an open economy, the impact of a tax on economic rents will depend on the mobility of the rent. Economic rents can be characterised as either firm-specific (or mobile) or location-specific. Investment generating mobile rents (arising from factors such as management know-how, a brand or a businesses' possession of a particular technology) can be moved from one jurisdiction to another. Location-specific rents may arise from exploitation of natural resources, existing fixed investments (such as factories), agglomeration (where businesses obtain benefits from co-location such as economies of scale), attractive local infrastructure, public services and institutions or consumer preference for domestically produced over imported goods.

For a mobile rent, source-based taxes can reduce investment. Investors will simply shift the investment to a lower tax jurisdiction so they can receive a greater share of the rent. In contrast, a source-based tax on a location-specific rent will not distort investment decisions.

Source-based taxes and profit-shifting

A high rate of source-based company income tax relative to other countries — including a tax on economic rents — creates an incentive for multinational groups to shift taxable profits from Australia to low-tax foreign jurisdictions.

In the absence of anti-abuse provisions, this can be done by shifting debt and the associated deductible interest payments and other expenses including management and intellectual property costs from foreign affiliates to Australian members of the multinational group (thin capitalisation) and by manipulating transfer prices and royalties for intra-group transactions. For example, a foreign company that purchases goods from an Australian subsidiary for much less than the goods are worth would reduce the subsidiary's taxable income.

Most advanced countries have specific rules to prevent or limit transfer pricing and thin capitalisation, which, while increasing the costs of tax administration and compliance, are an important means of defending source-based investment taxes. Withholding taxes can also tax profits shifted through interest payments or as royalties, although typically at lower rates than the company income tax rate.

Despite these rules, there is ample international empirical evidence that multinationals are able to shift at least part of their profits to countries with low statutory tax rates (de Mooij & Ederveen 2008). The possibility of international profit-shifting therefore remains an important constraint on tax policy in an open economy.

Australia's dividend imputation system may reduce the incentive for Australian multinationals with a large domestic shareholder base to shift profits offshore, because these companies have an incentive to pay tax in Australia in order to pay fully franked dividends.

Why retain source-based taxation?

The analysis of the costs and benefits of source-based taxation suggests that small open economies, such as Australia, should not levy source-based capital taxes. However, in practice, despite the trend towards lower company income tax rates, they are far from zero. There are a number of reasons for retaining source-based capital taxes, and the company income tax in particular.

First, the argument that small open economies should not impose source-based taxes relates to taxing the normal return to capital. As previously discussed, where an investment generates a location-specific rent, the rent can be taxed without deterring the investment, making it a relatively efficient tax base. As a resource rich country with a well-educated workforce, effective regulatory regimes and a relatively large existing capital stock, Australia has substantial location-specific rents. Australia's geographic isolation may also give rise to some economic rents due to high transportation costs, while limiting the scope for others (such as those derived from economies of scale associated with serving large markets). Rents may also arise from preferences for Australian products that are differentiated from imported imperfect substitutes.

Second, although the international mobility of capital has grown, capital is still not perfectly mobile. This is particularly true of equity markets. Investor portfolios are still biased towards domestic assets, perhaps because investors are less familiar with foreign financial markets, have less control over foreign investments and would need to manage foreign exchange risks. Firms often face significant adjustment costs if they want to relocate business investment across borders. These factors allow governments some scope for imposing source-based investment taxes without causing significant capital flight.

Third, source-based capital taxes may also be justified on the basis of the 'treasury transfer' effect. For example, a foreign country taxes its residents on their global income may provide a credit for source-based taxes paid in Australia. A reduction in Australian company income tax would result in a lower foreign tax credit in the country of residence, leaving the foreign investor's worldwide tax liability unchanged. A reduction in Australian tax therefore results in revenue shifting from Australia to the other country with no increase in the level of investment in Australia.

The extent to which the treasury transfer effect applies in practice is unclear. Most countries are moving away from worldwide income taxation. For example, the United Kingdom and Japan, which previously practised worldwide taxation, have recently moved to dividend exemption systems. This means that most income from equity investments in Australia is exempt from tax. However, the United States, which has around 23 per cent of foreign direct investment in Australia, still has worldwide taxation. But even for countries that still tax worldwide income, the ability to avoid or defer taxation can reduce the value of credits and may limit the extent of the treasury transfer effect.

As discussed previously, the company income tax also operates as an integrity (or backstop) measure for the personal income tax system.

Principle

In setting the effective company income tax rate, a balance needs to be struck between:

  • the benefits of a lower rate in attracting internationally mobile investments or capital; and
  • the benefits of a higher rate in reducing opportunities for domestic residents to defer or otherwise reduce tax on their personal income, and in taxing the returns to less mobile investments or capital.

Targeted responses to international tax competition

The previous section suggested that there is a case for taxing different types of investments at different rates depending on their international mobility.

Many countries tax investments according to their mobility. For example, resources, which generate location-specific rents, are typically taxed at higher rates, while more mobile investments such as research and development are often concessionally taxed. In Ireland, the manufacturing and traded services sectors are subject to a preferential corporate profit tax rate, while developing countries often use tax holidays to attract international investment, and many countries have adopted tonnage taxes for international shipping.

The most effective tax instrument for attracting investments generating economic rents that are also highly mobile is a reduction in the tax rate. This would reduce the amount of tax applying to the firm-specific economic rent that the investment generates. However, reducing income tax rates for particular investments would also reduce tax on the normal return to those investments relative to other investments, potentially distorting investment allocation.

An alternative approach is to allow eligible investments to be written-off at an accelerated rate. This reduces the tax on the normal return to the investment as opposed to the firm-specific rent, and so is likely to have greater downside costs due to inefficient allocation of investment and the potential for also distorting production decisions within a sector.

Another problem with targeted tax concessions is the difficulty of determining which sectors or investments they should apply to, particularly in terms of identifying activities or sectors with significant firm-specific rents. Where tax concessions are inappropriately targeted they will further adversely distort resource allocation. As such, the use of targeted provisions needs to be based on strong supporting evidence and must be balanced against the distortions they create to investment allocation and the additional compliance and administration costs.

Principle

Differential tax arrangements for particular sectors or types of investment, as a response to international tax competition, should not be adopted given the potential effects on resource allocation, except in limited circumstances where there is strong evidence to support their use.

International tax coordination

Early efforts at international tax coordination centred on eliminating the double taxation of cross-border investments. Bilateral tax treaties became the primary means of reducing the risk of double taxation, and of reducing other tax barriers to cross-border investment such as tax discrimination and compliance costs.

The focus of international tax coordination has now changed. Concerns now centre on the potential impacts of international tax competition and a 'race to the bottom' in company and capital income tax rates, in the face of a worldwide decline in company income tax rates in recent decades and the potential for international tax evasion.

Competing reductions in source-based capital taxes may arise because the supply of capital to an individual country is more responsive to taxation than the global supply of capital. From a global perspective, however, the consequence of individual countries' decisions to reduce capital income taxes may be an inefficiently low level of capital taxation that limits their ability to finance public services and undertake redistribution.

This characterisation of the effects of international tax competition is not, however, universally accepted. International tax competition is one of the many brakes on increasing taxes, and some argue that this limits the over-expansion of government. There may also be countervailing factors that limit company income tax rate reductions. For example, as economies become more open and the proportion of domestic companies owned by non-residents increases, governments may have an incentive to raise company income taxes on the basis that this exports, or at least appears to, part of the tax burden to foreign investors.

A radical form of international tax coordination would see countries relinquishing source taxation altogether and only imposing residence-based taxes. However, the constraints on national sovereignty implied by such an approach make it highly unrealistic. An alternative approach would be to permit countries to retain source-based taxation but on a harmonised basis. Tax harmonisation of company income taxes has been discussed within the European Union for a number of years, although with little apparent progress to date.

Estimating the potential benefits or costs from international tax coordination is challenging. Standard tax competition models, which assume a large number of small, homogeneous countries, fixed national populations with identical tastes and preferences, and perfectly mobile capital flows, predict that all countries will unambiguously benefit from tax harmonisation (Zodrow 2003). However, these results are challenged by other models.

For example, the 'new economy geography' model considers the case where there are two types of countries: those with agglomeration rents (typically large) that can support high levels of investment taxation and provide high levels of public service as desired by their citizens; and smaller, low-taxing countries that do not have these agglomeration rents. In this model, tax harmonisation is not beneficial. It reduces the ability of smaller countries to compete for mobile capital and the ability of larger countries to provide the level of public services desired by their citizens (Zodrow 2003).

Attempts have been made to estimate the impacts of tax harmonisation within a region, in particular Europe. Harmonisation within Europe has been estimated to lead to a modest increase in total welfare, with an increase in GDP of around 0.1 to 0.4 per cent. However, these benefits are estimated to be unevenly distributed between individual countries, with losers as well as winners (Griffith, Hines & Sørensen 2009). The likely divergence in outcomes, and the fact that the winners are typically those countries that achieve harmonisation by reducing tax rates and revenues (making compensating transfers problematic), suggest the potential for tax harmonisation is limited on a worldwide basis.

Harmonising worldwide investment tax bases and rates may therefore be an unrealistic goal, even if it is of potential benefit to Australia (which is unclear). But given the potential costs of a worldwide trend to very low company income tax rates, Australia should not aim to radically cut its company income tax rate ahead of other countries. Furthermore, as discussed previously, the lower the existing company income tax rate and closer it is to that of other countries, the lower the likely benefit from additional reductions.

Reflecting the difficulties and uncertain benefits of deeper forms of tax coordination, recent global developments have largely had more limited objectives. These have included shoring up countries' abilities to impose residence taxation by improving the exchange of information between tax administrations. This more limited approach permits countries to craft their individual tax systems to reflect differences in factor endowments and productivities, and national preferences towards redistribution.

The global economic crisis has led to unprecedented action to improve international standards of transparency and information exchange. This work is undertaken through the Global Forum on Transparency and Exchange of Information, which Australia currently chairs. Since April 2009, more than 90 tax information exchange agreements have been signed and over 60 tax treaties have been negotiated or renegotiated to reflect improved standards on transparency and exchange of information.

Australia's tax treaties provide for exchange of information, and to date Australia has entered into nine tax information exchange agreements with several more being negotiated.

Principles

Australia should not be at the forefront of any 'race to the bottom' in company income tax rates.

International tax coordination is required to support cross-border income taxation, particularly the effective exchange of information to allow for the enforcement of taxes on the savings income of residents.


1 This can be exacerbated for more risky investments where the tax system places limitations on the use of losses.

2 The results refer to a sample of firms extracted from the Amadeus (Bureau van Dijk) database (covering European OECD member countries) and the Worldscope (Thomson Financial) database (covering non-European OECD countries).

3 Gentry (2007) provides a comprehensive discussion of these and related studies on the incidence of the company income tax.