Introduction. One of the important constraints on tax reform in Australia is widespread ignorance about notions of tax incidence. A mistaken theory of tax incidence – the “flypaper theory” – suggests that taxes impact on those groups that they are directly levied on. So, payroll taxes and superannuation levies fall on the companies they are levied on. Economists call this type of incidence “nominal incidence” and distinguish it from “effective incidence” which shows who ultimately bear the impact of a tax. Nominal incidence varies from effective incidence because agents can take actions that transfer the tax to others. For example, to a firm a payroll tax and a superannuation levy are simply additions to the cost of labour employed. Firms, therefore, pay wages that are reduced by the size of these charges and the effective incidence of the tax is on labour, not the firm. These are fairly obvious examples of the distinction between nominal and effective incidence that many will understand. But some confusions are pervasive and are damaging to the case for sensible tax reform.
One of the worst confusions is with respect to company taxes – more specifically to taxes on the profits of incorporated enterprises with shareholders. Here there is a confusion about the effective incidence of a tax and an incorrect view of the way such firms operate. Let us first consider the case of corporations that are primarily domestically owned. We then consider the case of Australian firms where equity is primarily owned by foreigners. Finally, we consider the role of government budget constraints. Does cutting back on company taxes when governments have a binding need for a certain level of revenue, force reliance on taxes that are even more distorting than the company income tax?
These notes are subject to revision although I will note at the end any significant changes. This is work-in-progress.
Domestically-owned firms. Firms sell products or services and hence earn revenues. Out of these revenues, they pay for various contracted costs – the costs of the inputs they use (labour and firm management are usually important inputs) and the recipients of these incomes are taxed. Workers and firm managers, for example, pay income taxes.
If the firm’s revenues exceed its costs then it earns a gross profit. That profit can be either (i) retained by the firm and used to build up the business by investing in new plant and equipment, or buying other assets or, (ii), distributed to shareholders as dividends. By assumption, all of these shareholders are Australian residents. These dividends are taxed in the hands of shareholders as income. There is no other “third party” who benefit from these gross profits.
Company taxes are then levied ONLY on the earnings retained by the firm for purposes (i) namely for investment. As an inessential digression, in Australia, company taxes are levied on all profits earned by the firm including those paid to shareholders. But shareholders receive an imputation credit for the taxes paid on their dividends by the firm so that effectively only the retained earnings are taxed. In effect, the firm is acting as a collection agency for the Australian Tax Office. The firm collects at part of the taxes that shareholders would have to pay on their dividends as ordinary income tax so that shareholders in doing their tax return pay only the difference between their marginal tax rate (the tax rate that applies to their dividend income) and the rate of company tax.
So proposals to cut company taxes are not handing out money to anyone. Such cuts are increasing only that part of the firm’s surplus that can be reinvested. But the main direct beneficiary of this cut will be the workers employed by the firm, who gain access to more capital or to better job opportunities, or the workers employed by other firms who sell inputs to the firm. It is true (as JB notes) that shareholders will enjoy capital gains as a result of the retained earnings. If these gains care realised they are taxed and if, as is so, there is a discount to the capital gains tax rate so that this rate is less than the tax rate paid on ordinary income there might seem to be some leakage in value to shareholders. This leakage reflects the way capital gains tax is levied – the discount is customarily justified as a way of increasing savings. If the capital gains are not realized and shareholders retain their investment then the gains reflect the expected present value of the extra dividend income and this too is subject to tax.
In particular, shareholders get no direct benefit from a company tax cut at all since it only falls on the part of surplus that is not paid in dividends. Shareholders do not pay less tax since the tax they pay depends on the income tax schedule not the company tax schedule. A company tax cut simply alters the amount of tax they pay themselves compared to the tax that is paid for them by the firms they invest in. Shareholders might enjoy taxable capital gains reflecting increased dividends in the future from increased investments by the firm but they will, naturally, be taxed on those.
All this is really basic but I think many in the community – including some who call themselves economists – don’t get it. There is still the basic illogic that someone in the firm (maybe wealthy managers, shareholders?) are getting a huge transfer from a tax cut. They are not. The main group who benefit from a tax cut are a firm’s workers who bear most of what has been called above the effective incidence of the company tax. This is why most economists – and certainly the Australian Treasury – support lower company tax rates: See Cao et al (2015). A very plausible argument is that corporate income taxes should, in fact, be zero.
It is difficult in Australia to reform the tax system because the vast bulk of the population are ill-informed on how it works. Ignorance is a major practical constraint on policy design. This constraint means that policy-makers cannot do anything that can be propagandized into ignorance. Like “Trumpism” in the US – our national policy debates are becoming debased by ignorance.
This analysis is based on the assumption that all shareholders are Australian residents. How do things change if firms are primarily foreign owned?
Foreign-owned firms. Large sections of Australian industry, for example, the mining sector, are foreign owned. How does the preceding analysis change? Now the profits repatriated to foreign residents may not be subject to Australian income taxes. Now reducing corporate income taxes does reduce the tax take of the Australian Government since the reduced taxes paid by firms as a withholding tax on dividends received by foreigners is not offset by increased income taxes paid by these foreign shareholders.
A claim often raised in this connection is that these foreign firms pay little corporate taxes anyway since they use transfer pricing to relocate their profits outside Australia where they are subject to lower tax liability. There are strong nationalistic arguments for seeking to prevent this type of tax avoidance but, if this cannot be done, then lowering tax rates is likely to have few adverse effects on tax revenues since little is being paid. If anything reducing company taxes will reduce incentives to avoid taxes in this way since the costs of avoidance need to be compared with the returns from avoidance and the latter will be reduced with a tax cut. If corporate taxes are reduced to the level of countries used as tax havens then there is no incentive at all to transfer price. If this cannot be done then, if transfer pricing can be limited, then , of course, this should be done. One way of tackling transfer pricing in the resource sector is to substitute taxes on sales and output levels for what seem to be nominally more efficient profits-based taxes but exploring this issue is not relevant for immediate purposes.
So ignoring transfer pricing issues, so firms become liable for their full corporate tax liability in Australia, the question is whether the losses in revenue from reducing corporate taxes received from foreigners is worth the gains in terms of increasing the size of a firm’s surplus that can be used to augment a firm’s capital stock. This is an empirical issue but the standard theory that justifies free trade generally is that the net gains to Australia from international capital flows will be maximized, in a world where capital is “perfectly mobile” (so Australia is a small country and cannot affect the rate of return on capital internationally) by not taxing the capital inflows at all. There a no “second best” issues here. This is again the view of the Australian Treasury: reSee Cao et al. (2015).
Government Budget Constraints. An important issue is whether, irrespective of efficiency arguments for company tax cuts, the need for government to realise preset levels of revenue needs means that cutting company taxes would force reliance on other more distorting taxes. Company taxes levied at around 30% raised around $74b in 2014/15 which were around 16.5% of total taxes (here). The Coalition’s proposed long-run company tax rate is only 25% although this full reduction will not occur until 2026/27. If this tax cut were introduced immediately (a hypothetical, it won’t be) then the loss of revenue would be around $12b. This is an upper bound to the likely impact of the tax if it is believed that the cut would promote economic growth and hence increased firm profitability over the decade to 2026/27.
The GST in Australia in 2014/15 raised $56b while personal income taxes raised $136b while payroll taxes raised $20b. All of these taxes have much lower efficiency costs – measured by Treasury as their marginal excess burdens (see Cao et al. 2015, page 53 ) than did the company tax. Indeed the excess burdens of these substitute taxes were half those of the company tax which is one of the most distorting taxes in the economy. It would be advantageous from an economy-wide perspective to make a substitution of these less distorting tax for the company tax. To take a straightforward example the swap could be achieved by a 20% increase in the GST to a rate of 12%. As mentioned above, the main impact of company taxes is on labour via wage effects. Thus the higher wages that should stem from a cut in company taxes could help contribute towards funding a company tax cut.
Dixon and Nassios (2015) (here) assert that real national income losses of several thousand dollars per year will accrue to Australia as a consequence of a company tax cut using a CGE model with imagined data. This seems to defy basic trade theory and the findings cited on the relative excess burdens of the respective taxes. Basic trade theory asserts that free trade in international capital makes sense if capital is perfectly elastic. So Australia’s national advantage is optimised with such free trade. The material on the respective marginal excess burdens suggests that fixed revenue targets by the public sector can be better met with taxes other than the company income tax.
The argument that fiscal constraints limit the possibilities for cutting company taxes does not seem to hold water.
Comments: JB pointed out the role of capital gains but it seems to me this does not alter the story.