Australia's Future Tax System

Consultation Paper

Section 6: Taxing business and investment

Overview

The tax system needs to evolve to respond to the opportunities, as well as challenges, arising from globalisation. Attracting investment to Australia, directed to activities with the greatest national return, will improve the returns to Australians from working and saving.

An internationally competitive business environment is necessary to attract investment and international businesses, consistent with an objective of increasing national income. Achieving an internationally competitive business environment depends, in part, on getting the right balance of tax bases and rates.

The quality of investment is equally important. Improving the allocation of resources and investments, not discouraging risk taking, and removing tax biases that negatively affect business and household investment decisions, offers the potential to increase productivity and Australia's long-term prospects for economic growth.

Consultation questions

Q6.1 Can the tax system be structured to better attract investment to Australia in a way that increases national income, and if so how? For any given revenue outcome, what are the relative merits of broader base/lower rate (comprehensive income tax) or narrower base/higher rate (a narrow income tax or an expenditure tax) approaches?

Q6.2 What changes, if any, to the tax system would improve the ability of Australian companies to operate internationally orientated businesses? How should the tax treatment of companies and shareholders be integrated in an open economy?

Q6.3 Can the tax system be restructured to improve resource allocation within the economy and minimise operating costs, and if so, how? What changes would reduce distortions to risk taking and encourage entrepreneurial activity?

Q6.4 What principal goals should inform the taxation of capital gains in Australia, and what, if any, changes should be made to capital gains tax as a result?

Q6.5 Should the tax system provide a more neutral treatment of different financing arrangements (debt, equity and retained earnings), and if so, how? What principles should inform approaches to entity taxation?

Q6.6 Should the tax system be structured to cater for the specific circumstances of small business, and if so, how?

Q6.7 Should the tax system be restructured to deliver a more neutral tax treatment for the different forms of return on household savings and investments, and if so, how?

The living standards of Australians are linked to Australia's economic performance. That performance is affected by the level and productivity of investment in Australia, which significantly affect the level of economic output. In the long-run, productivity growth drives per capita economic growth and determines the improvements in the welfare of Australians. Chart 6.1 provides a summary of the sources and drivers of economic growth.

Chart 6.1 Economic growth — sources and drivers

Chart 6.1 Economic growth — sources and drivers

Source: Adapted from OECD (2007b).

Taxes on investments in Australia and, to a lesser degree domestic savings, can affect many of the drivers of economic growth. Taxes affect investment in fixed (including intangible) capital, innovation, allocative efficiency, entrepreneurship, labour productivity and exposure to trade and foreign direct investment (FDI). Recent studies suggest that the impacts on the economy are potentially large (see Schwellnus and Arnold (2008) and Johansson et al (2008)).

For a given revenue objective, structuring the tax system to maximise Australia's global share of investment and business (the focus of Sections 6.1 to 6.3) and to improve business and investment choices (the focus of Sections 6.4 to 6.7) can result in higher economic growth and national income.

6.1 International tax competitiveness and domestic investment

Australia relies on domestic and foreign savings to fund domestic investment. Taxing the returns on investment can reduce the willingness of domestic and international investors to invest in Australia. Reduced investment in plant and equipment, software, innovation and other intangibles involves forgoing the higher labour productivity arising from 'capital deepening' — where there is more capital available for each worker.

However, Australia has achieved a high level of investment compared to other developed countries (Chart 6.2).

Chart 6.2: Gross national investment

Per cent of GDP (1982-83 to 2007-08)

Australia, Canada and New Zealand

Chart 6.2: Gross national investment - Per cent of GDP (1982-83 to 2007-08) - Australia, Canada and New Zealand

Australia, United States and United Kingdom

Chart 6.2: Gross national investment - Per cent of GDP (1982-83 to 2007-08) - Australia, United States and United Kingdom

Source: ABS (2008a), IMF (2008), Statistics New Zealand (2008).

Summary of key messages from submissions

Most business submissions indicate that globalisation offers major opportunities for Australia. However, they also note the disadvantages arising from Australia's remoteness from world markets, our relatively small economy and geographically dispersed population.

Many submissions comment on the international trend towards less tax on capital income, citing reductions in company tax rates among OECD and neighbouring countries. These reforms are generally seen as providing countries with a competitive edge in global markets and enhancing their ability to attract globally mobile investment.

There are also concerns that over-reliance on capital income taxes, especially corporate income taxes, is not conducive to maintaining a stable and robust revenue base.

Many submissions indicate that Australia's tax arrangements, particularly taxes on corporate income, are internationally uncompetitive. This is said to adversely impact on Australia's productivity and potential for economic growth.

Submissions supporting lower capital income taxes argue it will ultimately benefit many Australians, reflecting a view that the incidence of high effective corporate income taxes falls on labour in the long-run.

Organisations that represent small and medium enterprises generally view reducing the company tax rate as secondary to reducing personal tax rates. Such organisations prioritise aligning the top personal tax rate with the company tax rate.

Some non-business organisations contest the need to cut capital income taxes to maintain competitiveness. Such submissions view equity considerations as being of greater importance, reflecting a view that the incidence of corporate income tax largely falls on shareholders.

There is also a concern that any reduction in company tax rates could result in an increase in taxes on labour, with the increased burden of labour taxes largely falling on low to middle income earners.

International tax trends and comparisons

Statutory and effective company tax rates

International tax competition occurs where countries reduce taxes in an attempt to increase their share of global investment, generally or in specific sectors. Competition may also exist between countries in terms of where businesses report or allocate their profits.

The decline in international company tax rates observed in Chart 1.1 is the most significant indication of international tax competition. While the decline in company tax rates has generally been accompanied by a broadening of the company tax base, measures of effective tax rates — which take into account the statutory rate as well as significant elements of the tax base — have also generally declined (OECD 2007a).

Chart 6.3 below shows how Australia compared with other OECD and regional countries across several indicators of tax competitiveness in 2005.

Chart 6.3: Comparison of statutory and effective company tax rates(a)

Selected countries (2005)

Chart 6.3: Comparison of statutory and effective company tax rates - Selected countries (2005)

  1. Effective marginal tax rates (EMTRs) on investment measure the effect of taxation on the return to a marginal investment. Effective average tax rates (EATRs) measure the tax burden on projects that generate above normal returns. See the Architecture paper, page 189.
  2. The company tax rates shown for Ireland apply to active income of new operations. Different statutory company tax rates apply to other activities.

Source: For Singapore, Hong Kong, China and India, KPMG (2008). For all else, Botman et al (2008) (The EATRs shown are those calculated for a project that generates a pre-tax profit of 20 per cent).

Chart 6.3 indicates that Australia's statutory company tax rate is higher than some neighbouring economies (in particular, Singapore and Hong Kong). However, reflecting Australia's relatively broad company tax base, the effective marginal tax rate (EMTR) and effective average tax rate (EATR) for Australia were higher than for many countries, including some with higher statutory rates.

To achieve international competitiveness, many submissions in effect propose matching overseas' tax rates and bases. Such submissions typically assume but do not explain how this would be of net benefit to Australia.

It may be the case that as the gap between a country's tax rate and those of other countries increases, foreign investment may become more responsive to a rate change, increasing the potential benefits of a reduction. There is some evidence that foreign investment becomes more sensitive to tax where a country's tax rate is significantly above average. Conversely, where a country's tax rate is around or below average, the response to a change in the rate may be reduced (Bénassy-Quéré et al 2003).

Where foreign countries have foreign tax credit regimes, the impact of rate differentials is unclear. In theory, where a country operates a foreign tax credit system, investment in Australia will be deterred only if Australian rates are above those in the foreign country. However, empirical evidence for this is not strong, suggesting multinationals undertake significant tax planning (for example, defer repatriation of foreign income) that limits how foreign tax credit systems operate in practice (OECD 2008b). In 2008, around half of the stock of Australia's inbound FDI was from countries with a foreign tax credit system.

Differences between the Australian and overseas statutory rates can influence the degree and direction of profit shifting. Reasonably strong empirical evidence shows that tax differences between countries can induce profits to be shifted (Griffith et al 2008).

Other aspects of international tax competition

There are a number of other international tax competition trends.

  • Declining withholding tax rates on dividend, interest and royalty payments to non-residents. In part, this reflects the influence of the OECD Model Treaty (the basis for most of the world's bilateral tax treaties).
  • A move away from dividend imputation, with most European countries abolishing imputation systems for other forms of shareholder relief (generally for European Union specific reasons).
    • However, there has been no general trend away from providing relief to shareholders in recognition of company tax paid. For example, the United States has recently moved to provide dividend tax relief (by applying a lower rate of personal tax to dividend income taxed at the company level).
  • A move away from taxing the worldwide equity income of resident companies with a credit for foreign tax paid, towards exempting dividends received from foreign affiliates. Some large capital-exporting countries (in gross terms) that still run credit systems (the United States and Japan) have been considering moving to dividend exemption regimes. The United Kingdom has recently announced its intention to introduce a dividend exemption regime for large and medium sized businesses.
  • Consistent with the movement to dividend exemption systems, a broader trend of not taxing foreign source income of non-residents derived through resident entities ('conduit income').

International tax coordination efforts

Accompanying international tax competition has been a trend towards international tax coordination or cooperation. It has been in part motivated by fears of declining company or capital income tax revenue arising from a 'race to the bottom' in company tax rates or of capital flight.

Such cooperation has had more success in addressing 'harmful' tax competition by improving information exchange between countries' tax authorities, including countering bank secrecy in tax havens and moving to abolish or amend 'harmful' preferential tax regimes. Efforts to cooperate on tax bases and rates have been less successful, possibly because even if there is a potential overall net gain for countries in cooperating, some countries would lose out relative to their current position.

The incidence of taxes on investments

As discussed in Sections 1 and 2, the economic incidence of a tax is particularly important when considering the efficiency and distributional consequences of a more internationally competitive tax system. Submissions supporting lower capital income taxes argue it will ultimately benefit many Australians, reflecting a view that the incidence of high effective corporate income taxes falls on labour in the long-run. This view is contested by non-business organisations, which consider the incidence of company income tax to largely fall on shareholders.

Increasing taxes on investment can affect the returns to other factors, in particular labour. It reduces the capital stock in the economy, which reduces marginal labour productivity and thus wages. Box 6.1 describes how this tax increase can reduce investment but not affect after-tax returns from domestic savings.

An increase in a tax on investment can also affect wages through wage bargaining. Where there are economic rents (for example, arising from imperfect competition), a tax increase could reduce the labour share of the rent through reducing the overall size of the rents or by improving the bargaining power of firms. Economic rents are defined in Box 6.2.

However, a range of factors complicate this analysis.

In reality, capital stock reallocations would be expected to occur over time, not immediately. While the real economy adjusts over time, the capital markets respond quickly through asset price revaluations. Thus, in the short-run, some of the economic incidence of the investment tax increase is likely to fall on the owners of existing investments. In the long-run, the extent to which the domestic investment owners can pass on that tax burden also depends on factors such as the substitutability between labour and capital, the relationship between domestic and foreign capital, product substitutability and the responsiveness of labour supply to taxes.

A number of overseas studies have attempted to estimate the incidence of corporate income tax. Gravelle and Smetters (2006) and Randolph (2006), using general equilibrium models, estimate that, in the United States, domestic labour bears around 70 per cent of the corporate tax burden — with foreign labour being the main beneficiary of capital outflows. Randolph also predicts that for smaller open economies, like Australia, domestic labour would bear even more, and domestic capital even less, of the corporate tax burden. However, those models make simplifying assumptions including perfect capital mobility. Other overseas studies, using a variety of empirical approaches, consistently indicate that a large proportion of the burden of a corporate tax increase falls on wages. See for example Felix (2007), Hassett and Mathur (2006), and Arulampalam et al (2007).

Given the importance of incidence for the efficiency and distributional consequences of company income tax and other investment taxes, the Review Panel is commissioning further work in this area.

Factors driving cross-border investments

Foreign investment between countries takes different forms. Broadly, it can be segmented into FDI which confers ownership and control on the foreign investor, and portfolio investment where the foreign investor does not have control over the project or firm.

The level and composition of cross-border investments can depend on factors such as investors' desire for liquidity and risk diversification, as well as the institutional frameworks of the country in which the investment is made.

  • FDI tends to be more long-term. Hence, foreign investors with lower liquidity needs (large, mature firms) tend to undertake FDI, while investors with higher liquidity needs (for example, managed funds) undertake portfolio investment.
  • Portfolio investment offers risk diversification opportunities. In spite of this, there is significant evidence that investors' portfolio holdings exhibit 'domestic bias' (overinvestment in the investor's domestic market) and/or 'foreign bias' (under or overweighting between different foreign markets).
  • Portfolio investment tends to be more sensitive to market openness and development as well as the existence of quality economic, political and regulatory institutions. Where these features are not present, any foreign investment into a country will more likely be in the form of FDI.

Box 6.1: Savings and investment in an open economy

In the case of a small, open economy with efficient capital markets, the after-tax return to foreign investors and the pre-tax rate of return to domestic savers are determined in the international capital market. A tax imposed on the savings of resident individuals will not affect the pre-tax rate of return available. A tax imposed on investment in Australia will increase the pre-tax rate of return required by foreigners from investments in Australia to provide the international after-tax rate of return.

Chart 6.4 illustrates this disjunction between savings and investment. A tax on domestic savings does not affect the total level of investment in an open economy, which is determined by the supply of foreign capital. As domestic savings fall (to Se), they are offset by an increase in imported capital. In contrast, a tax on investment decreases the total level of investment in the economy but, of itself, does not reduce returns to domestic savings (which remain at r — ts) nor the returns to foreigners (r, the cost of capital globally).

Chart 6.4: Taxes on savings versus taxes on investment in a small open economy

Chart 6.4: Taxes on savings versus taxes on investment in a small open economy

Source: Adapted from Sørensen (2006).

Foreign direct investment

There are a number of theories about the geographic pattern of FDI. The new economic geography theory focuses on the impact that economies of scale and concentration of firms (agglomeration) can have on firms' location decisions.

As trade costs decline, more foreign firms are likely to enter the domestic market, particularly where that market is large. It is expected that the subsequent concentration of firms will bring about economies of scale, which increase the scope for economic rents. Beyond a certain point, there will be forces favouring geographic dispersion. These 'dispersion effects' come about as the increased competition that accompanies co-location results in less potential for economic rents.

From a taxation perspective, new economic geography theory suggests there is not a smooth relationship between taxation and firms' location decisions. Where agglomeration benefits are strong, firms should be less responsive to higher levels of tax. However, as agglomeration economies weaken, investment becomes more responsive to tax.

Another perspective offered by international trade theory suggests that firms will undertake FDI (for example, locate production overseas rather than service the foreign market via exports) where some combination of the following benefits is present:

  • ownership advantage — the firm has some knowledge capital (for example, a superior production process) that it can exploit in the foreign market;
  • location advantage — there are certain benefits available in the foreign market that induce the firm to produce or headquarter there (for example, lower factor costs); or
  • internalisation advantage — the firm chooses to exploit its knowledge capital, rather than license it to an agent, to prevent dissipation of the knowledge.

This model provides a useful framework for understanding how tax affects the decisions that must be made by a firm considering locating production overseas.

Where there are location advantages, taxes imposed by the host country on any location-specific rents may have a minimal impact on the decision to invest. In the absence of location-specific advantages or rents, different business and investment choices can be related to different tax rate measures:

  • the effective average tax rate (the EATR) on the total return (the sum of the normal return to capital and firm-specific rents, similar to ownership advantages) affects the location of the investment;
  • once location is determined, the effective rate of tax on the marginal cost of capital (the EMTR) affects the scale of investment — where the EMTR is zero, tax will not affect the marginal investment; and
  • the statutory tax rate affects the (artificial) allocation of profit between countries.

Box 6.2: Economic rents

Economic rent can be defined as the difference between the return to a factor of production in its current use and what it would be paid in its next best use.

One property associated with an economic rent is that the supply of the relevant factor of production is invariant to a change in its price. Land and natural resources are commonly cited as giving rise to economic rents. However, rent may also arise from a firm's superior technologies or management techniques, as well as from barriers to entry of new firms.

In the short-run, certain resources may also exhibit qualities of an economic rent where the supply cannot be readily altered in response to a change in price. A country's highly-skilled workforce may be an example of this. In time, increases in the supply of the factor would be expected to dissipate the rent.

Rents are sometimes categorised as being either 'location-specific' or 'firm-specific'. A location-specific rent arises where firms can only generate a rent from investing in a specific geographic location, as is the case with natural resources and land. A 'firm-specific' rent is not tied to a specific geographic location. It is commonly associated with a firm's intangibles, such as product brand or management know-how. In practice, location-specific and firm-specific rents may not be always readily distinguishable.

Portfolio investments

Portfolio investment can be in the form of debt or equity. The effects of tax differ between the two forms. Portfolio equity investors are generally subject to company income tax or (less frequently) dividend withholding tax. They can share in a firm's rent, provided these rents have not already been capitalised in the firm's share price at the time of purchase. Portfolio debt investors do not share in the rents of a business and are subject to tax on debt, such as interest withholding tax (IWT).

A number of submissions propose reductions in IWT. The trend in Australia and other countries has been to reduce IWT, lowering EMTRs on this highly mobile source of financing for investments. There are a number of IWT exemptions, including for publicly offered debentures and syndicated loans, and (in certain tax treaties) lending by financial institutions. Submissions consider these to be too narrow and of less relevance, with implementation through tax treaties seen as too slow. Submissions argue that improved exemptions would enhance liquidity and provide access to alternative sources of financing.

Royalty withholding tax (RWT) is also relevant to the treatment of investment in Australia. Royalties include payments to non-residents for the use of copyrights or patents, or technical or industrial knowledge. Royalties are related to a firm's intangible assets. Submissions propose that existing reductions in RWT provided in tax treaties be expanded to other major trading partners, preferably through domestic law.

Revenue raised by the withholding taxes applying to dividends, interest and royalties paid to non-residents are low compared to associated income flows. It is also low compared to company income tax and other business taxes directly or indirectly paid by non-resident investors (see Box 6.3).

Box 6.3: Revenue from non-resident investment in Australia

Non-residents are potentially liable to a number of withholding taxes on the payment of returns from investments in Australia. However, given the range of exemptions provided (for example, dividends with imputation credits are exempt) the level of taxes collected is relatively low compared to the associated income stream (Table 6.1).

Table 6.1: Non-resident withholding tax revenues and income flows (2006-07)

Type of tax Estimated revenue for 2006-07
($ billion)(a)
Investment income flow
($ billion)
Dividend withholding tax 0.2 20.4(b)
Interest withholding tax 1.3 36.6(c)
Royalty withholding tax 0.3 3.2
  1. Withholding tax revenue estimates should be used with caution as collections for specific withholding taxes have not been separately identified in tax returns since 2000-01.
  2. Assumes 60 per cent of portfolio equity investment income is distributed.
  3. Includes income from other investment liabilities.
  4. for revenue, Australian Treasury estimates; for investment income flows, ABS (2008e).

Non-residents are also subject to company income tax either directly (where investment in Australia is through a branch) or indirectly (through their shareholding in an Australian company). Given that non-residents own around 30 per cent of equity in Australian companies and around 50 per cent of equity in the mining sector, in 2006-07 indicatively $21 billion in company income tax and resource taxes and royalties may be attributed to non-resident investors.

6.2 Achieving international tax competitiveness

Many countries are examining their capital income and company tax arrangements in light of the increasing mobility of capital and of globalisation generally. As businesses have increased choice as to where they locate their investments and source and structure the related finance, the economic costs to a country of unilaterally trying to tax such investments has increased. Structuring tax arrangements in the face of international tax competition is the focus of this section.

Company tax and other business tax arrangements cannot necessarily be set by referring to international competitiveness alone. For example, company income tax also functions as a withholding tax on the company income of resident shareholders, and so its design and rate have implications for how resident individuals are taxed on their savings (a focus of Section 3.2) and labour income, and shareholder relief mechanisms. Changes made for competitiveness reasons also need to take into account potential implications for allocative efficiency and productivity, including compliance costs, discussed below.

Summary of key messages from submissions

Business submissions strongly advocate a more internationally competitive tax system. Most submissions support both reducing the company tax rate and narrowing the company tax base. Submissions proposing lower company tax rates generally suggest reductions of 5 or 10 percentage points.

A number of submissions suggest that the current treatment of tangible and intangible assets is inappropriate and uncompetitive compared with other countries. They say that more generous write-offs for depreciable assets and other tax base arrangements are needed.

Many submissions support retaining and enhancing the imputation system because it is well understood and liked by Australian investors. Such submissions say a compelling case for abolishing imputation has not been made.

Some other submissions remain open to winding back imputation or to introducing alternative means of relieving the double taxation of resident shareholders, but note that any significant changes would require careful consideration.

A number of submissions propose reductions in withholding taxes, particularly IWT. It is claimed the existing IWT exemptions are too narrow and that expansion of existing exemptions (preferably through domestic law rather than tax treaties) would provide Australian firms with access to alternative forms of financing.

There is some interest in considering alternative approaches to taxing capital income, including providing an allowance for corporate equity (ACE) or otherwise taxing economic rents, or moving to a dual income tax system.

General approaches to achieving international competitiveness

Two broad approaches to improving international competitiveness through tax measures are to reduce statutory tax rates or to narrow the tax base.

The first approach would involve retaining a broad income tax base and lowering the company tax rate. More radically, it could involve limiting interest deductions either fully, as under the 'comprehensive business income tax' (CBIT) proposal by the United States Treasury in 1992, or in part, as done recently in Germany.

The second approach would involve narrowing the company tax base in preference to reducing the existing company tax rate. A narrower base could be achieved by adjustments to the current income tax base (for example, through more concessional write-off arrangements) or, more radically, by moving to a business level expenditure tax, such as a cash-flow tax or an ACE. Box 6.4 provides an overview of these taxes, while Appendix E provides further detail.

Many submissions propose reducing the statutory company tax rate by around 5 or 10 percentage points. They also indicate the current treatment of both tangible and intangible assets (particularly goodwill) is inappropriate and unsatisfactory when compared with other countries (Section 6.4 discusses the treatment of depreciating assets). Hence, most submissions advocate a hybrid approach, with few discussing the priority or relative merits of each.

For a given level of revenue, the two approaches have differing implications for the statutory rate adopted and the EMTRs and EATRs that arise from the combination of the chosen base and rate. As such they have different strengths and weaknesses (see Table 6.2). One complication to the analysis below is that Australia's tax system alone will not fully determine the investor's EMTR or EATR if they are subject to tax in their home country or a third country.

Table 6.2: Comparing alternative approaches to international competitiveness

Type of return
(relevant tax metric)
Effect on type of return
Lower statutory rate Narrower base
Normal returns
(EMTRs)
Taxed more Taxed less
Location-specific rents
(EATRs)
Taxed less Taxed more
Firm-specific rents
(EATRs)
Taxed less Taxed more
Profit-shifting
(statutory rate)
Less incentive to shift profit More incentive to shift profit

Reducing the statutory rate of tax on capital has the advantages (relative to a narrower base) of increasing competitiveness with respect to investments that earn high firm-specific rents and of reducing incentives to shift profits offshore. However, adopting a narrower base (rather than a lower statutory rate) has the advantages of increasing competitiveness in respect of marginal investments and increasing tax on location-specific rents (an immobile base).

In theory at least, the potential disadvantages of the narrower base approach (higher taxation of firm-specific rents and increased incentives to shift profits) could be avoided by implementing a 'destination-based' expenditure tax, which would exclude export sales from gross receipts and exclude expenses relating to imports (similar to the approach of the GST). Such an approach was proposed by Auerbach et al (2008) as part of the Mirrlees Review, but the full implications and practical feasibility of such an approach are unclear.

Not shown in Table 6.2 is that reducing the statutory rate would reduce tax on existing investments. This can be seen as a transitional cost or as an ongoing loss of revenue on what would be a relatively efficient tax. Moving to a narrower base can avoid this problem.

Company income tax is not the sole means by which investments are taxed. Trade-offs between the base and rate need to be seen in this broader context. Some natural resource rents are subject to tax through the petroleum resource rent tax (PRRT) and a range of specific taxes and non-tax revenue arrangements (see Section 14).

For withholding taxes, abolishing or reducing IWT, by broadening the current exemptions, would be consistent with the second approach of adopting a narrower base (that is, by effectively excluding returns to debt from the investment tax base). However, the current role that IWT plays in limiting the gains to profit shifting through the thin capitalisation of Australian investments needs to be taken into account.

To the extent that RWT is imposed on payments to the firm in respect of firm-specific rents, it may deter investment in Australia. On the other hand, it is arguable that, particularly in the non-traded sector, returns to firms even where they have significant intangibles include elements of location-specific rents. In such cases, RWT is a way of taxing such rents. RWT also acts as a back-stop against firms using intra-firm pricing (particularly of intangibles) to avoid corporate income taxes.

Box 6.4: Business level expenditure taxes

Business level expenditure taxes, in effect, only tax the above normal returns of investments, whether financed by debt or equity. As they involve a narrower business tax base, a higher rate of tax will be required to achieve a given revenue objective. While they have attracted considerable interest among tax policy specialists, they have only been implemented in a few countries and so the practical consequences are not fully understood.

Expenditure taxes can be either based on cash flows or on providing an allowance for the return on equity (or ACE). Cash-flow taxes have been implemented in Estonia and in Australia (the PRRT). Belgium recently adopted an ACE, Brazil and Italy had variants, and Croatia had an ACE for several years.

A business cash-flow tax provides a deduction in full for new investment at the time of acquisition. Income and expenses are recorded at the time the cash comes in or goes out, making income and expense recognition and depreciation rules unnecessary. The treatment of debt and equity is also made more neutral. The nature of transactions included in the tax base depends on which variant of the cash-flow tax is implemented.

An ACE operates by allowing a deduction equal to the imputed ('normal') return to equity. By providing a deduction for an imputed return on equity, the ACE can provide more neutral treatment between debt and equity. It operates within the existing income tax framework (existing timing and depreciation rules continue to be specified). Hence, while easier to implement, the ACE does not offer some of the 'cut-through' simplicity potentially offered by a cash-flow tax.

Expenditure taxes have implications for how the tax treatment of owners is integrated with that of the business. Transitional issues and interactions with the tax system in general (including integrity rules) may also need to be considered as part of any move to a business level expenditure tax.

Further information on expenditure taxes is provided in Appendix E.

Shareholder taxation and international competitiveness

More controversial is how the tax treatment of dividends and capital gains accruing to the underlying shareholders of firms affects firms' investment decisions.

One view is that as financial capital is highly mobile, the cost of capital for an Australian company is set internationally and shareholder tax arrangements therefore do not affect the investment decisions of firms. The economic literature that addresses issues of international tax competitiveness and cross-country comparisons typically makes this assumption.

Under this view, increasing tax at the resident shareholder level (for example, by abolishing dividend imputation as proposed in CEDA (2006)) to fund a reduction in company level tax will reduce the cost of capital for Australian firms and help attract foreign investment. This argument pre-supposes that if dividend imputation were abolished no other form of shareholder tax relief would be provided. Submissions open to reconsidering dividend imputation generally suggest alternative relief be considered.

An alternative view is that since capital is not fully mobile, resident shareholder tax treatment affects the cost of capital of Australian firms and, hence, investment decisions. Submissions that support retaining imputation argue that imputation credits are valued by the market and by firms (which would be unlikely if non-residents set the cost of capital) and so lower the cost of capital for Australian firms. There is some limited, though mixed, evidence that imputation credits have a market value and so affect the cost of capital.

Submissions supporting imputation also point to other advantages, such as the integrity benefits of providing incentives to pay Australian, rather than foreign, company tax and reduced incentives to avoid tax. Another advantage claimed is imputation provides a more neutral tax treatment between debt and equity finance, though (as discussed in Section 6.5) this also depends on an assumption about the mobility of capital.

The impact of more internationally competitive taxes on investment returns

Significant reform of taxes on investment returns, designed to make Australia a more internationally competitive location for investment and to reduce distortions between different investments, could have significant structural and macroeconomic impacts on the Australian economy.

Firstly, the intended increase in post-tax returns could result in increased investment in Australia, whether funded by domestic or foreign capital, leading to an increase in the capital stock (capital deepening). Secondly, reducing distortions between different investments could lead to a more efficient allocation of capital across the economy. These impacts would increase the productivity of labour, leading to higher real wages and increasing the wellbeing of Australians.

Such reform would result in structural adjustment, with resources reallocated across the economy to more productive uses. During the transition, increased demand for resources, including land, labour and other inputs may lead to increases in prices and wages increasing the cost of investment projects and offsetting the increase in the expected post-tax return. However, this latter effect would be ameliorated to the extent that higher demand is met from foreign sources. For instance imports could rise, as potentially could net migration.

To the extent there is an increase in investment this would be matched by an increase in net capital inflow and the current account deficit, unless there were offsetting increases in domestic savings. Net foreign liabilities would also rise as a proportion of GDP (at least initially). Associated exchange rate movements and the lift in real wages would mean that not all sectors of the economy would experience equal improvement in overall competitiveness.

Australia has arguably experienced effects of this type over recent decades. Australia's strong terms of trade and other economic settings, in part driven by economic reform, has meant Australia has been a favourable place to invest. The level of investment in Australia in recent years has represented a much higher share of GDP than the OECD average. The high level of capital inflow to finance that spending has matched a high current account deficit. Real wages have increased strongly, and net migration has increased strongly as well.

Where reductions in the tax on capital income are offset by increases in other taxes (for revenue neutrality), changes in these other taxes will also have implications for structural adjustment and may reduce some of the benefits discussed above. Impacts will vary depending on which taxes are adjusted. Higher labour taxes may lead to a reduction in labour supply and consumption. Higher consumption taxes would be likely to have a smaller effect on labour supply decisions as part of the burden will fall on existing holders of capital and on rents.

Consultation question

Q6.1 Can the tax system be structured to better attract investment to Australia in a way that increases national income, and if so how? For any given revenue outcome, what are the relative merits of broader base/lower rate (comprehensive income tax) or narrower base/higher rate (a narrow income tax or an expenditure tax) approaches?

6.3 Australia as a location for international businesses

Investments overseas by Australian firms or financial intermediaries raise additional issues relating to Australia's attractiveness as a place from which to manage global or regional businesses or export financial services.

Many non-tax and tax factors are relevant to Australia's attractiveness as a location for international business, such as access to skilled labour and tax system simplicity. The focus in this section is on the taxation of returns to Australian-based multinationals from foreign investment, at the business level and the level of underlying investors (either resident or non-resident), and certain issues relevant to financial service providers.

Summary of key messages from submissions

A number of submissions propose allowing imputation or other credits for taxes paid on foreign income, to lower the cost of capital for Australian firms seeking to invest offshore and thereby address a bias against offshore investment. For similar reasons, some submissions also support the streaming of foreign source income to non-resident shareholders.

A number of submissions support mutual recognition of imputation credits with New Zealand on the basis it will progress the development of a single economic market and increase efficiency in trans-Tasman investment.

Submissions support recent reviews by the Board of Taxation into Australia's anti-tax-deferral rules and taxation of managed investment trusts, on the basis these would improve the treatment of outbound investment and further Australia's development as a financial services centre. Submissions indicate that recommendations from the Board of Taxation's reviews should be progressed independently of the Australia's future tax system review.

A number of submissions note there is strong competition from regional financial services centres, such as Singapore. They propose expanding concessional tax arrangements for regional financial services businesses, possibly through expanding the offshore banking unit concessions. Some submissions also raise concerns with other taxes on financial services, including withholding taxes and input-taxing of financial services.

Some non-business organisations suggest that tax concessions for business, such as the offshore banking unit concessions, should be limited.

International competitiveness of Australian-based multinationals

The Architecture paper provided an overview (at page 267) of the efficiency benchmarks that guide policy on the tax treatment of outbound investment. Traditionally, capital export neutrality (CEN) was thought to be the most appropriate benchmark for maximising global efficiency. However, there has been a trend away from CEN towards capital ownership neutrality (CON), which allows the most productive firms to manage investments. This trend is reflected in the adoption of dividend exemption regimes.8

Countries that have adopted exemption regimes, such as Australia, typically only do so in respect of their resident companies' active (business or trading) income, and continue to tax the foreign passive income of resident companies (such as interest and dividends on portfolio investments) with credits for foreign taxes. Such a policy aims to strike a balance between competing objectives. It allows resident firms to attract foreign capital — that is, engage in the business of managing international capital. At the same time, it protects the home country's ability to tax the savings of its residents.

Dividend imputation and offshore investments

Many submissions support dividend imputation, indicating it is well understood by Australian investors, generally avoids the double taxation of company profits and lowers the cost of funding for Australian firms. However, submissions suggest there is scope to review aspects of the imputation system to improve how it operates for Australian firms investing offshore.

A number of submissions argue that the denial of imputation credits for foreign taxes paid on foreign income distributed to resident shareholders limits their ability to access capital for offshore investment. This impairs their international competitiveness. In effect, under the imputation system, resident shareholders are provided with a deduction, rather than a credit, for foreign taxes paid by the company. To redress this situation, submissions propose a credit or some recognition for foreign tax paid.

However, paying foreign tax does not benefit Australians, whereas Australian tax funds public services. The absence of a foreign tax credit then aligns an investor's private return from investing overseas with the national return and provides a counter-balance to incentives for Australian companies to shift investments to low-tax countries. This view is consistent with maximising Australian (rather than global) welfare, but assumes no spillover benefits from offshore investment and disregards any costs of biasing the saving portfolio choices of residents (see Section 6.7). Providing a credit for foreign tax paid might also reduce the integrity benefits associated with imputation.

A number of submissions propose the mutual recognition of imputation credits between Australia and New Zealand. This would see imputation credits being provided for foreign taxes on a reciprocal rather than unilateral basis. Mutual recognition is said to lead to greater efficiency in trans-Tasman investment and help develop a single economic market. These benefits would need to be balanced against potential distortions to the location decisions of Australian companies with a choice between investing in New Zealand or a third country.

The above arguments for and against providing imputation credits to resident shareholders for foreign tax assume that shareholder-level taxation is relevant to companies' investment decisions. An alternative view is that shareholder-level taxation is not relevant (see Section 6.2) as non-resident investors are the marginal source of financing.

On this alternative view, providing a credit to resident shareholders for foreign taxes paid is unlikely to affect the offshore investment decisions of Australian companies. However, as one business submission notes, dividend imputation may still increase the cost of capital in these cases. This is because raising equity from non-residents to fund an offshore investment will see those non-residents claiming a share of any imputation credits the company generates from domestic investments. The availability of imputation credits for resident shareholders would therefore fall.

To address the bias arising from the loss of credits, or the more general bias against offshore investments, a number of submissions propose that dividend streaming be allowed to maximise the use of imputation credits. In particular, they favour streaming of (unfranked) foreign income to non-resident shareholders. This would require a change from the current policy of trying to prevent streaming on the basis that it is inconsistent with the integrated treatment of shareholders and companies upon which imputation is premised.

Dividend streaming raises issues beyond the treatment of foreign income earned by Australian companies. Dividend streaming is arguably already achievable in certain ways, for example, through dual listed company structures or share buy-backs. Submissions note that existing anti-streaming rules add considerable complexity to the tax system and increase business compliance costs — including for those that are fully foreign-owned.

Dividend streaming proposals can also have different objectives. For example, foreign multinationals with a secondary listing on the Australian Stock Exchange could be allowed to 'pay' franked dividends to Australian shareholders in those multinationals (out of credits generated by their Australian subsidiaries). The rationale for this alternative would be to improve Australian capital markets and provide an incentive for foreign multinationals to pay Australian tax.

Competitiveness of Australian-based managed funds and other financial service providers

For Australian-based managed funds and other financial services providers, taxing the foreign source income from the investment of funds provided by non-resident investors could disadvantage them relative to overseas funds. Providing targeted concessions to remove or reduce tax on such conduit income may still give rise to higher operating costs. However, if exemptions are broader, it may be more difficult to maintain the ability to tax resident investors on these funds and non-residents on Australian investments.

The Australian Government has asked the Panel to consider tax settings that would assist in positioning Australia as a financial services centre in the region. The Government hosted, in conjunction with the NSW Government, a financial services hub summit in July 2008. Following the summit, the Australian Government announced the establishment of an Australian Financial Centre Forum to further Australia's development as a regional financial services centre.

Participants at the summit identified tax, regulatory and other impediments. Participants cited the complexity, uncertainty and inflexibility in the administration of tax law as deterrents to foreign investment. They proposed lower taxes on inbound investment through reductions in withholding taxes, expansion of the offshore banking unit concessions, and a reduction in the company tax rate. Matters related to these issues are discussed in Sections 6.1 to 6.2, and Section 8. A further issue, raised in submissions, is discussed below.

Input taxing of financial service providers

Financial services providers in Australia, as in many other countries, are input taxed on financial supplies under the GST. Taxing inputs into a production process is generally considered to be inefficient, as it distorts production as well as (once the input taxes are passed on) consumption choices.

This results in what submissions described as an 'embedded' cost, which increases the provider's cost structure and that can cascade through the prices of other goods and services in the economy, contrary to the basic intention of a GST. It can also give rise to additional complexity (rules relating to reduced input tax credits are required) and increase compliance costs. For highly mobile financial services, input taxing may reduce international competitiveness.

Financial services give rise to technical problems under the invoice-credit-style GST because the tax is applied to the expected profit margin for each transaction. This is problematic for many financial services as implicit fees are typically charged by adjusting interest rates, with millions of transactions occurring daily.

Submissions suggest adopting alternative approaches to taxing financial services, such as New Zealand's approach to taxing financial services, to mitigate some of these effects. Alternatively, there are some variants of business cash-flow taxes (discussed in Appendix E), which could potentially address issues around taxing implicit fees. Changes would need to balance the potential benefits of removing taxes on business inputs with the implications for the treatment of household consumption of financial services.

Consultation question

Q6.2 What changes, if any, to the tax system would improve the ability of Australian companies to operate internationally orientated businesses? How should the tax treatment of companies and shareholders be integrated in an open economy?

6.4 Investment and risk-taking biases

Effective tax rates on investments in Australia vary considerably depending on the investment and associated risks. This variation reflects the different tax treatments of various assets, of net losses compared to net gains, and a range of specific rules, concessions and exemptions.

Through altering relative prices, these tax biases can affect the efficient allocation of resources within the economy by potentially diverting inputs and outputs from their most valued use to lower valued uses, discouraging some productive investment and reducing the overall productivity of the economy. These tax arrangements are also among the more complex parts of the tax system, resulting in a system that is difficult for government to maintain and for business and households to understand and comply with.

Summary of key messages from submissions

Many submissions express concern that current allowances for depreciation or the amortisation of certain tangible and intangible assets are inadequate and reduce international competitiveness. In particular, there are concerns about the limited recognition for certain business intangibles, such as acquired goodwill.

A number of submissions support stepped rates for capital gains tax (CGT), with rates declining the longer an asset is held, to encourage more long-term investments. However, some express concern over disincentives to sell assets ('lock-in').

A number of other specific changes are suggested, including providing additional roll-overs, clarifying the revenue/capital distinction, and providing for managed fund assets to fall only within the CGT provisions.

Submissions note that the treatment of losses is asymmetric and negatively affects risk taking and international competitiveness. A number of changes were suggested, most commonly to allow the carry-back of losses.

A number of submissions suggest that the tax treatment of research and development should be made more generous. The recommendations of the Innovation Review (2008) are also supported. Submissions also propose providing tax incentives for a range of other activities or sectors, including those relating to small business, shipping, the environment, technology and infrastructure.

Submissions suggest that the compliance costs and risks imposed on taxpayers arising from the business tax system — its administration, complexity and uncertainty — should be reduced.

Measuring business profits and losses

Australia notionally operates an income tax base at the company or business level. While some countries' tax systems deal with the challenges of implementing an income tax better than others, taxing investments on an income basis inevitably gives rise to distortions and significant complexity due to inherent difficulties in measuring and recognising gains and losses.

The difficulties inherent in a comprehensive income tax include adjusting for inflation, measuring changes in asset values and accounting for the timing of inflows and outflows. The current tax system also measures investment gains and losses differently depending on the form of investment, the type of investment or industry in which it occurs, and the entity or entities involved. Even when annual income is measured accurately, the tax system treats measured net gains and losses asymmetrically.

Most of these biases and complexities could potentially be addressed under an expenditure tax system, though the treatment of net losses would remain an issue. Box 6.4 and Appendix E outline the principal types of business expenditure taxes: a cash-flow tax or an ACE system.

Broad reform approaches are to either improve on current income tax arrangements (either by adopting a broader base or, as submissions suggest, a narrower base) or move to a business level expenditure tax. Under either approach, the treatment of losses may need to be further considered. Some of the issues involved in adjusting arrangements in an income tax framework are discussed in more detail below.

Taxing returns that compensate for inflation

As discussed in Section 3.2, the income tax system generally taxes the full nominal return on an investment, rather than the real return which excludes the inflation premium. This means the effective tax rate on the real return to investment can be higher than the statutory tax rate.

There is a trade-off between the efficiency gains from reducing distortions by trying to accurately adjust for inflation and the efficiency losses from the increased operating costs that would result. Given that price stability is a key objective of monetary policy, the case for comprehensive adjustments for inflation appears weaker now than it was in the past.

The measurement of declines in asset values

Australia moved to effective life depreciation in 1999. More recently, the diminishing value rate for depreciation deductions was increased from 150 per cent to 200 per cent (commonly referred to as 'double declining balance' depreciation). These changes were made to better reflect the underlying pattern of economic depreciation for most assets and so improve the neutrality of investment decisions in an income tax framework.

Some submissions express the view that some effective lives do not currently reflect experience in the market, discourage investment and create biases against certain investments (including long-lived assets). Submissions also express the view that capital allowance rules for both tangible and intangible assets should be brought into line with other countries to improve international competitiveness (consistent with an approach of narrowing the tax base, as discussed in Section 6.2). In particular, there are concerns there is no recognition for the decline in value of acquired goodwill.

However, more generous arrangements could increase efficiency costs arising from distorting investment choices.

Tax depreciation affects the effective tax rate and the after-tax profitability of an investment project. Even where the effective life of an asset is accurately assessed, tax depreciation allowance schedules represent approximations of the actual pattern of economic depreciation. True economic depreciation, which is the real decline in the value of assets as they age in use, is likely to vary significantly across different types and uses of depreciating assets.

A number of exceptions allow tax depreciation rates to diverge from those based on effective life. A significant exception is the building depreciation provisions, which provide deduction rates of either 2.5 per cent per annum or 4 per cent per annum. Also significant are the statutory life caps that have been placed on the effective life of certain assets, providing accelerated depreciation. Another example is immediate deductions for expenditures, such as certain repairs and maintenance expenses, even where the expenditure is consumed over time — providing an incentive to extend the life of existing assets rather than replace them.

Chart 6.5 compares the EMTRs of various tangible assets depending on tax depreciation regime and asset effective life. All investments that are immediately expensed face an EMTR of zero. This is because immediate expensing effectively exempts normal returns. Where tax allowances equal the economic depreciation, the EMTR is equal to the statutory tax rate as the normal returns are fully taxed. Where tax allowances are underprovided, the EMTR faced would be above the statutory tax rate. The downward sloping nature of the EMTR schedules reflects capital allowances based on historical cost rather than current cost.

Chart 6.5: Comparison of nominal EMTRs of equity financed investments
by depreciation arrangement and effective life

Chart 6.5: Comparison of nominal EMTRs of equity financed investments by depreciation arrangement and effective life

Note: Assumes a nominal interest rate of 6 per cent, inflation of 2.5 per cent and statutory tax rate of 30 per cent. Depreciation allowances under 'double declining balance' and '150% loading' are calculated based on effective life and diminishing value method at historical cost. Under the 'economic depreciation' method, capital allowances equal economic depreciation at current cost. The capital allowances for tractors, trucks, aeroplanes and gas transmission assets are calculated based on their statutory effective life caps. The effective lives for these assets as determined by the Commissioner of Taxation are 12, 15, 20 and 30 years respectively (ATO Tax Ruling 2008/4).

Source: Australian Treasury estimates.

Intangible assets pose even greater difficulties in estimating appropriate rates of economic depreciation (or in many cases, appreciation). The value of these assets, and how values change over time, can be inherently difficult to ascertain as intangibles exhibit different rates of economic depreciation (or appreciation). As discussed in Box 6.5, the treatment of intangibles can vary markedly.

The measurement of gains in asset values

Appreciating assets are generally subject to CGT. CGT was introduced in 1985 partly to enhance the neutrality of treatment for assets that generate gains via increases in their value (such as land and some financial assets) compared to assets that generate gains via cash flows (such as interest-bearing accounts). For businesses and certain other taxpayers, appreciating assets may also be taxed on revenue account or under accruals-like rules.

Submissions raise several concerns with the current CGT system. A number of submissions also raise concerns about the clarity of the revenue/capital divide while others seek a CGT treatment.

Box 6.5: Intangible assets and goodwill

Intangible assets and goodwill form a large part of the book value of listed Australian firms. The concentration of reported intangible assets is likely to vary depending on industry sector and firm type. PricewaterhouseCoopers (2006) found that in their 2005 year-end financial statements, ASX 200 companies reported around $112 billion in intangible assets. (The market capitalisation for the ASX 200 as reported by Standard & Poors (2008) was around $800 billion on 30 June 2005). Of these intangibles, goodwill represented 58 per cent, contract-related assets (such as franchise agreements) 24 per cent, marketing-related assets (such as brands and mastheads) 9 per cent and customer-related assets (such as customer lists) 1 per cent.

Some intangibles, such as patents and in-house software, are currently treated as depreciating assets for tax purposes. For other intangibles, such as acquired goodwill, there are no provisions to allow taxpayers to deduct or amortise these amounts. The sale and acquisition of goodwill, for example, falls within the CGT provisions. To the extent that acquired goodwill and other intangible assets are depreciable assets with finite effective lives (accounting standards prohibit the amortisation of intangibles with an indefinite effective life), an income tax system should recognise real declines in value.

However, in other respects the tax system provides for a more generous treatment of intangibles than appropriate when measured against an income tax benchmark. In particular, expenditures incurred to build goodwill and certain other intangibles are immediately expensed, without the value of the asset generated being recognised. The taxation of the cash flow arising from the sale of these intangibles plus the immediate expensing means that this form of investment is (when equity funded) afforded expenditure tax-like treatment, with a zero EMTR. When debt funded, the EMTR is negative.

Where acquired goodwill declines in value, the expenditures required to maintain goodwill are typically immediately deductible. The deductions for expenditure sufficient to maintain the level of goodwill means that the investment in acquired goodwill has access to deductions equivalent to allowing write-off based on economic depreciation.

Biases arising from the CGT treatment of appreciating assets

Levying CGT on realisation (when an asset is disposed) results in tax deferral, which creates two biases.

  • It results in a falling effective rate of CGT the longer an asset is held. Thus, the effective rate of CGT is lower than that applied to a comparable asset that generates cash returns (see Box 6.6).
  • Asset owners may be discouraged from selling their assets, even when a potential buyer values them more highly (the 'lock-in' effect).

The decline in the effective rate of CGT the longer an asset is held is avoided under current asset test arrangements in the transfer system that deem a return to capital assets, effectively proxying the accruing gain.

While the extent to which lock-in is a problem in practice is unclear, the current law contains a large number of roll-over provisions that address potential lock-in where taxpayers are particularly sensitive to realising a liability. Some submissions propose further specific roll-overs, such as to allow superannuation funds to merge or for the transfer of intellectual property to a spin-off company.

Improving the CGT system

To improve incentives to invest and to encourage long-term investment, some submissions propose introducing stepped CGT rates, with the rate of tax declining the longer an asset is held. Such stepped-rate approaches have been a feature of CGT arrangements in some other countries. However, adopting stepped rates would have potential downsides. Short-term investments are not necessarily less productive than long-term investments. A yet more favourable CGT regime could further distort investment choices and exacerbate lock-in.

An alternative approach suggested in academic literature would be to continue to assess capital gains and losses when they are realised but to provide an uplift to realised gains, with symmetrical treatment for realised losses. This is equivalent to accrual-based taxation. However, it could exacerbate problems arising from the lumpiness of realised capital gains when assessed against progressive tax rates, and could increase complexity.

Submissions also place emphasis on reducing the complexity and operating costs associated with current CGT arrangements. In particular, some submissions propose CGT exemptions for assets held beyond five or 10 years on the basis it would simplify record-keeping requirements. The CGT regime is complex and costly to operate. General reasons for this include:

  • the provisions have a broad reach and there are numerous concessions;
  • they have also been drafted in a highly prescriptive way and have become outdated;
  • the CGT rules can interact with other parts of the tax and general (equity, property and contract) law in complex ways; and
  • changes to the provisions can be ad hoc.

The four small business CGT concessions are also a major area of increasing complexity.

Box 6.6: CGT tax deferral benefits

This example compares two assets held by a taxpayer facing a 30 per cent tax rate: a bank account paying 10 per cent interest taxed on an annual receipts basis (when net interest accumulates), and a piece of land which appreciates in value at 10 per cent a year, but which is taxed on disposal. The land owner will have more post-tax cash available than the bank account holder, even in the absence of a CGT discount.

Table 6.3: Example of the CGT deferral benefit

  Bank account Appreciating land
Pre-tax interest Tax Post-tax interest End period balance Net cash flow Appreciation End period value Tax on sale Net cash flow
Year 0       $10,000 -$10,000   $10,000   -$10,000
Year 1 $1,000 $300 $700 $10,700   $1,000 $11,000    
Year 2 $1,070 $321 $749 $11,449   $1,100 $12,100    
Year 3 $1,145 $343 $801 $12,250   $1,210 $13,310    
Year 4 $1,225 $368 $858 $13,108   $1,331 $14,641    
Year 5 $1,311 $393 $918 $14,026   $1,464 $16,105    
Year 6 $1,403 $421 $982 $15,007 $15,007 $1,611 $17,716 $2,315 $15,401
Internal rate of return 7.000%   7.463%
EMTR 30%   25%

Although there is a large tax liability for the land in the final year when it is sold, the deferral benefit means the effective tax rate is significantly lower than the interest-bearing investment. The land owner has the benefit of tax-free accumulation in the preceding years. The tax deferral benefit means that the effective tax rate under CGT declines the longer the asset is held (Chart 6.6).

Chart 6.6: Nominal EMTR on a CGT asset

By holding period (in years)

Chart 6.6: Nominal EMTR on a CGT asset - By holding period (in years)

Source: Australian Treasury estimates.

Risk taking

Entrepreneurial activity can make an important contribution to economic growth. New entrants in a market can introduce more highly valued products, new production methods and processes, and organisational innovations. These in turn can provide spillover benefits to existing firms. Potential entrepreneurs typically face a choice between returns from risky entrepreneurial projects and a more stable income from the current use of production factors.

As identified in a number of submissions, an important structural element in the tax system that can affect risk taking is the extent to which the treatment of net losses matches (is symmetrical to) the treatment of net income or gains. Submissions argue the current asymmetric treatment of losses, described in the Architecture paper, inhibits Australia's international competitiveness.

The treatment of losses and risk taking

A proportional (flat rate) income tax with full loss offset can be expected to share risk and returns between an investor and government. Thus, the tax has little effect on investors' risk taking. This is because investors can increase the proportion of risky assets in their portfolios so the after-tax risk is unchanged. In a full loss offset case, government is effectively a 'silent partner' in the investment, by taking a share of the risky return if it succeeds, and providing a full offset if it fails. Broadly, the tax imposed on the risky project reduces the rewards of success and the losses from failure.

Partial loss offsets, as in Australia, can distort risk taking in either direction, depending on the size and direction of income and substitution effects (IMF 1995). If the project is part of a large entity, such as a consolidated group, that has profits against which to offset a loss, the entity will receive full value for the loss. If a business does not have other profits against which to offset a loss, and it cannot pass the loss to the individual investor, it must carry forward the loss to be offset against future income. Losses carried forward lose value over time, and tax law can also limit access to current and carried forward losses. These effects can create a tax bias in favour of large companies and less risky investments.

The income tax system can also distort risk-taking behaviour where tax is not levied proportionately, for example where there are progressive income tax rates as may apply to a sole trader or partners in a partnership. Where gains are assessed against a higher tax rate than the rate at which losses are accessed, progressive personal rates effectively tax success more than they subsidise failure. This effect can be further exacerbated by progressive credits such as the entrepreneurs' tax offset, which reduces the tax liability for entrepreneurs whose income is lower than a specific threshold.

Providing a more neutral treatment of losses

If the economic costs of the current treatment of losses are considered sufficient to justify moving to a more symmetrical treatment, or full loss offset position, a range of approaches could be considered.

To improve the treatment of losses, submissions generally support allowing loss carry back, against (time-limited) past tax payments. Suggestions as to the period within which losses can be carried back range from one to three years. Another approach could be to index losses carried forward using a risk-free rate of return, with an adjustment to compensate investors for the risk that the loss will never be utilised.

Other options similar to full loss offset include providing refunds proportionate to the losses, allowing losses to be offset against a firm's other tax payments, and allowing losses to be traded. These offsets would address loss issues for projects with uncertain overall returns. However, integrity issues would be significant. Tax collections would also likely become more variable and cyclical.

Loss offset could also be improved by allowing losses to pass from an entity to the underlying owners. This is part of the proposal to provide a flow-through treatment to small business and is a specific objective of proposals to provide flow-through treatment for certain exploration companies (see Box 6.7).

The merits of such proposals depend in part on: how they interact with other aspects of the tax system, such as dividend imputation and CGT; long-standing integrity concerns around artificially generated losses; and the net impact on operating costs. It also becomes more important to prevent tax losses arising from timing misalignments, such as for negatively-geared rental properties. Further, any move to a more generous treatment also needs to consider the treatment of existing accumulated losses.

Box 6.7: Flow-though for exploration companies

Loss offset could be improved by allowing losses to pass from an entity to the underlying owners, as currently happens for sole traders and partnerships, by using flow-through share schemes. This type of scheme has been proposed for junior exploration companies.

Broadly, a flow-through share scheme encourages investment in exploration in preference to other investment options, by allowing deductions (or equivalent tax credits) generated from exploration expenditure to 'flow-through' from the exploration company to its shareholders. An exploration company generates losses as it incurs exploration expenditure with, generally, little income to offset that expenditure. While the losses are able to be carried forward, the risk that they will not be absorbed is predictably high, given the risky nature of exploration.

Reforms to the treatment of losses incurred by exploration companies need to be considered in the context of any broader reforms to the treatment of losses and entities across the business tax system.

Other business concessions

Submissions call for a range of new tax concessions or improvements to existing exemptions for small business.

Like other countries, the business tax system in Australia provides specific tax concessions for particular types of investments. The major business tax concessions currently available in Australia include research and development (R&D) concessions, statutory caps on the effective lives of some depreciable assets, accelerated write-offs for certain capital expenditures, film investment incentives, and small business concessions. There is also a range of non-tax sector-specific industry assistance including measures for primary production (such as relief for exceptional circumstances, including interest rate subsidies) and for the automobile sector (structural adjustment payments and the Green Car Innovation Fund).

A rationale for certain business concessions is that they can help productivity growth by providing incentives for particular activities that may be underprovided by the market. For example, incentives to undertake R&D are usually justified on the basis there are spillover benefits to the rest of the economy. However, business tax concessions alter the allocation of resources in the economy by changing the relative prices of inputs and outputs. These price distortions can result in an inefficient allocation of resources within the economy, reducing productivity.

Another rationale for some concessions (also advanced in a number of submissions) is international tax competition, with concessions proposed to achieve comparative outcomes with other countries for investments that could be undertaken elsewhere. Such proposals need to be considered from the broader perspective of the overall competitiveness of the tax regime (as discussed in Section 6.1), while also taking into account the potential misallocation of domestic investments they create.

Consultation questions

Q6.3 Can the tax system be restructured to improve resource allocation within the economy and minimise operating costs, and if so, how? What changes would reduce distortions to risk taking and encourage entrepreneurial activity?

Q6.4 What principal goals should inform the taxation of capital gains in Australia, and what, if any, changes should be made to capital gains tax as a result?

6.5 Biases affecting commercial decisions

As well as affecting the investment choices of businesses, the tax system can also affect other commercial choices, such as financing and the distribution of profits to owners, and the choice of business structure.

Summary of key messages from submissions

Submissions support dividend imputation because it provides a neutral treatment of debt and equity for resident investors by addressing the double taxation of corporate profits. Most submissions consider that the imputation system generally lowers the cost of capital.

A number of submissions propose flow-through treatment for companies and, possibly, other entities either in general or in particular cases (including for small businesses, indigenous ventures or venture capital).

Some non-business organisations express concern over the tax advantages arising from the use of certain business entities, particularly discretionary trusts.

There are a few other concerns about the current entity arrangements. One is the potential for managed funds to be taxed as companies.

Sources of finance: debt and equity

Firms can raise capital to finance investments in a number of ways. Firms can issue equity or debt or finance investment from retained earnings9. Nominal interest payments are deductible from Australia's company income tax base but total corporate profits (or returns on equity) are taxed. This can provide a tax incentive for firms to finance investment out of debt rather than equity.

The different treatments of debt and equity are a major source of complexity in the income tax system. For example, they necessitate complex rules to classify instruments as debt or equity and require 'thin capitalisation' rules to prevent profits being shifted from Australian firms to firms in low-tax jurisdictions. A number of submissions express concerns around Australia's thin capitalisation rules, citing their complexity and potential interactions with the transfer pricing rules.

To the extent capital is not perfectly mobile, as may be the case particularly for small unlisted domestic firms, financing decisions may be influenced by taxes on capital income (dividends, capital gains, interest) at the personal level. Even with dividend imputation, investments financed by retained earnings can be favoured over new equity, due to the concessional treatment of capital gains. The tax system may therefore provide a tax advantage to more mature firms and discourage the entry of new firms. Distortions to firms' payout policies may also arise (Jones 2008).

However, where the marginal source of finance is the international capital market, interest deductibility coupled with a lack of credit for Australian company taxes may bias the capital structure of the firm towards higher levels of debt. This bias might then affect other factors driving the firms' choice of capital structure such as liquidity, the ability to match asset/liability durations and to adapt to changing economic conditions.

Providing a more neutral treatment of debt and equity

There are other approaches to address distortions arising from the debt/equity distinction at the business level apart from dividend imputation, which becomes less effective as the economy becomes more open and capital more mobile.

Business level expenditure taxes, such as an ACE or business cash-flow tax, could provide a more neutral treatment of debt and equity at the business level. As discussed in Box 6.4, an ACE system allows a deduction for company equity at an interest-equivalent rate. Under a cash-flow tax, the immediate expensing of investment means that the normal return on equity is not taxed, thereby providing neutral treatment between debt and equity.

Another approach, the CBIT proposed by the United States Treasury in 1992, would be to include debt interest payments in the company income tax base by removing interest deductibility. However, under this approach, the cost of debt financed from foreign investors would increase. The extent to which debt-equity neutrality is achieved also depends on the tax treatment of capital income in the foreign investor's country of residence. As noted in Section 6.2, while the CBIT has not been formally adopted by any country, there have been partial steps taken in some countries (for example, Germany) to limit interest deductibility.

Choice of business organisation

Businesses and investors can use a variety of organisational forms, with considerable variation in the income tax treatment of the entity type and the underlying owners. As discussed in the Architecture paper, this sets up the potential for inefficient outcomes that can affect overall business productivity. A potential inefficiency is that businesses will be conducted through multiple entities or a sub-optimal entity structure.

The different tax treatments applying to different entity types largely revolve around the degree of integration between the firm and the investor. For example, partnerships reflect full integration, while companies are taxed separately from their shareholders with dividend imputation providing partial integration.

In the past, proposals have been made for uniform treatment across most entity types, such as company tax style treatment. The intention was to achieve consistency and so reduce distortions and complexity. However, doing so can introduce complexities of its own, imposing higher tax operating costs on many businesses. An alternative viewpoint is reflected in Auerbach et al (2008), who argue that allowing for heterogeneity in organisational form is a means by which to accommodate the different circumstances of firms and owners.

Another approach would be to move away from taxing entities separately from their underlying owners, by looking through the entity — 'flow-through' treatment. This is the reform path favoured in submissions, generally on an optional or elective basis. Such an approach would allow for a more integrated, partnership-like, treatment of companies and, possibly, other entities. In the United States, 'S-corporation' rules provide for such an outcome and 'check the box' rules (also proposed in a submission) allow entities to elect for flow-through treatment.

A flow-through approach would potentially make tax affairs simpler for small businesses by allowing business income to be taxed in the individual's hands, rather than at the company level. This would avoid the need to comply with complex company tax provisions. It could also reduce the cost of capital for small startups, as losses could be more readily utilised. A specific flow-through proposal for small business is discussed further in Section 6.6.

Possible disadvantages include additional complexity arising from two distinct company tax treatments. The choices facing business could also increase, particularly if flow-through was optional. While the United States' experience demonstrates the practicality of flow-through options, its rules were developed as a means of addressing the double taxation of company profits under the classical system and, hence, had a stronger rationale. In Australia, imputation is the primary means of addressing this. The United States has also experienced integrity issues with its 'check the box' approach.

Another possible approach is to set key elements of the overall system, including business and personal income tax rates, to allow for a simpler set of rules to align the tax treatment of entities and owners. An example is the combination ACE tax system at the business level and a dual income tax system at the personal level, as advocated in Griffith et al (2008). The authors propose setting business and personal income tax rates so that the combined taxes on capital income are equal to the top tax rate on labour income. This is said to avoid the need for crediting provisions and remove incentives to characterise labour income as capital income.

Consultation question

Q6.5 Should the tax system provide a more neutral treatment of different financing arrangements (debt, equity and retained earnings), and if so, how? What principles should inform approaches to entity taxation?

6.6 The treatment of small business

A range of specific provisions intended to assist small business activity, or reduce tax operating costs, are contained in the income tax system, as well as other taxes such as payroll tax. These provisions may temper the relatively high operating costs facing small business, but can add to the overall complexity of tax law and affect resource allocation in the economy.

Summary of key messages from submissions

Several submissions indicate that tax concessions for small business are justified, given the inherent disadvantages faced by small business. These submissions consider that small business makes important contributions to employment and economic growth.

Some submissions propose further rationalisation of existing small business concessions to minimise operating costs. Other submissions are more critical of existing small business concessions and indicate that separate arrangements (such as a separate tax code) for small business are required, possibly with more concessional arrangements and exemptions from state taxes and duties.

Some submissions claim that existing concessions for small business cannot be justified on efficiency or equity grounds. These submissions argue for more neutral treatment of small business, with the abolition or reduction of current concessions, such as the CGT and payroll tax concessions.

Rationales for small business specific rules

The tax system provides a range of concessions or separate rules for small business.

One rationale for these arrangements is the contribution small business makes to the overall economy, through product differentiation, entrepreneurship, job creation and increased competition. A number of submissions call for lower income taxes for small business, generally based on such a rationale. Thresholds exempting small businesses from payroll taxes are also often supported on this basis, as well as to reduce operating costs.

A second rationale is to counter the inherent disadvantages of being small, including high tax operating costs and potentially less ability to offset net business losses against other income streams. Submissions acknowledge current tax concessions are designed to address some of these problems, but there is a view that they have not succeeded in their purpose. Some submissions propose the development of alternative small business arrangements that could provide for increased upfront write-off of capital expenditure and more extensive exemptions from state taxes and duties.

Small businesses are inherently more closely aligned with the individuals or family that own the business. The profits of a small business represent a return to work (labour income) and invested capital. The small business CGT retirement concessions reflect this relationship, as do various integrity measures. Also reflecting this alignment, submissions with a small business focus support reducing the top personal income tax rates before reducing the company tax rate.

Some submissions express concerns about the robustness of the underlying rationale for providing specific concessions for small business. Such submissions take the view that existing concessions cannot be justified on either efficiency or equity grounds. Recent work also suggests that small business incentives have no discernible impact on economic growth (Johansson et al 2008). The discussion of small business issues in the Mirrlees Review (Crawford and Freedman 2008) provides a critical perspective on whether concessions are appropriate and whether the benefits outweigh the costs.

Entity flow-through taxation

The Australian Government has asked the Panel to consider a proposal for an optional entity flow-through arrangement, which is also raised in a number of submissions. The proposal would allow small businesses to operate formally within a limited liability entity, typically a company, while effectively treating the business as a partnership for tax purposes.

Broadly, the deemed partnership would calculate its taxable income or tax loss and allocate it to individuals based on their interest in the entity. Allocated profits and losses would be assessed at the individual investor's personal tax rates. In the case of a taxable income distribution, the outcome would be the same as currently provided through dividend imputation. In the tax loss situation, to the extent the investors have other taxable personal income it would allow losses to be used in the year they are generated.

Partnership-like treatment also means a number of rules associated with companies are not required, including rules on payments to associated entities, franking accounts and the carry forward of losses.

However, as noted in the discussion of business structures, a disadvantage of such an approach is that it could give rise to additional complexity. Hence, the impacts of entity flow-through on tax system operating costs would need to be carefully considered. Entity flow-though may also offer an opportunity to simplify other parts of the tax-transfer system, such as the small business CGT concessions, or to simplify the arrangements for all small business structures on a more uniform basis.

Consultation question

Q6.6 Should the tax system be structured to cater for the specific circumstances of small business, and if so, how?

6.7 Biases in the personal investments of residents

As well as affecting the overall level of savings of a household (discussed in Section 3), the tax-transfer system also affects the way households allocate their savings between different financial and real investments.

This section provides an overview of issues regarding household savings. The discussion in previous sections around dividend imputation, capital gains, the treatment of different entities, and of losses and risk taking, is also relevant to household choices. The discussion of housing in Section 10, of retirement savings in Section 5 and the separate retirement incomes paper, are also of particular relevance in light of the share of housing and superannuation in total household assets.

Summary of key messages from submission

Submissions note that interest-bearing accounts and assets are taxed heavily compared to other investments, with implications for incentives to save and for equity. These submissions suggest a variety of means of providing more favourable treatment for interest income such as through exemption, taxation at a low flat rate or tax preferred savings accounts.

Some submissions suggest moving to a 30 per cent capped rate on capital income or considering a low flat rate tax on capital income (a dual income tax).

A number of submissions raise concerns regarding the 50 per cent discount available for individuals (particularly for rental properties) and the CGT exemption for principal residences. These submissions are concerned that the concessions favour the wealthy or increase house prices.

Reflecting concern over negative gearing, some submissions also propose capping the level of deductible interest to income generated by the investment, with excess deductions carried forward.

Other submissions take an alternative view of the 50 per cent CGT discount, negative gearing and the general availability of interest deductions, citing their role in encouraging the supply of housing and rental properties and referring to similar arrangements overseas.

The treatment of household savings

The principal assets of Australian households are the houses they own and live in (44 per cent of household assets), other property including rental properties (16 per cent), superannuation (13 per cent), shares and interests in trusts (12 per cent), personal use assets (11 per cent), and bank accounts and bonds (4 per cent).

There is considerable variation in the treatment of different household assets and investments.

Owner-occupied housing receives a treatment close to that of an expenditure tax, reflecting the non-taxation of imputed rent and a CGT exemption. While a number of state taxes apply to residential land and housing, including rates, land tax and stamp duty, they only provide a limited shift towards an outcome consistent with an income tax benchmark. In addition, some of these taxes will have been capitalised in the purchase price and so do not affect marginal returns.

For rental properties, although rental income and capital gains are subject to tax, interest and depreciation expenses are fully deductible, while capital gains are only partially taxed on realisation. A number of submissions express concern over the treatment of negative gearing, which is discussed further in Box6.8. Investments in shares also fall below an income tax benchmark, principally due to the availability of the CGT discount.

The ability to invest in superannuation out of pre-tax income through SG contributions or salary sacrifice arrangements can provide a tax treatment more favourable than under an expenditure tax for individuals on higher personal rates. Individuals on lower personal tax rates do not receive such favourable treatment, though they may benefit from superannuation co-contributions.

The entire nominal return on interest-bearing bank deposits and bonds in the hands of a resident investor are taxed on an annual receipts basis at the full personal income tax rate. This difference increases when inflation is taken into account. Submissions express concern that, relative to the other types of savings, term deposits are taxed unfavourably. One submission notes that the total value of financial assets of households held in the form of deposits has fallen from 30 per cent in 1990 to 18.5 per cent in mid-2007. However, where bank deposits are held for transaction purposes, the full return may not be taxed under the income benchmark. Most financial institutions offer cheque and transaction account products with free or reduced price transaction services in exchange for lower interest yields on deposits.

Box 6.8: Negatively geared property

Submissions raise a number of concerns about the concessional treatment for negatively geared investment properties. For an individual investor, the tax treatment of a negatively geared property would typically involve: the full taxation of rental income; a 50 per cent CGT discount on disposal of the property (with the building and land sharing a joint cost base); annual building depreciation allowances; full loss offset where losses can be offset against other income; as well as payment of land tax, rates and any stamp duty on conveyancing.

As demonstrated in Chart 6.7, ignoring state taxes, this tax treatment results in a significant deviation from the income tax benchmark because the individual is able to deduct annual interest and depreciation deductions with a full loss offset, while the capital gains from the property are taxed on realisation and — most importantly — at a 50 per cent discount. In addition, the 2.5 per cent annual depreciation allowance available in relation to the building component of an investment property represents another deviation from the income tax benchmark.

Chart 6.7: EMTR of equity investment in property by gearing ratio and tax treatment

Individual taxpayer on top marginal rate

Chart 6.7: EMTR of equity investment in property by gearing ratio and tax treatment - Individual taxpayer on top marginal rate

Source: Australian Treasury estimates.

If the gains from the property were taxed without discount, investment properties would be taxed closer to the nominal income tax benchmark with full loss offset. The existing treatment of property losses and capital gains for individual investors potentially crowds out housing investment by companies, which do not receive a CGT discount, and superannuation funds, which are unable to borrow.

Not shown in the chart is that the realisation basis for taxing capital gains may enable the owner to time the sale of the property so that they pay tax on the capital gain at a marginal rate below that at which the net losses were claimed. For example, a negatively geared property could be acquired before retirement when the tax value of the net deductions is high, and sold after retirement when income is low (ignoring means and assets testing).

Approaches to reducing distortions

The preceding discussion points to some ways that the various biases affecting household investment choices, such as inflation, capital gains lock-in, the accessibility of losses and the favouring of domestic equity over foreign equity investments could be addressed.

With respect to the unfavourable treatment of interest income, submissions point out a number of approaches, including taxing only real interest returns, following the lead of countries such as the United Kingdom by allowing tax-preferred bank accounts (the most commonly suggested approach) or moving to a dual income tax system.

In contrast, where submissions see the current tax treatment as too favourable, the suggestion is to remove or limit the perceived favourable treatment. This is the case for the CGT discounts or exemptions and negative gearing.

In general, while submissions point to solutions specific to a given problem, they broadly suggest two approaches can be adopted to provide for more neutral treatment of household investment choices. One is to remove or limit concessions and move closer to an income tax benchmark. The other is to move away from an income tax benchmark for all assets, either through discrete adjustments (as for interest income), or, more radically, by adopting a dual income tax. The relative merits of either approach depend in part on the efficiency and equity arguments surrounding the taxation of savings (as discussed in Section 3.2).

Consultation question

Q6.7 Should the tax system be restructured to deliver a more neutral tax treatment for the different forms of return on household savings and investments, and if so, how?


8 A tax system reflects CEN where all investments by residents of a country are taxed the same regardless of the location of the investment. It can be achieved by taxing residents on all their income from offshore investments as they accrue with a full credit for foreign taxes paid. A tax system reflects CON where the cross country ownership of assets is not distorted by tax considerations. One way of achieving CON is to not tax the offshore income of resident companies (Griffith et al 2008).

9 In practice, the distinction between debt and equity can be blurred for hybrid instruments that combine debt and equity features, such as non-cumulative preference capital.