Final Report: Detailed Analysis
B1. Company and other investment taxes
The increasing globalisation of the Australian economy raises questions about the appropriateness of the existing company income tax system and the dividend imputation system.
In this light, a number of options were considered for the fundamental reform of the company income tax system. These options, which have received widespread attention in the international tax policy debate, particularly in recent years,5 can be characterised by the location of the tax base, and the type of income subject to tax (see Table B1–1).
There are three possible locations of the tax base:
- income from where the investment takes place (source-based taxation);
- income, wherever earned, of a company resident in a country (residence-based taxation); and
- the sales (net of costs) in the country where the goods or services are consumed (destination-based taxation).
There are also three types of income that can be subject to tax:
- the full return to all capital (equity and debt);
- the full return to equity; and
- economic rents.
Table B1–1: Alternative options for taxing company income
|Type of income subject to tax|
|Location of base||Full return to capital||Full return to equity||Economic rent|
|Source country||Comprehensive business income tax||Conventional corporate income tax with exemption for foreign source income||Source-based business expenditure tax (such as an allowance for corporate equity or capital and source-based cash flow tax)|
|Residence country||Conventional corporate income tax with credit for foreign taxes|
|Destination country||Destination-based business expenditure tax (such as a full destination-based cash flow tax and a VAT-type cash flow tax)|
Source: Based on Devereux and Sørensen (2006).
The existing company income tax is essentially a source-based tax on the full nominal return to equity.6 As noted previously, there is a case for small open economies, such as Australia, to reduce source-based taxes on the normal return. Of the remaining options, the comprehensive business income tax taxes the full return to capital (debt and equity), albeit at a possibly low marginal rate, and the various forms of business expenditure tax exempt the normal return from tax, only taxing economic rents.
The comprehensive business income tax is based on an income tax system, but with the difference that interest expenses would no longer be deductible. Removing the deductibility of interest removes the distortion between debt and equity. The broadening of the tax base could facilitate a reduction in the company income tax rate, but this would reduce its effectiveness as a backstop to the personal income tax system. As a significant amount of debt is currently untaxed, this option would also increase the cost of debt financed investment. There would also be significant transitional issues for highly leveraged businesses.
Business level expenditure taxes can be imposed on either a source or destination basis. A source-based tax, such as an allowance for corporate equity or allowance for corporate capital, would tax all economic rents generated in the country where the investment takes place. Under a destination-based tax, only economic rents used for consumption in the domestic economy would be subject to tax.
Business level expenditure taxes also provide greater neutrality between debt and equity. In addition, these systems also reduce pressure around the timing and recognition of income and expenses. For example, under an allowance for corporate equity the timing of capital allowances becomes less important. Such systems are also neutral in relation to the effects of inflation. In effect, such systems would reduce distortions across asset types which could assist in promoting efficient resource allocation and may also provide opportunities for further simplification of the company income tax system. The case for these systems has been outlined for the Review by Auerbach (2010) and Sørensen & Johnson (2010).
A resource rent tax based on an allowance for corporate capital model is recommended for the taxation of resource rents (see Section C1 Charging for non-renewable resources).
However, in contemplating the replacement of company income tax with an expenditure tax, a significant concern for the Review is that there has been limited or no practical use of such taxes for this purpose.7 Replacing the current company income tax system with one of these alternatives would therefore involve considerable risks. For example, the practical implications from a tax administration and compliance perspective are unknown. From an international context there may also be opportunities for tax arbitrage if Australia is one of only a few countries using a system.
On balance it is therefore recommended that Australia maintains the existing company income tax system, at least in the short to medium term.
For the longer term, a continuing trend of increased openness and greater capital mobility suggests consideration needs to be given to eventually moving away from the dividend imputation system as a means of integrating the personal and company income tax systems. A business level expenditure tax would provide an alternative means of integration, though not the only one (see Section B2 The treatment of business entities and their owners).
In addition, in light of the potential benefits of business level expenditure taxes there is likely to be increased interest internationally in them as a replacement for company income taxes. Such a system may suit Australia and is worthy of further consideration and public debate. It is possible that other economies will move towards such systems over coming years and it could be in Australia's interest to join this trend at an early stage. An example of a blueprint for the reform of Australia's company income tax system, based on the allowance for corporate equity, is presented in Sørensen and Johnson (2010).
The structure of the company income tax system should be retained in its present form, at least in the short to medium term.
A business level expenditure tax could suit Australia in the future and is worthy of further consideration and public debate. It is possible that other economies will move towards such systems over coming years and it could be in Australia's interest to join this trend at an early stage.
As discussed previously, economic theory and growing empirical evidence support a shift away from company income tax towards taxes on less mobile factors as a means of increasing investment, GDP and growth. Over the past 25 years, company income tax rates across the OECD have fallen, and until more recently, Australia has followed this trend. However, Australia's current company income tax rate is now high relative to similar sized OECD economies.
The company income tax rate should be reduced to encourage investment in Australia, particularly highly mobile foreign direct investment. In the long-run this would increase income for Australians, by building a larger and more productive capital stock and by generating technology and knowledge spillovers that would boost the productivity of Australian businesses.
In the long-term, a larger and more productive capital stock would not only result in higher growth but is also likely to result in higher wages. A lower company income tax rate would also reduce incentives for foreign multinationals to shift profits out of Australia.
Given the continued expected growth of China and India, Australia should continue to be able to attract investment into its resource sector. However, other sectors of the economy may find attracting investment more challenging. Reducing the company income tax rate may help other sectors attract investment.
Against this, company income tax currently has an important role in ensuring the community receives a return for the exploitation of Australia's non-renewable resources. Reducing the company income tax rate in the absence of other measures would lead to lighter taxation of Australia's location-specific rents. But it would be more effective to tax such rents directly, through a uniform resource rent-based tax, as recommended in Section C1 Charging for non-renewable resources.
The benefits of a reduction in the company income tax rate also need to be considered against potential interactions with the personal tax and transfer system. For example, a reduction in the company income tax rate would increase incentives for domestic residents to defer taxation by retaining income in a company.
Taking account of these considerations, the company income tax rate should be set on the lower side of the average rate in small and medium OECD economies, while balancing other considerations such as interactions with the personal tax-transfer system (to minimise incentives to defer or avoid taxes on labour and savings).
A move over the short to medium term to a company income tax rate of around 25 per cent would be consistent with this approach, and allow for the transition to that lower rate to take account of fiscal and economic circumstances over that period (see Chart B1–7). Given that company income tax also acts as a tax on profits derived from Australia's non-renewable resources, improved arrangements for charging for the use of non-renewable resources should be introduced at the same time.
Chart B1–7: Restoring Australia's relative company income tax rate ranking
Source: OECD (2009d).
A number of submissions to the Review have also recommended a concessional tax rate for small companies. A lower company tax rate targeted at small companies would only benefit companies and owners that are in a position to accumulate funds in the company. Furthermore, it would target a company income tax rate cut at those businesses most likely to be earning a return to the personal efforts and savings of owner-managers, thereby negating the backstop functions of company income tax while attracting little additional investment or otherwise improving productivity. It could also benefit non-business accumulation, such as rents and profit retention.
Certain tax arrangements or concessions may need to be adjusted in response to a reduction in the company income tax rate. This would include adjusting the level of the research and development tax credits (in respect of the loss offset component) and maintaining the current effective 10 per cent tax rate for offshore banking units.
The company income tax rate should be reduced to 25 per cent over the short to medium term, with the timing subject to economic and fiscal circumstances. Improved arrangements for charging for the use of non-renewable resources should be introduced at the same time.
6 Australian resident companies are technically taxed on their worldwide income with an exemption for profits from permanent establishments and non-portfolio foreign dividends.
7 No country has replaced their company income tax system with a destination business cash flow tax. The allowance for corporate equity has been adopted by Belgium (2005) and Latvia (2009) and was also used in Croatia for a short period of time.
Next Page – B1–4: Refining the business income tax base >>
<< Previous Page – B1–2: Australia relies heavily on company income tax