August | 2017 | Outlier

[This is a copy of a story I wrote that has been published in the August edition of In The Black. The story as it appeared in the magazine can be found here: https://www.intheblack.com/articles/2017/08/01/cutting-company-taxes]

Cutting taxes is an expensive business, so it seems odd that debt-laden governments are rushing to lower corporate tax rates.

A budget deficit of US$588 billion has not deterred Donald Trump from announcing plans to slash America’s nominal corporate income tax rate from 35 to 15 per cent[1] at an estimated cost of US$190 billion[2]. Despite uncertainty about the long-term economic impact of Brexit, the United Kingdom has just reduced its corporate profits tax to 19 per cent, and will lower it to 17 per cent in 2020.

In Australia, the Turnbull government has secured support for a phased reduction in its company tax rate from 30 to 27.5 per cent for businesses with a turnover of up to $A50 million at a cost of $29.8 billion[3], and eventually wants an across-the-board rate of 25 per cent, which in total will cost $65.4 billion in foregone revenue[4] – this at a time when the deficit sits above 2 per cent of GDP and no surplus is in prospect until at least 2020-21. Even Hong Kong, which has lower company tax rates than most, is feeling the pressure to continue cutting, announcing that 75 per cent of its 16.5 per cent profits tax will be waived up to a ceiling of $HK20,000[5].

These governments, and others like them, are betting that the benefits expected to flow from cutting company taxes – increased investment, improved productivity, higher wages and a bigger economy – will eventually overshadow the short-term cost to both taxpayers and government coffers.

In this, they can expect some assistance from improving international conditions. The International Monetary Fund reckons the global economy is finally gaining momentum and will expand by 3.5 percent this year and 3.6 percent in 2018[6], with indicators for investment, production and trade all pointing up.

But much rests on how investors, particularly those from offshore, will respond.

Can less be more?

Foreign investment has long been the lifeblood of growth for Australia – current account deficits have for decades been a permanent feature of the economy[7].

The Australian Government expects that cutting the corporate tax rate will attract more international capital to the country, spurring investment in technology, equipment and skills and generating more jobs and higher incomes.

Modelling and analysis by economists such as former Treasury Secretary Ken Henry suggests they are right.

In 2009, Henry recommended a cut in the company tax to 25 per cent on the grounds that “reducing taxes on investment, particularly company income tax, would…encourage innovation and entrepreneurial activity…[and] increase income by building a larger and more productive capital stock, and by generating technology and knowledge spill-overs that boost the productivity of Australian businesses”[8].

Treasury officials have put some numbers on the likely benefit, estimating that a cut in the company tax rate to 25 per cent would deliver a permanent 0.6 to 0.8 percentage point lift in real gross national income, underpinned by an increase in investment of almost 3 per cent, a 0.4 per cent boost to employment and a 1.2 per cent rise in before-tax wages^[9].

The tax changes agreed to so far by Australia’s Parliament fall well short of this lofty goal but the Government is undeterred, and has introduced legislation seeking approval for a cut to 25 per cent.

Observers like Melbourne University professor of economics John Freebairn and Jim Minifie, Productivity Growth Program Director at the Grattan Institute think-tank, think Government policy is right to push for corporate tax cuts.

“If we were to reduce our corporate tax rate, that would reduce the tax burden on non-resident investors, so they pour a little more money into Australia,” Freebairn says. “That means slightly better, more sophisticated machinery and equipment, they might bring some extra technology and managerial expertise with their investment and, with people working with better machinery and technology, their productivity goes up and that pushes them into higher wages.

“That is the story in the Henry Review, and that has been backed up by modelling by Treasury and the Centre for Policy Studies.”

Minifie calculates that the Government’s eventual goal of an across-the-board reduction to 25 per cent could deliver a 15 per cent rate of return over 10 years – “not bad for a government that can borrow at 3 per cent”.

Freebairn is more cautious about estimating the long-term benefit of such a tax cut.

“Whether Australia in general wins or loses depends on how much bigger the Australian economy grows as a result of the extra investment,” he says. “Treasury modelling is saying you are going to recoup about half of it, but it could quite easily be 20 or 30 per cent plus or minus that.”

A hard sell

It is no surprise that governments are keen to talk up the potential for wages to rise on the back of corporate tax cuts, and to claim that they will effectively pay for themselves in stronger economic growth.

The idea that investors, many of them foreign, should get a hefty tax break in return for uncertain and delayed gains would be a hard sell at any time, but particularly so when budgets are constrained and wages are stagnant.

The Trump administration, which will have to win congressional approval for its tax plan, argues that the massive cost of its proposed corporate tax cut will be covered by a sustained increase in economic activity.

Though the claim has been dismissed as “fanciful” by The Economist[10], the cut is part of a package of reforms that in aggregate could boost US corporate tax collections.

America’s labyrinthine tax laws are riddled with loopholes and exemptions that mean the effective tax rate is more like 20 to 25 per cent, well below the nominal 35 per cent rate. The system is further distorted by arcane rules that discourage companies from repatriating profits (it is estimated they have up to US$2.5 trillion stashed abroad[11]) and encourage them to adopt exotic legal structures and take on debt rather than raise equity.

US Treasury Secretary Steve Mnuchin wants to reform the system, including allowing company profits to be taxed by the country where they are earned and offering a one-off tax rate (rumoured to be set at 10 per cent[12]) on repatriated profits[13] in order to lure much of this money back home. Some estimate the change could tip an extra US$250 billion into federal government coffers[14].

Unfortunately for the Australian Government, it does not have a similar pot of potential revenue to draw upon to help pay for its corporate tax cuts.

Instead, it is banking on increased domestic growth, a stronger global economy and extra taxes and charges on income earners, banks and employers to help offset the cost and put its finances on a path to recovery.

But a soft employment market and slowing wage growth has forced the Australian government to downgrade its anticipated tax take from workers and shoppers. It has trimmed $6.3 billion from its four-year forecast for individual and other withholding tax revenue in its 2017-18 budget, and expects to receive $2.5 billion less from the goods and services tax than it originally thought[15].

Instead, it predicts in the short-term that corporate tax revenue will pick up on the back of stronger global commodity prices, tipping an extra $6.9 billion into its coffers, while a 0.5 percentage increase in the Medicare levy combined with a levy on the major banks and a charge on businesses employing foreign skilled workers it expected to raise an extra $14.9 billion over four years.

This, in tandem with a swathe of cuts to higher education spending, welfare payments and price cuts for subsidised medicines, is expected to help drive a return to budget surplus in 2020-21, even accounting for the cut in the corporate tax rate to 27.5 per cent.

Some, such as CPA Australia chief executive Alex Malley, have questioned the Government’s forecast for GDP growth to accelerate to 3 per cent by 2018-19[16], and ANZ Banking Group economist David Plank says that although the budget’s numbers looked plausible, they were “at the optimistic end of what is likely to happen”.

Malley worries that the country is riding its luck on improved international conditions rather than undertaking the difficult reforms that are needed.

“We’re concerned we may be falling back on our ‘lucky country’ mentality and hoping that world growth will be sufficient to see us through,” Malley says. “There are still underlying structural issues in our economy that have not been effectively addressed in this budget.”

He says the government is over-reliant on individual and company income tax revenue, and will eventually have to confront difficult choices regarding the nation’s tax mix.

If the global economy falters again, or corporate tax cuts fail to deliver on hopes for an increase in investment, productivity and wages, that moment may come sooner than it expects.

[1] https://www.theatlantic.com/business/archive/2017/01/trump-corporate-tax-cut/514148/; “Cutting the tangle”, The Economist, 29 April, pp50-1.

[2] The Economist estimates the tax cut would cost about 1 per cent of GDP: “Cutting the tangle”, The Economist, 29 April, pp51.

[3] http://thenewdaily.com.au/money/news-federal-budget/2017/05/11/budget-2017-scott-morrison-tax/

[4] http://parlinfo.aph.gov.au/parlInfo/search/display/display.w3p;db=CHAMBER;id=chamber%2Fhansardr%2Fd376893a-a137-4f4f-8358-337edb90aa4b%2F0125;query=Id%3A%22chamber%2Fhansardr%2Fd376893a-a137-4f4f-8358-337edb90aa4b%2F0000%22

[5] http://www.ird.gov.hk/eng/tax/budget.htm#a01; http://www.gov.hk/en/residents/taxes/taxfiling/taxrates/profitsrates.htm

[6] http://www.imf.org/en/Publications/WEO/Issues/2017/04/04/world-economic-outlook-april-2017

[7] https://knoema.com/search?query=current+account+balance+australia&pageIndex=&scope=&term=&correct=&source=Header

[8] https://taxreview.treasury.gov.au/content/downloads/final_report_part_1/08_AFTS_final_report_chapter_05.pdf, p40

[9] http://www.treasury.gov.au/~/media/Treasury/Publications%20and%20Media/Publications/2016/TWP2/Downloads/PDF/Treasury-Working-Paper-2016-02.ashx

[10] “Under audit”, The Economist, April 29, p8.

[11] https://www.minnpost.com/politics-policy/2017/05/trump-s-tax-plan-seeks-bring-back-trillions-corporate-profits-held-abroad-ca

[12] https://www.bloomberg.com/news/articles/2014-04-17/u-dot-s-dot-states-target-corporate-tax-shelters-overseas