As the world’s zero-tax havens disappear and corporate tax rates are slashed, many economists say the outcome will be smaller government budget deficits, stronger growth, higher wages and more jobs. While presidents and prime ministers are advocating tax reform, not everyone is convinced.
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 the US president, Donald Trump, from announcing plans to slash that nation’s nominal corporate income tax rate from 35 to 15 per cent. The Economist estimated the tax cut would cost about US$200 billion per year (US$2 trillion over a decade). Despite uncertainty about the long-term economic impact of Brexit, the UK has 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 A$50 million. This will cost the budget A$5.2 billion over four years. Ultimately, the government is aiming for an across-the-board company tax rate of 25 per cent, which in total will cost A$65.4 billion in forgone revenue over 10 years – this at a time when the deficit is more than 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 HK$20,000.
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 government coffers.
In this, they can expect some assistance from improving international conditions. The International Monetary Fund says the global economy is finally gaining momentum and will expand by 3.5 per cent in 2017 and 3.6 per cent in 2018, with indicators for investment, trade and production all pointing up. However, much rests on how investors respond.
Can less be more?
Foreign investment has long been the lifeblood of growth for Australia, and current account deficits have for decades been a feature of the economy.
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 Ken Henry, Australia’s former Treasury secretary, suggests they are right. In 2009, Henry recommended cutting the company tax to 25 per cent in his final report for the Australia’s Future Tax System Review [the Henry review]. He opined that “reducing taxes on investment, particularly company income tax, would also encourage innovation and entrepreneurial activity … [and] increase income by building a larger and more productive capital stock, and by generating technology and knowledge spillovers that boost the productivity of Australian businesses.”
Treasury has put some numbers on the likely benefits in its analysis of the long-term effects of a company tax cut. It estimated 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.
“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.” John Freebairn, University of Melbourne
The tax changes agreed to so far by Australia’s parliament fall short of this goal. While the company tax rate has already been reduced to 27.5 per cent for small businesses, it won’t hit 25 per cent until the 2026-27 financial year, and then only for those with an annual turnover up to A$50 million. However, the Turnbull government has another bill before parliament that, if passed, will extend the 25 per cent tax rate to all corporate entities within a decade.
University of Melbourne professor of economics John Freebairn and Jim Minifie, from the Grattan Institute think-tank, believe the government is right in reducing corporate tax.
“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 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’s 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 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 is a hard sell at any time, but particularly when budgets are constrained and wages are stagnant.
The Trump administration, which will have to win approval from Congress for its tax plan, argues 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, the cut is part of a package of reforms that in aggregate could boost US corporate tax collections.
Income tax for companies - workshop 2017. Keep up to date with the changing tax regulations as they relate to the reporting of company income, losses, deductions and multi–jurisdictional tax issues.
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 US companies have up to US$2.5 trillion stashed abroad, as reported in the MinnPost) and encourage them to adopt exotic legal structures and take on debt rather than raise equity.
US Treasury Secretary Steven 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 10 per cent) on repatriated profits in order to lure much of this money back home. MinnPost pointed out some observers estimate the change could tip an extra US$250 billion into federal government coffers.
Australia is not the US
Unfortunately for the Australian Government, it does not have a similar pot of potential revenue to draw on 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 offset the cost and put its finances on a path to recovery.
However, a soft employment market and near-stagnant wages growth has forced the Australian Government to downgrade its anticipated tax take from workers and shoppers. It has trimmed A$6.3 billion from its four-year forecast for individual and other withholding tax revenue in its 2017-18 budget, and expects to receive A$2.5 billion less from the goods and services tax than it originally thought.
The Australian Government also predicts, however, that in the short term corporate tax revenue will pick up on the back of stronger global commodity prices, tipping an extra A$6.9 billion into its coffers. Added to this, the 0.5 per cent increase in the Medicare levy, starting in 2019, combined with a levy on the major banks and the new charges on businesses employing foreign skilled workers are expected to raise an extra A$14.9 billion over four years.
These measures, in tandem with a swathe of cuts to higher education spending, welfare payments and price cuts for subsidised medicines, are expected to help drive the federal budget back into surplus in 2020-21, even accounting for the cut in the corporate tax rate to 27.5 per cent.
Some, such as CPA Australia head of policy Paul Drum, have questioned the government’s forecast for GDP growth to accelerate to 3 per cent by 2018-19, 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”.
“There are still underlying structural issues in our economy that have not been effectively addressed in this budget,” Drum says.
For example he says that the government remains overly reliant on both individual and company income tax revenue, and it 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 that hoped-for increase in investment, productivity and wages, that moment may come sooner than Australia’s leaders expect.
Who gains the most when company taxes go down?
The Australian Government’s A$65.4 billion push to cut corporate taxes has been characterised by some as a handout to big business. However, as with anything to do with the tax system, the reality is more complex.
Australia’s system of dividend imputation, under which domestic investors receiving fully franked dividends are effectively taxed at their personal marginal rate while offshore shareholders are not, mean the biggest beneficiaries in the first instance will be foreign investors.
“Clearly there will be a net loss [from Australia] to foreigners [in the short term],” says John Freebairn from the University of Melbourne. “Some of the tax cut flows straight from the Australian Treasury to international investors.”
Jim Minifie from the Grattan Institute calculates that a cut in the corporate tax rate to 25 per cent would result in a 7 per cent jump in the rate of return for those offshore, compared with just 2 per cent for domestic investors.
If the increased rate of return results in more foreign investment, then the balance of benefit is likely to shift.
Treasury officials and other economists, such as former Treasury secretary and now National Australia Bank chairman Ken Henry, think the boost to foreign capital will encourage investment in equipment, machinery and skills, boosting productivity and raising wages.
“There are still underlying structural issues in our economy that have not been effectively addressed in this budget.” Paul Drum, CPA Australia
In an influential analysis published in 2014 that looked at company tax in Australia, Treasury concluded that the biggest winners from a company tax rate cut were workers, because in the long term at least half the benefit would end up in their pockets in the form of higher wages and more jobs. In comparison, investors would receive a third of the benefit.
However, as Victoria University economist Janine Dixon points out, this is not the end of the story.
Company taxes are an important source of revenue for the government, and Dixon says the funds forgone from a reduction in the corporate tax rate will add to the deficit, increasing the pressure for spending cuts or alternative imposts.
In addition, although GDP grows, foreign remittances also rise, with the net effect being a fall in gross national income, and this concerns Dixon.
“It is national income, and not production, that provides an indicator on living standards,” she says. “Overall, we conclude that while a cut to company tax will boost domestic production, it will lead to a fall in real incomes in present value terms … [of] the order of A$800 to A$2000 per person.”
In addition, any boost to wages will be offset to some extent by higher taxes and other imposts levied to help pay for the company tax cut, Dixon argues. The increased cost of labour (if, as forecast, wages rise after a corporate tax cut) will also make life harder for locally owned small and medium enterprises that do not benefit from a lower corporate tax rate to anything like the extent of foreign investors.
Dixon’s analysis has come under vigorous challenge. Business Council of Australia chief executive Jennifer Westacott told the Australian Financial Review that Dixon’s findings reflected “a highly theoretical view of the world rather than the reality of how Australia, in the context of a global economy, operates”. Dixon’s approach has also been disputed by the Minerals Council of Australia and the Australian Chamber of Commerce and Industry.
While a company tax cut is likely to help the economy to grow, just who gains most from the change is likely to remain hotly debated.
Dodging is dead
The days of stashing cash in an exotic locale out of the reach of the taxman are rapidly coming to an end. Pascal Saint-Amans, director of the OECD’s Centre for Tax Policy and Administration, has spearheaded a multinational drive to shut down zero-tax havens such as the Cayman Islands. He senses victory is close.
The BEPS (base erosion profit shifting) Project seeks to shut down the notorious habit of multinational companies shifting their profits to zero-tax jurisdictions, depriving source and host countries of an estimated US$240 billion in revenue.
“The consequence of the BEPS Project if it works, and we think it is likely to work, will realign the location of the profits with the location of the activity and therefore kill the zero-tax jurisdictions. I think the schemes where you have all the profit in Bermuda are over,” he says.
Critics complain that it will undermine tax competition between countries, bringing the downward drift of tax rates in recent decades to a stop.
However, Saint-Amans argues that far from reducing company tax competition between countries, eliminating zero-tax havens and bringing effective tax rates more into line with nominal rates will only serve to intensify it.
Instead of complex arrangements shuffling contracts and other transactions from high-tax to low-tax regimes, companies seeking to lower their tax bill will face more straightforward choices.
“If you want to take advantage of the 12.5 per cent [company tax rate] in Ireland you need to move people there. It means that countries are likely to try to be more attractive to the real activities by reducing their rates, and that is something that we can see with the UK move [in April the UK reduced its corporate profits tax to 19 per cent; it drops to 17 per cent from 2020] and some others,” Saint-Amans says.
He expects the gap between nominal and effective company tax rates will narrow, bringing nominal rates into sharper focus and increasing the incentive for countries to compete to reduce their corporate tax imposts.
However, the need for tax revenue, and the constraint of ensuring corporate tax rates do not undercut those for personal income, should put a floor under company tax rates. Saint-Amans predicts that small, open economies such as Singapore and Ireland will be able to afford corporate tax rates in the range of 12.5 to 19 per cent, while larger economies with bigger funding needs will rarely go below 20 per cent.
The global race to slash company tax rates: where will it end?