Why corporate tax reform is tricky

But designing a better corporate tax system is tricky. Across tax experts, economists, and even among the business community that stands to gain the most, there is no agreement on the right model.

The only significant corporate tax change of recent years – cutting the rate from 30 per cent to 25 per cent for companies with turnovers of less than $50 million – was fairly easy because it was not especially costly for the budget, and it played well politically.

One proposed reform is to extend this tax cut to all companies. Australia’s headline rate of 30 per cent has not shifted for two decades (excluding the tax cuts for small firms), even as the OECD average has fallen from 31.4 per cent in 2001 to 23.9 per cent today. But this would be eye-wateringly expensive, and would cost the budget about $18 billion in 2025-26.

Although a lower rate would be likely to make Australia more attractive for new foreign investment, it would provide a windfall tax cut for existing investments. And simply cutting the tax rate doesn’t address the deeper issues with the design of company tax. To fix these aspects, there is a menu of alternatives, each with pros and cons on the economics, implementation, and political viability.

A cash-flow tax – a tax on business cash inflows minus outflows – would only tax companies’ excess profits from investments, while removing the current bias towards debt over equity finance. The Productivity Commission recommends a small cash-flow tax to boost business investment. Although sound in theory, such a tax is largely untested in practice, and the transition from the current system would be challenging.

It should be evident that none of these ideas are easy politically.

A simpler path could be to keep the existing company tax system, but to expand the instant asset write-off to all investments. However, enthusiasm for such tax breaks should be tempered: recent Reserve Bank research suggests that temporary instant asset write-off policies in the 2010s did little to boost investment.

An allowance for corporate equity is a third alternative. This would allow companies to deduct the cost of equity finance from taxable income. It would tax only excess profits from investments and reduce the debt bias. But it would also be expensive, as it would increase the size of the deductions a company can make on any investment.

An option to ease the fiscal impact could be to remove or pare back Australia’s unusual dividend imputation system. Ending franking credits would raise revenue, but it’s politically tough because franking credits are very popular among retirees and retail investors.

For all this, the impact of corporate tax reform on business investment is likely to be modest. Modelling for the Productivity Commission suggests that a 5 percentage-point cut to the corporate tax rate, paid for by higher personal income taxes, would boost productivity by 0.8 per cent and GDP by just 0.6 per cent. Under the PC’s preferred approach of a 5 per cent cash-flow tax and a tax cut for businesses with turnover of less than $1 billion, the modelling suggests a 0.3-to-0.4 per cent boost to productivity, a 0.2-to-0.4 per cent boost to GDP, but no change or a small fall in real wages from revenue-neutral corporate tax changes.

In other words, corporate tax reform is worthwhile, but not game-changing. That is the world we’re in: we need to think about a broad set of economic reforms with smaller payoffs that will add up over time.

However, the productivity and economic growth dividends are not large enough to pay for tax cuts or a new system, such as an allowance for corporate equity, which has a large upfront cost.

Two main options

This leaves two main options to fund major corporate tax changes.

The first is to make them budget-neutral across the business tax system. The Productivity Commission took this approach, proposing higher taxes on very large companies and lowering them for small ones. Another approach would be to make changes to business taxation more broadly by getting a bigger share of economic rents from resources through tweaks in the Petroleum Resource Rent Tax or new rent taxes on other resources.

The second option is to pair corporate tax reform with increased revenue from more efficient taxes. The best option here is broadening and/or lifting the GST.

It should be evident that none of these ideas is politically easy.

These conditions mean the burden of persuasion falls on business groups. If business wants change, it needs to do more than just call for “lower taxes”. It needs a clear model, a credible way to fund it, and a persuasive case to win over the public.

Until business groups make that case clearly and convincingly to voters, Australia’s corporate tax system will remain stuck where it is.