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Sorry Treasurer, but your corporate tax sums are not adding up

Analysis | 17 April 2018

John Taylor

Professor

Peter Swan

Professor

New research refutes the benefits of a proposed cut in the top rate

Supporters of a cut in the Australian corporate tax rate argue it will increase investment, which in turn will stimulate the economy and create more jobs and higher wages.

But Peter Swan, a professor of finance at UNSW Business School, questions this assumption, based on his latest research on the taxation of corporate profits and the flow-on effects of changing the headline rate.

Swan's paper, Investment, the Corporate Tax Rate, and the Pricing of Franking Credits, comes as the Coalition government makes its case to the Senate cross-benchers to pass its tax bill, which would progressively reduce the corporate tax rate for large businesses to 25% from the present 30%.

Proponents of the corporate tax cut argue it will make Australia a more attractive place for foreign investors and the extra capital coming in from offshore will raise real wages and increase economic growth.

However, Swan says this view presupposes that foreign marginal investors pay the headline tax rate and thus are unable to time their trades with Australians to gain full value from recycling franking credits.

Marginal investors are defined as those who are most likely to either withdraw or increase their investment if returns change and consequently are the investors who 'set' the price of an investment in a market.

Thus, the pro-tax cut argument goes, if foreign investors pay less tax on the returns from their Australian assets, they will invest more. But Swan's research implies that, even before the tax cuts, they are not paying tax.

Hence, cutting the tax rate will not influence investment. Moreover, Australia is fortunate in that it has already accomplished an efficient and desirable level of investment.

Even the research of the strongest advocates for tax cuts shows that the Budget bottom line will worsen by almost $5 billion each year, and once this gap is filled by 'bracket creep' – that is, not indexing taxes for inflation – the rise in after-tax wage will be negligible (0.25%) and employment will fall.

'These tax cuts are unlikely to add significantly to investment ... How then are we going to suddenly become richer? It just doesn’t make any sense'
PETER SWAN

Close to zero

Swan's argument hinges on his research about imputation credits and whether foreigners receive the benefit of these credits which are supposed to be reserved for Australians.

Under Australia's system of dividend imputation, individual Australian taxpayers receive a credit for the corporate tax a company has already paid.

So, if a company earns $1 and then pays 30c tax at the corporate rate of 30% and pays the remaining 70c to a shareholder as a dividend, the shareholder receives a tax credit for the 30c tax already paid, the same as if they had paid it themselves.

The result is the amount of tax the individual has to pay on their dividend is reduced and in some circumstances they may pay no tax or even receive a refund.

The system also means that for individual Australian taxpayers, the rate of company tax is irrelevant, because the amount of tax they ultimately pay on dividends is determined by their own marginal income tax rate, not the corporate tax rate.

The company tax rate is important for foreign investors because they cannot use imputation credits themselves but, under Australian law, they can sell these credits to eligible Australians 47 days prior to the franking credit being paid and then repurchase the stock.

In this way, their effective tax rate is close to zero. Common wisdom is that imputation credits are not (fully) priced into share prices while tax cut advocates assume negligible pricing.

However, Swan has conducted an analysis of the return on every stock since the 30% tax rate was introduced almost two decades ago.

By comparing the amount of systemic risk faced by stocks with franking credits with those without, he found that franking credits were either fully priced or very close to fully priced, because the return Australian investors were receiving is – after taking account of the effect of imputation credits – similar to the supply price of global investors in the absence of any corporate tax.

In contrast, unfranked dividends (not receiving a credit) from Australians investing overseas require the global return on capital and, in addition, the full burden of Australian corporate taxation.

Better off as things are

According to Swan, it is both the marginal Australian investor and the marginal foreign investor, with neither paying corporate tax, who are the beneficiaries of Australia's franking credit system.

Moreover, this is an ideal outcome for Australia as it gains the largest and most efficient corporate sector undistorted by taxes. There are no tens of billions of dollar notes left lying on the table due to inefficient taxing of foreign capital.

This means that all Australians are better off as things are with no cuts to the corporate tax rate and no watering down of the system of imputation.

And since the present design of the imputation system and current tax rate provide the best of all possible worlds and an efficient level of investment, the last thing Australia should do is cut the corporate tax rate. This could well reduce rather than increase the level of investment, Swan says.

He also notes that most foreign investment in Australia is in mining because Australians are over-committed to mining, and some investment isn't so much motivated by earning a marginal return as by extracting rents from Australia's diminishing mineral deposits. Continuing to gain a return from these rents is of vital national importance.

"The government has estimated that it will collect $65 billion less in revenue as a result of tax cuts over the next 10 years. These tax cuts are unlikely to add significantly to investment since investment is already at its maximal (and efficient) level. How then are we going to suddenly become richer? It just doesn't make any sense," Swan says.

"It will cost every man, woman and child approximately $2500. Where is the case to show that higher investment, even in the unlikely event that it were to eventuate, would yield a gain of this magnitude, even in the longer term?"

Swan says the government would have to increase its taxation of locals, or cut expenditure by this amount, to make up for the lost revenue. Even the most optimistic modelling by proponents of the tax cuts indicates negligible benefit for workers, and lower employment.

'... there may be a tendency to retain more profit given that a greater proportion of tax will be paid at the shareholder level'
JOHN TAYLOR

Distributing profits

John Taylor, a professor in the school of taxation and business law at UNSW Business School, agrees that for many local investors the corporate tax rate is unimportant, because the amount of shareholder-level income tax they ultimately pay on company earnings is based on their own personal tax rate, not the corporate tax rate.

However, he says this view presupposes that a company distributes its profits via dividends rather than retaining them.

"Given that individuals, trusts and super funds get discounts on capital gains there may be a tendency to retain more profit given that a greater proportion of tax will be paid at the shareholder level," Taylor says.

Further, small businesses – which have already received a corporate tax cut to 25% – could be tempted to retain their profits and find 'creative' ways of using them rather than paying dividends.

There are rules to stop business owners misusing company profits, but Taylor says "the bigger the gap between the corporate rate and the personal income tax rate the more pressure you're placing on these sort of rules".

The recent corporate tax cuts in the US have given renewed impetus to the push for tax cuts in Australia, with proponents stating Australia will become less internationally competitive.

However, Swan warns against drawing parallels with the US, because the two taxation systems are so different. The US doesn't have a dividend imputation system, so income tax is paid on top of corporate tax and this is a huge incentive for US companies to leave profits offshore.

By cutting the tax rate and providing discounts for repatriating profits, the recent US tax cuts will bring more money back into the US and hence boost its economy.

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<h1>Sorry Treasurer, but your corporate tax sums are not adding up</h1>

<figure><img src="https://assets-us-01.kc-usercontent.com:443/4df0558d-5779-0012-00f2-b3fa06d6c950/3692a48c-df50-4dd1-8d7e-77c0e0f43de5/iStock-529684030.jpg?w=1320" alt="tax cuts" /><figcaption>tax cuts</figcaption></figure>
 Supporters of a cut in the Australian corporate tax rate argue it will increase investment, which in turn will stimulate the economy and create more jobs and higher wages.
But Peter Swan, a professor of finance at UNSW Business School, questions this assumption, based on his latest research on the taxation of corporate profits and the flow-on effects of changing the headline rate.
Swan's paper, Investment, the Corporate Tax Rate, and the Pricing of Franking Credits, comes as the Coalition government makes its case to the Senate cross-benchers to pass its tax bill, which would progressively reduce the corporate tax rate for large businesses to 25% from the present 30%.
Proponents of the corporate tax cut argue it will make Australia a more attractive place for foreign investors and the extra capital coming in from offshore will raise real wages and increase economic growth.
However, Swan says this view presupposes that foreign marginal investors pay the headline tax rate and thus are unable to time their trades with Australians to gain full value from recycling franking credits.
Marginal investors are defined as those who are most likely to either withdraw or increase their investment if returns change and consequently are the investors who 'set' the price of an investment in a market.
Thus, the pro-tax cut argument goes, if foreign investors pay less tax on the returns from their Australian assets, they will invest more.  But Swan's research implies that, even before the tax cuts, they are not paying tax.
Hence, cutting the tax rate will not influence investment. Moreover, Australia is fortunate in that it has already accomplished an efficient and desirable level of investment.
Even the research of the strongest advocates for tax cuts shows that the Budget bottom line will worsen by almost $5 billion each year, and once this gap is filled by 'bracket creep' – that is, not indexing taxes for inflation – the rise in after-tax wage will be negligible (0.25%) and employment will fall.
<blockquote>'These tax cuts are unlikely to add significantly to investment ... How then are we going to suddenly become richer? It just doesn’t make any sense'PETER SWAN</blockquote>
<h4>Close to zero</h4>
Swan's argument hinges on his research about imputation credits and whether foreigners receive the benefit of these credits which are supposed to be reserved for Australians.
Under Australia's system of dividend imputation, individual Australian taxpayers receive a credit for the corporate tax a company has already paid.
So, if a company earns $1 and then pays 30c tax at the corporate rate of 30% and pays the remaining 70c to a shareholder as a dividend, the shareholder receives a tax credit for the 30c tax already paid, the same as if they had paid it themselves.
The result is the amount of tax the individual has to pay on their dividend is reduced and in some circumstances they may pay no tax or even receive a refund.
The system also means that for individual Australian taxpayers, the rate of company tax is irrelevant, because the amount of tax they ultimately pay on dividends is determined by their own marginal income tax rate, not the corporate tax rate.
The company tax rate is important for foreign investors because they cannot use imputation credits themselves but, under Australian law, they can sell these credits to eligible Australians 47 days prior to the franking credit being paid and then repurchase the stock. 
In this way, their effective tax rate is close to zero. Common wisdom is that imputation credits are not (fully) priced into share prices while tax cut advocates assume negligible pricing.
However, Swan has conducted an analysis of the return on every stock since the 30% tax rate was introduced almost two decades ago.
By comparing the amount of systemic risk faced by stocks with franking credits with those without, he found that franking credits were either fully priced or very close to fully priced, because the return Australian investors were receiving is – after taking account of the effect of imputation credits – similar to the supply price of global investors in the absence of any corporate tax.
In contrast, unfranked dividends (not receiving a credit) from Australians investing overseas require the global return on capital and, in addition, the full burden of Australian corporate taxation.
<h4>Better off as things are</h4>
According to Swan, it is both the marginal Australian investor and the marginal foreign investor, with neither paying corporate tax, who are the beneficiaries of Australia's franking credit system.
Moreover, this is an ideal outcome for Australia as it gains the largest and most efficient corporate sector undistorted by taxes. There are no tens of billions of dollar notes left lying on the table due to inefficient taxing of foreign capital.
This means that all Australians are better off as things are with no cuts to the corporate tax rate and no watering down of the system of imputation.
And since the present design of the imputation system and current tax rate provide the best of all possible worlds and an efficient level of investment, the last thing Australia should do is cut the corporate tax rate. This could well reduce rather than increase the level of investment, Swan says.
He also notes that most foreign investment in Australia is in mining because Australians are over-committed to mining, and some investment isn't so much motivated by earning a marginal return as by extracting rents from Australia's diminishing mineral deposits. Continuing to gain a return from these rents is of vital national importance.
"The government has estimated that it will collect $65 billion less in revenue as a result of tax cuts over the next 10 years. These tax cuts are unlikely to add significantly to investment since investment is already at its maximal (and efficient) level.  How then are we going to suddenly become richer? It just doesn't make any sense," Swan says.
"It will cost every man, woman and child approximately $2500. Where is the case to show that higher investment, even in the unlikely event that it were to eventuate, would yield a gain of this magnitude, even in the longer term?"
Swan says the government would have to increase its taxation of locals, or cut expenditure by this amount, to make up for the lost revenue. Even the most optimistic modelling by proponents of the tax cuts indicates negligible benefit for workers, and lower employment.
<blockquote>'... there may be a tendency to retain more profit given that a greater proportion of tax will be paid at the shareholder level'JOHN TAYLOR</blockquote>
<h4>Distributing profits</h4>
John Taylor, a professor in the school of taxation and business law at UNSW Business School, agrees that for many local investors the corporate tax rate is unimportant, because the amount of shareholder-level income tax they ultimately pay on company earnings is based on their own personal tax rate, not the corporate tax rate.
However, he says this view presupposes that a company distributes its profits via dividends rather than retaining them.
"Given that individuals, trusts and super funds get discounts on capital gains there may be a tendency to retain more profit given that a greater proportion of tax will be paid at the shareholder level," Taylor says.
Further, small businesses – which have already received a corporate tax cut to 25% – could be tempted to retain their profits and find 'creative' ways of using them rather than paying dividends.
There are rules to stop business owners misusing company profits, but Taylor says "the bigger the gap between the corporate rate and the personal income tax rate the more pressure you're placing on these sort of rules".
The recent corporate tax cuts in the US have given renewed impetus to the push for tax cuts in Australia, with proponents stating Australia will become less internationally competitive.
However, Swan warns against drawing parallels with the US, because the two taxation systems are so different. The US doesn't have a dividend imputation system, so income tax is paid on top of corporate tax and this is a huge incentive for US companies to leave profits offshore.
By cutting the tax rate and providing discounts for repatriating profits, the recent US tax cuts will bring more money back into the US and hence boost its economy.

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