It is often argued that reductions in the corporate tax rate are necessary to create employment, increase investment and deliver a range of other benefits to the Australian community. However, despite the widespread support for this view, particularly among the business community, the theoretical and empirical case for such an expensive change in policy is weak.
Between 1960 and 1987, with high company taxes, investment in the private sector averaged 20.7 per cent of GDP. In the period since 2001 with a decrease of corporate tax to 30 per cent, it was 22.1 per cent. This increase of one per cent of GDP in private investment is more than accounted for by the sales of public utilities and the mining boom. Also other economic variables have not been significantly affected. Since 2001, with the lower tax, the unemployment rate has averaged 5.2 per cent. Between 1950 and 1987 when the tax was 45 to 49 per cent the average unemployment rate was 3.3 per cent.
Some people even argue that company tax is really a tax on wages. The logic is that with company tax the company has to increase its prices to cover that tax to preserve after-tax profit. The increase in prices is equivalent to a reduction in wages (adjusting for inflation). But that does not show up in the evidence.
From 1940 to 1987 the corporate tax rate was fairly stable within the range 45 to 49 per cent but since 2001 the rate has been 30 per cent. If the corporate tax is at the expense of wages then the reduction in corporate tax should have produced an increase in wages. That is easy to check.
Australian Bureau of Statistics figures show that from 1960 to 1987 (45 per cent corporate tax) the wages of total factor income was 57 per cent. If this thesis were correct the 2001 drop to 30 per cent corporate tax would result in the wages share to increase to 66 per cent. But what happened? The wages share since 2001 has fallen to 54 per cent which severely contradicts the proposition.
What about the theory?
The obvious point to make about company tax is that it is levied on profits. Before being liable for any tax the company has to have covered all expenses including notional expenses such as the allowance for depreciation and amortisation as well as any capital write downs. So no matter what the rate of company tax, it is only paid when the business has covered expenses. As Nobel Prize winning economist Stiglitz puts it 'if it were profitable to hire a worker or buy a new machine before the tax, it would still be profitable to do so after the tax...'. What is so striking about claims to the contrary is that they fly in the face of elementary economics: no investment, no job that was profitable before the tax increase, will be unprofitable afterward.
As it happens the US Congressional Research Service has recently reviewed the empirical evidence that might or might not support claims to the effect that lower company tax rates increase economic growth, boost employment and the like. It generally debunks the notion that lower company taxes are beneficial in the ways often suggested.
If the business interests and others who advocate cutting corporate tax rates were just motivated by the impact on employment and investment then there are much better policies that could achieve the same end.
It is worth making the point that some of the recent discussion of company tax completely neglects the role of company tax in the overall progressivity of the tax system and the need for a company tax high enough to deter the use of the corporate form as a tax avoidance device by high income earners. Indeed, ever since the Barwick High Court it has been imperative that the company and top personal tax rates be aligned as closely as possible to counter tax avoidance.
A good deal of the debate overlooks the role of dividend imputation which Keating introduced in the 1980s. Before then profits were taxed in the hands of the company and then again in the hands of the shareholder when profit was distributed as dividends to shareholders. Under the system Keating introduced, people who get dividends have to pay tax but they get a credit for company tax already paid. Over all the tax on profits (company plus individual) cannot exceed the personal tax rate. In Australia the maximum tax rate is 46.5 per cent (with the Medicare levy).
In most other countries profit is still taxed with both a company tax and then at the personal level when dividends are paid at to shareholders. The practical effect of that is that the tax on profit is a maximum of 46.5 per cent in Australia. In theory, countries such as the UK and US have lower company tax rates but the effective tax on profits by the time it is received by investors is 51.4 and 56.5 per cent respectively. Ireland boasts a company tax rate of only 12.5 per cent but by the time the dividends are paid to shareholders in Ireland the tax on profit is higher than Australia.
Given imputation it can be strongly argued that an assessment based on company tax alone is based on an incomplete view of the Australian system of profit taxation.
What about International tax competition?
An important strain of the argument is concerned with Australia's attraction as an investment destination relative to the rest of the world. The idea is that the various countries are competing for investment and that the most competitive will win. This assumes that all potential investors collectively have limited investment budgets and will go to only the most profitable host nation.
In practice we observe for example mining companies investing in projects in many countries at once, even though the fiscal and other attractions are vastly different. Companies with investment projects in Australia also have undertakings in Africa, the Gulf of Mexico, and so on. So long as a project meets the Stiglitz condition, it covers its costs, a company that did not go ahead would be voluntarily ignoring a profit opportunity. In addition we find a good deal of foreign investment in Australia from Asian countries with much lower company tax rates, in apparent contradiction of the argument that we would be losing out to those economies. In 2011 China was the third highest foreign investor in Australia by value while India was fifth, Singapore was sixth, Thailand 12th, and Malaysia 14th. The simple point is that Australia attracts investments originating in the very economies that are supposed to have much more competitive taxation systems.
It is also worth noting that foreign investment dominates large parts of the Australian economy. For example the mining sector is estimated to be 83 per cent foreign-owned. With that level of foreign ownership a reasonably high company tax rate is necessary to ensure that at least some of the benefits of the mining industry remain in Australia.
Even if it were true that lower company tax rates attracted foreign investment it may not necessarily benefit Australians, especially if it just displaces Australian investment. Huge capital intensive projects with 100 per cent foreign ownership offer very little in the way of local employment or other input purchases and any profit flows overseas in any case. When the Reserve Bank tries to keep unemployment at around 5 per cent it is hard to argue that additional foreign investment is going to help the Australian workforce. In addition these projects impose costs on the rest of Australia via exchange rate. Tax forces at least some of those profits to remain in Australia.
Analysis by the US Congressional Research Service showed there was no convincing empirical evidence that suggested international capital flows were influenced by international differences in corporate tax rates.
Of course none of this addresses the international tax avoidance issue. International tax avoidance is rampant and multinational companies operating in a number of countries will attempt to shift paper profits to where tax is lightest. When talking about tax avoidance the threat is not other OECD countries that may have rates plus or minus 5 points around the Australian rate, but rather the tax havens which often have no tax at all. While it may be argued that such tax avoidance could be addressed by lowering tax rates, that would be throwing the baby out with the bathwater. The OECD is trying to address international tax avoidance and Australia has said it will raise international tax avoidance with the G20 group of countries.
There is another very important pragmatic argument for not reducing Australia's tax rate so long as it is at or around the rate of many of our foreign investment source countries. Australia has a double tax agreement with most countries in the world so that the same income is not taxed twice. The US Internal Revenue Service gives taxpayers credit for tax paid overseas. Hence if Australia were to lower its rates a US company would pay less here but then pay the difference between the two rates to the US. The US Treasury would win at the expense of the Australian tax system. For a company based in New York paying 40 per cent company tax, changes in the Australian rate will not affect their decision-making.
Download the full report "The case against cutting the corporate tax rate"
By David Richardson
Senior Research Fellow
The Australia Institute