IAN McAULEY. Can we please have a more intelligent debate about corporate taxes

The simple explanation behind the Commonwealth’s proposal to cut corporate taxes is in terms of a struggle between the interests of business and of the broader community, but it is also about the Coalition’s determination, under pressure from vested interests, to wind back the economic reforms of the Hawke-Keating Government. 

The Hawke-Keating Government made two far-reaching reforms of Australia’s corporate taxes.

The first, in 1985, was to introduce a well-designed capital gains tax system, carefully calibrated to encourage long-term investment while discouraging speculation. Under pressure from the finance sector the Howard Government undid those reforms in 1999.

More on capital gains taxes next week: for now I will focus on dividend imputation.

Dividend imputation dates from 1987. When Australian shareholders receive a dividend from a corporation they receive a tax credit for company tax already paid on the profits that have funded that dividend.

Most of what passes for public debate on corporate taxes has ignored the effects of imputation, focussing instead on headline rates, which, for our largest companies, are 30 per cent. (Under thedeal with the Senate, the rate is to phase down to 25 per cent for companies with annual turnover below $50 billion.)

That headline rate is indeed high in comparison with the rates applying in other “developed” countries, and a 25 per cent rate would bring us more in line with those other countries.  But that’s before considering imputation, which effectively lowers the tax rate paid by investors. For a company paying out half its profits as dividends – a typical long-term payout ratio for Australia – the effective corporate tax rate for the investor is only 15 per cent, which puts us among the very lowest among comparable countries. Unsurprisingly, the corporate lobby groups crying out for tax cuts have failed to mention imputation.

One may ask why Treasurer Keating went for dividend imputation. While in office the Hawke-Keating Government did cut corporate taxes, from 46 per cent to 36 per cent, but why, in 1987, did they not simply cut corporate taxes further, rather than bringing in imputation?

The answer lies in two distinct aspects of imputation, both particularly suited to Australia’s economic situation.

The first is that imputation apples only to domestic investors. In a country which, in spite of successive mining booms, has a chronic deficit on current account, it makes sense to privilege domestic investors over foreign investors in order to reduce dependence on foreign capital. The main beneficiaries from a tax cut for large corporations would be foreign investors: as David Richardson of the Australia Institute explains, it would be “a gift to foreign investors”. Imputation should be seen in the context of Treasurer Keating’s other move to mobilise domestic saving and investment through compulsory superannuation.

As I suggest in a recently-published New Matilda article, the Commonwealth’s enthusiasm for tax cuts at the top end of town is to keep up this flow of foreign investment – to wring a few more years’ life out of our economic model of using foreign investment to support our demand for foreign-sourced consumer goods.

That model may have made sense when Australia was essentially a high-growth developing country, particularly in the postwar years, but in a country with modest economic growth, as Australia has become, it’s dangerous to expect foreigners to go on financing our lifestyle. Our net foreign liabilities at $1.02 trillion, are now 60 per cent of GDP, one of the world’s highest.

The second aspect of imputation, relevant to Australia’s situation, is that it encourages companies to pay dividends rather than to retain earnings for re-investment in their own firms.

At first sight, when we think of domestic investors with their parcels of shares, we may believe that such an incentive encourages investors to go out and spend, but in fact the bulk of shares in listed companies (and in many unlisted companies) are held by superannuation funds and other financial institutions, which tend to re-invest dividends. Even self-managed superannuation funds must re-invest dividends in their accumulation phase.

Those re-investments will not necessarily be in the same firms that pay those dividends. As economists point out, and as Keating and the Treasury Department were well aware in 1987, it’s often better to have investable funds in the hands of comparatively disinterested parties rather than corporate executives and boards. This is particularly relevant for a medium-sized country where, in many industries, there is the potential for monopolisation and other concentrations of market power.

Lobby groups such as the  BCA claim to speak for “business interests”, but such claims should be met with a solid dose of scepticism. Businesses themselves are not incarnate beings, but their stakeholders – employees, customers, investors – are, and they all have their own interests.

The most powerful of those stakeholders are the elites within existing large corporations – the senior managers and board members. As any student of business knows, contrary to the models in economics textbooks (models of pure “principal-agent” relationships), their objectives are more about growth, particularly short-term growth, rather than long-term profitability. Growth means higher salaries, more prestige, a higher rank on the stock-exchange league tables, a taller office tower,  a corporate jet ….

A reasonably high headline corporate tax rate, combined with imputation, goes some way to countering this bias that favours managers over investors. It provides an incentive to allocate corporate profits to where long-term returns are highest, and by the simple laws of diminishing returns that is unlikely to be in firms that are already big. Some of those high returns may be in entrepreneurial startups which have little interest in corporate tax rates because the day when they will be profitable enough to be liable for tax (having carried through losses) is probably well into the future.

Unfortunately, apart from some Fairfax journalists, few commentators in the mainstream media have raised these issues in the current tax debate – a debate that is likely to continue well past next month’s budget. The Murdoch media have been characteristically on the side of established large corporations, and the ABC has virtually ignored these complexities: in its influential Radio NationalBreakfast program, for example, the journalists have failed to challenge politicians when they argue about headline tax rates, and there has been no mention of the broader economics of imputation and its relevance to Australia’s situation.

Ian McAuley is an Adjunct Lecturer in Public Sector Finance at the University of Canberra and a Fellow at the Centre for Policy Development. 


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7 Responses to IAN McAULEY. Can we please have a more intelligent debate about corporate taxes

  1. Wayne McMillan says:

    Thanks Ian for some clear enlightenment on a complex area of taxation.

  2. bushwalker says:

    The comments you make on dividend imputation (DI) are totally irrelevant. DI is there to avoid double taxation of dividends. Shareholders are owners of the company and the earnings of the company are attributable to them. So when the company pays tax on its earnings it is paying tax on behalf of the shareholders who own those earnings. From its after tax earnings the company then pays dividends to shareholders who must declare that as income and pay tax on it. DI is simply an application of tax justice for taxpayers who earn their income from dividends.

    • Ian McAuley says:

      Thanks Bushwalker,

      A policy initiative can have more than one purpose, and eliminating double taxation of dividends was certainly one of them. Indeed, it was the main selling point of imputation, and it was popular with a constituency that was not a normal source of Labor support. But that doesn’t negate its other purposes.

      It would have been hard to have presented the policy to the electorate in terms of portfolio allocation theory — hardly exciting content for the 7 pm TV news. It’s pretty hard getting postgraduate students excited about it, let alone the average swinging voter.

      That said, I believe it is unfortunate — indeed patronizing — that politicians don’t explain the full reasons for their policies to the general public.

  3. Bruce says:

    As a former company director (very small) the idea of a reduction in tax increasing employment is ludicrous. Employment costs are a tax deduction and as such any money that goes to employing people is not taxed anyway. As you have said any reduction in company tax rates is purely for foreign investors who are the most unlikely to reinvest those profits into employment. Like many another policy, it is a very dubious and they get away with it because the vast majority of people have no understanding. The rationale for most business to incorporate is simply the tax rate is lower than the highest personal rate and to avoid liability if the business goes sour.

  4. Don Macrae says:

    Ian, would you mind explaining how it is that dividend imputation encourages dividends over retained earnings?

    • Ian McAuley says:

      Thanks Don,

      It’s a question of investor demand. Investors seek some combination of dividends and capital gain. If dividends are made comparatively attractive, e.g. through imputation, there is more demand for a payout. If capital gain is made more attractive, e.g. through the Howard changes, there is more demand for firms to retain earnings.

      Of course the other side of the demand-supply equation is the firm’s response. If the firm’s managers and directors feel they can ignore investors completely, they may not respond, but if they feel investors have some power, they will respond.

  5. Jaquix says:

    Great to see this issue getting some airing, and allowing a bit of reason into “what passes for debate” on this and so many other issues today. Housing is another. So much rubbish is peddled, from the Treasurer downwards, and everyone ends up running around chasing their tails. We need THE WHITEBOARD – for jotting down all the problems (and good points like imputation in the article), and possible solutions, AND the effects of same.

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