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Submission No. 15 Back to full list of submissions
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Business Coalition for Tax Reform

16/379 Collins Street, Melbourne VIC 3000 Telephone: 03 9610 4208 Fax: 03 9610 4223

SUBMISSION

to the
REVIEW OF BUSINESS TAXATION's
First Discussion Paper

A STRONG FOUNDATION

DECEMBER 1998

Executive Summary

The Business Coalition for Tax Reform (BCTR) appreciates the opportunity to participate in the Review of Business Taxation and welcomes the consultative character of the Review's processes.

This submission reflects the BCTR's approach of constructive engagement with the Review with the aim of contributing to a rebuilding of the business taxation system in a way that enhances Australia's ability to meet our economic and social objectives.

The BCTR accepts the broad approach of the Review's First discussion paper A Strong Foundation in identifying the flaws with the present business tax arrangements, tracing these to the absence of a firm foundation for business taxation and proposing that a rebuilt business tax system be based on clear national objectives and principles. The BCTR also applauds the Review's inclusion of the processes of policy design, legislative design and the administration of business taxation.

The submission makes a number of contributions to the issues raised in A Strong Foundation. These range across the specification of national objectives, the definition of the benchmark tax base, the consideration of entities as extensions of their ultimate owners, the treatment of tax incentives and the legislative and administrative design principles and processes including the proposal for a Board of Directors.

In all these instances the BCTR's contributions are intended to build constructively on the discussion initiated in A Strong Foundation.

In the same spirit we have attached for discussion a paper commissioned by the BCTR on the important question of the most appropriate direct business tax base.

Contact Person
Rosemary Krajina
Phone: (03) 9610 4208
Fax: (03) 9610 4223
e-mail:
rosemaryk@bca.com.au

 

1. Introduction

The Business Coalition for Tax Reform (BCTR) welcomes the opportunity to provide a submission to the Review of Business Taxation first discussion paper - A Strong Foundation. The BCTR supports the Government’s initiative to review the business tax system. Comprehensive reform of the business tax system has the potential to improve business competitiveness, encourage investment, promote savings, lead to higher economic growth and more jobs. The BCTR also appreciates the efforts of the Review team in this very substantial task and applaudes the consultative charter of the Review and the spirit in which this is being applied by the Review team.

The BCTR comprises almost 40 industry associations drawn from all sectors of the economy and represents small, medium and large business. Our members are listed below:

Australian Chamber of Commerce and Industry

Australian Institute of Petroleum

Aluminium Council

Association of Consulting Engineers Australia

Association of Superannuation Funds of Australia

Australasian Railway Association

Australasian Soft Drink Association

Australian Bankers Association

Australian Business Limited

Australian Constructors Association

Australian Food Council

Australian Hotels Association

Australian Industry Group

Australian Institute of Company Directors

Australian Retailers Association

Australian Society of CPAs

Australian Stock Exchange

Business Council of Australia

Corporate Tax Association of Australia

Employers Federation of NSW

Electricity Supply Association of Australia

Federal Chamber of Automotive Industries

Investment and Financial Services Association

Institute of Chartered Accountants

Insurance Council of Australia

Master Builders Association

Minerals Council of Australia

National Association of Forest Industries Ltd.

National Farmers Federation

Property Council

SA Employers Chamber of Commerce & Industry

State Chamber of Commerce NSW

Tasmanian Chamber of Commerce and Industry

Tourism Council of Australia

Urban Development Institute of Australia

Victorian Employers’ Chamber of Commerce and Industry

Victorian Automobile Chamber of Commerce

West Australian Chamber of Commerce and Industry

 

The BCTR was formed in October 1997 to co-ordinate business input to the taxation reform process. Following a detailed research effort and extensive discussions both within the business sector and with other groups in the community, the BCTR set out clear objectives and established five foundation principles for tax reform.

BCTR Objectives for Tax Reform

To enhance international competitiveness and fairness in taxation and to create a climate favourable for investment, job creation and saving.

BCTR Foundation Principles of Reform

  • The elimination or reduction of as many of the existing indirect taxes as possible.
  • Adoption of a single-rate consumption tax levied on as broad a base as practicable.
  • A remodelling of Federal/State financial relations.
  • Reductions in marginal rates of tax on income and simplifications to company taxation.
  • A reworking of the interface between the tax and social security systems to reduce the high effective marginal tax rates confronted by low and middle income Australians.

The Government’s tax reform proposals as announced in A New Tax System (ANTS) and the terms of reference to the business income tax review, are broadly consistent with these objectives and the foundation principles.

Whilst there are specific policy issues in the ANTS document which the BCTR would not endorse (such as the potential application of the deferred company tax measures to international investment flows), this submission is limited to the matters raised in the Review’s first discussion paper. Specifically, this submission relates the BCTR’s responses to the objectives, principles and processes outlined in the first discussion paper and does not address policy issues raised in the ANTS document.

2. The Scope of the Review

Business income, as described in the discussion paper, includes investment income of individuals. Clearly, individuals would not consider activities such as investment in a cash management trust or property trust as a business activity. Furthermore, it has been a longstanding practice of taxation of income generated by individuals that the taxation point is at the time of receipt. This must be remembered when designing business tax principles that apply to investors.

The BCTR supports the inclusion of Fringe Benefits Tax (FBT) in the scope of the Review. The taxation of fringe benefits is a business cost. The BCTR agrees with the Review that there is a high level of dissatisfaction with the current FBT arrangements and that they are in need of comprehensive reform.

The terms of reference of the Review impose a revenue neutrality constraint. The BCTR encourages the Review to consider this as a long term objective and one which does not prohibit short term investment (revenue reduction) for longer term economic growth and, therefore, increased revenue and prosperity for the nation.

The BCTR recognises that given the available time frame and the terms of reference of the Review, there will be dimensions of business tax reform that, though worthy of consideration will not able to be addressed in full. Accordingly, the BCTR submits that the Review give consideration to making recommendations to the Government for an ongoing reform agenda and the establishment of appropriate avenues for ongoing submissions on the development of policy.

3. The Need for Reform

The discussion paper sets out in detail why reform of the business income tax system is needed. The BCTR endorses the comments contained in chapters 2,3 & 4 of the discussion paper. In particular the BCTR broadly agrees with the connections drawn between the:

  • lack of a consistent foundation for business taxation,
  • widespread anomalies and unintended distortions to business decision-making,
  • complexity of the business tax system, and
  • many of the shortcomings in the present processes for the development of policy, legislation and administration.

Another dimension of the need for reform inherent in the present arrangements that might have been explored further is what can be characterised as the relationship gulf between the tax authorities and taxpayers. It may be argued that the less than satisfactory climate of relations between the tax authorities and taxpayers ultimately can be traced to the structural and procedural faults clearly identified in the Review’s paper. While there is undoubtedly a great deal of truth in this argument, it may, nevertheless, be useful to acknowledge and explore this problem further. One key reason for this is that the existing relationship gulf between the taxpayers and the tax authorities may stand as an obstacle to the development of the structural and procedural reforms necessary to remove the systemic factors that have tended to undermine relations in the past.

Additionally:

  • Whilst the discussion paper does refer to the need for reform to capital gains tax provisions, it does not highlight the significant obstacles to business re-organisation and investment decisions created by the capital gains tax provisions. Those provisions are in need of comprehensive reform.
  • The revenue costing of "selected tax concessions" in table 2.1 of the discussion paper is based on a premise that the appropriate benchmark to cost such "concessions" is an income tax base. The BCTR does not, necessarily, accept that benchmark and we have more to say on that issue later.

 

4. National Objectives

The BCTR supports the framework approach adopted by the Review and the need to establish appropriate national objectives for the business tax system. Australia’s business tax system needs a strong and level foundation on which to build a durable super structure.

The objectives put forward by the Review are broadly supported by the BCTR with the following qualifications:

  • International competitiveness and the creation of a climate favourable to national saving are seen by the BCTR as objectives that are fundamental to the business tax system. Whilst it is noted that balanced taxation of international investment is contained in proposed policy design principle no. 9, it is considered that international competitiveness and saving are of such importance as to merit consideration as national objectives in their own right.
  • The BCTR notes the review recommends that substantially increased weighting be accorded the national objective of simplification. Whilst the BCTR appreciates the need for trade-offs amongst the national objectives, it is questionable whether substantially increased weighting should, in fact, be given to simplification. Economic growth, international competitiveness and equity are considered to be of equivalent importance.
  • The BCTR views certainty of taxation outcomes as being as important as simplification of the business tax system. Whilst not detracting from the obvious benefits of simplification, the BCTR recommends that the third national objective be amended to read Facilitating Certainty and Simplification.

5. Policy Design Principles

The BCTR agrees with the Review that appropriate policy design principles are fundamental to an improved business income tax system. They constitute the highest level of supporting principle and, therefore, require careful consideration. Furthermore, depending upon whether each principle carries equal weighting, their impact on achievement of the national objectives will differ.

Principles Defining the Tax Base

Clearly, the key business tax design issue is the appropriate business tax base. The Review proposes, as a benchmark, a comprehensive full nominal income tax base. The alternatives are dismissed for reasons of their impact on revenue, difficulty of transition from the current hybrid base and lack of time given the terms of reference.

The BCTR accepts the advantages of a clear articulation of the benchmark tax base in terms of greater coherence and certainty. However, in the absence of more detailed consideration of an expenditure tax alternative or, indeed, a schedular approach to the income tax base, the BCTR must necessarily flag significant concern with the first three policy design principles dealing with the tax base. Furthermore, the BCTR submits that consideration be given to the advantages of the evolution over time of the business tax system in the direction of an expenditure as opposed to an income tax base. These potential advantages include the promotion of saving, investment, international competitiveness, long-term growth and job creation. As a contribution to further discussion of this issue, a paper prepared for the BCTR by Geoff Carmody of Access Economics is attached.

It is noted however that, in any given year, an expenditure tax would imply a narrower direct tax base relative to the present business tax base. It is acknowledged that, under the constraint of revenue neutrality, in the short to medium term at least, a movement in the direction of an expenditure tax base might imply a higher rather than a lower company tax rate.

A strict interpretation of the tax base proposed by the Review implies outcomes that would be difficult to accept without further clarification and analysis of impacts both at the industry and national levels. These could include, for instance, the taxation of unrealised gains, the removal of accelerated depreciation provisions, the spreading over a number of years expenditure currently allowed as an outright deduction, the removal of indexation of capital gains and the treatment of losses. Alternatively, a comprehensive income tax base should provide tax relief for all business expenses (removal of blackholes).

The discussion paper makes it clear that, strictly speaking, the comprehensive income tax base is a conceptual benchmark rather than an achievable outcome. A number of reasons are given for departures from the comprehensive income tax base. Some departures are judged necessary on practical grounds, others reflect policy considerations and another because it would be a threat to the revenue. These criteria are very broad and could, conceivably, cover a very wide range of departures from the comprehensive income tax base.

While this sort of flexibility clearly would carry advantages it may also detract from the coherence and certainty sought from the articulation of objectives and principles. The BCTR submits that consideration be given to the clearer specification of the reasons for departures from whatever benchmark tax base is proposed. For example, if as a general rule tax was not to be levied on unrealised gains, this could be included as a principle.

The BCTR acknowledges the benefits of designing the business tax system in a way that treats general inflation in a consistent way. The implications of the suggested full nominal base should be carefully explored with due recognition given to the possible re-appearance of higher inflation.

Determining Tax Liability

The BCTR acknowledges the proposal to treat entities as extensions of their ultimate owners for the purposes of business taxation and understands the benefits of a uniform treatment of investors irrespective of the legal form through which the investment is effected.

It should be noted, however that the entity tax framework outlined in the ANTS document can be seen as a departure from this principle rather than a movement towards it. Importantly, that framework may extend the coverage of the business entity tax regime to collective investment vehicles that have developed in Australia through public offer unit trusts. This industry comprises three million Australians who utilise public offer unit trusts as vehicles for their savings decisions. These savings vehicles provide an efficient and effective mechanism for individuals to diversify and be taxed as if they held the investment directly.

The inference in the discussion paper to the fact that full integration of ownership would impose, at most, a single layer of taxation and that "at most" refers to whether tax preferred income retains tax relief on pass through is a fundamental issue for the BCTR. If tax preferred income does not retain tax relief on pass through then it would reduce the attractiveness of collective investment vehicles such as public offer unit trusts and encourage direct investment by individuals so that tax preferences would pass through. This will adversely impact small investors who have insufficient monies to achieve adequate diversification through direct portfolio investment. Furthermore, it will place Australia’s collective investment vehicles at a competitive disadvantage with the USA. Australia’s investment vehicles will be competing with US products that attract a zero tax rate with income taxed in the hands of savers.

In addition, the discussion in para. 6.64 of the paper states that the treatment of profits retained in entities is a key departure from the integration of ownership interest design principle. It is arguable that if tax preferred income does not retain tax relief on pass through then this is also a key departure from the integration principle. Furthermore, the BCTR would be extremely concerned if para. 6.64 implies a re-introduction of an undistributed profits tax. In this connection the BCTR would emphasise the structural advantages of an alignment of the top personal income tax rate with the entity tax rate.

Promoting Equity

The BCTR endorses the principle promoting equity and particularly welcomes the dimension of transitional equity under which it is acknowledged that changes affecting taxpayers should be designed and implemented fairly. For instance, the BCTR recommends that any detrimental changes in the taxation of investors in public offer unit trusts or timing of capital allowances must be designed with this principle in mind.

Risk Neutrality

Under the heading of risk neutrality, the discussion paper states that the Review intends to consult widely on the taxation of financial arrangements with a view to bringing the ongoing examination of those arrangements to finality. The taxation of financial arrangements issue has been ongoing for five years and raises many complex issues dealing with, among other things, taxation of unrealised gains, mark-to-market of traded financial instruments and appropriate tax treatment of hedge instruments. Whilst the BCTR supports an initiative to bring the taxation of financial arrangements to finality, it is important that any proposed reforms do not impede the international competitiveness of Australian industry - including the manufacturing and commodity producing sectors - or the competitiveness and attractiveness of Australia as a regional financial centre.

 

 

Balanced Taxation of International Investments

The principle dealing with balanced taxation of international investment is supported by the BCTR. Indeed, the comments in para. 6.78 of the discussion paper lend support to the argument that the proposals announced in the ANTS document in relation to deferred company tax should be reconsidered. The risk to economic growth of a less than optimal system of taxing international inbound and outbound investment should not be underestimated.

The BCTR submits that consideration could be given to a more explicit recognition of the importance to the competitive performance of the Australian economy of foreign investment in Australia, offshore investment by Australian-based companies and the earning of foreign source income by Australian firms.

Tax Incentive Provision

The BCTR supports the adoption of a process of formal assessment of the full impacts of tax incentives.

The BCTR submits that:

  • The basis of assessment of appropriate incentives should be open and transparent.
  • In particular, the definition of "tax incentives" against the benchmark of a comprehensive income tax base should be examined thoroughly. Many so called "tax incentives" or "tax concessions", notably those related to the timing of the receipt of income or the allowability of deductions, are entirely dependent on the selection of the comprehensive income tax base as the benchmark against which "tax concessions" are assessed. In many instances such features of the tax system would be negative tax expenditures or "tax penalties" if assessed against an expenditure tax base.
    • Any switch from tax incentives to direct grants or subsidies by Government places considerable pressure on Government agencies to pick winners and to ensure the measures operate in a certain and simple manner. Industry experience has shown that these objectives will not usually be met.

Reflecting Incidence and Substance

The principle dealing with effective tax incidence is supported by the BCTR. However assessment of economic incidence is contingent on the assumptions underlying the economic analysis employed. The BCTR submits that the methodologies used to assess economic incidence should be transparent and specified sufficiently to enable replication and fully-informed discussion.

Finally, the last principle dealing with taxation based on economic substance over form raises considerable concern for the BCTR in relation to achieving an outcome of certainty. Whilst the BCTR appreciates that taxation based on economic substance over form may be an appropriate basis for formulating tax policy, it is not an appropriate basis for interpreting taxation law. Business needs certainty in relation to tax outcomes and this is achieved by paying regard to the legal form of a transaction.

6. Legislative Design Principles

The BCTR supports the legislative design principles. The adoption of the principles will lead to improved legislation and contribute to the simplification objective and the certainty outcomes suggested by the BCTR. There are two particular items the BCTR raises in relation to these design principles:

  • There is a need to formalise within the legislative process an annual Technical Corrections Bill to remedy errors contained in legislation. This type of process exists in other countries (eg. UK and USA) as a mechanism to address errors identified in legislation that has passed through the legislative process.
  • The BCTR supports the comments in relation to anti-avoidance provisions but notes that where a specific anti-avoidance rule is to be introduced, its operation must be limited to the particular circumstances of concern. In recent times the anti-avoidance rules have become rules of substance. For example, the recent trust loss provisions commenced as anti-avoidance measures but the final legislative outcome extends much further and creates a new framework for taxing trusts with losses.

 

7. Administrative Design Principles

The administrative design principles are generally supported by the BCTR and should lead to significant improvements provided there is an appreciation by government agencies of the degree to which the relationship between business and the administration has, or at least is perceived to have, deteriorated over the last decade.

It is often argued that one of the major reasons for the exponential growth in the volume of tax legislation has been the preoccupation on the part of government agencies with tax avoidance, and their determination to close off every conceivable loophole regardless of any collateral damage caused to the majority of tax payers who are largely compliant. Indeed, the BCTR is concerned with the comments in ANTS about perceived abuses perpetrated by corporate groups. We are prevented by lack of access to records to test the conclusion but evidence suggests the level of tax avoidance is overstated (eg. The "high wealth individuals" project). The principle of proportionality is intended to deal with this problem. The BCTR recommends that the principle should explicitly state that it will sometimes be neither practical nor desirable to tax every dollar and a well designed and administered tax system must be sufficiently flexible in order to avoid obstructing business activity with inappropriate and harsh compliance measures. This would be consistent with the national objective of facilitating certainty and simplification.

The BCTR also has some concern with the language contained in the principle dealing with enforceability. The principle refers to the sticks in the tax administration armoury and whilst these are important, the administration must not lose sight of the fact that tax is the only area of law where the onus of proof is reversed and taxpayers must prove that an assessment is excessive. It is, therefore, critical that the tax administration only revert to the sticks in the tax administration armoury as measures of last resort.

8. Reforming Business Tax Processes

The processes underlying the business tax system are in need of significant reform and the Review has recognised this concern. The BCTR welcomes the concept of establishing integrated teams, more involvement of external advisers and a more open and consultative approach. In particular, the BCTR endorses proposals to reduce "legislation by press release" and the emphasis on early consultation including as to policy development.

It should be noted, however, that the difficulty in the past has not always been a lack of consultation but the kind of consultation engaged in, with participants often complaining about being politely listened to but not really heard, nor having their views seriously taken into account when deciding policy or administrative matters. The government agencies must be prepared to engage in effective and genuine consultation and be prepared to provide feed-back and explanation as to why suggestions and ideas have not been accepted.

In relation to the target to reduce the size of the Act by 50%, the BCTR supports any move to reduce the number of pages of legislation and, in fact, questions whether the target is ambitious enough. Furthermore, it is not only the size of the legislation which should be reduced, but also the number of pages of accompanying material (explanatory memorandum, regulations and rulings). We do caution, however, that less pages associated with less certainty of outcome is not what business is seeking. In this regard, we refer the Review to the suggested amendment to the third national objective to include certainty and simplification as the appropriate measure.

A Board of Directors

The proposal to establish a Board has widespread business support. The creation of a Board of Directors to oversee administration of the business tax system is an integral part of the reform process and a necessary step in order to achieve improvements to business tax processes.

The BCTR would not want to limit the charter of the Board to an advisory capacity, which is one option suggested in the discussion paper. The BCTR strongly recommends that an independent Board be established to oversee the operations of the Australian Taxation Office. The charter of the Board would extend to areas such as strategy development, annual business plans, information technology, capital investment, human resource management, communication, taxpayer service levels, and performance measurement and rewards. The Board’s performance would be measured against the national objectives for the business tax system and adherence to the agreed administrative design principles.

The Board, like the Commissioner of Taxation, would not be responsible for policy development which would remain with the Treasurer.

In order for the Board to be successful, it should comprise representatives of the major stakeholders in the ATO including the Commissioner of Taxation. The private members of the Board must be remunerated and the Board will need to have sufficient financial and other resources in order to operate independently. The Board should ultimately be accountable to the Treasurer or the Assistant Treasurer. The BCTR considers that the Board must operate independently from the administration of the business tax system in a way that is similar to the model of Boards in the private sector. In other words, the Board would not actually conduct or supervise consultation on particular tax measures but rather play the role of an independent assessor of the tax system and seek reports from management (ATO and possibly, other agencies) in relation to key performance issues.

The Board should be responsible to report on the effectiveness of the business tax system, including:

  • Adequacy of resources within the ATO;
  • Quality of consultation;
  • Quality of action following consultation.

It is imperative that for the Board to have a genuinely beneficial impact on the level of community trust and confidence in the business tax system, it must be effective in influencing the consultative process.

The BCTR submits that the establishment of a proper, independent Board is a fundamental aspect of the reform process which requires further consultation with stakeholders. There are many examples of models that need to be assessed in order to arrive at the appropriate model to be introduced in Australia (e.g. USA Board for IRS, Canadian Board for Inland Revenue and Reserve Bank of Australia Board).

ParliamentaryProcess

The discussion paper is silent in relation to the roles of existing Committees such as the Joint Committee of Public Accounts and Audit. The BCTR considers that these committees have played an important role in the past and that their responsibilities could be included within the Charter of the Board.

 

9. Tax Administration

The BCTR agrees that particular aspects of tax administration need to be addressed in their own right.

Reform of Audit Process: Involvement of Board

We do not understand the comment made in paragraph 8.6 of the discussion paper that "in relation to tax audits":

"The ATO has designed wide ranging programs to monitor taxpayer compliance in this self-assessment environment, and to make adjustments within specified time limits where it is considered that the correct tax position of a taxpayer is not reflected in the tax returns. The current arrangements do not allow enough flexibility to accommodate the full range of taxpayer circumstances".

We submit that:

  1. Taxpayers are entitled to certainty in respect of their affairs after a specified number of years. In all other developed jurisdictions, and in Australia, there is a time limit in relation to income tax returns, after which tax audit adjustments will not be countenanced (in the absence of fraud or evasion.)
  2. It is the responsibility of the Australian Taxation Office to have available sufficient audit resources and processes to discharge its obligations under the law.

If the ATO considers it requires:

  • Additional resources; or
  • Different approaches to the time limits for audit adjustments

this should be stated transparently in the next discussion paper to be issued by the Review.

We suggest that this is one of the functions which a Board of the Australian Taxation Office would have as a focus - the efficient deployment of ATO resources in order to provide taxpayers with certainty and satisfactory outcomes from the audit processes.

Rulings

The rulings system has been subject of much criticism, particularly in recent times as a result of cases such as Bellinz Pty Ltd v FCT (1998) ATC 4399. This case raised many concerns in relation to the style of drafting of tax rulings, the scope of tax rulings and the extent to which taxpayers can rely on public rulings.

The need for business to obtain rulings will continue even after tax reform and it is, therefore, imperative that the rulings process be improved so that they are timely, accurate, complete, reliable and contestable within the objection and appeal processes.

The government announced in the ANTS document changes to the ruling system which will address some but not all, of the concerns of business. A discussion paper prepared by Professor Graeme Cooper on behalf of the Australian Society of Certified Practicing Accountants highlights a number of additional deficiencies with the current ruling system and suggests a number of improvements. We understand that a copy of that submission has been provided to the Review.

 

A STRONGER FOUNDATION?

SHOULD AUSTRALIA MOVE TOWARDS
A MORE COMPREHENSIVE
INCOME OR EXPENDITURE
TAX BASE?

WHICH IS THE MORE COMPREHENSIVELY NEUTRAL DIRECT BUSINESS TAX BASE?

THE CASE FOR AT LEAST EXPLORING ALTERNATIVES

GEOFF CARMODY
ACCESS ECONOMICS

Contents

1. Focus Of Paper

2. Defining (Direct) Business Taxation

3. Broad Objectives And Principles

4. From Where Are We Starting?

5. The 'Lights On The Hills'

An Income Tax Base

An Expenditure Tax Base

6. Can We Reach Either Summit?

7. Realistic Tax Reform Ambitions

8 Some Conclusions And Suggestions For Further Work

Conclusions

Suggestions For Further Work

1. Focus Of Paper

The tax base is truly the foundation on which any tax system rests.

If the tax base is riddled with exemptions and loopholes, and/or treats similar activities and transactions differently, it distorts taxpayer behaviour and, in so doing, undermines the capacity of the tax system to do the primary job for which it is designed - to raise general revenue to pay for government activities.

Unless there are good reasons for doing otherwise, the basic design criteria for a 'good' tax system include a requirement that the tax base be defined comprehensively. The tax rate structure applied to that base should be as uniform as possible. These two features produce an acceptable compromise between the (to some extent) competing tax design objectives of economic efficiency, reasonable fairness (both horizontal and vertical equity), and administrative/compliance simplicity.

They also help to ensure that the system itself is reasonably robust, capable of meeting the revenue demands placed on it as the economy grows.

The Coalition's proposed reforms to Australia's decrepit indirect tax system go a long way to making it a more comprehensive and uniform system. Replacing a variety of more selective and distorting indirect taxes, the proposed GST applies a uniform tax rate (10% ad valorem) to a reasonably comprehensive tax base.

As far as is practicable, the GST tax base is a working approximation to consumption expenditure. While there are deviations from that base, it is clearly the GST taxation target. In short, the Coalition, with strong and united support from business, has explicitly opted for a more comprehensive expenditure tax base in reforming the indirect tax system. It has also given more revenue-raising weight to expenditure taxation by shifting the balance between direct and indirect taxation significantly towards the latter.

As far as the direct tax system is concerned, the separate Review of Business Taxation (RBT) is considering how business taxation should be reformed. Its first Discussion Paper A Strong Foundation: Establishing Objectives, Principles and Processes was released on 23 November 1998. It concentrates on business tax processes and tax administration, as well as offering some general suggestions on broad objectives and tax design principles.

The key business tax design issue addressed in the Discussion Paper is what should be the business tax base? More specific tax design issues will be addressed in the second Discussion Paper, to be released late January/early February 1999. This paper also concentrates on this business tax base issue, and raises for consideration an alternative approach to the comprehensive (accruals-based, nominal) income base suggested as the appropriate starting point in the RBT Discussion Paper.

The fundamental tax design premises on which this paper is based are as follows:

  • tax design should primarily reflect broad national objectives rather than appeals to narrow business interests
  • the cardinal tax design principles of economic efficiency, fairness and simplicity must be reflected in reform proposals: these offer practical compromises that promote strong economic and employment growth while giving due weight to fairness and a workable tax system.

One feature that typifies tax systems based on national objectives and broad tax design principles is neutrality. Unless there are good reasons to do otherwise, well-designed tax systems should treat business activity - whatever the entity involved - similarly.

But, unless defined carefully, an appeal to neutrality does not produce a unique answer to the question what should be the business tax base? Unless neutrality itself is defined as comprehensively as possible, alternative tax bases are still possible.

In releasing the first Discussion Paper, the RBT Chairman, Mr. John Ralph, AO, likened the business tax system to the leaning tower of Pisa, noting that 'it cannot be fixed simply by adding another storey, what is required is a stable foundation before we can start the task of rebuilding'.

This is a useful analogy. To amplify its implications, Australia's business tax system needs a strong and level foundation on which to build a durable superstructure. Properly defined, neutrality is a very important feature promoting a strong and level foundation. Any tax base that violates the neutrality criterion weakens the foundation.

Apart from neutrality across different business entities and activities, there is the important question of intertemporal neutrality. Specifically, a business tax foundation that favours present consumption (and borrowing) against future consumption (saving), rather than being neutral between the two, raises questions about its durability.

A comprehensive income base would remove distortions (non-neutralities) in the tax treatment of different uses of saving, but would more comprehensively bias the direct tax system against saving and in favour of (consumption) expenditure now.

A comprehensive expenditure base would also remove distortions (non-neutralities) in the tax treatment of different uses of saving, and also would remove the bias against saving and in favour of (consumption) expenditure now. It would be saving-neutral across the board.

This paper examines whether it is worth considering an expenditure tax base for the business tax system, on the grounds that an income tax base, by tilting the tax foundation away from saving towards present consumption, is itself likely to threaten the durability of the business tax structure too. This threat is the more serious for Australia, given its poor national (and private sector) saving performance, against the need for strong investment as a prerequisite for strong economic growth that benefits Australians.

2. Defining (Direct) Business Taxation

What is included in the term 'business taxation'?

While a variety of definitions might be envisaged, the neutrality criterion itself suggests that the more comprehensive the definition, the better.

This appears to be the approach taken in its first Discussion Paper by the RBT. As defined in the Government's 13 August 1998 document A New Tax System, business income:

' ... includes all investment income of whatever form and however derived. Business income is earned by a variety of entities including companies, trusts, partnerships, superannuation funds and individuals. ... Business income includes dividend, interest and rental income as well as capital gains and the returns from operating a business. So defined, business income is a very broad concept.'

Based on this definition of business income, business taxation applying to an income base would cover all direct taxation revenue except for direct tax on personal exertion income in the form of wages and salaries (and, because fringe benefits are a very close substitute for wages, FBT). As it happens, FBT is included in the scope of the RBT because at present it is administratively more like a business tax (based on total fringe benefits paid by a business) than a personal tax (with PAYE arrangements that are employee-specific).

Under an expenditure tax approach, the appropriate business tax definition would be at least as broad (ideally broader to cover wages and fringe benefits) in terms of sources of expenditure. The essential difference would be that those portions of business income (from whatever activity) that are not spent (ie, consumed in the relevant taxation period) would be excluded from the business tax base in that period.

3. Broad Objectives And Principles

If discussion about tax reform is not to descend into an inconsistent morass of sectional interest arguments, it must rest on broad policy objectives and supportive taxation design principles.

This is a strength of the approach taken in the RBT's first Discussion Paper provided that one accepts that a comprehensively-defined measure of income is the appropriate tax base. A brief review of possible national objectives, and supporting tax design principles, suggests that the RBT approach might be further strengthened.

National Objectives

Amongst the priority national objectives, the leading candidates surely must be:

  • Fostering strong and sustainable economic growth, in particular to reduce unemployment and also to underwrite rising living standards generally.
  • Addressing Australia's poor national (and private) saving performance.
  • Ensuring that Australia is a competitive place in which to invest.

These are interdependent, mutually reinforcing, objectives:

  • Strong investment is needed to sustain strong economic and employment growth.
  • International competitiveness is needed for Australia to be an attractive investment destination for mobile investment funds.
  • Better national and private saving is needed so that more of the required investment in Australia can be financed from our own resources, rather than from other countries.
  • A better domestic saving/investment balance is needed to maximise the benefits of strong growth for Australians, rather than for foreign sources of saving.

How does the business tax system support these national objectives?

All real-world taxes, to some extent, impose costs and distortions on economic activity. This is unavoidable. These costs must be weighed against the benefits of the uses to which tax revenue is put. But as far as possible, taxes - including business taxes - should be designed with economic efficiency in mind. That is, they should minimise these distortions and costs in order to allow the best use of scarce resources, which in turn supports strong growth.

There are social constraints on how far economic efficiency can be pursued. Fairness, in particular, requires that the tax system not tax poor people more heavily than the wealthy. It also requires similar tax treatment of people in similar situations, and likewise for business entities.

Simplicity may add further modifications in the interests of minimising costs of administering the business tax system and reducing taxpayer compliance burdens.

A strong conclusion is that the abovementioned national objectives will be supported (or at least less damaged) by a business tax system that is comprehensively-based and entailing neutral tax treatment across all business activity, regardless of the entity involved.

The national (and private) saving objective hightlights the need for neutrality to extend to the choice between present and future consumption. For a country with a poor saving record relative to investment needs, this highlights the need to shift away from a tax regime that double taxes income that is saved relative to income that is consumed, to one that handles this intertemporal choice more neutrally or even-handedly.

In short, broad national objectives and supporting tax design principles strongly suggest the need for comprehensive tax bases and rate structures that are neutral across activity, business entity and time.

Conceptually, at the very least, a comprehensive direct expenditure tax therefore is preferable to a comprehensive direct income tax.

That's all very well in theory. But is it practical?

4. From Where Are We Starting?

To adapt the old Irish joke, if we wanted to arrive at a really good reform outcome for Australia's business tax system, ideally we wouldn't start from where we are today!

We do not have a clean slate. Changes involve winners and losers. Transition arrangements can be costly and complex.

But it is worthwhile considering the nature of the status quo.

Australia's direct tax system, including its business tax elements, can be characterised as a hybrid system, comprising income tax and expenditure tax components. This is not to suggest that the system evolved in any comprehensive, principled or rational way. In large part the evolution has been haphazard and incremental.

But the fact remains that the (direct) business tax system can be decomposed into pure income tax elements and pure expenditure tax elements, weighted together in differing proportions for different activities and business entities. For example:

  • interest income is generally subject to nominal income taxation, pretty much on an accruals basis
  • realised capital gains on the principal private residence are effectively expenditure-taxed (on an up-front basis): such gains are tax-free, but the house is purchased out of post-tax income and operating expenses, etc., are not deductible
  • other realised capital gains have income- and expenditure-tax elements: a realisation basis allows some expenditure tax-like deferral advantages; inflation adjustment of realised gains before applying tax sometimes offers a deviation from a nominal to a real income base, and sometimes averaging provisions modify the applicable income tax rate compared with what applies to other forms of income
  • sheltering income as undistributed saving within corporate entities offers partial tax deferral for those on the highest personal marginal tax rates. Analytically, that deferral is expenditure tax-like (note that if the Government reduces the corporate tax rate to 30% from 36%, this increases the incentive to seek such deferral)
  • repairs and maintenance expenditures can be expensed for tax purposes in the financial year incurred, while capital outlays are often subject to accelerated write-off periods for depreciation deduction purposes: these can be viewed as partial application of immediate expensing of capital outlays as would apply under a cash-flow company tax system (which could be a component of an expenditure tax approach)
  • the tax treatment of superannuation involves concessionality relative to an income benchmark, but the opposite relative to an expenditure benchmark: effectively it comprises a blend of each.

It must be stressed that the business tax system is a mess, which has grown like topsy.

But that mess can be viewed as a more or less random combination of income tax elements and expenditure tax elements.

And that gives rise to the question: if we want to rationalise the status quo, which component - income or expenditure - provides the best benchmark around which to rally?

The first Discussion Paper issued by the RBT opts for the income tax component as the best direction in which the business tax reform should move. But it does so with very little discussion about the alternative tax base, including discussion about how the expenditure tax base supports broad national objectives.

It seems sensible to spend a little time reviewing the two alternative 'ideal' tax bases. The next section does that.

5. The 'Lights On The Hills'

An Income Tax Base

For direct taxation systems, an income tax base has a long history as the appropriate approach.

'Income' is defined as the difference between a taxpayer's current income, less costs incurred in earning that income, in any period, plus the net change in the value of the taxpayer's assets and liabilities between the beginning and end of that period. (Operationally, the period involved typically is one year.) The sum of these concepts measures the accretion in the taxpayers net wealth in the period - but says nothing about how that wealth is used.

The equity criterion for 'good' tax design is often cited as a key reason for supporting an income tax. Uniform taxation of business income meets one element of the horizontal equity criterion. Progressive rate scales for individual income tax contribute to the vertical equity criterion (albeit inefficiently: rich people benefit from low or zero tax burdens on the lower tranches of income). Income, as defined here, is widely regarded as a good measure of capacity to pay tax, itself an important element in promoting equity.

Efficiency and simplicity are less clearly promoted by a properly-defined income tax.

As to simplicity, asset valuation issues can be practically difficult if no market transaction is involved. This leads to deviations from the accrual ideal and adoption of a realisations basis (which has the advantage of reasonable objectivity and avoidance of cash flow problems in relation to tax liabilities) or a 'mark to market' basis. Depreciation allowances are an essential part of a properly-designed income tax system, adding to its complexity, especially if allowance for inflation is to be permitted. Progressive rate scales also add to complexity.

As to economic efficiency the income tax base is of mixed value too. Progressive rate scales give rise to incentives to defer or split income to maximise use of the lower tax brackets. Inflation causes problems for taxpayers, including rising real tax burdens due to 'tax bracket creep' in the absence of tax bracket indexation to inflation. (Governments - the revenue beneficiaries of this effect - seem less concerned about 'taxation by stealth'.)

And, as noted earlier, income taxes inherently tax income that is saved and reinvested more heavily than income that is spent:

  • income that is consumed is taxed once under an income tax: when income is earned
  • income that is saved is taxed when the income is earned, and then the returns to investment of the (post-tax) income saved is taxed again: in effect, the income is taxed twice.

An income tax therefore imparts a tax bias against saving and in favour of present spending, as the following simple two-period utility diagram for a taxpayer shows.

Figure 1

Effects Of Taxation On Saving:

Illustration Of Income & Consumption Effects*

* This is a very simplified illustration. More complex examples can be presented, but the basic distinction between income and substitution effects of income and consumption taxes remains.

This tax bias also sets up a conflict of interest between the taxing authority and taxpayers.

Measured in present value terms:

  • the taxing authorities have an incentive to encourage taxpayers to save more, because the double taxation of income from saving results in a higher present value of taxation revenue
  • but for the taxpayer, maximising the present value of consumption spending requires saving to be minimised!

This conflict is illustrated in Figure 2 below.

 

 

 

Figure 2

The Conflict Between Taxpayer And Government Under An Income Tax

Under an income tax, the taxing authority is perfectly rational to attempt to 'bring forward' tax revenue by moving towards a full accruals-based income tax, and at the same time to exhort taxpayers to save more as well. Under an income tax, taxpayers are being equally rational if they completely ignore these exhortations and in fact do the opposite! Viewed from this perspective, increasing reliance on income taxation in Australia has been associated with entirely understandable changes in private saving, as well as revenue 'bring forward' operations by Federal Governments. Income taxes corrupt intertemporal choices, both by taxpayers and by governments.

However, if an income tax approach is to be pursued, there is much to be said, on efficiency, equity and simplicity grounds, for ensuring that the income base is:

  • comprehensively defined
  • comprehensively and automatically adjusted for general inflation
  • defined as far as is practicable on an accruals basis
  • business entity-neutral
  • designed to treat income gains and losses symmetrically.

An Expenditure Tax Base

The direct tax alternative to an income tax base is an expenditure tax base.

Under this alternative, the focus is not on sources of income, but on how income and wealth are used. If income, from whatever source, is saved, it is excluded from the direct tax base. If income and/or wealth are consumed in the period concerned, they are included in the tax base.

From an equity perspective, a direct expenditure tax can be made progressive with respect to expenditure. It has a major advantage in that respect over indirect expenditure taxes such as a GST. The latter target products, not people, so that exclusions from the base (eg, food) are very inefficient vehicles for promoting vertical equity. The former target people, not products, and a progressive rate structure can be applied to total consumption spending in a period by the taxpayer concerned.

From a simplicity perspective, the expenditure tax base has some advantages over an income tax. Essentially, the tax is transaction-related, obviating the need for imputation of values for accruals tax purposes in most cases, at least. The need for inflation adjustment is avoided in some cases: for example, capital expenditures could be expensed fully in the year incurred under a cash flow tax (a business entity element that could be part of an expenditure tax approach), although tax bracket indexation would still be needed under a progressive rate scale. On the other hand, more comprehensive recording of asset accumulations and disposals might be needed.

From an efficiency perspective, the use of a progressive rate scale is likely to give rise to the same sorts of incentive effects (distortions) as arise under a progressive income tax. However, the inherent bias against saving and in favour of present consumption is eliminated under an expenditure tax, as shown in figure 1 above.

An expenditure tax does not interfere with the saving/investment/accumulation process. It taxes the accumulated proceeds when they are spent (or, in the case of the family home, their present value equivalent up-front).

This absence of a tax bias against saving also removes the conflict of interest between the taxing authority and taxpayers, as shown in figure 3 below.

Figure 3

The Consumption-, Saving- & Tax-Neutrality Of An Expenditure Tax

As Figure 3 above shows, under an expenditure tax system, the present value of consumption and the present value of taxation revenue (for given income and total tax burdens) does not change as a result of changes in saving. In this sense there is no conflict between taxpayer and government: the present value of consumption and taxation are not affected by saving rates. Intertemporal choice can be based on other factors.

For a country with a poor national and private saving record, removal of this tax bias against private saving would seem highly desirable in terms of the national objectives set out in Section 3 above.

6. Can We Reach Either Summit?

The merits of 'ideal' income and expenditure tax systems are worth examining at the conceptual level, but is either ideal comprehensively attainable?

The practical answer is 'no'. Realistically, there will be exemptions from either of the 'ideal' tax bases. For example:

  • capital gains from sale of the family home, or imputed rent from owner-occupied dwelling, are unlikely to be comprehensively taxed under the income tax ideal, even though they fall within the income base
  • imputed spending on dwelling rent by owner-occupiers (the notional transaction related to the consumption of dwelling services by owner-occupiers) is unlikely to be included comprehensively in an expenditure tax base
  • comprehensive inflation adjustment (income tax base) or tax bracket indexation (income or expenditure tax bases) seem unlikely to be introduced: governments prefer to get political credit for refunding the proceeds of tax bracket creep in arrears on a case-by-case discretionary basis
  • symmetrical tax treatment of gains and losses under an income tax seems an unlikely prospect (because of concerns about revenue - tomorrow, if not in a present value sense).

In reality, Australia is likely to have to continue with a business/direct tax system that, analytically, can be regarded as a hybrid, comprising pure income tax elements and pure expenditure tax elements (plus more than a few features that fit into neither category).

But the 'lights on the hills' give us some feel for the broad directions in which Australia should head, or the consequences of adopting a particular course.

Which way should Australia head? Should we head towards a more comprehensive income tax base or towards a more comprehensive expenditure tax base?

If neutrality is a key design criterion - and there is much to be said for it - then the expenditure tax base inherently reflects a more comprehensive definition of neutrality, picking up the important saving/consumption neutrality issue.

If simplicity is also desirable, again, the expenditure tax base offers some benefits because of its greater focus on current dollar transactions rather than on accruals-based, often transactionless, increments to net wealth.

From a fairness perspective, the situation is less clear. Direct expenditure taxes can be progressive with respect to taxpayer expenditure, but (for any given rate structure) less so across taxpayer incomes.

But broad tax-based instruments directed at promoting vertical equity are very inefficient anyway: progressive rate scales give the same dollar of tax relief to the rich as to the poor. That relief is worth proportionately less to the rich than to the poor, but it reduces the efficiency of the redistribution mechanism. There is less relief to those really in need for any given budget cost. Targeted social welfare transfers are far more efficient.

7. Realistic Tax Reform Ambitions

While neither a truly comprehensive income base nor a truly comprehensive expenditure tax base are realistic reform options, significant progress in either direction, from where Australia is now, seems feasible.

Income tax-oriented reforms to the business tax system might include the following:

  • removal of, or reduction in, all acceleration components presently included in depreciation or building allowances
  • removal of, or reduction in, the 125% R&D allowance (under an income tax 100% might be deductible)
  • further bringing-forward of income tax collections to more fully reflect an accruals basis for income taxation
  • more consistent treatment of inflation - probably by reducing or eliminating present inflation adjustments (eg, for some realised capital gains) rather than moving to more comprehensive inflation-adjustment for income taxation purposes
  • where asset realisations are not involved, but market valuations are regularly published for the assets involved (eg, financial assets) use of 'mark to market' rules to extend the application of an accruals-based income tax.

More generally, given that the Treasury's annual Tax Expenditures statement defines income tax-related tax concessions against something approximating an income tax benchmark, all such concessions represent deviations from an income tax base, as such are defined as 'concessions' and as such might be candidates for removal or reduction in order to finance a reduction in the business tax rate.

While revenue-positive changes of the type listed above are likely to be considered, other changes that would promote a more income tax-like tax base may not be considered because of concerns about possible tax revenue losses, combined with a desire to generate net revenue increases from base-broadening to finance a business tax rate reduction to 30%.

This inconsistent and asymmetrical approach is already evident in the RBT's first Discussion Paper - see page 73, paragraph 6.56 on the tax treatment of losses.

Expenditure tax-oriented reforms to the business tax system might include the following measures designed to move the system closer to a cash flow tax:

  • immediate or phased-in extension of acceleration of depreciation allowances to bring the tax treatment of more capital expenditures into line with that accorded repairs and maintenance and some smaller capital items: this would at the same time reduce problems associated with inflation and historical cost accounting
  • extension of present roll-over relief arrangements applying to realised capital gains, effectively deferring tax collection until closer to the point when the income is spent and away from the point when it is earned
  • applying the business tax/cash flow tax as a withholding tax, with imputation credits (fully refundable) applied so as to pass through any tax preferences fully to shareholders, rather than allowing such preferences to be 'washed out' as happens under the present franking system
  • if superannuation is included as part of business income, removal of, or reduction in, the contributions and earning taxes on superannuation funds (at least in relation to compulsory superannuation, but preferably to all superannuation), with increases in the taxation applying to superannuation payouts to retirees.

These types of changes tend to produce year-one revenue losses relative to the status quo. Depending on the desired revenue target for the Government, they may therefore require an increase in the 'headline' business tax rate.

Note, however that, provided franking credits refunds can be obtained, a change in the business tax rate, as far as Australian resident shareholders are concerned, entails nothing more than minor tax timing effects: if the personal tax rate scale is unchanged, so is the ultimate tax burden on business income faced by the shareholder.

Which is the best way to go?

Other things being equal, the income tax approach reduces incentives to invest (apart from repairs and maintenance?) and, via the tax base, more comprehensively imparts an anti-saving bias to the business tax system. This bias is modified via a lower 'headline' business tax rate. At best, Australia's saving/investment imbalance might be improved at the expense of lower investment.

The expenditure tax approach increases incentives to invest and, via the tax base, more comprehensively reduces the anti-saving bias in the business tax system. This benefit is modified via a higher 'headline' business tax rate. At best, Australia's saving/investment imbalance might be improved while financing higher investment.

If strong growth is a key national objective, and strong investment is needed for growth to be viable, the latter direction seems preferable to the former.

But the latter direction has received little attention in the first Discussion Paper released by the RBT on 23 November. This should be corrected.

8 Some Conclusions And Suggestions For Further Work

Conclusions

There is no doubt that a strong foundation is an essential ingredient for a durable, robust business tax system (and indeed any tax system). Without it, piecemeal reforms will not save the system from failing to deliver revenue efficiently, fairly and reasonably simply.

There is doubt - especially in a savings-scarce country such as Australia - that building a business/direct tax superstructure on a comprehensive income base is building on a strong foundation.

For a start, the income foundation is not a level tax base: it is tilted against private saving and in favour of borrowing in Australia. If the business tax system is the leaning tower of Pisa, moving to a more comprehensively tilted foundation will not correct the problem: it may well make it worse.

Moreover, realistically, the income foundation won't be comprehensive or anything like it anyway. Asset valuation will be one area where anomalies will be inevitable. The treatment of inflation will be, at best, non-uniform, or, at worst, comprehensively ignored. Symmetrical treatment of gains and losses will continue to be a principle honoured in the breach rather than in the observance. So the tilted tax base will be full of bumps and holes as well.

International tax comparisons need to be treated carefully too. Tax systems are evolving, they are not static. 'Freeze frame' snapshots at a point in time do not convey the dynamics of adaptation. Are international tax systems - hybrids all - moving towards income tax-like systems or expenditure tax-like systems? Does Australia want to be up with the pack or ahead of the pack? Should world's best practice be defined by reference to the past or the point towards which tax systems are evolving? If tax systems can only evolve over time, what is the competitive end-point to which Australia itself should be preparing to move over time?

The revenue/tax rate targets imposed on the RBT need to be questioned.

On revenue-neutrality:

  • Should the RBT be tax-revenue neutral?
  • How is revenue-neutrality defined: in year one, over time, or in some present value sense?
  • Should the focus be on public saving or national saving? If RBT proposals raise or leave unchanged public saving, but lower private saving, what about the effect on national saving?

On the 30% business tax target:

  • If getting to 30% means corrupting the income tax base by going beyond comprehensive income (eg, by ignoring inflation, not allowing symmetrical treatment of gains and losses, and not moving to genuinely full dividend imputation), is it worth pursuing?
  • If moving closer to an expenditure tax base is feasible, but is deemed to require an increase in the business tax rate above 36% for whatever revenue reason, should that be ruled out of consideration - especially if the top personal tax rate remains at 48.5%?

Suggested Further Work

Given the sorts of national objectives set out in Section 3 above, it seems desirable for the RBT itself more fully to investigate the advantages and disadvantages of the expenditure tax alternative to the income tax base. In particular:

  • Which is conceptually preferable, especially from a broadly-defined neutrality perspective?
  • To what extent can practical reforms - eg, moving towards a comprehensive cash flow business taxation approach - be adopted over time to make the business tax system more expenditure tax-like?
  • To what extent can practical reforms - eg, concerning the taxation treatment of superannuation and other forms of saving - be adopted over time to make the personal tax system more expenditure tax-like?
  • What problems are likely to be encountered with a partial move towards and expenditure tax? What are the specific transitional and international problems that might be encountered and how might these be addressed?
  • If an expenditure tax is taken as the benchmark, what would be the direct tax concessions - positive or negative - if a Tax Expenditures Statement was prepared?

 

 

Geoff Carmody

Access Economics

Canberra

2 December 1998

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