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Submission No. 65 Back to full list of submissions
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Review of Business Taxation
Preliminary Response to :"A Strong Foundation"

 

Introduction

The Australian Food Council (AFC) has reviewed the first Discussion Paper, A Strong Foundation: Establishing Objectives, Principles, and Processes, released by the Review Of Business Taxation (RBT) on 23 November 1998.

This Submission presents the AFC’s preliminary reactions to that Paper. The reactions are preliminary because AFC members need more time fully to digest all of the ramifications of the proposals contained in A Strong Foundation, notwithstanding the RBT requirement for submissions to be lodged by 31 December 1998. The AFC will advise reserves the right to come back to the RBT of any with further submissions on the contents of A Strong Foundation if that is necessary.

  1. Reconciliation of tThe Broad Approach in "A Strong Foundation" with AFC Policy Principles And Overall AFC Reactions

The AFC agrees that business tax reform is needed. The case is well developed by the RBT (Chapters 2, 3, and 4).

The AFC agrees very much with the nature of the approach adopted by the RBT consistent with national objectives and design features of a "good" tax system. Specifically, the AFC it agrees that:

  • the starting point for the review of business taxation should be specification of broad national objectives that should guide the broad direction of tax reform, not considerations which appeal to particular businesses or sectoral interests;
  • broad revenue-raising criteria - efficiency, equity and simplicity - should guide the design details of the business tax system;
  • 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;
  • efficiency - that is, the requirement of tax to minimise distortions and associated costs - should minimise adverse effects on taxpayer behaviour;
  • as far as possible, neutrality should be sought in the tax design outcome - neutrality itself should be defined comprehensively: across business entities, across activities, and over time;
  • on balance, these criteria, in practice, suggest comprehensively defined tax bases and uniform tax rates applied to those bases
  • on balance, these criteria, in practice, suggest comprehensively defined tax bases and uniform tax rates applied to those bases;
  • consistent with the comprehensiveness concept, the definition of business activity/income should be as broad as possible too;
  • comprehensiveness and neutrality dictate that tax be applied on the basis of the substance of the activity involved rather than the legal form of the entity undertaking that activity; and
  • there is considerable scope for improving the consultative process between the taxation authorities and taxpayers, and for improving the process of formulating taxation policy, developing legislation to give effect to that policy, and putting the policy into practice.

The RBT proposals on business tax processes (Chapter 7) and tax administration (Chapter 8) generally seem logical sensible and offer the potential for improved tax system design and better relations between the taxing authorities and taxpayers.

Of course, Ttranslating that potential into reality will depend very much on how these processes operate in practice.

As to the approach to the task of reform (Chapter 5) and framework objectives and principles (Chapter 6) the AFC has more mixed views.

The AFC agrees that business tax reform should be based on:

  • a systematic approach rather than a piecemeal, ad hoc approach; and
  • a strong foundation (in terms of objectives and design principles).

The AFC understands the RBT requirement that business tax reform be revenue-neutral, but recognises that this constraint is capable of a variety of interpretations:

  • revenue-neutral in year one;
  • revenue-neutral some years into the future; or
  • revenue-neutral in some present value sense.

The AFC is not attracted to the first of these interpretations, especially if achieving it is at the expense of potentially larger revenues, generated by a stronger economy as a result of tax reform itself, in the future. The AFC is attracted to the second and third interpretations, and especially the third. Indeed, the AFC is concerned that business tax reform should not be constrained by a requirement that there is no loss to revenue in the first year reform is implemented, and welcomes the Chairman’s intention to be ‘adventurous’ in this respect.

The AFC remains to be convinced on two key assertions:

  • that business entity taxation should not be abolished (Chapter 5); and
  • that the business tax base should be some variation of an income concept (Chapter 6).

The AFC’s reservations on these assertions arise for three reasons.

  1. Business entity taxation in Australia - specifically the company tax system - retains some of the features of the old ‘classical’ double taxation of corporate income, because of defects in the operation of the dividend imputation system. The Government proposal to grant refunds of franking credits to some (Australian resident) shareholders recognises and partially addresses one of these defects, but the ‘washing out’ of tax preferences via the imputation system remains, and indeed would be extended to non-corporate businesses under the Government’s business entity taxation proposals. Requiring all dividends to be fully franked raises serious questions about tax preferences and Australia’s international competitiveness.
  2. Non-corporate business entities presently are not taxed in most cases: tax is applied to the ultimate owners of the business. Given that the status quo is a hybrid, with some business entities directly taxed and others not, why is it clear that Australia should move consistently to the present company tax approach rather than consistently to the present non-corporate business tax approach? The AFC supports neutrality across business entities, but which model for neutrality should be applied?
  3. Using income as the business tax base is not the only possibility. Indeed, the AFC’s concerns about what the appropriate business tax base should be underpins most of its concerns about the more specific issues covered in the preceding two paragraphs. If income is the appropriate tax base, the case for making imputation nothing more than a withholding tax - rather than a non-transparent means for recouping tax preferences or over-taxing company income (relative to shareholders’ personal tax rates) - is strong. But if income is not the appropriate tax base, then the appropriateness of any business entity taxation, or at least the design of business entity taxation, become key issues. The question of what is a tax preference or tax concession itself is not immutable: it depends entirely upon the accepted definition of the appropriate business tax base.

Clearly, the AFC is very concerned about getting the fundamental issue right - what is the appropriate business tax base? - before getting into more specific issues. Resolution of this issue affects all of the detailed reform issues that will arise later, including the definition of tax preferences or concessions.

Getting the tax base issue right is essential if the business tax system is truly to rest on a strong foundation.

The AFC does not support the conclusions of the Discussion Paper that summarily dismisses consideration of an expenditure tax base. As such, consistent with the "principles" focus of the Discussion Paper, this Submission canvasses consideration of an appropriate alternative tax base judged against economic and social objectives and criteria of a "good" tax system. Accordingly, the rest of the AFC’s Submission explores this alternative tax base more carefully and contrasts it with an income tax base.

2. Broad Objectives and Principles for Business Taxation Reform

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 consistent with the AFC’s approach to tax reform and is a strength of the approach taken in the RBT’s first Discussion Paper but only if 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

Among the priority national objectives, the leading candidates 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; and
  • 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;
  • internationale 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; and
  • a better domestic saving/investment balance is needed to maximise the benefits of strong growth for Australians, rather than for foreign sources of saving.

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 highlights 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 inter-temporal 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.

3. Defining (Direct) Business Taxation Under Income Or Expenditure Taxation

What is included in the term ‘business taxation’?

As defined in the Government’s 13 August 1998 document A New Tax System, business income is defined broadly, and appropriately so given the importance of the neutrality criterion. 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).

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

4. Australian Business Taxation: The Status Quo

We do not have a clean slate.

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.

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, virtually 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); and
  • 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.

While It must be stressed that the business tax system has evolved, growing like topsy, it 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 rationalisinge the status quo is the objective, 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 from where we are now. But it does so with very little discussion about alternative tax bases, including discussion about how the expenditure tax base supports broad national objectives.

The basis of this AFC Submission is to correct that shortcoming, in the first instance, in principle.

The AFC believes that it is sensible to spend a little time reviewing the two alternative ‘ideal’ tax bases and drawing practical conclusions about which way the present hybrid tax system should be shifted.

5. The Business Tax Base: What Should It Be?

 

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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 (which supports job creation and economic growth), 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 much maligned 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 RBT is considering how business taxation should be reformed.

The fundamental tax design premises which the AFC believes should drive business tax reform are as follows:

As indicated earlier, the AFC considers that national objectives and broad tax design principles should drive business tax reform rather than narrow sectional interests. A critical factor of this system is neutrality.

Unless there are good reasons to do otherwise, well-designed tax systems should treat business activity - whatever the entity involved - similarly.

One feature that typifies tax systems based on national objectives and broad tax design principles rather than narrow sectional interests 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, comprehensive 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 neutrality over time. 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.

Such a foundation may well be largely free of holes or bumps in the tax base, but it will not be a level foundation.

A comprehensive income base suffers from this fundamental defect. It 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.

The AFC believes that 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.

3. Defining (Direct) Business Taxation Under Income Or Expenditure Taxation

What is included in the term 'business taxation'?

As defined in the Government's 13 August 1998 document A New Tax System, business income is defined broadly, and appropriately so given the importance of the neutrality criterion. 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).

Under an expenditure tax approach, the appropriate business tax definition would be at least as broad (ideally broader to cover running down of stocks of savings) 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.

4. Broad Objectives And Principles For Business Taxation Reform

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.

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.

Is an expenditure tax approach practical?

5. Australian Business Taxation: The Status Quo

We do not have a clean slate.

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.

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 from where we are now. 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.

The AFC believes that it is sensible to spend a little time reviewing the two alternative 'ideal' tax bases and drawing practical conclusions about which way the present hybrid tax system should be shifted.

6. The Theoretical Ideals: Income Versus Expenditure Tax Bases

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 also 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 ‘market 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 this '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; and
  • 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.

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!

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! Income taxes corrupt inter-temporal 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; and
  • designed to treat income gains and losses symmetrically.

Not all of these criteria are accepted in the RBT’s first Discussion Paper. In particular, inflation adjustment and treatment of losses are regarded as cases where deviations from the ideal are ‘justified’ on revenue grounds (of course excise indexation will be retained - also on revenue grounds!)

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 (for example, food and other so-called essentials of life) 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.

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.

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. Inter-temporal 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 earlier sections 4 above.

7. Can Either Ideal Be Implemented?

The merits of ‘ideal’ income and expenditure tax systems are worth examining at the conceptual level but, practically, neither is either ideal is 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 an 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; and
  • 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 ‘ideals’ give some indication 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 The AFC is considering whether a move towards a more comprehensive income tax base or towards a more comprehensive expenditure tax base is preferable.?

If neutrality is a key design criterion - and there is much to be said for it - then the AFC can see merit in the expenditure tax direction. An 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.

8. 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 the "half-way" house in which Australia finds itself now, is seems feasible.

The options to iIncome tax-oriented reforms to the business tax system could 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 (for example, for some realised capital gains) rather than moving to more comprehensive inflation adjustment for income taxation purposes; and
  • where asset realisations are not involved, but market valuations are regularly published for the assets involved (for example, financial assets) use of ‘mark to market’ rules to extend the application of an accruals-based income tax.

More generally, Ggiven 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 (removal of or reforms to existing "concessions") areof 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%.

As already noted, 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 options 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; and
  • 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 may be 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 and more of that investment needs to be financed by domestic saving, the latter direction seems preferable to the former.

Recommendation

The AFC considers believesthat a move closer to the expenditure tax approach is at least worthy of serious attention, and certainly more than that .

But the latter direction hasreceived little attention in the first Discussion Paper released by the RBT on 23 November. AFC believes that this gap in the RBT analysis should be corrected.

9. Conclusions

The AFC agrees 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.

But the AFC also considers believes that 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. 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.

Any 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, surely what isAustralia should be striving for a the competitive end-point to which it Australia itself should be preparing to move over time?

The AFC is in the process of surveying its member companies to ensure the application of the principles discussed here are a benefit and not a hindrance to business competitiveness and growth.

The AFC also intends to closely toreview the findings of the forthcoming information paper on international comparisons of business tax systems with these considerations in mind, and may present a further Submission based on this review.

An income base may well not be the base on which overseas business tax systems rest. If overseas business tax systems on average deviate further from some income tax benchmark than does Australia’s - and indeed as a result are closer to an expenditure tax approach - then international competitiveness considerations would also support serious reconsideration of the tax base proposed in the RBT’s first Discussion Paper.

The AFC considers believes that 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; and
  • 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 (for example, by ignoring inflation, not allowing symmetrical treatment of gains and losses, and not moving to genuinely full dividend imputation), is it worth pursuing; and
  • 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%?

It seems desirable for the RBT itself more fully to investigate the advantages and disadvantages of practicable reforms moving in the direction 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 - for example, 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 - for example, 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 an expenditure tax? What are the specific transitional and international problems that might be encountered and how might these be addressed; and
  • 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?