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Submission No. 73 Back to full list of submissions
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ACOSS response to the first discussion paper of Review of Business Taxation

January 1999

Summary and recommendations

In general terms, we consider that the Review’s first discussion paper: "A Strong Foundation" does indeed provide a strong foundation for business income tax reform. ACOSS supports the broad thrust of the proposed policy objectives and principles outlined in that paper, especially the need to tax income as comprehensively and consistently as possible in the interests of equity, efficiency in the allocation of resources, and simplicity.

An income tax base that is as comprehensive as possible, with any exceptions strongly and clearly justified, must be the starting point for reform of business income taxation. Broadly speaking, if business income is not taxed in a consistent way then business decisions will be made on the basis of tax considerations rather than profitability, high income individuals will find legal avenues to avoid their tax obligations, considerable resources will be devoted to such avoidance activities, and the tax law will become more ever more complex in an effort to curb them.

However, ACOSS is deeply concerned that. some of the options for business income tax reform which are raised for consideration in the Review’s Terms of Reference would undermine the fairness and integrity of the income tax system instead of strengthening it in accordance with the principles outlined above. Those options are:

  • a 30% cap on the rate of Capital Gains Tax;
  • a reduction in the corporate income tax rate to 30%, in the absence of firm measures to prevent high income individuals from avoiding personal income tax by establishing private companies.

These proposals would have very substantial and serious implications for the integrity of the personal income tax system. They would open up fresh opportunities for tax avoidance by high income individuals and bias investment decisions and the choice of business entity, in some cases in an economically harmful way.

If these policy options were implemented, then for many high income earners, payment of tax at a marginal rate above 30% would in effect be optional.

This raises the more fundamental issue of the relationship between the Review of Business Taxation and the wider tax reform package. The tax reform package has, in effect, been divided into two parts. The Review is not due to report until June 1999, after the Parliament is due to deal with the GST and other legislation arising from "A New Tax System".

ACOSS understands that some aspects of business tax reform, such as the tax treatment of financial arrangements, are complex and that it will take some time to develop sensible policy proposals in those areas.

However, it is vital that personal income tax reform and consumption tax reform are legislated as an integrated package. A tax reform package that is confined essentially to a GST and income tax cuts and fails to seriously address the many weaknesses and tax avoidance opportunities in the personal income tax system would be one-sided and unfair. Consumption tax reform poses major risks for the living standards of low income people, while the income tax cuts substantially benefit high income earners. Whether or not these measures are acceptable in their own right, they should not be passed into law until legislative action is taken to curb personal income tax avoidance by high income individuals.

The Review’s recommendations will have major implications for the personal income tax system. As well as dealing with the government’s proposals to tax trusts as companies (which should strengthen the system) it will address proposals to reduce the rates of capital gains tax and corporate income tax rate (which could seriously weaken it).

It is therefore crucial that:

  • The measures outlined in "A New Tax System" to stem personal income tax avoidance, including the measures dealing with trusts, should be legislated in advance of any GST or personal income tax cuts.
    • The Review should give the highest priority to finalising legislation to ensure the effective administration of these measures, without revising their policy intent, by the end of May.
  • The Review should clearly define its scope in order to ensure that it does not assume a defacto policy-making role in regard to personal income tax reform.
  • The Review should recommend that the government not proceed with the proposal to cap the rate of Capital Gains Tax at 30%, and make a policy announcement to that effect be made before a GST or personal income tax cuts are legislated.
  • The Review should recommend that the corporate tax rate should not be reduced unless firm legislative action is first taken to curb the use of private companies by high income individuals for tax avoidance purposes, and should give high priority to developing policy options to achieve that end.

ACOSS strongly supports the requirement in the terms of reference to the Review that further reform of business income tax arrangements flowing from the Review must be revenue neutral. The proposals outlined in "A New Tax System" would reduce federal revenues by over $7 billion in 2002-03, and by more in later years when the winding down of the company tax "bring-forward" would further reduce revenue. There is no scope for further revenue erosion without raising the prospect of socially damaging cuts in public expenditure. For this reason, any revenue obtained from further personal income tax base broadening measures (such as the removal of FBT concessions for certain classes of fringe benefits) should be used to finance personal income tax cuts and consolidate the budget surplus.

We do not advance a detailed reform agenda in the business income tax area. Instead, in our federal budget submissions, we have advanced a number of basic principles that we believe are consistent with those outlined in "A Strong Foundation". These are outlined in Recommendation 1 below.

Our concerns about some of the policy options advanced in the Review’s Terms of Reference, the scope of the Review, and the timing of legislation, are outlined in more detail below. Recommendations 2 to 6 deal with those concerns.

Recommendations

R1

The Review of Business Taxation should follow the following principles:

  • Business income tax reform should be revenue neutral.
  • Effective rates of business income tax should be broadly consistent with those applying in comparable countries.
  • Business income tax reform should broaden and strengthen the income tax base and should close off rather than opening up opportunities for high-income individuals and businesses to avoid tax.
  • The business income tax system should be as transparent and simple as practicable.

R2

The Review should more clearly define the scope of its work, in order to exclude personal income tax reform agendas that are more appropriately addressed elsewhere.

R3

(1) Policy measures announced in "A New Tax System" that are designed to stem income tax avoidance, including the taxation of trusts as companies, should be legislated in advance of any GST or personal income tax cuts.

(2) The Review should give the highest priority to finalising legislation to ensure the smooth implementation of these measures, without revising their basic policy intent.

R4

The Review should recommend to the government that in implementing its policy (outlined in "A New Tax System") to tax trusts as companies:

(1) legislative action be taken to prevent the use of trusts and company structures for the purposes of avoiding tax by way of artificial income splitting;

(2) administrative measures be introduced to reduce or eliminate the need for individuals on very low incomes to lodge a tax return in order to claim imputation credits.

R5

Capital Gains Tax should continue to be levied at the marginal rate of income tax of the individual or entity concerned, and this should be announced as policy by the government in advance of the introduction of any GST or income tax cuts.

R6

(1) A surtax should be introduced on income retained in private companies in order to counter tax avoidance strategies which exploit the gap between the corporate income tax rate and the top marginal rate of personal income tax.

(2) The Review should give high priority to developing detailed legislative options to achieve this end.

(3) The corporate income tax rate should not be reduced unless this or similar policies are first legislated.

Scope of the Review and timing of tax reform legislation

Our basic concern about the scope of the Review is that it will separately address issues of personal income tax reform that should be closely integrated with the other key elements of the broader tax reform package – consumption tax reform and the personal income tax cuts. The Review is not due to report until June 1999, by which time legislation to introduce these other elements of the package will already have been considered by the Parliament.

To some extent, it is inevitable that the Review will deal with personal income tax issues since it is difficult to draw a clear boundary between the business and personal income tax systems. For example, a reduction in the corporate income tax rate has direct implications for personal income tax base – given that individual tax-payers can conduct their business or investment activity through private companies.

However, it is essential that personal income tax reform and consumption tax reform be treated as a package – as the government itself has consistently argued. In particular, the key elements of personal income tax reform should be in place before any GST or personal income tax cuts are introduced.

Moreover, it would be inappropriate for a Review charged with developing proposals to reform the business tax system to take on a leading role in regard to personal income tax reform.

This gives rise to three specific concerns about the work of the Review.

The first concern is that the scope of the Review appears to be very broad and needs clarification. The Review should make it clear that it will focus exclusively on issues that primarily fall within the ambit of the business income tax system as distinct from the personal income tax system. For example, business income tax concessions and the corporate income tax rate are issues that are appropriately addressed by the Review, but superannuation tax arrangements are not.

The second concern is that the personal income tax base broadening proposals announced in "A New Tax System" – particularly the taxation of trusts as companies – must not be delayed or weakened as a result of the Review’s deliberations. The policy intent of these measures should be implemented in full, and legislated in advance of any GST or personal income tax cuts.

While ACOSS appreciates the need for consultation with business to fine-tune the proposed new tax arrangements for trusts, we regard this policy as crucial to any serious attempt to curb personal income tax avoidance in Australia. This is a personal income tax issue as much as a business income tax issue, since it is mainly the personal income tax base that is placed at risk by the abuse of trusts for tax avoidance purposes. The basic intent of the policy with regard to trusts is not negotiable, and must not be prejudiced in any way by the Review’s deliberations.

Those who currently rely on trusts for tax avoidance purposes will oppose this measure, and may attempt to use the Review as a means of delaying, reversing or weakening the policy. This should be strongly resisted, and the Review should focus its attention on recommendations to ensure the smooth implementation of the policy, rather than a reassessment of the policy itself.

There are two administrative measures that should be recommended by the Review in order to ensure that the policy achieves its objectives without adversely affecting tax-payers who are not using trusts to avoid tax.

Legislative and administrative measures should be recommended to prevent the use of private companies and trusts for the purposes of avoiding tax through artificial income splitting. This is the practice of artificially splitting income between spouses or business partners so that the income of the high income spouse is minimised while that of the low income spouse or partner is maximised. This creates an unfair tax advantage for couples on different income levels, compared with single individuals and couples whose marginal income tax rates are the same.

Unless anti-income splitting measures are introduced in conjunction with the proposed reforms to the imputation system, there is a danger that these reforms will increase the scope for artificial income splitting. This would occur because the proposed refundable tax credits for low income investors (who cannot take full advantage of imputation credits due to their low taxable incomes) would extend to low income individuals who are the owners of shares transferred from their high income partners.

The Review should also consider ways in which the imputation system could be simplified for tax-payers on very low incomes, especially those who are entitled to the new refundable tax credits. Consideration should be given to a system which does not require these tax-payers to lodge a tax return in order to claim imputation credits.

Our third concern is that any fresh proposals emerging from the Business Tax Review that have a major bearing on the integrity and fairness of the personal income tax system should be clearly resolved before the major elements of the package (including the GST and personal income tax cuts) are legislated. This refers particularly to the proposals mooted in the Terms of Reference of the Review that the Capital Gains Tax rate be capped at 30% and that the corporate rate also be reduced to 30%.

This particular concern would be allayed if the government announced that it does not intend to proceed with a 30% cap on Capital Gains Tax, and that legislation will be introduced to curb tax avoidance through the abuse of private company structures before any reduction in the corporate income tax rate is implemented.

R2

The Review should more clearly define the scope of its work, in order to exclude personal income tax reform agendas that are more appropriately addressed elsewhere.

R3

(1) Policy measures announced in "A New Tax System" that are designed to stem income tax avoidance, including the taxation of trusts as companies, should be legislated in advance of any GST or personal income tax cuts.

(2) The Review should give the highest priority to finalising legislation to ensure the smooth implementation of these measures, without revising their basic policy intent.

R4

The Review should recommend to the government that in implementing its policy (outlined in "A New Tax System") to tax trusts as companies:

(1) legislative action be taken to prevent the use of trusts and company structures for the purposes of avoiding tax by way of artificial income splitting;

(2) administrative measures be introduced to reduce or eliminate the need for individuals on very low incomes to lodge a tax return in order to claim imputation credits.

Capping the rate of Capital Gains Tax at 30%

The proposal to cap the tax rate for capital gains at 30% directly challenges the principle, articulated by the Review, that different business structures and investments should be taxed in a consistent manner. There is no economic justification for the artificial distinction between ordinary income and capital gains which featured in Australian tax law before 1985: capital gains are simply a form of income (that which is derived from the sale of an asset). It is obviously unfair that $1,000 earned from labour should be taxed while $1,000 received from sale of commercial property goes untaxed - yet this was largely the case in Australia prior to 1985.

There is a strong case on both equity and efficiency grounds for tightening the CGT and broadening its base, rather than introducing another major capital gains tax concessions such as a 30% cap. Under the present CGT regime, capital gains are taxed on realisation (not as they accrue) only the after-inflation component of capital gains is taxed, and owner-occupied housing is exempted. There may be a case for some form of concessional treatment for capital gains, for example on the grounds that capital gains are often not available to be spent as they accrue and that there are social benefits in facilitating owner occupied housing. However, these concessions already give rise to considerable tax avoidance opportunities and economic distortions and further concessions such as a 30% cap are likely to be economically harmful as well as unfair. The basic principle should be that, as far as possible, capital gains are taxed at the same effective tax rates as other income, with any concessions clearly justified on their merits.

It is obvious that capping the CGT at 30% would seriously undermine this principle, even if this were traded-off against existing concessions such as inflation adjustment. It is also obvious that this would have adverse effects on both equity and economic efficiency:

  • Earnings and investment income other than capital gains would be taxed at marginal rate of up to 48.5% while income from the sale of property would be taxed at a maximum of 30%.
  • Investment decisions would be biased in favour of those which deliver large capital gains as distinct from profits in other forms.
    • In particular, the present economically damaging bias in favour of investment in real estate would be worsened.
  • Tax avoidance opportunities for high income individuals would be greatly expanded and considerable legal and accounting resources would be devoted to artificially converting "ordinary income" into "capital gains", as was the case in the "bad old days" of blatant tax avoidance before Capital Gains Tax was introduced in 1985.
    • These tax avoidance opportunities may be considerably enhanced by new financial arrangements such as derivatives which enable the outward form of economic transactions to be manipulated without changing their underlying economic character.

Indeed, it is likely that a cap on the rate of CGT would give rise to greater opportunities for tax avoidance than the abuse of trusts, which the government rightly seeks to curb in its tax package.

Those who favour a lower rate or cap for CGT argue this case on two main grounds:

(1) It would raise the overall level of investment by reducing effective tax rates on investment returns.

This tax reduction would only apply selectively to investment income in the form of capital gains, giving rise to the economically damaging tax biases referred to above. If it were demonstrated that "high" income tax rates were discouraging investment in Australia (which we doubt), the appropriate solution would be to reduce tax rates generally, not the rates applying to one particular form of income.

(2) It would particularly improve the supply of venture and development capital in areas such as information technology.

This argument relies firstly on the assumption that much of the profit that is made by investors in these areas comes in the form of capital gains rather than a steady stream of profits or dividends. For example, investors who specialise in providing capital for new business ventures may sell their interest in a venture before it becomes profitable in order to realise their capital gains and invest the proceeds in new ventures. This is a reasonable assumption.

The second key assumption is that increased investment in new Australian business ventures would be attracted if capital gains tax rates were reduced. For example, it is argued by some that pension funds in the United States would invest more in new information technology ventures in Australia if the capital gains tax were capped at a lower rate as is apparently the case in the U.S. This argument lacks firm empirical support, and relies instead on anecdotes and misleading international comparisons.

The U.S. experience is sometimes held up as an example of the alleged economic benefits of CGT cuts. It is argued that cuts in the CGT rate in the U.S. in the late 1970s spurred a boom in investment in new ventures, especially by pension funds. While it is true that such investment expanded rapidly during the 1980s, it is very doubtful that this was due substantially to the CGT reductions, or that similar outcomes would be achieved in Australia.

To begin with, U.S. pension funds are not taxed in the U.S. on their income. In order to encourage a redirection of their investment from the U.S. to Australia, in theory a zero tax rate would be required. This could hardly be justified on either equity or efficiency grounds.

The argument that CGT reductions spurred investment in new ventures in the U.S. in the 1980s has been strongly criticised on this ground and others by Poterba . A copy of his analysis is attached. We should look elsewhere for the main causes of the rise in venture capital investment in the U.S. over the 1980s and 1990s. For example, it is likely that the loosening of prudential requirements in respect of investments by U.S. pension funds in the early 1980s was a significant factor.

Although federal CGT rates in the U.S. are nominally lower than those applying to high income individual investors in Australia, simple comparisons are misleading. They fail to take account of the existence of state taxes in the U.S. and the fact that capital gains are indexed for inflation in Australia but not in the U.S. Moreover, the capital gains tax rates for companies in the two countries are similar.

A low or flat rate of CGT is sometimes justified on the grounds that capital gains are eroded over time by inflation. However, while inflation adjustment gives rise to serious distortions in the tax system, it at least addresses this concern more fairly. For example, a low income tax-payer does not benefit at all from a 30% cap on CGT, yet his or her capital gains are still "eroded" by inflation. High income tax-payers - especially one who holds an investment asset for a short period only - would be the main beneficiaries of the substitution of inflation adjustment by a flat cap on the rate of CGT. Low income earners, especially those who hold an asset for a considerable period of time, would lose. Inflation adjustment is a major concession of dubious value, given that other forms of income such as bank interest are not indexed for inflation. However, capping the rate at 30%.is much more unfair and distortionary.

The intended benefits of a cut in the CGT rate – an increase in investment in certain activities - could be achieved in a fairer and more efficient way without compromising the integrity of the entire personal income tax system. For example, the United Kingdom has for a number of years successfully used direct expenditures (investment incentives) to encourage such investment.

It might be argued that a more tightly targeted CGT concession would minimise both the above risks and the loss of revenue involved. For example, some would advocate restricting the concession to certain types of investment in new ventures in the information technology industry. However, based on the experience with the Australian Research and Development tax concession and infrastructure bonds, there is no doubt that this concession would be widely exploited for tax avoidance purposes unless its scope were very tightly defined using complex tax rules and it was very closely administered. Even then, a tax concession confined to new business ventures would encourage existing businesses to establish new entities to carry out functions already undertaken (such as IT research) in order to claim the concession. Public revenue would be expended without any a net increase in the desired investment.

In contrast to direct outlays programs, a tax concession is an inefficient way to encourage the development of a specific industry because it is much more difficult to:

  • target the concession precisely to encourage the desired activity (due to the greater likelihood of manipulation of eligibility conditions that are enshrined in tax legislation);
  • control public expenditure;
  • abolish the program when it is no longer needed.

This was a central conclusion of the Mortimer Report on industry assistance programs.

For the above reasons, ACOSS strongly opposes any artificial "cap" on the rate of Capital Gains Tax, whether confined to certain investments or applied across the board.

R5

Capital Gains Tax should continue to be levied at the marginal rate of income tax of the individual or entity concerned, and this should be announced as policy by the government in advance of the introduction of any GST or income tax cuts.

Reducing the corporate income tax rate to 30%

ACOSS does not have a fixed view on the appropriate rate for company income tax. Account should be taken of comparisons with rates a of personal income tax in Australia and corporate tax rates overseas, especially in countries such as the U.S. which are the source of much foreign investment in Australia. Corporate tax rates in industrialising East Asian countries are of much less relevance because other factors (such as the quality of infrastructure and skills of the workforce) are likely to play a greater part than tax considerations in influencing investment choices between these countries and Australia.

We are not convinced that there are significant economic advantages for Australia in having a lower corporate tax rate than those of comparable countries. International tax treaties generally have the effect of transferring any gains from lower corporate taxation in Australia from overseas investors to overseas Treasuries.

Moreover, under the imputation system domestic investors are practically indifferent to the corporate tax rate, apart from tax exempt investors and those whose investments attract tax concessions. In respect of these two exceptions, a rigorous corporate income tax system plays an important role in closing off opportunities for tax avoidance.

Assuming that the business income tax reforms are revenue-neutral, our main concern with any reduction in the corporate tax rate lies in the tax avoidance opportunities which this would facilitate. ACOSS has argued consistently that high income tax-payers should no longer enjoy opportunities to avoid personal income tax by incorporating. These tax-payers can presently avoid tax by retaining income in a private company, where the tax rate is already 12.5 percentage points lower than the top rate of personal income tax.

Australian Taxation Office statistics indicate that the number of private companies has increased by 32% since 1991, while employment has grown by only 10% over the same period. A number of factors have contributed to this growth in private companies, but tax avoidance is undoubtedly one of them. Both the Treasury and the Australian Taxation Office have at various times throughout the 1990s expressed concern about he abuse of such "interposed entities" as private companies to avoid personal income tax. For example, in 1995-96 the Federal Budget Papers indicated that that the Treasury would shortly release a discussion paper on the abuse of such entities by tax-payers to avoid tax on their earnings . Private companies are also used for artificial income splitting purposes and to reduce tax on investment incomes.

To its credit, "A Strong Foundation" raises this issue directly:

"Perhaps the major distortion that would remain stems from the misalignment of the entity tax rate with marginal rates of personal taxation. The differential taxation of entity earnings as between retentions and distributions, effects both equity financing and entity distribution policies, particularly in respect of privately owned entities. A reduced rate of entity tax, which is raised in the review’s Terms of Reference would exacerbate this distortion"

We do not consider that it is feasible to align the corporate and top marginal personal tax rates without undermining the fairness of the personal income tax system. This is because the weight of international tax competition falls more heavily on corporate tax rates than personal tax rates. This is demonstrated by the fact that the rate alignment achieved in the mid 1980s was soon undermined by international pressures to lower the corporate rate.

As we argue in our Agenda for Tax Reform, this loophole should instead be closed by re-introducing a surtax (along the lines of that which existed in Australia until the mid 1980s) on the retained income of private companies. Unless this or similar action is taken, ACOSS would oppose any reduction in the corporate income tax rate on the grounds that the existing loophole would be widened.

R6

(1) A surtax should be introduced on income retained in private companies in order to counter tax avoidance strategies which exploit the gap between the corporate income tax rate and the top marginal rate of personal income tax.

(2) The Review should give high priority to developing detailed legislative options to achieve this end.

(3) The corporate income tax rate should not be reduced unless this or similar policies are first legislated.