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Submission to the Review of Business Taxation

 

By VECCI

 

29 January 1999

The Review of Business Taxation

 

Introduction

This paper represents the final submission of the Victorian Employers’ Chamber of Commerce and Industry to the review of businesses taxation. This submission is divided into three parts.

The first, looks at the general economic environment and the potential business tax reform options available to the Government and what the impacts of those options is likely to be on the economy.

The second, is to look at the role of the tax system in encouraging a dynamic business culture. Rather than using the standard paradigm for analysis of the business tax system ie. does it achieve appropriate taxation principles or what and the economic effects. We have taken the perspective that if we want to encourage a dynamic business culture what should the Australian business tax system look like.

The third area for discussion is to look at the distributional impact on corporate Australia of different tax reform options and to examine which sectors may be potential winners or losers relative to each different case study.

1. The Economic Environment

In examining different reform options to Australia’s business taxation system, it needs to be acknowledged, that different tax structures, even involving revenue neutral options, can have significantly different effects on the performance of the Australian economy.

Therefore, it is critical that not only those potential effects are acknowledged, but also their full effects are examined to determine how they will impact on different parts of the Australian economic system.

VECCI has undertaken this activity by re-examining the economic modelling that was undertaken in a major research paper, titled ‘The Role of Government and the Balance of Payments Problem’, released in July of 1996. The purpose of this paper was to look at seven different options the Federal Government could undertake in achieving a fiscal consolidation program and then examining the relative impacts of each of these different options on a range of economic issues, with particular emphasis on Australia’s current account deficit.

The modelling work was undertaken by the National Institute of Economic and Industry Research (NIEIR) through their use of the IMP model of the Australian economy.

In examining different tax reform options, it is appropriate to focus on four of the most critical issues to economic policy makers is the current account deficit, GDP growth, the labour market and overall fiscal policy.

The Current Account Deficit

Based on previous economic modelling by VECCI, it would appear that the Federal Government should give priority to reducing taxes in the following areas.

With regard to the current account deficit, it appears that the best policy action the Government could make is by increasing business support expenditures (such as R & D tax concessions or export incentives).

The second best course of action would be to cut business indirect taxes, such as payroll tax and business financial taxes.

The third best course of action would be to reduce company taxes via a reduction in the corporate rate of tax.

The least preferable course of action would be to reduce household taxes.

Therefore, in considering various trade-offs it is preferable to restructure the Australian business taxation system, at least from a current account perspective, in such a way as to increase the level of business tax concessions rather than cutting business indirect taxes.

It would appear that the impact of business behaviour, on the current account deficit, such as export and import activity, is more likely to be affected by direct change in business tax expenditures, rather than through changes in the overall business indirect tax take.

In comparing alternative options, it also appears preferable, to reduce business indirect taxes rather than reduce company taxes. This may come about because companies in loss-making situations don’t benefit from a company tax rate cut and that many small-unincorporated businesses don’t directly benefit from a cut in the company rate of tax.

Therefore, based on this analysis it is preferable to reduce payroll taxes and business financial taxes rather than reducing the company tax rate, in order to improve the current account deficit for a given level of taxation revenue.

It would appear that business indirect taxes impede international competitiveness by having a direct effect in distorting final selling prices, thereby, undermining export and import competitiveness.

GDP Growth

In terms of potential trade-offs within the business tax system to encourage short-to-medium term economic growth, it would appear, the most effective action the Government can take in the restructuring of Australia’s tax system is to cut company taxes.

The second most preferable option is to cut business indirect taxes with the third and least effective option, at least in terms of economic growth, would be to increase business tax concessions.

Changing the company rate of tax has a very significant effect on private investment activity, which in turn, not only has a significant impact on short-term economic performance but also in terms of the economy’s longer term potential.

Investment growth is the single most important economic condition to expanding the economy growth potential.

Changes in business indirect taxes, from an economic perspective, tends to have its greatest impact on current consumption patterns and the impact on overall business investment will be nowhere near as pervasive as a change in the company rate of tax.

The impact of changes to business tax concessions, in terms of short to medium term GDP growth, is likely to be less pervasive unlike their impact on the first economic condition we examined, namely, the current account deficit. Where their effect is likely to be much more important is in helping to restructure the economy from an international trade perspective.

The Labour Market

The short to medium effects of different tax changes, with regard to the labour market, will be in line with the general impact on overall economic performance. Therefore, in terms of improving the unemployment rate, the greatest consideration should be given to reducing the incidence of company taxes via the company tax rate.

The second priority area would be a reduction in business indirect taxes, while the least effective in terms of improving the overall health of the labour market, would be to extend business tax concessions.

Fiscal Policy

In terms of making changes to the overall collection of different taxes and their overall impact on a sustained improvement in the Government’s overall budget position, the first priority should be given to business indirect taxes. For example, increasing reliance on business indirect taxes will have a relatively minimal impact on other direct taxes resulting in the significant increase in indirect tax revenue assisting in a sustainable build-up in Government surpluses.

The second priority would be given to changes to business tax concessions, as the impact on sustainable revenue is relatively limited.

The third and least preferred option would be an increased reliance on company tax revenue, with the surpluses dissipated through lost economic activity via a significant loss in household tax revenue given lower employment opportunities created in the economy.

Conclusion

In the restructuring of Australia’s business taxation system, the structure that would result in a lowering of the reliance on company tax revenue, say relative to company indirect taxes, gives a short-to-medium term improvement in such economic factors as GDP growth and the labour market.

However, cutting indirect business taxes as part of that overall restructuring package relative to a reduction in the company rate of tax, will result in more sustainable economic benefits, through firstly, improving the current account deficit and secondly, an improved international competitive position.

The benefits of this improvement will be to make economic growth performance a much more sustainable one, and relax the constraint on Australia’s economic potential.

It also appears, based on this analysis, that providing greater business tax concessions could also produce more significant sustainable benefits relative to a reduction in the company rate of tax over the longer term through a more effective restructuring of the Australian economy.

2. The Role of the Taxation System in Encouraging a Dynamic Business Culture

In examining Australia’s business taxation system, the framework for that analysis is often undertaken on the basis of firstly, a taxation policy principles approach (such as efficiency, equity, neutrality etc.) or secondly, for its relationship with the macro-economy (such as GDP, Consumption or the labour market).

VECCI believes that this perspective has often led policy-makers to construct a taxation system not with the end user in mind, nor more importantly, one which fosters the type of business culture Australia should embrace.

As a result VECCI has decided to adopt a different paradigm in looking at Australia’s business tax system. That paradigm commences from the starting point of how should the Australian business tax system look if we want to encourage a business culture of dynamism, innovation and growth.

Therefore, it is imperative to identify how the tax system can operate as a barrier or a constraint to those sorts of businesses. How can those issues be ameliorated in order for a greater proportion of the Australian business sector to reflect those type of attributes and that the economic system specifically encourage businesses that demonstrate such attributes.

Key attributes that make up such dynamic growth businesses are outlined in the next section, along with the taxes that impact on those attributes, and what reforms should be considered as part of the overall business tax review.

Capital Growth and Mobility

It is axiomatic that dynamic innovative firms, focusing on the growth of their business, will experience an expansion in their capital base. Therefore, it is imperative that the design of the Australian business tax system facilitate not constrain such growth.

More importantly, it is imperative that capital be as mobile as possible so that capital that has grown and accumulated in one business can be transferred to another business as part of a legitimate business growth strategy.

The extent of capital mobility, is however, constrained by the operation of the capital gains tax system. Businesses that are sold in order to purchase alternative businesses come directly in to contact with the capital gains tax system. Current exemptions such as the goodwill exemption and the roll-over of assets exemption can ameliorate the negative effects of this.

However, the mere existence of the capital gains tax system does act to constrain the mobility of capital and thereby constrain an important business growth strategy.

One way of dealing with this issue would be to differentiate capital gains, which have accumulated through productive means as against speculative activity.

A company that undertakes a legitimate growth strategy which had increased their capital base encounters a problem when they want to use the proceeds to leverage into a larger business. The solution could involve the total deferment of that capital gains tax liability until the cessation of all business activities of that particular entrepreneur.

Whereas, capital accumulation based on speculative activity, such as, the purchase of artwork etc. would incur the total capital gains tax liability at the time of disposal of that particular asset.

Therefore, total deferment, of capital gains tax liability, on assets that were accumulated as part of business growth and leveraged up into a larger business, would be to create an environment which specifically encourages capital growth and mobility and facilitate a more dynamic and growth oriented business culture.

Innovative

A key feature of dynamic growth businesses is their preparedness to be innovative and seek out new solutions to existing problems. A critical element of the business infrastructure to underpin innovation is the level of research and development expenditure that businesses undertake seeking to either enhance its existing products and services or seeking to develop new opportunities.

The level of innovation within the business community means that there will be significant leveraging-up from the basic research undertaken across the economy into the development of commercial opportunities.

However, while Australia does quite good theoretical and even applied research the conversion of that into actual businesses and product development is comparatively weak on an international basis. The most critical way that business innovation and the Australian tax system has intersected has been through the operation of the research and development tax concession.

Bearing in mind the reduction of two years ago in the rate of that concession from 150 per cent to 125 per cent and the introduction of a new R & D grants program, called ‘START’, it is VECCI's view that the most effective way the Australian taxation system can encourage innovation would be to restore the original 150 per cent R & D tax concession. But to have the maximum level of benefit to any one individual company capped in such a way that the majority of beneficiaries would be small to medium companies, fitting the dynamic-growth profile that should be supported.

Risk Taking

A key feature of dynamic-growth businesses is their preparedness to undertake calculated risks in order to achieve business growth. A key factor which impacts on the preparedness of risk taking within the business community is the extent to which those individual entrepreneurs have to expose their own private individual assets in order to secure critical financing for expansion purposes.

One of the major structures that has allowed small business to undertake a level of risk taking in their business activities, without excessively exposing their own individual assets, has been through the operation of trust structures. For example, in Australia it was recently estimated that of the 400,000 trusts that were in operation, 250,000 of these were in fact small businesses.

Trusts involve the creation of a legal structure which are like a hybrid between a company and a partnership with certain types of trusts being used to protect assets in the event of a business bankruptcy.

Therefore, a common use of trusts, by small business, is not to avoid tax (via income splitting etc.) but rather for the protection of family assets.

Changes to taxation arrangements involve taxing of trusts on the same basis as companies, will ultimately result in an increased tax liability for many small businesses, thereby weakening their competitive position relative to what exists today.

Moreover, if those changes ameliorate the level of protection currently awarded to family assets, this would significantly constrain the overall level of risk-taking within the Australian economy.

Bearing in mind the already low level of risk taking, that already exists, within the Australian economy compared to other economies (the Australian financial sector being an example of this), then Australia’s economic growth potential will always remain significantly below its full potential.

Therefore, any arguments about the need to tax trusts in the same way as companies, for neutrality reasons, is entirely fallacious and does not take into account the increased tax burden this would place on the Australian small business sector. This would then create an additional barrier on risk-taking across the Australian economy.

Employment Generation

A key feature of any dynamic-growth business would be for that business to increase employment opportunities as its performance takes off. However, as that business experiences increasing employment numbers a whole range of employment based taxes come into force, the most notable of these being the payroll tax system.

A small dynamic growth business that crosses the payroll tax-free threshold for the first time will incur a tax liability that it had not been previously exposed to.

Some small businesses see this as a penalty for increased growth and providing additional employment opportunities and thereby alter their behaviour in order to minimise the impact of this tax impost.

This can manifest itself in a number of ways such as:

  • Changing the level of capital intensity in the firm so as not to increase employment above the threshold level.
  • Simply not expanding the business even when significant growth opportunities exist.
  • Attempt to create a multitude of business structures so as to avoid the liability altogether.

A range of other employment based taxes and imposts, such as the superannuation guarantee charge and workers compensation costs, also constrain and distort the business decision-making process for similar reasons.

There is therefore a need for a concerted effort by the Commonwealth and State Governments’ to work towards the ultimate abolition of the payroll tax system. While in the short-term reform of the tax system involving a reduction in the reliance on this tax base should occur ostensibly through a reduction in the existing statutory tax rate.

This would mean that companies that cross the threshold would not incur such a significant tax burden, thereby it would not be seen as such a constraint on business development and ultimately employment growth.

Development of Networks and Alliances

Dynamic-growth businesses will often identify potential opportunities with other businesses (in a myriad of different forms) in order for both to leverage off each other’s potential. As part of that legitimate strategy for business growth, it is integral that the tax system operates in such a way to encourage that type of behaviour.

However, the operation of the fringe benefits tax system, which impacts on entertainment expenses and a range of transport related expenses, can have the affect of discouraging business behaviour based around the development of effective alliances and networks through two ways.

  • The first, is the actual statutory incidence of the tax – involving the current tax rate at the highest individual marginal tax rate;
  • Secondly, the compliance cost burden, which for many small businesses has been estimated to be excessively onerous.

The most significant reform that the Government could make to encourage an increased take-up of potential networking and alliance opportunities, particularly, in the small to medium enterprise sector, would be to reform the fringe benefits tax system. Such an approach would be based on the approach of the statutory formula method used to calculate the value of a car benefit for fringe benefits tax purposes.

This approach if extended, right across the entire fringe benefits tax system, would result in the system being much more small business friendly and result in a significant reduction in compliance costs for the business sector.

3. The Distributional Impact on Corporate Australia of Differing Business Tax Reform Options

The analysis undertaken in section one examined the broader economic effects of different tax reform options. This section seeks to identify the likely distributional effects of tax on the Australian business sector of different tax reform options, such as cutting the company rate of tax, as against reducing indirect business taxes, as against increasing the use of business taxation concessions.

It is therefore worthwhile identifying which sectors of the business community, will in a relative sense, be comparable winners or losers from different tax reform options.

The following analysis attempts to do that.

A Company Tax Rate Reduction

Winners

-

Losers
  • Incorporated Businesses
  • Foreign Owned Companies
  • Profit Making Companies
  • Established Businesses
  • Unincorporated businesses
  • Domestic companies
  • Loss making companies
  • New start-up businesses

A Cut in Indirect Business Taxes

Winners

-

Losers
  • Companies with existing high indirect taxes (manufacturing etc.)
  • Export oriented companies
  • Import competing businesses
  • Labour intensive companies
  • Companies with low indirect taxes
  • Domestic focused businesses with little import competition
  • Importers
  • Capital intensive companies

An Increase in Business Tax Concessions

Winners

-

Losers
  • Domestic companies
  • Externally oriented companies
  • Innovative companies
  • Capital intensive companies
  • Capital deficient businesses
  • Manufacturing firms
  • Foreign owned companies
  • Domestic focused companies
  • Non-innovative companies
  • Labour intensive companies
  • Companies with an adequate capital base
  • Service firms

Therefore, in looking at different business tax reform options, bearing in mind the different relative weight that will be given to reforms and incidence of business tax, it is worthwhile understanding not only the economic consequences of these trade-offs but the likely restructuring on corporate Australia that these reforms could play.