As a consequence of some discussions on corporate tax policy, I wrote this paper to sort out my ideas. As I state, I am not a tax specialist. Indeed it turns out what I thought was a profound discovery – that New Zealand’s corporate tax on undistributed earnings is a sort of capital gains tax – is a commonplace idea among tax specialists. I’ve included it on the site, partly because it is a record of my thinking, and because it may stimulate other non-specialists to see more clearly what ar the options we face.
Keywords: Business & Finance; Regulation & Taxation;
To begin with a point that may be evident by the end of the paper. Economists are rarely experts on taxation. We use models which are highly simplified accounts of the grubby reality. I dont apologise for this, because sometimes our abstraction is helpful. I think it is in this case, because what I am interested in is whether we should have a corporation tax in 2016, say.
I am driven by two concerns:
First, economists find it very hard to justify a corporation tax, except in that it raises revenue reasonably effectively. It seems to have arisen when income tax was first imposed on persons (In 1892 in the case of New Zealand) and although not natural persons, corporations were included. Some economists suggest they are a fee for the right to have limited liability (although that may be pushing the historical story). By extension it may be a payment for the quality of the meta-technologies of a nation-state – the social and business infrastructure which contributes to effective commerce (as discussed in my next book The Globalisation of Nations).
And of course company taxes do have a redistributive effects which many people would think is more equitable than not having the tax, although some economists are less certain of their distributional impact. (I explain that below.)
But if they are effective revenue raises, there are various related consequences many of which are on the downside. That is true for almost all taxes, of course. But corporate taxation may have relatively higher downsides than most.
The second concern is that in a globalised world with highly mobile capital (I am concerned primarily here with physical investment) there will be downward pressure on corporation tax levels, especially for small open economies. Again I’ll develop that. What that may mean that in the long run New Zealand may have little choice than to follow the herd down. One option would be to lead the herd.
But whatever, the exercise I am asking, is I think worth doing in order that we clarify some of the issues. After all reducing corporation tax from 33 % to 30% is but one eleventh of the way to 0%. Thus, while I accept the ‘dont rock the boat (too much)’ incrementalist approach, I think we need to be clearer where the boat is heading, and what are its possible destinations.
It is a routine part of an economist’s thinking, to distinguish between the ‘legal’ (or ‘impact’ – there does not seem to be standard terminology) incidence of a tax with its ultimate (or actual) incidence. Those who are legally required to pay a tax, may shift the burden to others. The notion is conceptually very simple. Nobody thinks that breweries actually pay the excise duty on beer. Although they hand the cash over, they have shifted the payment to beer drinkers in higher prices. However, while the notion may be simple, calculating the ultimate incidence is not. The usual assumption is that while the corporation legally pays company tax, the ultimate incidence is shared between the owners of the capital, the corporations’ employees, and the purchasers of the corporations’ products. But there is little agreement on the proportions which the burden is shared.
Note in the following, I am anxious to maintain fiscal balance, and not unmindful of the redistribution effects. That is why I suggested the alternative of increasing GST to offset the company tax reduction.
By way of background we should notice the following international trends:
– Headline company rates have fallen across the OECD over the last 20 years;
– Effective rates have fallen much less over the same time as bases broadened;
– There appears to be a structural shift towards greater corporate profits relative to labour earnings remuneration which means revenue gains have been even higher.
My interpretation of the available research might be summarised as
– Low company rate not essential for successful countries…
– … but may matter more for small open countries
That is the main concern. Note I have added an extra adjective.
One further complication is that it appears that only Australia and New Zealand have ‘imputation’, that is that when tax liability is assessed on personal dividend, the company tax paid is treated as if it were a withholding tax, so that the company income is not doubled taxed (at the company and personal level) as it is in most jurisdictions.
The Revenue Effects of New Zealand’s Company Tax
– a withholding tax on shareholders who are New Zealand resident taxpayers, raising about $2.7b p.a. although were company tax zero, because of imputation this would be collected as income tax.
– a final tax for dividends to non-resident shareholders raising about $1.3b p.a. Were company tax zero, this would be lost to the tax system. Alternatively, there could be a withholding tax on all dividends, so that foreign recipients would be taxed.
– a final tax for non-taxpaying shareholders (e.g. charities). Because revenue is negligible this effect is ignored below,
– a tax on the accrual of retained earnings ($6.0b p.a.) his is the big immediate loss of revenue if the company tax were zero. Moreover, there would likely to be opportunities for tax avoidance by a zero dividend policy, retaining all earnings, and selling the asset, thus realising to the seller the retained profits. Selling offshore would mean any tax could be avoided completely.
A capital gains tax on such sales might partially reduce this effect. This conclusion haunts this paper. It appears we may have of an (imputed) company tax is because we have no capital gains tax.
Additionally company tax is a backstop against sheltering of investment and personal services income in companies. When I talked to Treasury officials a decade, this was their biggest concern. As I recall, they instanced a person turning her or himself into a company, retaining all profits and so not paying taxes, but the company making loans to the individual (secured on their shares?), with no personal income tax paid by the individual. I dont know how easy such schemes would be to stop nor do I underestimate the ingenuity of the tax advice industry.
Do we need company tax?
Currently Inland revenue collects around $10b p.a. at company level. were company tax zero it would still collect some of this as income tax on dividend distribution. However, a change of the rate is likely to change companies’ distribution policies. In particular a zero dividends policy, would avoid all tax, with shareholders realising the corporate incomes through capital gains on share sales. (The implications is a rational tax structure would require a capital gains tax, if there was no company tax.)
The alternative I have thought about is offsetting the revenue loss with a higher GST. (Alan Catt, for whom I worked as a research assistant in the 1960s, was an advocate for this, although in those days there was no GST.)
Since a 1 percentage point on GST raises about $.7b p.a. (private spending only with no adjustment for social security benefits and the like). To raise $10b p.a. GST would have to rise to 25%. If the current dividend distribution policy remained, dividends overseas were taxed at 33%, and there was a special tax on banks and similar financial institutions of $1b, say, the remaining $5b would require a GST of 19.5%. The conventional wisdom is that a GST rate much above 17.5% leads to significant avoidance and loss of revenue.
I have recently realised that were the corporations to cut their prices as a result of a lower tax and a GST was imposed instead, NZ consumers would be worse off, because foreign purchasers would also be beneficiaries of the lower prices. I mutter more about the export problem below.
Our GST is well-designed, raising a relatively high level of revenue at a relatively low rate. however it applies to only approximately 83% of expenditure. I had not realised this. Some of that will be overseas purchases, some will be financial services and interest. Any others. Should there be an attempt to broaden the base? (Query. would someone remind me why we dont impose GST on interest? I have a suspicion that the RBNZ might favour such an imposition in regard to consumer interest rates, so I would like to think more about it.) This lack of comprehensive coverage generates one of the places where a higher GST rate would lead to avoidance.
While GST is broadly proportionate relative to expenditure it is regressive relative to income. I am favourably disposed to expenditure taxes (taxing what you take out of the economy, rather than what you put in). (http://www.eastonbh.ac.nz/?p=663) Both GST and exempting savings from income tax are means of doing this. As for the anti-equalitarian distributional impact of GST. I would favour tilting the income tax, social security and families assistance to offset it. In effect I favour penalising the rich spendthrifts relative to the rich thrifty.
So what would a lower/no company tax rate achieve?
Lower tax on (internationally mobile) profits and capital would encourage more capital investment in New Zealand, as would Increased retentions. More capital employed should increase wages and probably increase human capital accumulation. Indeed since company taxes depresses wages in the corporate sector there may be a direct wage lift.
However it is unlikely to help other mobile factors (non-company capital, skilled labour). We cant, though, expect everything to benefit, although if all the effects are included (what we economists call general equilibrium analysis) it might.
However most of all lower tax rates put pressures on other parts of the tax system and increase the inefficiency and avoidance on it.
The economic case for corporate taxation
Corporation tax offends me as an economist, because there does not seem to be a rational for it. However, I am (now more) acutely aware of its importance as a revenue source and the difficulty of replacing that. This gives me a little comfort, because it may be difficult for other countries to reduce their taxes on business too, despite globalisation. Nevertheless these globalisation pressures present a constant threat. which force us to continually think about the rationale, structure, and levels of company tax.
I was surprised how often the analysis of ending of a company tax seemed to imply the introduction of a capital gains tax, which suggests to me that we might think of the tax on the retained earnings as being a substitute for a capital gains tax.
This conclusion was made clearer to me by a friend who wrote
“There is a very good economic rationale for company tax. A neutral income tax (assuming we want a neutral income tax) requires a full allowance for depreciation (loss of value of assets as it accrues) and symmetrically, full taxation of capital gains as they accrue. The relevant reference is Paul Samuelson ‘Tax Deductibility of Economic Depreciation to Insure Invariant Valuations’ JPE, 1964.
“In the absence of company tax, shareholders would need to be taxed on the gain on their shares as it accrued, whether or not that gain is realised. It is obvious that implementing such a tax is impossible in practice. The company tax is a proxy for that, and the dividend tax with imputation a backstop to catch any income that hasn’t been taxed in the hands of the company.
“Behind most avoidance opportunities, you will find some form of non-neutral tax treatment. The non-neutral treatment causes both a distortion of activity towards the activity associated with the avoidance and a consequential loss of revenue as activity is diverted into the avoidance activity. It is the distortion of activity caused by the avoidance activity and the distortion of activity caused by the higher rate of taxes needed elsewhere that is the primary reason we are concerned about the avoidance, not the loss of revenue itself.”
That puts elegantly what I had concluded clumsily . (And yes, I had not read the Samuelson paper – I have not read everything.)
Suppose that is right. At what level should we set the implicit capital gains tax? Might it be more ‘efficient’ to replace company tax with a capital gains tax on shares, and a withholding tax on dividends?
Next steps: modelling
I was disappointed that there was not more quantitative material about the economy-wide impact of company tax. I know these models do not give precise answers, but I think it essential we use them. Providing the modellers are competent, the models keep forcing us to ask deeper questions – deeper than the models can answer cleanly, but they provocation makes them worth it.
In particular New Zealand models have to make assessments about how an open economy would react (which is damned difficult, but even more important). Most of the academic/economics literature I have read applies to a closed economy, and it can be fiendishly misleading.
Next steps: changing tax rates
Other than to commission such a modelling project and keep the whole matter under review, what should be done?
The current situation appears to be is that the government is contemplating spending some of its revenue surplus (?) on business tax cuts next year.
I am loathe to recommend reducing the company tax rate, until there is a better understanding of the relationship between company tax, personal rates, opportunities for tax avoidance, in an open economy and company tax on retained earnings and a capital gains tax. This is not to say that the reduction should never be made. Rather, I would want a more robust analysis than currently seems available before I could support one.
So how might the available funds be used to reduce business costs. among the ones which interests me are:
1. Super-accelerating depreciation. (This was a timing issue, since it merely delays when they pay company tax. But since it is an incentive to accelerate capital investment, and New Zealand seems to lack capital, that may be a good thing.)
2. Super-deducting expenditure on skills acquisition and training. The logic here is these expenditures have spill-over benefits for the economy as a whole which are not captured by the firm (because workers are mobile and move to other firms).
3. Super-deducting expenditure on research and development. The logic here is these expenditures have spill-over benefits for the economy as a whole which are not captured by the firm (because the value of their property rights cannot be totally retained by innovating firm).
4. The lowering taxes on profits made from exports. I return to this notion below.
As far as spillover effects (2 and 3) are concerned, there is a strong case for some public subsidy to bring (marginal) spending in line with (marginal) public benefits (rather than the lower private benefits to the firm). Subject to that we know little about the size of the spillovers I am very favourably disposed to such subsidies. The best delivery system (e.g. tax exemptions, rebates, grants …) is a technical issue I have not thought about. However, I should not be surprised if we are spending too much on grants (say, through NZTE) compared to rebates.
The case for lower company taxes on profits made from exporting is not as clean as for spillovers. As far as I can see, it reflects a belief that our exchange rate regime is cocked up and the exchange rate overvalued, and that we cannot address the cockup any better than we are currently doing. It is sort of saying that such tax concessions are third best policy but not having them is a fifth best policy and we cant get to the first (or even second) best policy.
First, is such a concession allowed under WTO rules? Under ANZCERTA?
Second. how the concession would be delivered is presumably administratively complicated. We would want to be careful not to privilege a fully integrated company relative to one which outsources, while if it is only for export effort it privileges exporters against firms that compete against imports who may be just as worthy.
One way around this is to provide the concession to only a particular export activity, such as marketing. However I cannot see an economic justification for privileging one part of the export effort over all others, other than the ‘good thing’ argument – that export marketing is a good thing.
Lots of activities are ‘good things’, so why privilege one instead of the others? What worries most about the ‘good thing’ argument is that it what was a common driver before 1984 – what is sometimes call ‘Muldoonism’ (although I try to avoid that rhetoric). My point here is similar to my doubts about corporation taxation, which many people think it is a ‘good thing’ too. But that is not an economic rationale. The danger is – as happened before 1984 – that we start subsidising everything deemed to be a ‘good thing’ on an ad hoc basis and at the end of the day we have not got the foggiest idea what is being subsidised or penalised via taxation paid to subsidise others, other than we have enlarged the tax avoidance industry.
Third, the benefits of favourable treatment of exports are primarily on the production side. And may not increase domestic incomes directly (in a way that a cut in personal income taxes would). Once more we face the complexities of the open economy.
1. Apparently there is no Australian and New Zealand have no joint agreement to impute company taxes on the other’s dividends. It is said that the New Zealand government proposed it, but the Australian government is uninterested because they did not think it was in their interest. But it is surely in Australian business’s interest. Is there a place for a joint Australian-New Zealand business lobby pursuing this objective.
2. Calculating the tax base is always complicated, especially for transnational corporations which can use transfer pricing to shift profits from high tax jurisdictions to low tax ones. (They overprice imports and underprice exports where taxes are high.) Apparently California contemplated taxing on its share of the world-wide profit of its transnationals. Calculating the share is not straight forward, but it is an interesting idea. I do not know if it has been implemented.