Are you still feeling lucky punk?
Why Ken Henry’s hunch is right – we
should abolish dividend imputation and cut
company tax to 19%
Nicholas Gruen
Presentation at ANU
Canberra, 14th April 2009
Outline
1.
2.
3.
Introduction
Our current situation “are we still feeling lucky?”
The case for lower company tax
–
–
4.
‘Long clean lines of policy’
–
–
5.
In a closed economy
In an open economy
Alignment
Dividend imputation
Conclusion
Our Circumstances
Our Circumstances
“After all, Indonesia’s current account deficits had
been nowhere near as large . . . as its neighbours’ –
at less than 4 percent of GDP, Indonesia’s . . . deficit
was actually smaller than, say, Australia’s.”
Paul Krugman on Indonesia’s economic crisis
Our Circumstances
Australia’s current account deficits have been around 6%
and may rise to 9%
New Zealand has been in this situation for some time and is
now on S&P watch for credit downgrade
We need to
– Ensure we can attract the funds we need to make it through the
next few years
– Maximise extent to which recovery is investment driven
– Establish long term plans to increase savings
Tax is about choices
Except for taxing economic rent and ‘bads’, taxing is costly.
So . . .
• ‘Long clean lines’ of policy are valuable, but also come with costs.
– ‘Real reform’ - getting top rate down – versus ‘tinkering’ of lifting thresholds
– The argument for alignment of company and top personal tax
– Dividend imputation was a ‘long clean lines’ reform
• None of these issues can or should be decided in principle
• We must choose the lesser of evils based on the evidence in
specific cases.
Capital taxation
– Other things being equal it’s more economically costly
than taxation on personal exertion
– Why?
• The implicit tax on saving and investment compounds over
time (the closed economy argument)
• Capital is more mobile than – even highly skilled – people (the
open economy argument)
The closed economy argument
– Mankiw and Weinzierl’s ‘back of the envelope’ model
– A simple neoclassical growth model of the US with plausible
parameterisation and 25% tax on labour and capital
– In context of debates about extent of self funding of tax cuts
• Where are various taxes on the Laffer Curve?
– Conclusions are that in the long run
• Capital tax cuts are nearly 50% self funding through higher saving and
investment compounding through time
• Labour tax cuts are less than 20% self funding – through greater work
effort
Delong on the closed economy argument
• I very much fear that our current system of capital [taxation] leaves not just $20 bills on
the sidewalk but $1000 bills
• If there are important labor rents earned by workers in capital intensive industries then
the excess burden from capital taxation will be magnified and will fall on the fortunate
rent-sharers in labor as well.
• If total factor productivity does not fall from the sky but is instead linked to investments
in any of a number of ways, then any capital tax that reduces investment will reduce
productivity growth as well (Do we really believe that technological progress in making
computers was independent of investment in information technology?)
• Then by how much would more capital-friendly tax policies in the 1970s and 1980s that
encouraged investment, including investment in information technology, have brought
forward in time the high-tech productivity boom of the 1990s and 2000s? . . .
• This paper's estimates of growth effects and revenue offsets are more likely to be low
than high.
The closed economy argument
– Arguments only slightly weakened with
• Non-infinite time horizon for household savings decisions
• Recovery of lost revenue by alternative (distortionary) taxes.
– Arguments are greatly strengthened if
• Capital investment has positive externalities related to technology
development and transfer as has been suggested by DeLong and others
• The economy is open to capital flows
• Capital taxation cuts could be less regressive
The open economy argument:
Tax and foreign investment
A substantial body of research considers . . . the effects of taxation on
investment and on tax avoidance activities. . . . The first generation of
these studies . . . reports tax elasticities of investment in the
neighborhood of –0.6. [So] a ten percent tax reduction (for example,
reducing the corporate tax rate from 35 percent to 31.5 percent)
should be associated with six percent greater inbound foreign
investment. More recent evidence suggests that foreign direct
investment is even more tax sensitive than this.
Hines, J and Summers, L, 2009. “How Globalization Affects Tax
Design”, NBER
Tax cuts and growth - empirical evidence
– Lee and Gordon (2005)
• Strong negative correlations between company tax rates and economic
growth
– 10 percentage point cut in the company tax rate increases per capita annual
growth by between 0.57 and 1.82 percent
• Little or no correlation between top personal tax rates and economic growth
– Hassett and Mather (2006)
• Strong negative correlations between company tax rates and wages and
• Little or no correlation between personal tax and wages (against their AEI
priors)
Company tax and growth - empirical evidence
Djankov, Shleifer et al, 2008, NBER
Company tax over time
Source: OECD, 2004
The case for ‘alignment’ – company v personal tax
Practicality (anti-avoidance) suggests alignment
But economic theory suggests taxing different kinds of income
differently
One can earn money in a company shielded from personal tax rate.
But one can’t enjoy it!
To spend money earned in a company owners and employees must
be paid by company
Triggering personal tax liability
There is a tax deferral issue which, if it’s a problem should – and can
- be handled with appropriate anti-avoidance provisions
As it is elsewhere (and was here – till 1987)
Alignment: Lifting thresholds versus cutting the top rate
16
The other miracle economy: The case of Ireland
30,000
48.00%
38.00%
20,000
28.00%
15,000
18.00%
10,000
8.00%
5,000
-2.00%
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
Annual per capita GDP ($US)
25,000
Annual per capita GDP growth (%)
58.00%
Ireland GDP grow th
Australia GDP grow th
Ireland GDP per capita
Australia GDP per capita
The case of Ireland
Ireland’s economic renaissance dates to 1987 when it
aggressively courted foreign investment with tax cuts
Its out-performance is commensurate with Lee and Gordon’s
and Djankov, Shleifer’s results
Ireland has a huge gap between top personal (42%) and
company rate (12.5%)
Dividend Imputation
– We know its theoretical justification
• To improve tax neutrality between debt and equity investment
• To reduce double taxation of dividends
– But is it cost effective as a capital taxation expenditure?
– It now costs over $20 billion
– How much does it lower the cost of capital?
Ken Henry: 23 February 2009
An open economy model affects the way one
should think about our company tax
arrangements, including dividend imputation.
21
Dividend Imputation in economic theory
Foreign investors are the marginal, more elastic investor
So they disproportionately determine share prices.
In fact Australian policy has
• Extended domestic shareholders’ access to imputation credits
– Superannuation
– Refundability
• Restricted pass-through of imputation to foreign shareholders.
– So the marginal (foreign) investor purchases Australian
shares with little regard to imputation.
– So the value of credits is poorly represented in foreign
demand for shares and so in share prices
• which determine the cost of equity capital
Dividend Imputation – the evidence
Most reputable studies suggest that the value of imputation credits on
the markets is 50 cents in the dollar or less.
The most sophisticated econometric study by Cannavan, Finn and
Gray (2004) suggests something close to zero valuation.
Recent econometric evidence suggests that the introduction of
dividend imputation did not increase share prices (Ickiewicz, 2006)
Similar investigations of a tax credit scheme on dividends paid to UK
pension funds yielded the same result.
Credits under-valued and so were not reflected in share prices and did not lower
the cost of capital.
Removing these tax credits produced substantial reallocation of
ownership, but with second order effects on price. (Bond, Devereux
and Klemm; 2005)
Dividend Imputation
– Within firms credits are valued somewhere near
zero.
• Interview evidence suggests that in 80% of firms
project analyses ignores value of credits earned.
• Response of R&D to reductions in the tax
concession strongly suggests that firms manage for
profit after company tax, but before imputation
credits.
Recycling dividend imputation revenue as lower
company tax
– Accordingly we could ‘cash out’ an inefficient tax
expenditure for an efficient company tax cut.
– Allows cuts of up to 11 percentage points (Hathaway and
Officer, 2004)
– Company tax could go as low as 19% even without
behavioral responses
– Ireland cashed out its own dividend imputation system as
lower company tax
Recycling dividend imputation revenue as
lower company tax
• Likely effects
– Abolition of DI => sale of Australian equities to foreigners.
– Leads to only second order’ price effects (Bond, Devereaux and
Klemm, 2005).
– With lower company tax, FDI would rise substantially.
– Improved post tax return on foreign investment in Australian
shares rises lifting share prices
• This lowers the cost of capital.
• Increases investment
Recycling dividend imputation revenue as
lower company tax
– “The coefficient estimates suggest that a cut in the corporate
tax rate by 10 percentage points will raise the annual growth
rate by one to two percentage points” (Lee and Gordon)
– This would increase the payback above Mankiw and
Weinzierl’s result
– Or can be spent chasing lower company tax
• Anti-avoidance and resource rent tax could also bring the rate
lower, or generate higher revenue
Recycling dividend imputation revenue as
lower company tax
Equity
– This lowering of company tax is progressive – because it
only favours foreign suppliers of capital
– Downside is higher effective rate of tax on dividends to
Australian shareholders
• Share price rises provide compensation for those whose effective
tax rate on dividends rises.
Conclusion (i)
Pierre Mendes-France “Gouverner, c'est choisir” – To govern
is to choose
The economist’s job is to say “this or that, not both. You can't
do both”. Kenneth Arrow
– Alignment and dividend imputation stem from worthy
objectives
• They also have opportunity costs
• Those costs are greater than their benefits
29
Conclusion (ii)
What’s there not to like?