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 to Community Tax Forum
Sydney, 20th May 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
Australia’s current account deficits have been around 6%
Without compulsory super, New Zealand has been running
even higher deficits 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 and net export
driven
– Establish long term plans to increase savings
Tax is about choices
‘Long clean lines’ of policy are valuable, but also come with costs.
Alignment of company and top personal tax
Dividend imputation improves neutrality between debt and equity, but comes at
cost of higher company rate
None of these issues can or should be decided in principle
We must choose the lesser of evils based on the evidence
Capital taxation
– Other things being equal it’s more economically costly
than taxation on personal exertion
• 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
The closed economy argument
Additional issues strenthening the case for capital tax cuts
• Positive externalities from capital investment
• In an open economy, lower capital tax is also tax competition
But what about equity?
• Capital tax cuts are generally 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
Alignment: do it’s benefits outweigh its costs?
• Because companies are separate financial
entities to their shareholders, anti-avoidance
provisions are generally effective
• That’s why they’re often unpopular
• Like undistributed profits taxation
14
Alignment: do it’s benefits outweigh its costs?
15
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 1/3rd of company tax revenue
• ~ $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.
17
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 gets no imputation benefits.
So foreigners don’t value credits in their bids for shares
So a $20 billion tax expenditure doesn’t lower the cost of capital!
Dividend Imputation – the evidence
~ 80 percent of internal investment appraisals are done without
regard to the value of imputation credits earned.
Most reputable ‘drop off’ 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)
Dividend Imputation – the evidence
Abolition of dividend tax credits 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)
Recycling dividend imputation revenue as lower
company tax
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)
Several European countries have cashed out their own
dividend imputation for lower company tax
Recycling dividend imputation revenue as
lower company tax
• Likely effects
Abolition of DI
 Sale of Australian equities to foreigners
 Second order’ price effects (Bond, Devereaux and Klemm,
2005).
Lower company tax
 Improved post tax return on foreign investment in Australian
shares
 Increased FDI
 Increased foreign demand for portfolio investment increases
share prices
 Lower cost of equity capital
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 well 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
Equity
This lowering of company tax is progressive – because it
only favours foreign suppliers of capital
Effective tax on Australian shareholders actually rises
– Share price rises provide compensation for those whose
effective tax rate on dividends rises.
Conclusion (i)
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 exceed their benefits
25
Conclusion (ii)
• Swapping DI for lower
company tax improves
–
–
–
–
Efficiency
Growth
Equity
With foreigners paying
compensation to our
(mostly high income) losers
What’s there not to like?