LAFFERNOMICS VS CLOSING LOOPHOLES: TAXATION REFORM IN AUSTRALIA TODAY
TAX INSTITUTE BREAKFAST
FRIDAY, 3 JUNE 2016
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Our story begins with Dick Cheney, Donald Rumsfeld and a cocktail napkin.
In 1974, American economist Arthur Laffer met with two officials in the Ford administration. Cheney and Rumsfeld were young, ideological, and eager to find an excuse to cut taxes. Over dinner at the Washington Hotel, Laffer sketched out on a napkin his notion of how government revenue related to the average tax rate. If taxes were zero, the government raised no revenue. If taxes were 100 percent, he claimed, the government raised no revenue. Somewhere in between was a revenue-maximising tax rate. The graph was shaped like an inverted U.
The United States, Laffer claimed, was on the right side of the curve - meaning that cutting taxes could raise revenue. To conservatives like Rumsfeld and Cheney who wanted to cut taxes and shrink the deficit, it suggested an exciting possibility: the government could reduce tax rates and increase the tax take.
There was just one problem with this argument: it was wrong. As Greg Mankiw, former chairman of the Council of Economic Advisers under President George W. Bush has noted, ‘there was little evidence for Laffer’s view that US tax rates had in fact reached such extreme levels’.
Yet despite the lack of empirical evidence, US Republican leaders repeatedly quoted Laffer in debates over major tax reductions in the 1980s and 1990s. The facts told a different story: during the Reagan-Bush era (1981 to 1993), taxes were cut. Partly as a result, these two presidents added more than US$3 trillion to their country’s national debt.
You might say that Laffer’s theory wasn’t worth the napkin it was sketched on. Helping popularise the Laffer theory wouldn’t be the last time that Dick Cheney and Donald Rumsfeld helped take their country down a very costly path – but that’s another story.
This morning, I want to contrast the approaches to tax reform being put forward in this election. For those of you who attended my talk at the Tax Institute’s National Convention in Melbourne in March, some of the points I made today about Labor’s reform agenda will be familiar. On the flipside, you may be pleased to know that there is one major political party in this election that can say it has the same approach to tax reform as we had three months ago.
We live in times of great opportunity and significant challenges. Our nation has never been wealthier, and we are entering our 26th year of GDP growth. The centre of gravity of global growth is drawing closer to Australia. During the noughties, a once-in-a-lifetime surge in commodities prices fell upon us like a lottery prize.
Globally, interest rates are as low as they’ve been in 5,000 years. Smartphones, artificial intelligence, personalised medicine and a hundred other breakthroughs have the potential to raise productivity.
Since 2013, we’ve seen net government debt rise by more than $5,000 per person. This week’s national accounts showed a further fall in living standards, as measured by real net national disposable income per person. Living standards aren’t just down a little bit, they’ve slumped 4 per cent since 2013. For many people, the answer to the question ‘are you better off than at the last election?’ is a clear ‘no’.
Wage growth is at a 30-year low. The home ownership rate is at a 60-year low. Inequality is at a 75-year high. In the past generation, the top 1 per cent have doubled their share of income. But one in eight Australians say that they cannot afford dental care.
As Dickens put it, ‘It was the best of times, it was the worst of times … it was the epoch of belief, it was the epoch of incredulity … it was the spring of hope, it was the winter of despair’.
In this environment, the Government’s main tax plan is a significant cut to the corporate tax rate, estimated to cost nearly $50 billion over the next decade. By contrast, Labor believes that we should focus on closing tax loopholes. Let me deal with each in turn.
The Liberal Plan: A $50 billion Company Tax Cut
The Liberals’ plan for lower company tax rates rests on the notion that our current corporate tax rate - 28.5 for small businesses and 30 for larger businesses – is uncompetitive. So let’s take a moment to look at the data.
First, unlike most countries, Australia has dividend imputation. That returns around one in every three dollars of corporate tax revenue to domestic citizens in the form of franking credits. In terms of the revenue we raise, a 30 per cent tax rate with imputation is roughly equivalent to a 20 per cent company tax rate without imputation. As a simple rule, you shouldn’t take seriously anyone who wants to talk about Australian company tax rates but doesn’t mention imputation.
Now let’s look around the globe. The largest economy in the world, the United States, has a corporate tax rate of about 35 per cent. Germany, the European Union’s economic powerhouse, has a rate of 29.65 per cent. Canada has a corporate rate of between 26 and 31 per cent depending on the province. Across the world’s 10 largest economies, the corporate tax rate currently averages 29 per cent.
I expect to hear the immediate rebuttal that Australia is no United States, or even a sunnier version of Germany. So what about the resource-rich countries of Latin America then, which Australia has recently been competing with for foreign investment in the mining and resource sectors? Argentina’s company tax rate is 35 per cent. Brazil’s is 34.
My point is that countries like the US, Germany and even Brazil are powerhouse economies because they invest in growth. They build efficient rail and port systems that let companies be more productive and get their products to market more quickly. They fund research and development that leads to breakthrough new products and billion-dollar firms. In Germany’s case in particular, they support an education system that delivers workers with world-class skills, whether through university, a high-quality apprenticeship or other vocational training.
Now, let’s look at the purported benefits of a corporate tax cut. Treasury’s own analysis – titled ‘Analysis of the Long Term Effects of a Company Tax Cut’ estimates the impact on the economy of reducing the company tax rate for large businesses from 30 per cent to 25 per cent.
Initially, local shareholders don’t benefit much. Because Australia has dividend imputation, most of the gains initially go overseas. As the Grattan Institute’s John Daley has also pointed out, local shareholders only gain if profits are reinvested rather than paid out. However, our firms tend to have pretty high payout ratios, so a corporate tax cut will have a modest impact in practice. Even Goldman Sachs this week estimated that overseas shareholders would snaffle three-fifths of the benefit of a company tax cut.
Treasury’s analysis lays out the theory that after enjoying the first-round benefits of a company tax cut, foreign shareholders will respond to higher after-tax profits on their Australian investments, and in the long run invest less in other countries and more in Australia. So in the long run, more investment means greater demand for land and labour.
Given that the Liberal’s tax cut only reduces the tax rate on big business to 25 percent on 1 July 2026, and working on the basis that the ‘long run’ is 7 to 10 years, the Liberals are promising to raise wages somewhere between 2033 and 2035. By that point, Turnbull would be in his late-70s and surpassing Robert Menzies as Australia’s longest-serving Prime Minister.
And how big will the gains be? It depends how you pay for the company tax cut. The Treasury report suggests that tax cuts could be funded by a nationwide land tax, higher personal income taxes, or lower government spending. Since the Federal Government last levied land taxes in 1952, that option can be safely set aside as hypothetical.
So that leaves a company tax cut funded by less spending or higher income taxes. According to Treasury, if a big business tax cut from 30 per cent to 25 per cent is funded by lower spending, the boost to households is 0.7 per cent.
“It is important to recall that the modelling of government spending is assumed not to affect directly the welfare of households. While this is a common modelling assumption it ignores the fact that government spending provides goods and services that would otherwise not be provided by the market sector; households derive direct utility from government spending; and infrastructure spending can improve market sector productivity. This suggests the results reported in this section overstate the benefits of this funding alternative.”
So unless you believe that taxpayers get no benefit from spending more money on roads or schools, 0.7 per cent is an overestimate of the gains to households. Treasury knows that the benefit to households of a company tax cut funded by less government spending will be smaller than 0.7 per cent – they just can’t say how much smaller.
One more reason not to rely too strongly on the idea that we can get a big boost out of a company tax cut funded by lower government spending. Since the Liberals won office, spending as a share of the economy has gone up, not down.
That leaves us with higher personal income taxes to fund a company tax cut. According to the Treasury report, the benefit to households is 0.1 per cent.
I pulled up data back to the early 1970s, to see how household income (specifically, real net national disposable income per person) has grown. It turns out that over this period, household income has risen by an average of 0.1 per cent each month. So Treasury’s most likely scenario is that a company tax cut delivers a once off extra month of household income growth.
Other models have been similarly disappointing. In a careful analysis prepared for the US Federal Reserve Board, Alexander Ljungqvist and Michael Smolyansky look at changes in State company tax rates over the period 1970 to 2010. To identify the economic impact, they focus on counties that abut State borders, which gives them areas that are similar in all respects except the company tax rate. Analysing 270 company tax changes over this period, the two economists find ‘little evidence that corporate tax cuts boost economic activity, unless implemented during recessions’.
In some cases, models that support cutting the Australian company tax cut contain assumptions that – on closer inspection – appear to be heroic. One analysis, prepared for the Government by Independent Economics, estimates that reducing the company tax rate by 5 percentage points will add almost $4 billion per year into the government coffers from reduced profit shifting by multinationals. This result – which the Australia Institute’s Richard Denniss has dubbed the Government’s ‘morality dividend’ – is so large as to be scarcely believable.
With debt growing, our schools and hospitals starved of resources, and Australia desperately in need of infrastructure funding, Labor does not believe that this is the right time to cut the company tax rate to 25 per cent. The Government’s own modelling shows the impact on households to be small, distant, and heavily reliant on Laffer-style assumptions.
Labor’s Plan: Closing Tax Loopholes
At your National Conference in March, I spoke at length about tax expenditures - particularly in the context of the concessions in Australia’s tax system such as negative gearing and the Capital Gains Tax discount. In particular, I noted the influence of one of my lecturers Martin Feldstein. Feldstein was once the chair of the Council of Economic Advisers under Ronald Reagan, and not exactly regarded as one of Harvard’s most progressive economists.
One of Feldstein’s ideas that made a lot of sense was the principle that public finance reformers should look not only at spending levels and tax rates, but also at tax expenditures.
Feldman argued that tax loopholes had proliferated in the US and that ‘Congress should review these tax expenditures and eliminate those that the country cannot afford.’ Such an approach, Feldstein points out, raises revenue more efficiently than increasing tax rates. In economic jargon, closing loopholes has a lower deadweight loss than raising rates.
As their name suggests, tax expenditures look a lot like budgetary expenditures and the practical effect is pretty similar. As it turns out that tax expenditures tend to be much less fair than budgetary expenditures. So closing loopholes is more equitable than cutting spending.
Labor believes we have to take a thoughtful approach to tax expenditures. Labor in government means-tested the Private Health Insurance rebate, one of the fastest-growing tax concessions in the Budget. Last year, we announced a policy to rein in superannuation tax concessions, bringing down the Higher Income Superannuation Charge threshold from $300,000 to $250,000; and restoring a 15 per cent tax rate for earnings over $75,000 a year in the pension phase. I’m pleased the Government has adopted the first of these as their policy, imitation being the sincerest form of flattery.
But when it comes to personal income deductions, a conversation about tax expenditures is really a conversation about negative gearing. Rental deductions account for more than half of all personal deductions. So anyone who tells you they’re serious about cutting tax breaks, but won’t touch negative gearing, isn’t serious about broad-based tax reform.
Let’s start with how we got here. In 1999, the Howard Government proceeded with the Ralph Review’s recommendation of replacing indexation of capital gains tax with a 50 percent discount.
It was somewhat of an oversight that the Ralph Review did not mention real estate. Instead, it foresaw that cutting the Capital Gains Tax would lead to a surge in sharemarket investment, ‘particularly in innovative, high-growth companies’.
Reducing complexity and increasing investment were the ostensible aims. But the result was to give Australia a uniquely generous set of arrangements for housing investors.
Prior to the introduction of the Capital Gains Tax discount, net rental income was positive – typically about a billion dollars a year. Since 2001, not a single year has had positive net rental income according to Australian Taxation Office data. Most years have had net rental losses between $4 billion and $10 billion. Put another way, our tax system would be billions of dollars better off if we simply took landlords out of the tax system altogether.
Seventeen years later, the Financial System Inquiry – the Murray Review – commissioned by the current Government came to a different conclusion from the Ralph Review.
Under the title ‘Major Tax Distortions’, the Murray Review stated:
“For assets that generate capital gains, the tax treatment encourages leveraged investment, which is a potential source of financial system instability.
Investors are attracted by the asymmetry in the tax treatment of expenses and capital gains, where individuals can deduct the full interest costs of borrowing (and other expenses) from taxable income, but only half of their long-term capital gains are taxed.
The tax treatment of investor housing, in particular, tends to encourage leveraged and speculative investment in housing.”
The current tax treatment gives investors an advantage over first home buyers. That advantage was reflected recently when the value of loans for investment housing outstripped owner-occupier housing for the first time.
The effects on housing affordability are unavoidable. Between 1970 and 1996, the average annual median house price rise was 0.8 per cent. Between 1995 and 2012, median house prices grew an average of 4.3 per cent. According to ANZ figures released this week, median house prices last year grew by 9.8 per cent. In Sydney, they grew at 12.4 per cent. In Melbourne, 14.5 per cent.
Until the late 1990s, inflation, rents, and house prices tracked along roughly in step with one another. After the introduction of the Capital Gains Tax discount, the growth of house prices dramatically surged ahead of inflation. As I have noted, Australia’s homeownership rate today is as low as it has been since the 1950s.
Who is missing out? Young Australians are much less likely to own a home as they were in the early 1980s, with homeownership rates for 25-34 year olds falling from 62 per cent to 48 per cent.
Lower income Australians are hit too. In the mid-1970s, there was no difference in the homeownership rates of those in the top income quintile and the bottom income quintile. Today, the most affluent are 15 per cent more likely to own their home than the least well off.
The list of those who have raised concerns about the impact of negative gearing and the Capital Gains Tax discount on the housing market are Saul Eslake, Cassandra Goldie, Chris Richardson, Peter Morgan, John Daley, Joe Hockey, Jeff Kennett, the Grattan Institute and even the Reserve Bank of Australia.
Those arguing against reforming negative gearing have adopted similar tactics to those who spruiked the ‘Magic Pudding economics’ of the Laffer Curve.
First, they argue that 67 per cent of taxpayers who claim negative gearing earn a taxable income of less than $80,000.
The key phrase is ‘taxable income’ – in other words, income after taking account of negative gearing. As my colleague Chris Bowen has pointed out, if you take this figure seriously, you also need to realise that 64,000 Australians on taxable incomes of zero have investment properties. It’s not that they have no income – if they did, they wouldn’t be making mortgage repayments. It’s that they managed to use negative gearing to reduce their tax obligation to zero.
In fact, negative gearing disproportionately benefits the more affluent. Most of the benefits of negative gearing go to the top tenth of income earners. For example, surgeons claim 100 times the benefit that cleaners do, and 16 times the benefit received by nurses.
Second, critics of Labor’s plan also claim that negative gearing keeps rent prices lower than they’d otherwise have been. The basis for this claim is a Sydney-centric view of rents. In the years from 1985 to 1987 that negative gearing was stopped by the Hawke Government, rents did rise in Sydney and Perth. Yet the rate of growth in rental prices slowed in Melbourne, and all other capital cities had no change in the growth of rental prices. The rent rises in Sydney and Perth rental prices are more likely to be attributable to unusually low vacancy rates in those cities prior to the implementation of the policy.
A third canard is that negative gearing boosts housing supply. This misses the fact that 93 per cent of property lending goes to established housing. If the aim of negative gearing is to boost housing supply, this is a policy with a 93 per cent failure rate. That’s why Labor’s plan would restrict new claims for negative gearing to new homes, starting from July 2017.
Our plan will ‘grandfather’ negative gearing – allowing it to remain on investments made before 1 July 2017 – and restrict negative gearing to new housing on and after that date.
Labor’s policy will also ‘grandfather’ the Capital Gains Tax discount. The existing treatment will remain for assets purchased prior to 1 July 2017. Assets bought on or after that date will receive a 25 per cent discount instead of 50 per cent. Existing capital gains tax arrangements for small businesses will remain in place.
In the corporate tax space, Labor would also look to close loopholes that allow aggressive debt-shifting by multinational firms. From the ‘Luxembourg Leaks’, the Panama Papers, and the Senate Corporate Tax Inquiry, we have strong evidence of just how aggressive the tax planning of multinational firms in Australia has become. The community expects companies to pay their fair share, and confidence in our tax system cannot be taken for granted if people see companies getting away with paying very little tax.
Governments around the world are looking hard at their tax systems to see whether these are up to the task of ensuring a sustainable revenue base when business activity is global and finance is increasingly mobile. It’s relatively easy to keep track of how much tax a company should pay when they’re operating exclusively in your own backyard. But that task becomes much harder when companies have a worldwide footprint and an intricate arc of international holdings. That’s why both the G20 and OECD have identified multinational profit shifting as a major challenge for economies like ours.
Labor’s policy is to move to a worldwide gearing ratio approach for calculating the amount of debt that companies can claim deductions on in Australia. Under our preferred approach, deductions would be assessed on the third-party debt-to-equity ratio of a company’s entire global operations. We’re proposing to achieve this by eliminating the existing safe-harbour and arms-length tests, and making the worldwide gearing ratio the only test for the level of allowable deductions. This is a shift away from the current safe harbor rules which let companies claim deductions on up to 60 per cent of their Australian debt, without needing to show how this debt relates to their real business activity.
Because the 60 per cent ratio is an arbitrary figure, it is too generous for some businesses and possibly too strict for others. Our proposal aims to ensure there is strong support through the tax system for companies that have a legitimate need for high levels of debt. Indeed, if your multinational group has a worldwide gearing ratio of 70 per cent, then our proposal will see you being able to claim up to 70 per cent debt in Australia. For some entities, a worldwide gearing ratio is more generous than the arbitrary 60 per cent cap.
I’ve been surprised to see the Government defending this particular tax loophole. Indeed, prior to the Budget, Treasurer Scott Morrison was briefing out to a range of media outlets that he was going to tighten the thin capitalisation threshold. At the last minute, he changed his mind, and decided to do nothing about the debt-shifting rules. But if you need any proof that reform was on the cards, check out the Budget’s glossary, where you’ll see a definition of ‘thin capitalisation’. Only the term doesn’t appear anywhere in the Budget itself. They took the reform out of the Budget – but someone forgot to clean up the glossary.
It’s unfortunate that the Liberals didn’t take the chance to reform debt deduction rules. This is another case where closing a loophole would have been both equitable and efficient.
Since its inception in 1943, the Tax Institute has worked to raise the profile and values of the tax profession. You recognise that tax reform needs to be grounded in values, developed in consultation with experts, and carefully articulated. When it comes to improving our tax system, there are no short cuts and no quick fixes. No tax plans are so cunning they can be announced on Wednesday and adopted on Friday.
As Shadow Assistant Treasurer since 2013, this is the third occasion on which I have addressed a Tax Institute forum. As it happens, that is as many times as the number of Assistant Treasurers that the Abbott-Turnbull government has had during this period.
On each occasion, I have appreciated the insights and engagement from the Tax Institute.
I hope this will be my last address to you as Shadow Assistant Treasurer, but very much hope to continue a thoughtful and constructive engagement with you after July 2, as Assistant Treasurer in a Shorten Labor Government.
Thank you, and I look forward, as always, to your questions.