Current Issues Brief 9 1999-2000

Proposed Reforms to Business Taxation: A Critical Assessment of Some Budgetary and Sectoral Impacts

David Kehl, Bernard Pulle, David Richardson and Michael Emmery
Economics, Commerce and Industrial Relations Group
10 November 1999

Contents

List of Acronyms

Major Issues

Background to the Review of Business Taxation

Government's Response to the Recommendations of the Review

Summary of Government's Proposals for Business Tax Reform

Undecided Issues

Further Review of Business Tax Reform Recommended by the Review

An Alternative View of the Fiscal Impact

Changes in business income taxes paid by industries in 2004-05

Long-Term Effects of Tax Reform on Australian Industries

Impacts on selected sectors

Conclusion

Appendix 1: Terms of Reference

Appendix 2: Matters ruled out by the Review and the Government

Appendix 3: Impact on the Community Services Sector

Appendix 4: Impact on Primary Producers

Appendix 5: Impact on the Manufacturing Sector

Appendix 6: Impact on the Mining Sector

Appendix 7: Impact on the Financial Services Sector

Appendix 8: Impact on Small Business

Appendix 9: Impact on Research and Development

Appendix 10: Impact of the Reduction in Capital Gains Tax

Appendix 11: Project Selection and the Switch from Accelerated Depreciation to Lower Company Tax

Endnotes

List of Acronyms

Major Issues

The purpose of this paper is to provide a critical assessment of the fiscal consequences of the Government's responses to the Ralph Review of Business Taxation; it also examines the impact of these proposals on industry.

The Government's proposals are of considerable significance from an immediate budgetary and economic perspective. They could also have major long term implications for the sustainability of Australia's public sector finances, household taxation levels and the affordability of public services should their underlying premises and assumptions fail to be fully realised upon application.

To date the Government's proposals on business taxation reform have not attracted the same high level of public debate and analysis that was apparent in relation to the other major planks of the Government's tax reform agenda, namely the reform of indirect taxation and of the personal income tax system. The perceived benefits of the proposals have been set out in the official documentation and are not dealt with at length in this publication. Rather this paper sets out to critically examine some of the underlying economic assumptions behind the proposals and its broader industry implications.

The Government has vigorously argued that its business tax reform initiatives will benefit Australia by:

• taking Australia into the next century with a modern, competitive and fair taxation system.
• creating the environment for achieving higher economic growth, more jobs, and improved savings.
• providing a sustainable revenue base so that the Government can continue to deliver services for the community.(1)

This paper does not address the issues of the competitiveness of Australia's business tax system under the proposed regime nor the extent to which the proposals will create additional jobs and savings. Nor does it address the equity issues arising from the Government's response to the Ralph Review. Its main focus is on the fiscal impact of the proposals as this has been one of the primary interests of the Parliamentary debate so far. In addressing the fiscal impacts, the paper questions the assumptions underlying the estimated revenue effects of the proposed cuts in the capital gains tax rate. It also points to an absence of publicly documented economic modelling to support the revenue growth dividend predicted in the Ralph Report; raising questions over the assumptions behind the Review's assessment of the revenue implications of abolishing accelerated depreciation. The analysis in this paper suggests that the Government's objective of revenue neutrality may be at risk of being compromised as a number of the assumptions behind the Ralph Review analysis are questioned.

The paper observes that the Parliament's capacity to review and assess the Government's proposals on business tax reform have been inhibited so far by the deferral of the Government's announcement of a range of significant measures which comprise Stage 2 of the Government's response to the Ralph Review. In the absence of any articulation of its Stage 2 measures, the Parliament is compromised in its capacity to respond to Stage 1, particularly as the Government has indicated that the revenue neutrality of the overall package is heavily reliant on Stage 2 measures.

In addressing the industry impacts of the Government's proposals, the paper observes that whereas the ANTS II package delivered major benefits of cost reduction across industry generally, the main beneficiaries of the Government's proposals stemming from the Ralph Review are the finance and insurance sectors. The paper questions the macro-economic stimulatory effects of these benefits given that the demand for insurance and financial services is primarily a 'derived demand', i e. one which is heavily dependent on the level of demand in industries which call on the services of the insurance and finance sectors.

The paper concludes with discussions of the impact of the New Business Tax System on selected industry sectors noting:

• that there has been very little comment about the effects of the proposed measures on the community services sector
• that primary producers have emerged relatively unscathed by retaining existing concessions
• that despite initial press commentary that the manufacturing sector would be a looser from the proposed reforms, this does not appear to be the case
• the significant changes to the taxation arrangements would apply to the mining sector
• that although the finance services sector will receive a major boost from the proposed arrangements life insurance companies have not been critical of the proposed changes even though they will increase their company tax by an additional $500 million per year
• the favourable treatment given to the small business sector by the proposed measures
• that while the changes to capital gains tax may attract additional venture capital, research and development were not a major concern for the review
• that capital gains tax is going to become more complicated, that investors may prefer growth investments over income producing investments, that 'mum and dad' investors may not benefit from the proposals, and that the abolition of indexation may result in taxpayers paying capital gains tax on capital losses
• the impact on project selection and the switch from accelerated depreciation to lower company tax, and through the use of a hypothetical example, how project selection might be changed under the proposed arrangements

The reader is also referred to the Information and Research Service's compilation titled 'Ralph Review of Business Taxation', Current Comment No 1 1999-2000, which contains a useful selection of articles and commentary, many of which are referred to in this publication.

Background to the Review of Business Taxation

Origins of the Review

The Howard Government's taxation reform agenda has three major elements:

• the reform of the indirect tax system as addressed in the ANTS (A New Tax System) package
• including the introduction of a broadbased goods and services tax levied at a rate of 10 per cent with limited exemptions for some foods
• the abolition of wholesale sales tax
• reductions in fuel excises for petrol and diesel, and
• the abolition of Financial Institutions Duty
• changes to the taxation of business entities as announced in A New Tax System
• including taxing trusts as companies
• the introduction of a deferred company tax
• the introduction of refundable imputation credits, and
• measures affecting the life insurance industry.
• changes to business taxation arrangements which the Government announced in response to the Review of Business Taxation (the Ralph Review) on 21 September 1999.

On 13 August 1998 the Government announced proposals for A New Tax System (ANTS), which included the introduction of a Goods and Service Tax. The ANTS package set out plans for the reform of business taxes on two fronts:

• applying a framework of redesigned company taxation arrangements consistently to all limited liability entities, and
• considering the scope for more consistent taxation treatment of business investments with the prospect of achieving a 30 per cent company tax rate and further capital gains tax relief.(2)

On 14 August 1998 the Treasurer announced that the Government had decided to undertake a comprehensive review of the taxation of business on the lines proposed in the ANTS package(3). The Treasurer specified that its recommendations should be within the guidelines in ANTS I and should also be revenue neutral. Some of the measures in ANTS I were subsequently revised in agreement with the Australian Democrats before the passage of legislation to reform the indirect tax system (ANTS II). On 21 September 1999 the Treasurer announced measures for A New Business Tax System based on some of the recommendations in the Report of the Review.

Terms of Reference and Composition of the Ralph Review

The Review's Terms of Reference are reproduced at Appendix I. It is noteworthy that as part of the agreement the Government concluded with the Australian Democrats to implement the ANTS package (ANTS II) and with it the introduction of the GST, the Treasurer agreed to refer to the Review for its consideration:

• the adoption of a 20 per cent alternative minimum company tax (AMCT)
• measures to limit the use of company structures for personal services, and
• a review of the treatment of motor vehicle fringe benefits.

The Review's composition and modus operandi was as follows:

• Chair: Mr John Ralph, AO.
• other members: Mr Rick Allert, AM, and Mr Bob Joss.
• The Review could call on the expertise of both the public and private sectors and academic tax experts.
• Mr Ralph was to be assisted by the Tax Reform Task Force located in the Treasury.
• The Review was to report by 31 March 1999 to allow a reasonable time period for consultation with the business community, to allow draft legislation to be subject to consultative input from business and for the legislation to have effect from 1 July 2000. The deadline for the submission of the report was later extended to 30 July 1999.
• The Review was to be open and transparent.
• Outlines of the preliminary work done by the review are set out in the Information and Research Service's Current Comment No 1 1999-2000.

Government's Response to the Recommendations of the Review

The report of the Review of Business Taxation (the Review) entitled A Tax System Redesigned (the Report) was given to the Treasurer on 30 July 1999. The Treasurer released the Report and announced the Government's responses to the recommendations in Press Release No. 58 of 21 September 1999 titled The New Business Tax System. The Press Releases and other documents(4) released by the Treasurer on 21 September 1999 are available on the Treasury Website http://www.treasury.gov.au.

The Treasurer stated that the business tax reforms announced by the Government represented the first part of a two-stage consideration of the Review's recommendations. He added that the proposed reforms were broadly revenue neutral in 2000-01 and that the Government's consideration of the remainder of the Review's recommendations will be guided by the objective of achieving a broadly revenue neutral outcome from business tax reform in later years.

Summary of Government's Proposals for Business Tax Reform

The following key changes to the tax system were announced.

Introduction of an Entity Tax Regime and Lowering Company Tax Rate

The entity tax arrangements outlined in the A New Tax System (ANTS), will commence on 1 July 2001. This will include the taxation of trusts like companies.

The deferred company tax proposed in ANTS will not be implemented and instead the inter-corporate dividend rebate will be terminated.

The company tax rate will be lowered from 36 per cent to 34 per cent for the 2000-01 income tax year and to 30 per cent thereafter.

This rate will apply to other entities taxed like companies when the entity tax regime is introduced from 1 July 2001.(5)

The Review's recommendation for minimum tax arrangements for companies was not accepted by the Government.

Excess imputation credits will be refunded to resident individuals, complying superannuation funds and to registered charities where imputation credits are attached to donations by way of trust distributions.

Reforming the Capital Allowances System and the Removal of Accelerated Depreciation(6)

The removal of accelerated depreciation and moving to effective life depreciation took effect from 11:45 am AEST 21 September 1999.

Small business taxpayers will retain access to accelerated depreciation until 1 July 2001.

Introduction of a simplified depreciation scheme for small business to be able to write off assets costing less than $1000 immediately and to pool all other depreciable assets with an effective life of less than 25 years to be depreciated at 30 per cent.

The current special rates for primary producer assets, such as horticultural plants, water and landcare assets, and the current treatment of expenditure on research and development and on Australian films will remain unchanged.

Reduction in Capital Gains Tax

Only 50 per cent of net nominal capital gains of individuals will be taxed with effect from 1 October 1999 with the result that the highest rate of tax for individuals will effectively be 24.25 per cent.(7)

Only two thirds of the net nominal capital gains of superannuation funds will be taxed with effect from 1 October 1999 resulting in a concessional tax rate of 10 per cent.(8)

Indexation will be frozen at 30 September 1999 for all taxpayers.

Averaging provisions were to be no longer available on the disposal of assets after 11.45 am AEST on 21 September 1999.(9)

Small business capital gains tax concessions are increased by replacing the 50 per cent capital gains tax goodwill exemption with a 50 per cent capital gains tax exemption for all active assets. When combined with the general 50 per cent exclusion of capital gains individuals owning small business will be liable to tax on a maximum of 25 per cent of the gains when they sell business assets. This measure applies to capital gains tax events from 21 September 1999.(10)

Full exemption from capital gains tax is provided for a business asset that has been held continuously for 15 years and where the taxpayer is over 55 of age and intends to retire, or is incapacitated. These measures would apply to capital gains tax events on or after 20 September 2000.(11)

Roll-over relief is provided for scrip-for-scrip takeovers between companies and trusts (whether widely held or private entities). This measure will commence on the date of Royal Assent of the legislation.(12)

Exemption is provided for capital gains earned through Pooled Development Funds by Australian superannuation funds. This measure commences on the date of Royal Assent of the legislation.(13)

Exempt from capital gains tax is provided for investments in venture capital projects in Australia by non-resident tax exempt pension funds, such as the US and UK pension funds. This measure commences on the date of Royal Assent of the legislation.(14)

Simplified Tax System for Small Business

The introduction of a Simplified Tax System with effect from 1 July 2001 was foreshadowed to reduce the compliance burden for small business with an annual turnover of less than $1 million.(15) It includes:

• the option of cash accounting where income and expense will be recognised only when they are received or paid respectively
• a simplified depreciation scheme to be able to write off assets costing less than $1000 immediately and to pool all other depreciable assets with an effective life of less than 25 years to be depreciated at 30 per cent
• simplified treatment of trading stock as an alternative to an annual requirement for stock taking and stock valuation.

Broadening Taxation Base of Life Insurers

The taxation base of life insurers will be broadened so that all profit from funds management, underwriting and other life insurance and immediate annuity business is taxed. Under the new arrangements commencing from 1 July 2000:

• risk business (i.e. term insurance that does not have an investment component) will be taxed on the same basis as the risk business of general insurers (i.e. general insurers are taxed on their premium income)
• investment business will be taxed on the same basis as the investment business of other entities 3/4 but not like collective investment vehicles, and
• complying superannuation business of life insurers will be taxed on the same basis as pooled superannuation trusts (PSTs).

Improved Anti-Avoidance Measures

The following measures to reinforce the integrity of the tax system were announced:

• non-commercial loans from owners to closely held entities will be treated as equity (16)
• current defects and anomalies in the treatment of entity losses and value shifting will be addressed to protect the revenue base and integrity of the business tax system(17)
• the full consideration received on disposing of interests in leased plant or leases will be included in assessable income. The need for this integrity measure was highlighted in the discussion paper A Platform for Consultation released on 22 February 1999.(18)

Undecided Issues

The Treasurer announced that the Government's response to the Review will be in two stages, with a phased implementation. He added that some of the recommendations will be given further consideration. The Review had suggested that some matters be the subject of further review as the Review did not have sufficient time to examine the implications of these matters.

First Stage Response

The measures listed in the paragraph Summary of Government's Proposals for Business Tax Reform summarises the first stage response to the recommendations of the Review. As will be seen from that paragraph the implementation of those measures has been slowed.

Second Stage Response

The Treasure also announced on 21 September 1999 that the Government will consider the remaining recommendations of the Review in more detail over the coming months and will announce its response in a second stage. It is expected that the second stage measures recommended by the Report would be adopted to reduce the cost of the package in the outyears in accordance with the goal of revenue neutrality. The matters for consideration in the Second Stage include the following.

New Basis for Determining Taxable Income for Business

The Review recommended that to achieve a more robust and durable tax system, taxable income be calculated on the basis of cash flows and changing tax values of assets and liabilities - with increasing and decreasing adjustments to reflect tax policy effects. It added that the cash flow/tax value approach be reflected in tax law.(19)

Pointing out the need for a new approach for business taxation the Report noted that the existing law is based on legal concepts of income that have evolved over many years. Central to it are the concepts of ordinary income, statutory income including capital gains, and expenses and losses of either a 'revenue' or 'capital' nature.

As a consequence of the evolution of the existing law, assets may be taxed in a variety of ways depending on the purpose for which they are held. This creates uncertainty and complexity in the law, of the kind illustrated in the Review's first discussion paper, A Strong Foundation.

To distinguish expenses consumed in a tax year from expenses that essentially involve a conversion from one type of asset to another, the existing tax system uses the concept of capital expenditure. The absence of statutory principles guiding that differentiation has resulted in uncertainty and led to the mis-characterisation of some expenses.

Ralph argues that whether business expenditures are recognised for income tax purposes and, if recognised, the timing of their deductibility now depends more on the historical development of the law than on clearly enunciated principles. In particular, he also argues that the treatment of the changing values of different categories of assets and liabilities has been grafted into the law in an uncoordinated and thus non-comprehensive way.

The Review took the view that a more coherent and durable legislative basis for determining taxable income is essential to reducing uncertainty and complexity in the present system. That redesigned tax law would underpin a more consistent, transparent and sustainable tax system. Having a structure which is more enduring and robust, and which can flexibly accommodate future changes, has much to commend it. Of itself, it will not imply a broadening of the tax base; variations to the base should occur only by express intention.(20)

The Treasurer confirmed that second stage measures will include the Review's recommendation for a fundamental change in the method of determining taxable income for business. He added that the Government sees the merits of this approach and will be considering it further but with no new arrangements until 1 July 2001. That timing reflects concern for the ability of business to cope with the administration of the GST.

Imputation Credits for Foreign Dividend Withholding Tax

Under the current arrangements Australian residents can claim a credit for dividend withholding tax paid on dividends derived directly from a foreign company. In contrast, Australian based multinationals cannot pass onto shareholders a credit for foreign withholding tax paid on dividends derived from a foreign subsidiary. This discourages Australian multinationals from repatriating profits to Australia and this issue will increase in significance as Australian operations continue to expand offshore. The Review therefore recommended that imputation credits up to 15 per cent of repatriated dividends be provided for foreign dividend withholding tax (DWT) paid, including for DWT paid on repatriated exempt dividends.(21)

The Treasurer announced that the Government will be looking at the Review's recommendation to provide imputation credits for foreign dividend withholding tax up to 15 per cent, from 1 July 2001.

Alienation of Personal Services Income

The Treasurer stated that the Government will give close consideration to other issues raised in the Review, such as the recommendations dealing with the alienation of personal services income and non-commercial losses.

Ongoing Review and Consultation

The Government will also maintain the more integrated and consultative arrangements that have been central to the Review of Business Taxation. In particular the Government will establish an ongoing, non-statutory Advisory Board which would allow access to private sector expertise on a regular basis, not only on business tax but on all aspects of tax law. Details are to be announced in due course.

Draft Legislation

The Review had prepared draft legislation and explanatory notes as part of the Report to illustrate the type of legislative product achievable from more integrated design processes and a more principle-based legislative framework.

The Treasurer added that this draft legislation does not relate to the measures having effect from either 22 February 1999, 21 September 1999, 1 October 1999 or from Royal Assent. Legislation on these measures will be introduced into the Parliament as soon as possible. The draft legislation is designed to illustrate what is achievable in terms of simplicity under high level reform.

Matters ruled out by the Review and the Government are detailed in Appendix 2.

Further Review of Business Tax Reform Recommended by the Review

Section 23 of the report deals with improving Australia's international tax regime and recommends further review. The three aspects to be further reviewed are:

• rules for taxing foreign sourced income
• tax havens-claims for deduction of payments
• record keeping by multinational enterprises.

The issues for further review have an important bearing on tax minimisation schemes and are discussed in more detail below.

Rules for Taxing Foreign Sourced Income

Currently the tax law has the controlled foreign company (CFC) rules, the transferor tax rules and the foreign investment fund (FIF) rules to prevent tax minimisation in relation to foreign source income.

CFC Measures

The CFC measures apply to shareholdings in foreign companies that are controlled by Australian residents. Under the CFC measures resident shareholders are taxed on their pro rata share of certain income of CFCs called 'tainted income' as it is earned. These measures are intended to prevent tax deferral. Examples of 'tainted income' include interest, royalties, dividends and amounts arising from certain related party transactions.

Active income of CFCs, which is income other than tainted income is generally exempt from the CFC measures to enable Australian based multinationals to compete effectively offshore.

Transferor Trust Measures

These measures apply to Australian residents who have directly or indirectly transferred value to a foreign trust. The transferors are treated as controllers and generally taxed on the undistributed profits of a trust and an exemption is provided for amounts that have been comparably taxed offshore. An interest charge also applies to distributions to residents from a foreign trust to the extent that the distribution is made from low taxed profits accumulated offshore.

FIF Measures

The FIF measures apply to resident taxpayers that have an interest in a non-controlled foreign company or trust. The measures are intended to ascribe to a resident taxpayer the share of undistributed profits of an FIF for taxation purposes. The FIF measures are not effective in preventing tax deferral for interests in discretionary trusts. The transferor tax measures are the rules that can effectively deal with interests in these trusts.

These are very complex rules and the Review records that against its timeframe for reporting it was precluded from undertaking a detailed examination of these rules.

The Review has therefore recommended that there be a comprehensive review of the above foreign source income rules.

Tax Havens-Claims for Deduction of Payments

The Review left, for further review, the method of dealing with claims for deduction of payments to entities in tax havens that are unsupported by proper documentation.

The Review noted that in many tax havens, bank secrecy and other laws prevent revenue authorities from verifying the purpose of payments to tax havens. It considered such verification necessary whether such amounts were in fact returned to the person making the payment or to an associate of that person.

Two options for dealing with the problem of fictitious transactions with entities in tax havens were outlined by the Review.

Legislation could provide for:

• either the disallowance of a deduction
• or the imposition of a withholding tax

where all records are not available to support the economic purpose of the payment to the tax haven.

The Review notes that in the United States the legislation provides for the Secretary to the Treasury to determine in writing that certain interest payments are subject to the United States' higher levels of withholding tax where the interest is paid to a person in a country which has inadequate exchange of information arrangements with the United States.

Record Keeping by Multinational Enterprises (MNEs)

A Platform for Consultation highlighted the inadequacy as well as the inability of the tax administration to access records kept overseas by companies with international transactions.

Standardising Record Keeping Rules

One option for minimising Australia's record keeping requirements in relation to international transactions, and especially transfer pricing, would be to seek greater standardisation of requirements with our major trading partners. Of these trading partners, the United States has by far the most detailed and advanced rules. MNEs trading with the United States may maintain such information and hence similar Australian requirements should not be a significant burden for those MNEs. Such rules may, however, create problems for MNEs not dealing with the United States and could be very onerous on small and medium enterprises. In such cases, a minimalist approach may be more appropriate (that is, the minimum needed to make a reasonable assessment of compliance and to properly apply the law).

Linking Documentation and the Penalty Regime

The failure to keep contemporaneous records makes it extremely difficult for taxpayers and the ATO to satisfactorily resolve disputes. The United States has linked inadequate contemporaneous documentation to penalties and, from the point of view of their tax administration, this has been an important factor in improving compliance. In Australia, such a requirement could be incorporated into a simplified penalty regime to the effect that a taxpayer without adequate documentation does not have a reasonably arguable position for the purposes of penalty reduction.

Require Record Keeping for Expenditure Incurred in Tax Havens

A major feature of tax havens is the active promotion of their secrecy laws to entice individuals and corporations to do business, or to execute financial and commercial transactions, in their jurisdictions. The secrecy laws of tax havens facilitate the concealment of assets, activities, income sources, records and documentation from tax administrations. These secrecy laws, including bank secrecy laws, facilitate tax avoidance and evasion and therefore threaten the integrity of the tax base of other countries including Australia.

An approach to counter the use of low tax countries would be to deny a tax deduction or levy additional withholding tax for certain payments to tax haven entities if certain information is not made available. This option could be imposed where the taxpayer does not have evidence that the transaction has a substantive economic purpose and where the dealings between Australia and the tax haven are not transparent.

In the United States provision is made for the Secretary of the Treasury to provide in writing (and publish a statement) that certain payments of interest will be subject to the United States' general 30 per cent withholding tax where interest is paid to a person or on behalf of a person within a foreign country that the Secretary has determined has inadequate exchange of information arrangements with the United States.

Record Keeping

The review of record keeping in relation to international transactions was recommended to implement measures to ensure business entities keep appropriate documentation to verify income and deductions.(23) This has particular significance for transfer pricing in relation to multinational enterprises (MNEs). In A Platform for Consultation it was pointed out that Australia could improve record keeping requirements in relation to international transactions, and especially transfer pricing, by seeking greater standardisation of our requirements with those of our major trading partners. It added:

The Report of the Review observes that consultation and submissions noted that the US rules were quite onerous and so should not be used as a basis of record keeping in Australia.

Given the increased move towards globalisation, the perception of equity in the tax system will not be enhanced by knowledge that the record keeping requirements for business in place in Australia are deficient. All other measures to prevent profit shifting and value shifting would be of no avail if the basic record keeping system is incapable of ensuring that income and deductions are properly recorded and are verifiable. A reform measure which puts in place an effective record keeping system to verify international transactions would be a quantum leap in protecting the tax base as well as enhancing the equity of the tax system.

An Alternative View of the Fiscal Impact

The Ralph Review was asked to bring forward a revenue neutral package of business tax measures. Revenue neutrality is important, without that the Ralph measures would involve a redistribution of income to or from the household sector. That in turn would necessarily interfere with the previous agreements on the various measures included in ANTS II.

The following table sets out the fiscal impact of the response to Ralph as claimed by the Government. On these figures, the Government's assessment is that the measures are roughly revenue neutral over the coming years.

Table 1: Fiscal impact of Ralph tax measures ($m)

Source: The Treasurer, Hon. P. Costello, Press Release, The New Business Tax System, 21 September 1999.

Each of the above categories raises a number of issues that might be discussed. The main focus here is the validity of the Government's estimates as presented in Table 1. The reduction in the company tax rate implies a transfer of well over $3 billion to the corporate sector. The other main measure being discussed in the lead up to Ralph, abolition of accelerated depreciation, claws back over $2 billion in each of the years 2001-02 to
2004-05. This was the main trade off being discussed in the press and elsewhere-a lower company tax rate in exchange for scrapping accelerated depreciation.

The abolition of accelerated depreciation is only a bringing forward of future tax collections. (Accelerated depreciation does not give the taxpayer new concessions, rather it brings forward the tax benefits of future depreciation claims.) With time the $2 billion increase in revenue disappears and with it goes the approximate revenue neutrality of the Ralph proposals. This is taken up below.

The economic effect of the abolition of accelerated depreciation is addressed in the section 'Impacts on selected sectors' (below). However, the Treasurer did leave open the possibility of a successor to accelerated depreciation when he said:

No further details are given. However, the clear implication is that instead of a universally applicable scheme for all investors, the successor to accelerated depreciation will be applied on an ad hoc basis, if at all. No indicative costing has been provided by the Government.

Another important measure from a public finance perspective is the proposed package of changes to the capital gains tax. The exact changes are described elsewhere in this report. However, the dominant issue is the halving of the tax rate. To estimate the effect of changes to the capital gains tax, the Ralph Report relied upon some earlier American estimates of the elasticity of realisations [of capital gains] with respect to variations in the tax rate as reported in research provided to the Ralph Review by the Stock Exchange, but unfortunately not made public.

The Elasticity of Realisations With Respect to the Tax Rate

The elasticity of realisations with respect to the tax rate is the proportionate change in the annual realisations of capital gains divided by the proportionate change in the tax rate. That would be given by the percentage change in realisations divided by the percentage change in the tax rate. Because the capital gains tax is triggered by actual realised capital gains it is expected that the realisations and the tax rate would move in opposite directions. That is, a cut in rates would give an increase in realisations, at least in the short run. For that reason the estimated value of the elasticity is usually quoted as a negative number.

The stock exchange research suggested a long-term elasticity of more than minus 0.9. Ralph uses the same figure as the long run estimate with an even higher elasticity of realisations in the short run. This seems to be the main reason why the fiscal impact of the capital gains tax changes is an estimated increase in capital gains tax collections of $130 million in 2000-01, $150 million in 2001-02 with slightly less in subsequent years. Increasing tax collections following cuts in taxes reminds us of some of the American debates in the early 1980s associated with the 'Laffer curve' which purported to show that beyond a certain point increases in taxes were associated with reductions in tax collections. The Laffer curve became an important element in the thinking behind 'supply side economics,' a doctrine that basically said that tax cuts and other measures to increase incentives were required to boost economic growth.(26)

This estimate of a long run elasticity of the tax base with respect to the tax rate at around minus one is very hard to justify. If it were exactly minus one, then any variation in the tax rate would be followed by an equal and opposite proportionate change in the tax base. In that way the government would collect the same volume of tax no matter what rate it set.

Dr Gravelle of the US Congressional Research Service has looked at the relationship between capital gains tax collections and tax rates over many years. She is reported to have said that:

Doubts about estimated elasticities should normally suggest caution. Normally Government estimates of the budgetary impacts of changes in revenue arrangements (or indeed outlay arrangements) are calculated on the basis that there is no change in underlying behaviour. That sensible and cautious approach ensures that revenue measures are not based on speculative assessments of behavioural responses to particular measures. In a memorandum to all departments and agencies prior to the 1999-00 Budget, the Department of Finance and Administration required that 'assumptions and methodology underlying the costings are robust and credible, including that there is a sensible relation between expenses and cash flows.'(28) The memorandum also refers to instructions sent out in the Operational Rules in Estimates Memorandum 1998/28. Unfortunately, Memorandum 1998/28 is classified 'Cabinet-in-Confidence' and could not be consulted.

Even if we could be sure that capital gains tax receipts would increase, there would remain the concern that the increase would be at the expense of taxation on other forms of income. That could reflect people's attempts to disguise other income as capital gains to exploit the different rates on capital gains. It is also important to note that the Ralph Report expects some of this type of activity to occur 'from an expected tendency for some returns to investment to be taken as capital gains rather than as ordinary income. For example, there will be an increased incentive for shareholders to realise capital gains on shares rather than to receive income as dividends.'(29) Ralph does not refer to this as 'avoidance,' however, the 'cost [to revenue] of converting ordinary income to capital gains' was estimated to be $20 million in 2000-01 rising to $180 million in 2004-05. This seems to be a rather modest estimate given that there are no new proposals designed to prevent the type of avoidance that would be encouraged with lower taxes on capital gains.

Assumption on Inflation

Before leaving the capital gains tax issue it needs to be observed that our comments and the analysis underlying the Ralph Report are predicated on the assumption that inflation will remain at around present levels. If inflation were to return to double-digit rates then the proposal to ignore inflation when taxing capital gains would become a very important issue. As a consequence, high inflation scenarios can be envisaged under which the proposed capital gains tax would raise more revenue than the present system, even without any problematic behavioural assumptions. Nevertheless, for the moment revenue increases due to problematic behavioural assumptions cannot be accepted.

Reliance on Stage Two Measures to Achieve Revenue Neutrality

Other uncertain revenue measures which are significant to the achievement of the Government's goal of revenue neutrality are those initiatives yet to be announced under the Government's Stage 2 response to the Ralph proposals. These so called 'deferred measures' are expected to raise between $0.47 billion and $1.04 billion per annum between 2000-01 and 2004-05 according to the Treasurer's announcement on 21 September 1999.

With the revenue that the Government 'pencils in' for second stage measures the whole package raises net additional revenue of $390 million over the six years 1999-00 to 2004-05 inclusive. Without the second stage measures the impact over those six years is a revenue loss of $3.8 billion. Thus the fiscal implications of the overall package are very dependent on decisions yet to be made even though the Parliament has been addressing the already announced features of the package since September. It is evident that the capacity of the Parliament to review and assess the Government's proposals has been compromised so far by the lack of any detailed articulation of the Government's Stage 2 responses and their implications for revenue.

The Growth Dividend Assumption

As can also be seen from Table 1, the Government expects a 'growth dividend' by way of an eventual increase in annual Gross Domestic Product (GDP) of 0.75 per cent by 2009-10. This is expected to generate revenues which gradually increase to reach $150 million in 2003-04. This reflects views expressed in the Ralph Report to the effect that a 0.75 per cent increase in GDP is a conservative estimate of the likely beneficial effect of the package. However, there is no economic research cited to support that view. In the absence of a strong case the Ralph Report's growth dividend must remain largely a matter of faith. Moreover, the Ralph Report says:

That is of course entirely correct. However, using a model forces the modeller to make explicit any assumptions that lead to the model's results. The model is merely a systematic formalisation of the modeller's view of how the economy works. It is a means of laying bare the logic behind that view. It is reasonable to expect that the authors of the Ralph Report would therefore have supported their case that their proposed reforms would increase GDP with some logical model of cause and effect between economic reform and GDP. It is certainly not in the interests of transparency for their own logic to remain concealed where the Parliament and the public generally cannot validate the assumptions behind their thinking. A formal mathematical model is not necessarily required, just a logical argument in support of the conclusion would suffice. It should be pointed out that the Ralph Review was prepared to use economic modelling to examine inter-industry impacts despite their inevitable use of 'assumptions that are difficult to validate' in any modelling.

The modelling actually done by Econtech (using the Murphy Model) for the Ralph Report showed that the gains in certain industries are approximately offset by losses in others. Overall there is a net gain of 0.06 per cent in total output.(31) However the text warns against using these particular modelling results in the context of overall economic effects. The text warns that the results 'do not include the general increase in production from the growth dividend expected to flow from the Review's recommendations.' In particular, there was no attempt to measure 'any growth dividend from direct tax reform that may arise from treating entities, industries and assets more evenly for taxation purposes.'(32) This is surprising as normally the Murphy Model would be used to show macroeconomic effects of this type of reform. However, even if Ralph had managed to do that, Stage 1, which is under consideration at the present, does not include the new approach to determining taxable income. This is the fundamental structural change that is central to the philosophy of the Ralph Report.

Elsewhere Econtech has presented its modelling results in more detail.(33) This shows the effect of the Ralph Report's recommendations on the costs in various industries. These are produced in Table 2. Note that Table 2 relates only to Ralph, not Ralph plus ANTS II, which is examined elsewhere in this publication. In assessing the present package, any effects of ANTS II have to be treated as already given.

Table 2: Ralph Report Recommendations: Changes in Industry Costs $million

Source: Econtech, 'The long-term effects of tax reform on Australian industries, Report prepared for The Australian Bankers' Association,' 24 August 1999.

The changes in industry costs in the Murphy model will determine whether that industry expands or not. Clearly the increase in industry costs will cause a significant contraction in mining, manufacturing, utilities, as well as transport and storage with a significant expansion in finance and insurance and property and business services. The effects in other industries are too small to worry about. Overall there is a reduction in costs, which could be taken to indicate an increase in economic activity. However, if we exclude finance and insurance there is a large increase in business costs. Hence any stimulus to the economy must come from cost savings in the finance and insurance sector. Of course, it is unlikely that finance and insurance activity would increase markedly in the absence of concurrent increases elsewhere in the economy as the market demand for the services of this sector is primarily a 'derived demand'.

For the above reasons the growth dividend must be regarded as problematic. What is more, to include revenue from a growth dividend in this sort of documentation would appear to violate the Finance Memorandum 1999/06 mentioned earlier. In particular the memorandum requires that 'offsets ... are genuine.' Moreover, the memorandum specifies 'general revenue increases' as being among the 'specific types of reductions [that] are not genuine in terms of this criteria'(34) For all these reasons it is difficult to accept the growth dividend as a genuine offset to the budgetary cost of reducing the company tax rate.

Fiscal Impact of the Abolition of Accelerated Depreciation

The abolition of accelerated depreciation has the effect of bringing forward tax collections without increasing the overall revenue proceeds over the life of the particular asset subject to depreciation. Hence the revenue gain from the abolition of accelerated depreciation will gradually fall to zero. In 20 years time there will be no increased revenue. This is because the maximum assumed life of an asset for depreciation purposes is 40 years in the case of rental and office buildings. Hence these would be still getting the last benefits of accelerated depreciation in 20 years time in the absence of the planned measure.

The Ralph Report concedes that the value of the abolition of accelerated depreciation would eventually disappear. However, Ralph qualifies this by saying:

On our own modelling, as an example, with six per cent growth in nominal investment and assuming plant lasts 10 years then accelerated depreciation means 14 per cent more is claimed against income than under effective life depreciation. This difference grows with longer lived assets and shrinks with shorter lived assets. Likewise a higher assumed growth in investment would reduce the amount claimed under accelerated depreciation compared with effective life depreciation. However, the 6 per cent growth in nominal investment is perhaps difficult to justify for the time being. For 1999-00 the Budget Papers include forecasts for growth in business investment of zero for the year average and minus one for the four quarters to June 2000. For that reason it is difficult to allow for growth in investment to justify treating the savings to revenue as virtually permanent. At the very least in the light of Budget forecasts we should want some solid evidence that estimates should be based on optimistic future growth rates. In the absence of that evidence it is difficult to accept the view that the long run estimates are unchanged.

The fact that the value of accelerated depreciation falls to zero in the long run could be used as a justification for ignoring accelerated depreciation entirely. However, the bunching up of revenue in earlier years is worth something to the budget sector and is a genuine penalty for companies with depreciating assets. The bunching up of revenue means that government debt can be repaid and forever after interest outlays are lower than what they otherwise would have been. What we can do is attempt to estimate the consequent permanent improvement in the budget balance as a result of the interest outlays saved as a result of this exercise. Our methodology is to take all the identified revenue over the years 2000-01 to 2004-05, and add five times the estimate for 2004-05(36) as the total value of this measure going indefinitely into the future. That gives a figure of $23 580 million which can be assumed to come off the outstanding debt in 15 years time. Using the long bond rate of 6.49 per cent (Monday 11 October 1999) we find that this measure is consistent with a permanent improvement in the budget balance of $1530 million per annum. This will be the value we give to the abolition of accelerated depreciation, although it has to be acknowledged that it is a bit bold to add the full year effect from year one when the measure would have to last 15 years to produce the permanent change factored in for year one.

Adjusted Assessment of Overall Revenue Impacts

Table 3: Alternative estimates of the revenue effects of the Government's response to the Ralph Report
$ million

Source: Estimates prepared by Information and Research Services, Department of the Parliamentary Library. Note that the figure for accelerated depreciation is not exactly comparable with Table 1. The figure there includes accelerated depreciation but deducts the cost of small business initiatives.

Table 3 presents the Government's estimates of the revenue effects, as well as our adjustments. Overall, after examining the above issues we admit some reservations about the Government's estimates of approximate revenue neutrality in costing its responses to the Ralph Report (i e. its Stage 1 response and its yet to be announced Stage 2 response). Instead the analysis here suggests there is a revenue loss of $10.16 billion in the years 2000-01 to 2004-05. A substantial part of that is the $4.22 billion the Treasurer says will result from the impact of deferred (Stage 2) measures. While those deferred measures have not yet been articulated it is difficult to credit the overall package with hard figures at the moment. That $4.22 billion might be regarded as a target for future measures but, as mentioned earlier, it seems inconsistent to both defer consideration of the measure yet claim the revenue. The rest of the difference reflects behavioural and other assumptions that seem difficult to accept or which are not adequately supported in the analysis so far released by the Government or provided in the Ralph Report. Moreover, some of those assumptions would not be allowed in ordinary budgetary documentation if conventional Department of Finance and Administration budgetary statement guidelines were applicable. In addition the accelerated depreciation changes raise a question of whether short run revenue implications might also reflect long run implications.

All in all, for the years 2000-01 to 2004-05, it can be argued that the Government's claimed effect on the budget has been overestimated by around $10.66 billion. As suggested earlier, this will have some bearing on the distribution of the taxation burden between the business and household sectors. This shortfall would have to be addressed in future budgets. However, the deferred measures, if they were introduced would reduce the shortfall by $4.22 billion. Perhaps this also means that the Parliament would be justified in seeking to examine the details of Stage 2-the deferred measures-before accepting Stage 1. Some of the measures treated as business issues, such as the proposed capital gains tax arrangements, impact directly on the personal distribution of the tax burden. The benefit of lower capital gains tax rates will affect the distribution of the tax burdens assumed under ANTS II.

Changes in business income taxes paid by industries in 2004-05

The Report of the Review states that in May 1999, the Department of Industry, Science and Resources (ISR) commissioned Econotech to model the long-term effects of business tax reform on Australian industries. The changes modelled were the indirect tax measures announced in ANTS, the reduction in company tax rates proposed by the Review, and the Review's other recommended reforms.

The model produced estimates of the tax burden on various industries as set out in table 4. All estimates refer to the year 2004-05.

Table 4: Changes in business income taxes paid by industries in 2004-05