Current Issues Brief 9 1999-2000

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

RBT	Review of Business Taxation
CIV	Collective investment vehicle
CGT	Capital gains tax
ATO	Australian Taxation Office
ANTS	A New Tax System
DWT	Dividend withholding tax
GST	Goods and services tax
ACMT	Alternative company minimum Tax
CFC	Controlled foreign company
FIF	Foreign investment fund
MNE	Multinational enterprise
GDP	Gross domestic product
NBTS	New Business Tax System
R&D	Research and development
ASFA	Association of Superannuation Funds of Australia
IFSA	Investment and Financial Services Association
COSBOA	Council of Small Business Organisations of Australia
ACOSS	Australian Council of Social Service

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)

	1999-00	2000-01	2001-02	2002-03	2003-04	2004-05	Impact over 6 years
Measure
Lower company tax rate	-60	-1260	-3480	-3140	-3090	-3410	-14440
Changes to entity measures	-100	-430	-1040	-490	-690	-550	-3300
Depreciation and small business measures	40	1210	2240	2190	2440	2070	10190
Capital gains tax measures	0	130	150	80	40	-50	350
Integrity measures	20	390	540	580	630	620	2780
Growth dividend	0	30	50	100	150	250	580
Announced measures	-110	70	-1530	-670	-520	-1060	-3820
Impact of deferred measures	0	470	820	950	940	1040	4220
Total impact	-110	540	-710	270	420	-20	390

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

Industry	$M
Agriculture, forestry and fishing	28
Mining	226
Manufacturing	178
Electricity, gas and water	172
Construction	22
Wholesale trade	-97
Retail trade	37
Accommodation, cafes and restaurants	56
Transport and storage	207
Communication services	6
Finance and insurance	-934
Property and business services	-78
Government admin and defence	-1
Education	-2
Health and community services	-15
Cultural and recreational services	-7
Personal and other services	3
Total	-199
Total excluding Finance and insurance	735

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

	2000-01	2001-02	2002-03	2003-04	2004-05
Treasurer's claimed overall impact of announced and deferred measures	540	-710	270	420	-20
Deduct impact of deferred measures	470	820	950	940	1040
Deduct CGT receipts due to behavioural changes	610	580	540	520	430
Deduct accelerated depreciation	1150	2220	2300	2610	2550
Add back permanent improvement in budget due to abolition of accelerated depreciation	1530	1530	1530	1530	1530
Deduct growth dividend (as explained in the text)	30	50	100	150	250
Add successor to accelerated depreciation	?	?	?	?	?
Revenue impact of package	-190	-2850	-2090	-2270	-2760

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

Industry	Revenue from A New Tax System measures at 36% $m	Revenue from A New Tax System measures at 30% $m	30% Tax Rate - Existing Base $m	Remove Accelerated Depreciation $m	Other Reforms $m	Total $m
Agriculture, forestry & fishing	33	22	-39	84	-52	16
Mining	-8	-4	-316	385	121	186
Manufacturing	32	26	-554	662	100	234
Electricity, gas & water	3	2	-9	167	19	179
Construction	-2	-2	-83	86	9	10
Wholesale trade	18	11	-251	131	57	-51
Retail trade	25	16	-133	173	65	121
Accomm, cafes & restaurants	1	1	-29	77	-8	40
Transport	13	9	-87	285	-45	192
Communication services	-76	-53	-175	133	-34	-129
Finance & insurance	948	628	-940	67	17	-228
Property & business services	105	69	-303	210	42	19
Government admin & defence	..	..	-2	..	12	10
Education	3	2	-3	2	12	13
Health & community services	22	14	-25	21	12	23
Cultural & recreational services	6	3	-57	48	-2	-7
Personal & other services	9	6	-23	17	3	3
Total	1130	750	-3030	2550	360	630

Note: Totals may not sum due to rounding.

Source: Review of Business Taxation, A Tax System Redesigned, p. 744.

It will be seen from Table 4 that the reduction in the company tax rate from 36 per cent to 30 per cent of $3.030 billion is largely paid for by the abolition of accelerated depreciation of $2.550 billion.

Industries with a high proportion of taxpayers (such as sole proprietors and partnerships that are not taxed as companies, in agriculture, forestry and fishing) would not benefit to the same extent as other industries which predominantly use companies, from a reduction in the company tax rate.

Who are the beneficiaries of the trade off of accelerated depreciation for the reduced company tax?

General comments on accelerated depreciation

The term 'accelerated depreciation' refers to the situation where the cost of an asset is deducted over a shorter period than its effective life. Accelerated depreciation is the allowance of deductions for declines in the value of an asset at higher rates than are expected to occur in practice. Accelerated depreciation is allowed for plant and equipment. Buildings do not generally qualify for accelerated depreciation to the same extent as plant and equipment. Accelerated depreciation does not increase the nominal entitlement to taxation depreciation over the life of an asset. Rather it brings forward deductions. This results in tax being deferred during the early years of an asset's useful life and increases tax in the later years.

The benefit to the taxpayer of accelerated depreciation is confined to tax deferral. In after-tax terms, accelerated depreciation increases the net present value of an investment, or its rate of return above what it would be in the absence of accelerated depreciation.

Taxpayers value accelerated depreciation because it provides important cash flow benefits. Where a taxpayer has made a substantial up-front capital expenditure early positive cash flows are important in determining the overall rate of return on the project.

Spread of Accelerated Depreciation over Industries

The Discussion Paper titled A Strong Foundation - Establishing objectives, principles and processes issued by the Review in November 1998 notes that the existing legislation contains detailed sets of provisions to deal with the treatment of over 37 types of capital expenditure. These are illustrated in Figure 1 below.

Source: Review of Business Taxation, A Strong Foundation, p. 32.

It will be seen that capital intensive industries such as mining and manufacturing derive the most benefits from accelerated depreciation. Service industries such as finance, tourism or retailing will derive relatively little benefit from accelerated depreciation as the investment on plant and equipment relative to income can be expected to be significantly less than that expected of the mining and manufacturing industries.

Further, different capital assets are eligible for varying levels of accelerated depreciation and different depreciation regimes exists for different asset classes.

Long-Term Effects of Tax Reform on Australian Industries

As mentioned earlier the Treasurer in releasing the proposals for The New Business Tax System (NBTS) claimed that it will provide Australia with internationally competitive business tax arrangements and create the environment for achieving higher economic growth.

A key indicator of the potential for higher economic growth and international competitiveness is the impact of the proposals on industry costs. The Treasurer did not release any information on the impact of the measures in the NBTS on industry costs. Nor did the Treasurer release any information on the combined impact of the revised ANTS package now being implemented and the modified Review proposals in the NBTS on industry costs.

A report prepared by Econtech for the Australian Bankers' Association and released on 24 August 1999 examines the effects of indirect tax reform and the business tax measures recommendations of the Review on Australian industries. The object of this report was to ensure that the public debate about the merits of tax reform is supported by analysis of the effects of tax reform. The Econtech report analyses the effects of tax reform as an integrated package. It takes into account the final version of indirect reform which was amended in June 1999 (ANTS II) before being passed by the Senate. The report also takes into account business tax reform measures from the option suggested by the Review in their discussion paper A Platform for Consultation. The most important of the Review measures is to abolish accelerated depreciation tax concessions to pay for a reduction in the company tax rate from 36 per cent to 30 per cent.

A copy of the Executive Summary of this report is included in Current Comment No.1 1999-2000.

Table 5, reproduced from the Executive Summary, shows the changes in industry costs from the combined business tax reform measures.

Table 5: Changes in Industry Costs from the Combined Business Tax Reform Measures

	ANTS II	Ralph	Total
Agriculture, forestry, and fishing Mining Manufacturing Electricity Construction Wholesale trade Retail trade Accommodation, cafes and restaurants Transport and storage Communication services Finance and insurance Banking (Memo item) (a) Property and business services Government admin and defence Education Health and community services Cultural and recreational services Personal and other services Dwellings	-1300 -2000 -8400 -1000 -2100 -2300 -2300 -700 -2600 -1000 -800 430 -2600 -1200 -200 -900 -700 -400 2900	28 226 178 172 22 -97 37 56 207 6 -934 -230/-120 -78 -1 -2 -15 -7 3 0	-1272 -1774 -8222 -828 -2078 -2397 -2263 -644 -2393 -994 -1734 200/310 -2678 -1201 -202 -915 -707 -397 2900

Source: Econtech, The Long Term Effects of Tax Reform on Australian Industries, A report prepared by Econtech for the Australian Bankers' Association on 24 August 1999, Executive Summary, p. iii.

(a) The Ralph estimates are a range to reflect uncertainties arising from the limited public information available.

The general conclusion that may be drawn is that ANTS II has delivered to industry the major benefits of cost reductions which would give rise to economic growth. The major beneficiaries of the New Business Tax System based on the Ralph Review have been the Finance and Insurance sectors.

Impacts on selected sectors

This paper also discusses the impact of the New Business Tax System on a number of industry sectors, namely, primary producers, the manufacturing sector, the mining sector, the financial services sector, the small business sector, research and development and the community services sector. The reader is referred to Appendixes 3 to 11 of this paper for analyses of the proposed reforms of various sectors.

Conclusion

The Government's proposed reforms to business taxation are major reforms that will have fiscal and structural implications for Australian businesses. The legislation that would implement the proposed reforms would be extensive and complicated, but according to the Government would be beneficial to the nation. The Government's view of the proposed reforms is quite clear:

The companion to this publication, 'Ralph Review of Business Taxation' Current Comment No 1 1999-2000, also prepared by Information and Research Service contains a useful selection of articles and commentary on the proposed taxation reforms. These articles, some of which are referred to in this publication, question the revenue neutrality of the proposed measures, as well as the merit of some of the reforms. Other analysis has fully supported the proposed reforms and the purpose and objectives behind the Government's tax reform agenda. As is often the case with economic reforms, opinions differ on the merit of the proposals. Nonetheless, despite these differences of opinion, it is arguable that some of the analysis or assumptions used in the Review of Business Taxation may be over-optimistic in its assessment of the fiscal impact of the proposals, for example, the reliance on revenue dependent on decisions that are yet to be made and the estimated increases in capital gains tax revenue. In light of these and other uncertainties, it appears questionable whether the aim of revenue neutrality can be met. Only time will tell whether the reforms will benefit the nation in the manner that the Government outlined.

Appendix 1: Terms of Reference(38)

Business Income Tax Review

Business taxation is concerned with taxing investments in physical and financial assets (and their financing) and the collective vehicles or 'entities' through which these investments can be made.

Objectives

The Review will pursue the strategy specified in A New Tax System of consultation on the framework of reform of business entities and on the extent of reform of business investments recognising the current problems and objectives for business tax reform identified in A New Tax System. The process of consultation will include an assessment of the design and the administration of the tax regimes affecting business to identify their main shortcomings and their impediments to productive activity and innovation.

The Review will make recommendations on the fundamental design of the business tax system, the processes of ongoing policy making, drafting of legislation and the administration of business taxation.

The recommendations will be consistent with the aims of improving the competitiveness and efficiency of Australian business, providing a secure source of revenue, enhancing the stability of taxation arrangements, improving simplicity and transparency and reducing the costs of compliance. The Review will adopt a comprehensive approach to reform driven by clear, sound principles involving a move towards greater commercial reality.

Methods

The Review of business taxation arrangements will be open and transparent.

• Mr John Ralph, AO, will chair the Review.
• The Review will be able to call on the expertise of both the public and private sectors and academic tax experts.
• The Review is 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.

Outcomes

1. The Review will report on the state of the current arrangements relating to business taxation.

   This will involve reporting on:

   (a) The Australian business taxation system as a whole compared with international experience;

   (b) The structural flaws in the broad design of business tax arrangements and the degree to which existing business tax systems bias and impede business decisions;

   (c) The degree to which the current business tax arrangements meet the aims of certainty of taxation treatment, clarity of law, ease of administration and low compliance costs; and

   (d) The administration of taxation, including the drafting of legislation and technical corrections to legislation and the adequacy of existing procedures for consultation between the taxation authorities and the business community.

2. The Review will make recommendations about the fundamental re-design of business tax arrangements. While no aspect of the taxation of business entities and investments should be precluded from the scope of the review, consultations by the Review and associated recommendations will be directed to the strategy for reform spelt out in A New Tax System.
3. The Review will:

   (a) examine in relation to business entities, the re-designed company tax arrangements proposed to apply to companies, trusts, cooperatives, limited partnerships and life insurers 3/4 including a move towards consolidated group taxation and the achievement of a consistent treatment of distributions of profit and contributed capital;

   (b) examine in relation to business investments, the extent of reform in the areas of physical assets, financial assets/liabilities and intangibles and the potential use of accounting principles, taking into account the following considerations

   (i) the need to encourage business development with an internationally competitive tax treatment of business investments;

   (ii) the potential benefits of bringing tax value and commercial value closer together;

   (iii) the goal of moving towards a 30 per cent company tax rate;

   (c) examine in relation to capital gains tax (CGT), the scope for:

   (i) capping the rate of tax applying to capital gains for individuals at 30 per cent;

   (ii) extending the CGT rollover provisions to scrip-for-scrip transactions; and

   (d) need to achieve overall revenue neutrality in respect of (b) and (c) with these changes.

4. The Review will make recommendations concerning the question of consultative input from the business community into the ongoing processes of policy design, drafting of legislation and the administration of taxation.
5. The Review will make recommendations concerning possible improvements in the administration and the accountability of the taxation authorities in relation to business taxation.

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

Alternative Company Minimum Tax (ACMT)

The review did not recommend the adoption of the ACMT as applies in the US, Canada, India, Pakistan, Venezuela and Columbia arguing that the following proposed measures, taken together, will reduce substantially the capacity for companies to reduce their nominal tax liabilities, and therefore their effective rate, by taking advantage of tax preferences.

• The taxation of wasting assets (particularly the abolition of accelerated depreciation for all but small businesses).
• The 'freezing' of indexation of capital gains.
• The accrual of payments associated with the taxation of leases and rights.
• The tax consolidation of corporate groups.
• Taxing inter-entity distributions.
• Value shifting and loss duplication measures outside consolidated groups.

The Report of the Review did however note the likely impact of an ACMT on tax avoidance by companies

It is therefore relevant to take stock of the avoidance aspects which the Report has indicated requires further review, before concluding that the introduction of the ACMT would not add to the perception of equity in the tax system as a whole.

Appendix 3: Impact on the Community Services Sector

Commentary by Ms Jacqueline Ohlin, Research Specialist, Social Policy Group

While there has been substantial interest and analysis on the effect of the Ralph Report on both large and small business, there is still very little comment about the effects on the community services sector.

The sector itself has, so far, only commented on the effect of the Ralph Report proposals on the community in general. The Australian Council of Social Service, the Council on the Ageing, the Carers' Association, the Australian Pensioners' and Superannuants' Federation and the Sole Parents' Union issued a joint News Release on 20 September 1999. They criticised the Government for failing to take the opportunity to close tax avoidance loopholes for company cars, shelters for personal income tax and the use of business entities such as trusts and private companies to avoid tax. They pointed out that 'these loopholes mean ordinary Australians have to pay more tax than they otherwise would, or suffer cuts to pensions, benefits and public services through lack of revenue,' and warn against further cuts to social services to help pay for promised tax cuts.

In another Media Release on 21 July 1999, ACOSS President, Michael Raper, argued that a lower capital gains tax (as proposed by the Ralph Report) would unfairly advantage wealthy taxpayers, who could afford to invest in assets such as real estate and shares rather than directly in active businesses that obtain their profits from selling goods and services. Mr Raper noted:

Whether the 'business arms' of community service agencies can benefit from the Ralph Report proposals remains to be seen. ACOSS is currently undertaking analysis into the effects of the proposals on community services. However, a couple of points are worth noting:

• For some time now, the community services sector has maintained the view that, in its service dealings with the least advantaged in society, it should be regarded as fundamentally different from commercial operations-essentially, that it is a nonsense to consider human service provision as a tradeable commodity. In the discussion surrounding the Goods and Services Tax, for example, community sector agencies raised concern about the introduction of a GST on the 'commercial' activities of organisations, and changes to the Fringe Benefits Tax which, they argued, will 'reduce the sector's capacity to provide services to people in need'.(40) Agencies suggest firstly, that as non-profit agencies they are not operating on a so-called 'level playing field' with commercial service providers, and secondly, in ploughing their profits back into service provision in one form or another, they are actually effecting a community saving through current operations
• Very few community sector agencies are actually likely to directly benefit from changes to input taxes within the Business Tax System, simply because of their size and the nature of their operations. In the Industry Commission, Report Charitable Organisations in Australia, it was noted that the largest 50 organisations account for only a small proportion (0.05per cent) of all the organisations in the sector (and for a third of the total income of the sector). The remaining organisations tend to be quite small and dependant upon Government revenue for 45 per cent of their operations(41)

The other area in which community service agencies might indirectly benefit from Business Tax changes is through receipt of corporate donations, however at this stage any projected changes would be speculative. David Gonski, adviser to the Prime Minister on the drafting of tax incentives for gifts to charities, has spoken positively about the potential for people to 'give something back to Australia(42) including 'in-kind.' Nevertheless, Australia's record of corporate giving stands at about one-sixth the rate in the United States. We are not overly-generous when it comes to charitable donations, except, it would seem, among lower income households, where in the order of 75 per cent give to charities.

Appendix 4: Impact on Primary Producers

Commentary by Mr Peter Hicks, Research Specialist, Economics, Commerce and Industrial Relations Group

The farm sector has emerged from the business taxation changes relatively unscathed in terms of retention of existing tax concessions. This has been applauded by farmer organisations with, for example, the President of the National Farmers Federation (NFF) saying:

In their initial responses to the Government's announcement farmer organisations expressed relief that the Government had not implemented many of the original proposals by the Ralph Committee with regard to the rural sector but had 'recognised the peculiarities of the primary sector'.(44) They also responded particularly favourably to measures including the Simplified Tax System (STS) for small business, removal of CGT on assets held for more than fifteen years by retiring farmers, the 50 per cent CGT exemption and related provisions.

A major area of concern to farmers arising from the announcement is the proposal to tax trusts and limited partnerships like companies. While about 1 per cent of farms are operated by trusts it is estimated that around 20 per cent are owned by trusts. Although changes to the taxation of entities has been deferred until 1 July 2001:

• The NSW Farmers' Association is disappointed that this concept has not been thrown out completely and has stated that:

• The NFF has welcomed the deferral saying it will allow time for further consultation on the issue with the Government. They are confident this will 'ensure a clearer understanding of the importance of trusts and the necessity for flexibility in partnership re-organisation in assuring the intergenerational transfer of farm businesses'.(46)

Another major area of concern to farmers is the substantial reduction in depreciation allowances for farmers with turnover of more than $1 million.

• Farmer organisations have cited Australian Bureau of Agricultural and Resource Economics statistics that the 2.4 per cent of broadacre farmers with turnover in excess of $1 million account for over 17 per cent of broadacre farm production.
• The substance of the argument here is one of incidence in that the small number of (large) farmers who are responsible for a disproportionately large share of rural production will be disadvantaged through lower depreciation allowances. Further, larger farms tend to achieve better financial performance (profits and rates of return) than smaller farms. Thus the application of the threshold can be seen as penalising a more financially viable group of producers.
• The particular agricultural industry most likely to be affected is cotton which is highly capital intensive. According to the Australian Bureau of Statistics(47) the average turnover for cotton enterprises is $1.8 million and it is the only sector with an average farm business turnover in excess of $1 million. The industry with the next largest average turnover is the pig industry at $714,000 followed by the grain industry at $413,600.
• Average farm business turnover $255,500 and 78.5 per cent of farm businesses have turnover of less than $300,000. However these only account for 37.1 per cent of the total turnover of agricultural industries.

A third area of concern to farmers arising from the announcement is the proposal to restrict access to the STS for farms with turnover exceeding $1 million.

• The WA Farmers Federation says that such farmers "will not be afforded the luxury of a 'simplified tax system' and will be significantly affected."
• The issue here is also incidence, similar to that for depreciation allowances discussed earlier.
• With the Treasurer indicating that the Government is considering applying the STS generally to business, there is some chance that this concern will be addressed before the STS becomes operative.

The proposed changes will have a major impact on the agriculture sector. An analysis of the long-term effects of both the recent changes to the indirect taxation arrangements (ANTS II) and the measures outlined in the Ralph Report was prepared using the Murphy Model of the Australian economy.(48) Although this report was released prior to the Government's announcement of its proposed changes to business taxation arrangements, and the measures announced do not fully mirror the recommendations modelled in the report, they are sufficiently close to allow meaningful comment to be made.

According to the Murphy Model the Ralph recommendations would result in:

• Only a very small increase in agricultural production on top of that generated by ANTS II.
• An insignificant increase in industry costs with these being easily offset by the significant reduction in costs from ANTS II.

However, with the Government proposing to retain accelerated depreciation for most farmers, and hence the bulk of agricultural output, it is likely that there will be now be a very small fall in industry costs for the agriculture sector from the business taxation measures.

Appendix 5: Impact on the Manufacturing Sector

Commentary by Mr Michael Emmery, Research Specialist, Economics, Commerce and Industrial Relations Group

The initial press response to the release of Review of Business Taxation (RBT) has included frequent references to non-neutral treatment of different sectors of the economy and generally concluded that manufacturing will be a loser.

The Sydney Morning Herald editorial (22 September 1999) notes:

The Age editorial (22 September 1999) ran a similar line:

Professor Warren at the Australian Taxation Studies Program in the University of New South Wales makes two points about the impact of the proposed tax reforms on large businesses. First he argues that the benefit from a lower company tax rate may be more apparent than real because of the loss of accelerated depreciation and also because the benefits to resident shareholders will be reduced by the loss of franking credits under imputation. Secondly he argues that there will be winners and losers among large businesses. The losers will be in manufacturing and mining and the winners in the financial sector, but not life insurance companies.

While there is some substance in the above argument that manufacturing, and perhaps mining, may bear a greater burden of the proposed tax changes than the services sector, it does appear that the significance of this distortion, if any, may be exaggerated. The modelling of the impact on different sectors done for the Review of Business Taxation indicates that non-neutral impacts are of a relatively minor nature. Also there have been no cries of 'unfair treatment' from the usually vocal manufacturing lobby groups which would appear to indicate that they do not see this as a significant issue arising from the Government's response to the Review.

The modelling of the sector impacts of the RBTs recommended business tax changes was undertaken using the Murphy Model (MM303). It estimates the medium-term (taken to be 2004-05) change in taxes paid by different industries from both the measures proposed in a New Tax System (ANTS) and the RBT recommendations.

The modelling shows that business income taxes paid by all industries would rise by $630 million, with the major contributors to this rise being manufacturing ($234 million), mining ($186 million), transport ($192 million) and electricity, gas and water ($179 million). The main beneficiaries from the tax changes are finance and insurance with a reduction in their business tax of $228 million, and communications with reduced taxes of $129 million.

The next step in the modelling exercise was to estimate the direct and indirect effects of the business tax changes on production in each sector. The results show moderate tax induced increases in production in communication services and finance and insurance and also a small increase in production in manufacturing. The main industries to experience a negative impact on production are mining, electricity, gas and water and transport.

This section of the RBT report concludes:

The national industry associations have given a cautious, but overall favourable, response to the Treasurer's statement on the Ralph Review of Business Taxation. The Australian Chamber of Commerce and Industry chief executive Mark Patterson said the Government's package stacked up very well against the benchmarks set by industry(50). The Managing Director of Australian Business, Philip Holt, said the business tax reform package had many positive features, notably the lower rate of company tax, the new depreciation arrangements for small business and the lower capital gains tax rates for active businesses.(51)

Spokesperson for the Australian Industry Group, Heather Ridout, also welcomed the Government's response, noting that while industry needs to examine the report in detail, an early examination indicates a generally positive and balanced approach to business tax reform. The Australian Industry Group welcomes in particular the reduction in the corporate tax rate, simplified arrangements for small business which should substantially reduce compliance costs, the comprehensive reforms to capital gains tax and the establishment of an ongoing advisory board.(52)

The industry bodies indicated that they would have liked to see further reform in a number of areas-changes to the complex fringe benefits regime, action to avoid the dilution of the value of the R&D tax concession, the extension of the new depreciation allowances to medium sized and bigger businesses and a restriction on the lower capital gains tax to active businesses to avoid the incentive to speculative purchasing of assets.

To date there has been very little response from major companies, or interest groups, as to the impact of the tax reform package on individual industries within the manufacturing sector. However these groups made submissions to the Ralph Inquiry and it is possible to make broad comparisons between what they expected from the business tax review and the outcome.

A critical area of manufacturing that will be affected is the capital-intensive industries. The industries in this group, in particular, the manufacturers of motor vehicles and parts, chemicals and plastics and pulp and paper, generally expressed similar points of view in their submissions to the Review of Business Taxation. They supported the reduction in the corporate rate of taxation to 30 per cent but expressed concern about the impact of the withdrawal of accelerated depreciation on their ability to attract international capital, to replace obsolete plants and to make further investment in world scale plants. The Plastics and Chemicals Industries Association, for example, noted:

The Government has stated that with respect to large capital intensive projects with long lives, it will 'be prepared to consider such projects in the context of an expanded strategic investment coordination process, including consideration of the option of targeted investment allowances'.(54) The capital intensive industries have expressed a strong interest in learning more about the nature of this proposed assistance measure but it must be expected that there will be business concern about the uncertainty and 'picking winners' nature of this type of assistance.

Appendix 6: Impact on the Mining Sector

Commentary by Mr Michael Roarty, Research Specialist, Science, Technology, Environment and Resources Group

There have been significant taxation changes to Australia's mining industry resulting from the reforms of the indirect tax system and the business taxation changes resulting from the Ralph Review.

Probably (as a result of the Ralph Review) of most significance has been the removal of the accelerated depreciation schedule-the charging of the bulk of depreciation deductions in the early year's of a project life, in favour of a system where depreciation is charged over a projects 'effective lifetime'. However, any project underway before 22 September 1999-the effective date of the new depreciation regime-continues to enjoy the benefits of the accelerated depreciation schedule (grandfathering).

In general terms, the mining industry lobbied against such a move, although after consideration, the Ralph Review opted to push for the removal of accelerated depreciation. This option was adopted rather than adjust the proposed business taxation scales which involves the reduction of company taxation from the current 36 per cent to 34 per cent in 2000 and to 30 per cent in 2001. The Government also argued that as a result of reforms to the indirect tax system, the mining industry will benefit from the removal of hidden input taxes and will also benefit from lower transport costs flowing from the reduction in diesel costs. The Government however acknowledged the importance of major capital investment and stated that it may provide assistance to major projects in the form of one-off investment allowances rather than budget outlay items.

A particular positive outcome for the mining industry was the Government's rejection of the removal of the ability of mining companies to claim an immediate tax deduction for stripping or overburden removal costs. These cost are important elements of bringing any open cut operation into being, particularly applicable to coal and gold open pit operations. Other deductions for expenditure in prospecting and exploration and the research and development tax concessions have been retained. Further, from 1 July 2001, expenditures incurred by the mining sector, such as those for export market development, defending native title claims and mine closures, will be immediately deductible, provided that such costs do not create or improve an asset. Such costs, which are termed 'blackhole expenditures' are not currently deductible.

Appendix 7: Impact on the Financial Services Sector

Commentary by Mr David Kehl, Research Specialist, Economics, Commerce and Industrial Relations Group

The Government's response to the recommendations of the Review of Business Taxation will bring great benefits to the financial services sector. The measures announced in A New Tax System (personal tax cuts, replacing wholesale sales tax with a GST, reductions in fuel excises and the abolition of financial institutions duty, taxing trusts as companies, deferred company tax, increased tax on life insurance companies) combined with the measures outlined in the Review of Business Taxation (cuts in company tax rates and abolition of accelerated depreciation) make the financial services sector the second biggest beneficiary of tax reform.

Understandably, the boost to the financial services sector has brought favourable comments from financial service organisations. For example, The Association of Superannuation Funds of Australia (ASFA) hailed the Ralph Report and the Government's response to it has been hailed as positive and balanced.

ASFA stated:

ASFA praised the decision to exempt capital gains earned through pooled development funds by Australian superannuation funds from tax, and welcomed significant improvements in the review's report compared to options canvassed in the consultation document Platform for Consultation, namely:

• Taxing pooled superannuation trusts as companies (i.e., replacing the existing 15 per cent tax superannuation rate for with the company tax rate of 36 per cent) and providing a complex system of franking credits that allowed for a 21 per cent tax refund at some later date.
• Taxing CIVs as companies (i.e., replacing the tax treatment of collective investment vehicles pay zero tax as long as investment income is distributed to the unit holders who pay tax at their marginal rate) with a system where the fund paid tax at the corporate tax rate (36 per cent) and investors receive franking credits equivalent to their share of the fund income paid in tax.

The Investment and Financial Services Association's (IFSA) stated that overall, the Government's proposals are pro-savings and investment, and the Ralph Review is to be applauded.(56) IFSA also applauded the Review for not proceeding with the options canvassed in the consultation document Platform for Consultation regarding pooled superannuation trusts and CIVs.

These proposals were dropped from the final Report, due to the realisation no doubt that pooled superannuation trusts and CIVs are not used to income split or minimise tax, and learning of the likely cash flow disadvantages and permanent competitive detriment that would be placed on these arrangements from the proposals.

The response of life insurers to the announced measures has been rather curious in that life insurance companies are to pay an additional company tax of over $500 million per year, yet there have been few complaints. The taxation of life insurance companies is complex, with five different tax rates applying to different insurance products. Underwriting income is presently exempt from tax, as is profit from investment management. It has been argued by Mr John Giannakopoulos of Deloittes Touche Tomahtsu that the Government was concerned that life insurance companies might be sheltering income and surplus money in low-tax operations, like statutory funds with superannuation business. He argues:

Given the low level of public comment about the measures affecting life insurance companies (or perhaps more accurately, 'superannuation' companies since over 80 per cent of the business written by life insurance companies is superannuation business(58)), there may be something to the comments of Mr Giannakopoulos. Alternatively, since many life insurance companies are involved in other commercial activities (such as banking, general insurance superannuation and management investments) the effect of increased tax expenses may be offset by gains in other areas of their operations.

The financial services sector also will be boosted by the proposed changes to capital gains tax for superannuation funds investing in pooled development funds, which will boost the pool of short-term speculative capital. This pool will also be boosted by the explicit tax exemption for pension funds from the USA, UK, Japan, Germany, France and Canada on income and capital gains taxes derived from the disposal of investments in new equity in eligible venture capital projects.

The sector will also be boosted by the availability of optional roll-over relief from capital gains tax for exchanges of membership interests in companies or fixed trusts in takeovers involving at least one widely held entity. This provision will overcome the impediment that capital gains tax places on corporate acquisitions. In addition, it will encourage start-up and innovative enterprises to remain in Australia by providing roll-over relief when a venture capital project proceeds to an initial public offering.

Appendix 8: Impact on Small Business

Commentary by Commentary by Mr Michael Emmery, Research Specialist Economics, Commerce and Industrial Relations Group

Representatives of small business put strong submissions to the Ralph inquiry pointing to the potential adverse impacts of proposed business tax reforms on this sector and seeking special treatment for small business in a number of key areas. The Council of Small Business Organisations of Australia (COSBOA) emphasised that:

• Only 12 per cent of small businesses, i.e. taxable companies, technically benefit from a lower corporate rate, and the bulk of these hold little capital
• Amongst unincorporated small businesses, some 32 per cent would potentially lose access to accelerated depreciation with no benefit from a lower corporate tax rate, and
• Costs of complying with taxation laws, and the lack of compensation for those costs, is one of the most important issues of concern to small business today.(59)

The Government responded positively with the inclusion in The New Business Tax System announced on 21 September 1999 of a number of measures specifically aimed at benefiting small business. The main measures are:

• Extension of the current capital gains tax exemption for small business which will result in individuals owning small business being liable for tax on a maximum of 25 per cent of their capital gains when they sell business assets
• Full exemption from capital gains tax on the disposal of a business asset which has been held continuously for 15 years and where the taxpayer is at least 55 years of age and intends to retire, or is incapacitated
• A simplified depreciation scheme for small business which should greatly reduce the paper work and effectively maintain its access to accelerated depreciation
• A simplified treatment of trading stock, and
• The proposed future move to a more straight forward and less costly cash accounting regime.

The response from small business has been favourable. Chief Executive of COSBOA, Rob Bastian, noted:

COSBOA listed the main pluses from the package as the changes to capital gains tax, cash accounting, the depreciation changes and the simplified treatment of trading stock. It noted also that more work is needed on compliance costs and the taxing of small business trusts as companies.

Accounting representatives said the reforms for small business were positive and would help ameliorate the added workload of implementing the GST over the next 12 months(61). However this question of the administrative and compliance costs for small business is far from clear. For example, a move to cash accounting will involve a major upheaval for many small businesses. While they will likely benefit from the new system in the long run, small business may incur large adjustment costs simply because they are less well equipped to deal with major change than their larger counterparts.

Finally there have been some adverse comments in the Press to the effect that the Government has gone too far in responding to the special needs of small business. The Editorial in The Australian(62) refers to the 'pork-barrelling to small business'. It argues that, unlike big business, small business is not paying for its tax cut due to the Government's decision to continue accelerated depreciation for most small businesses. (Note this point is not relevant to the majority of small businesses which are not incorporated and will not benefit from lower company tax). Ross Gittens in The Sydney Morning Herald(63) also is critical, referring to 'indulging in so many "carve-outs" for politically powerful groups-farmers, miners and small business'.

Appendix 9: Impact on Research and Development

Commentary by Dr Rod Panter, Research Specialist, Science, Technology, Environment and Resources Group

Economic research has consistently shown that research and development (R&D) generates large benefits to society that far outweigh the benefits that accrue to the sponsors of R&D. The strength of those findings persuaded the Industry Commission (later the Productivity Commission) of the need for the Australian Government to encourage private R&D activity in Australia by tilting the level playing field in favour of private R&D.(64) The Industry Commission left open the question of how that might be done. However, tax concessions are certainly one of the traditional methods for encouraging socially desirable activities. As such it might have been expected that the Ralph Report might have made some contribution on that issue.

While the words 'research and development', 'innovation' and the like do not appear prominently in either the Ralph Report or the ensuing Government decisions, some pluses and minuses for R&D can be found. Firstly, on the positive side, it has long been recognised that raising private finance for small innovation-dependent companies to carry out research and development is problematic, partly because of Australia's traditional reluctance to accept business risks associated with small innovative companies. Many Australian inventions and 'clever' companies have moved overseas, with little or no value from the inventions or companies remaining here.

The Ralph Report addresses a frequently criticised aspect of the Australian tax system, namely, that Australia cannot easily raise domestic or foreign private R&D funds because of its relatively high capital gains tax. It can be expected that the exemption on capital gains tax on foreign pension funds invested in relatively risky start-up ventures plus a concession on taxes on Pooled Development funds will slow or perhaps even reverse the flows of ideas and companies overseas.

Australia's private spending on R&D is proportionately among the lowest among developed countries. Some major sectors, for example the $44 billion food industry, are notorious for their relative neglect of research. Following the 1996 reduction in tax concession for R&D from 150 per cent to 125 per cent, business R&D investment is reported to have declined from $4.343 billion in 1995-1996 to $4.044 billion in
1997-1998. There is evidence for a further decline in business spending in 1998-1999. The 1996 tax concession reduction meant that the government subsidy on R&D fell from 18 cents on every R&D dollar to nine cents.

While the Ralph Review has left the R&D concession unchanged at 125 per cent, the company tax has been reduced to 30 per cent. This means that the effective subsidy on R&D has been further reduced, from 9 cents to 7.5 cents in the dollar. The overwhelming opinion of research oriented businesses is that the Ralph Review should have recommended an adjustment to the R&D tax concession so that at least the nine cent (if not the 18 cent) subsidy could be restored.

Under present capital gains tax arrangements, capital gains are calculated by taking the selling price and deducting the purchase price with the latter being adjusted for changes in the Consumer Price Index since the time of the original purchase. For those R&D investments likely to attract capital gains tax, albeit at a reduced rate, the decision to remove indexation may present problems for 'patient capital', that is, investment which is not rewarded in the near term. This is because the new capital gains tax environment will encourage the targeting of investment in high growth areas and holdings will tend to be sold off more quickly. Even if inflation is expected to remain at relatively low levels, long term investment decisions will still be distorted by the failure to index the cost base when calculating capital gains. However, the future course of inflation is simply unknown and unknowable. Under quite plausible scenarios the taxation of nominal capital gains may well mean that real capital gains are taxed at extremely high rates. For example, a company that trebles in value in 20 years as a result of the combination of real capital gains plus inflation of 5 per cent per annum would be taxed at 48.5 per cent of the real capital gain under present arrangements for a taxpayer on the top marginal tax rate. Under the proposed changes, 140 per cent of the real capital gain would be taxed in the hands of the same taxpayer.

While information technology and communication-type investments may be relatively unaffected, 'patient capital' is especially needed in biotechnology industries where R&D tends to be drawn out. For example, the Australian 'flu drug Relenza took over twenty years from its scientific conception to reaching the market. Australia makes a strong claim to have potential for biotechnology but investment in the sector is inherently risky and the development of products is usually long-term.

Of course the Government will maintain that the lowered company tax rate means that businesses will have more available funds from earnings to invest in R&D. But, given the poor and worsening R&D performance of established industry, it can be argued that government more than ever needs to encourage company funds into R&D. The situation with start-up companies is different; they are more reliant on grants and/or private investors for funding R&D and usually cannot make use of tax concessions. Established industry, on the other hand, must innovate more in order to remain competitive in a global sense.

In the wake of criticisms of the Ralph Review as regards R&D, the Government is pointing out that there is to be an Innovation Summit in February next year which can serve as a conduit between industry, researchers and government policymakers. It seems unlikely that any major taxation changes will result from this meeting, however. One hope for a better outlook for R&D is for greater government support of research in the higher education sector. It is most obviously in the earliest stages of R&D, that is, basic and near-basic research, that the private sector needs assistance. What is often overlooked, however, is the need for encouragement of such necessary aspects of R&D as market research, industrial design, etc. Australian governments have traditionally been reluctant to fund these and other product development work. Thus, problems of support for commercialisation remain.

Appendix 10: Impact of the Reduction in Capital Gains Tax

Commentary by Mr David Kehl, Research Specialist, Economics, Commerce and Industrial Relations Group

The Review of Business Taxation proposes that major changes be made to the taxation of capital gains. The Review stated that the purpose of its proposed changes were to 'enliven and invigorate the Australian equities market, to stimulate greater participation by individuals, and to achieve a better allocation of the nation's capital resources'.(65)

A point frequently overlooked in some press commentary is that current capital gains tax arrangements remain preserved up until the end of the September quarter 1999. Individuals or complying superannuation and related funds will have the choice on the sale of a capital gains tax asset acquired before the end of the September quarter 1999 to reduce nominal capital gains for tax purposes by either:

• The 'frozen' indexation amount to the end of the September quarter 1999 (if the asset has been held for more than 12 months), or
• 50 per cent of the nominal gain in the case of individuals or one third of the gain in the case of complying superannuation and related funds.

The proposals for capital gains tax are likely to make assessment much more complicated due the current arrangements being 'grandfathered'. The proposals will lead to creation of three relevant periods for assessing capital gains tax, namely pre 20 September 1985 assets, assets acquired between 20 September 1985 and the end of the September quarter 1999, and assets acquired after the end of the September quarter 1999. A complicating factor is that taxpayers will have the choice on the sale of a capital gains tax asset acquired before the end of the September quarter 1999, enabling an element of arbitraging to reduce liability for taxation. These added complexities have made capital gains tax begin to resemble the grandfathered taxation provisions applicable to superannuation, which it can be argued, are hardly the model of simplicity and efficiency.

The impact of the proposed changes will be different for individual investors depending on when the taxable asset was acquired. Taxpayers who have a capital gains tax asset acquired before the end of the September quarter 1999 can choose the method that minimises their tax liability. Taxpayers who acquired assets after the end of the September quarter 1999 will pay tax capital gains tax on a proportion of their nominal gain. For these taxpayers, the impact may be quite significant.

For example, the proposal tilts the taxation playing field in favour of assets which generate high capital gains. In Australia the two highest capital growth asset classes have been equities and property. Consequently, investment strategies which accentuate capital growth (such as borrowing to invest) would probably become more widespread. With capital gains tax more favourable than income, shareholders may encourage companies to retain earnings (to boost the capital value of the share) rather than distribute income via the payment of dividends. Should this strategy become widespread, there may be adverse consequences for self-funded retirees (that typically prefer to invest in companies that pay high dividends) who rely on regular income distributions.

The removal of indexation of capital gains on investment made after 20 September 1985 will also make investing more confusing and complex, particularly for small 'mum and dad' investors. It will also force investors to become far more active in the way that they buy and sell assets. This is because the real rate of tax will be lower the faster you sell an asset, consequently, 'asset churning' (or selling one assets and purchasing another with the proceeds) may become popular. Over the longer term, the pool of capital allocated to long-term investments may be switched to short-term investments.

The Government's rationale for its reforms to capital gains tax appear contradictory.(66) Share ownership is already at record levels (due to privatisations and de-mutualisations) and despite this record level of ownership, a lower capital gains tax needs to be cut, in the Treasurer's words, 'to encourage [mums and dads] to come into the stock market'.(67) Share ownership is something that many people are already undertaking. The proposed changes will arguable result in behavioural responses by investors that purchase shares after the end of the September quarter 1999. It is likely to encourage capital mobility and discourage long term investments (in effect a reversal of existing arrangements, yet also gives breaks to superannuation funds that are designed to make long-term investments). Patient long-term investing will no longer be a virtue since investors will have to be quick, and savvy, to capitalise on the reduced tax rate.(68) But 'mum and dad' investors are, in general, passive investors who prefer unexciting, slow-growth, blue chip stocks. Some may be shocked to discover that under the new arrangements for assessing capital gains tax, they could be liable for more tax, and, in some circumstances be liable for capital gains tax on real losses (due to the loss of averaging and indexation on assets acquired after the end of the September quarter 1999 and the taxation of nominal capital gains).

Small business owners are also major beneficiaries of the proposed tax reforms. The 50 per cent good will exemption (currently applying to small businesses with net assets under $2.3 million) will be replaced with a 50 per cent active asset exemption for all active assets for all small businesses with net assets of up to $5 million. As a result, individuals operating a small business will be eligible for the 50 per cent exclusion from capital gains tax and will be eligible for the 50 per cent active asset exemption on the balance of the capital gain. At the same time, they will be able to roll the remaining 25 per cent of the gain into replacements assets or apply it towards the $500 000 capital gains tax retirement exemption. Taken together, the reform will make investment in a small business a much more attractive proposition.(69)

There has also been concern that the loss of capital gains tax indexation and an inflationary shock caused by the introduction of the GST could mean investors will be worse off under the Government's capital gains tax changes.(70) This view also has been endorsed by Mr John Ralph, who argued that the capital gains tax threshold and rate would need to be adjusted in time to reflect the effect of inflation.(71)

There also have been concerns that the capital gains tax changes will lead to serious inequity and rorting. The proposed top rate on capital gains is 24.25 per cent, which is lower than the proposed future general corporate tax rate of 30 per cent. It is arguable that the new tax system is issuing an invitation to tax arbitragers (that is it encouraging people to take income in the form that attracts the lowest rate of taxation). Smart investors will do all they can to maximise capital gains and minimise operating profits.

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

Commentary by Mr David Richardson, Research Specialist Economics, Commerce and Industrial Relations Group

As mentioned in the section titled An Alternative View of the Fiscal Impact, over the life of the project the value of depreciation deductions is the same whether or not accelerated depreciation applies. It is only the tax rate itself that affects total life-of-project returns. However, when making investment decisions, project sponsors are going to want to take the timing of the resultant cash flows into account. For example, a dollar today is worth more than a dollar expected in five years time. That reflects both the interest that could have been earned on alternative investments as well as the normal risks associated with any business investment. (A bird in the hand is worth two in the bush.) An example of a project is now examined to suggest how project selection might be changed under the proposed changed taxation arrangements.

The present example is based on a hypothetical investment of $200 million which generates a net income (excluding depreciation) of $30 million per annum over a 14 year period. The accelerated depreciation provisions currently allow the project to be written off over 7 years. Under the current company tax arrangements, that means an after tax income of $29.49 million for 7 years and $19.20 million for the next seven years.(72) However, under the proposed scrapping of accelerated depreciation allowances and the 30 per cent tax rate, the after tax income would be $25.29 million for each of the 14 years life of the project. Under the proposed changes the investor faces a loss in after tax income in the early years of the project but receives an increase in the second half of the project.

There are a number of ways the investor may look at the project under the two regimes. Firstly, and rather crudely, the total after tax income is $340.8 million under the current arrangements and $354.0 million under the proposed arrangements with the lower company tax rate. Notice that over the life of the project the value of depreciation deductions is the same whether or not accelerated depreciation applies. It is only the tax rate itself that affects total life-of-project returns.

Second the investor may use a more sophisticated investment tool and calculate the present value (PV) of the project. The after tax return in future years is discounted back into present values and aggregated to give a total value. A positive number indicates that the project earns more than the (risk-adjusted) cost of capital employed. Assuming an interest rate hurdle of 9.5 per cent is chosen (that can be justified as a risk premium of approximately 300 basis points over the current long term interest rate on government bonds) then the project has a positive PV of $4.8 million. Under the proposed arrangements the PV turns negative and becomes minus $3.7 million. Hence under these assumptions and using the PV criteria, the decision-maker would accept the investment under present arrangements but would be forced to reject the project under the proposed arrangements.

As a third criterion we can calculate the payback period. The payback period tells the investor how long it is going to take to get back the money expended on the project. It is the period over which the investor is out of pocket. This is a common decision tool. While crude, it at least gives the investor in an uncertain world the length of time it takes before the breakeven point. Since potentially anything can happen to a real world investment, the shorter payback period means the time during which there is a risk of loss is minimised. Under the current tax arrangements and using the above example, the payback period is 6.8 years. Under the proposed changes the payback period is 7.9 years. This seems quite a significant extension in the time before the breakeven point is reached.

We might use something a little closer to an important real world example. In 1997 Mitsubishi sold 59 275 locally produced Magna vehicles, 41 579 were sold locally and the rest exported.(73) No doubt Mitsubishi would not base its planning on the assumption that it could always maintain this figure. Export sales are often problematic and new models can flop. Mitsubishi would probably want to base its planning on a cautious scenario under which its sales may fall to about 40 000. Retooling for a new model costs roughly $1 billion and new model series tend to run around 8 years. Profit before interest depreciation and tax tends to be around 25 per cent of wholesale prices(74) or around $5500 a medium or upper medium vehicle. Suppose Mitsubishi's head office is looking for a rate of return on capital of 10 per cent-the rate that they would use in their calculations to discount future values to the present. On these figures we find that Mitsubishi has a positive PV of $44 million. However, with the proposed changes in the tax arrangements Mitsubishi's PV would have a negative value of minus $7.0 million on these assumptions and the project would be scrapped.

If we turn to the payback period for Mitsubishi the results of our modelling show that the payback period increases from 4.5 years to 5.2 years, an increase of roughly seven months before Mitsubishi gets its money back.

Of course we do not have any inside knowledge of Mitsubishi's thinking. In addition, it has to be stressed that if one was actually doing this sort of exercise for Mitsubishi there would be a thousandfold increase in the complexity of the accounting and other data that would have to be fed into the modelling of the discounted present value and payback period. The capital outlay alone is obviously not a single point outlay. To begin with there would be a host of engineering, market research and feasibility studies and the outlay would be spread over a good deal of time. Also we can only guess at the rate of return that Mitsubishi might require. Indeed, all of the assumptions here are illustrative only. Nevertheless, the modelling does indicate that projects such as Mitsubishi's new-model-retooling may well be sensitive to the planned change in the tax arrangements.

Endnotes

2. The New Business Tax System, Press Release No 58 of 21 September 1999 by the Treasurer, The Hon. P. Costello, MP, p.1.

3. Tax Reform, not a new tax a new tax system: The Howard Government's Plan for a New Tax System: Circulated by the Hon. Peter Costello MP, Treasurer of the Commonwealth of Australia (AGPS) August 1998, Chapter 3, pp. 107-127.

4. Press Release No. 81 of the Treasurer dated 14 August 1998.

5. Publication: Review of Business Taxation - A Tax System Redesigned; Explanatory Memorandum: A New Tax System (Income Tax Assessment) Bill 1999; Legislation: A New Tax System (Income Tax Assessment) Bill 1999; Treasurer's Press Release: The New Business Tax System; Treasurer's Press Release: Small Business and Primary Producers to Benefit from the New Business Tax System; A New Business Tax System: Press Releases A New Tax System: Time Line.

6. The New Business Tax System, Press Release No 58 of 21 September 1999 by the Treasurer; Attachment A.

7. ibid., Attachment B.

8. ibid., Attachment D.

9. ibid.

10. ibid.

11. ibid., Attachment E.

12. ibid., Attachment F.

13. ibid., Attachment G.

14. ibid., Attachment H.

15. ibid., Attachment H.

16. ibid., Attachment I.

17. ibid., Attachment P.

18. ibid., Attachment Q.

19. ibid., Attachment R.

20. Report of the Review of Business Taxation-A Tax System Redesigned, Recommendation 4.1; Section 4, p. 155.

21. ibid., Section 4, p. 156.

22. ibid., Recommendation 20.1, Section 20, p. 627.

23. A Platform for Consultation-Discussion Paper 2, Volume II released by the Review of Business Taxation, Chapter 33, paragraphs 33.58-33.59, p. 709.

24. ibid., Recommendation 23.2 pp. 684-685.

25. A Platform for Consultation-Discussion Paper 2, Volume II, released by the Review of Business Taxation; Chapter 33, paragraph 33.60, p. 709.

26. The Treasurer, Hon. P. Costello, Press Release, 'The new business tax system,' 21 September 1999.

27. See M. White, 'Creative statistics-the Laffer curve and taxation incentives,' Journal of Australian Political Economy, vol. 14, April 1983, pp. 63-76.

28. The Australian Financial Review, 29 September 1999.

29. Department of Finance and Administration, 'Costings of policy proposals for 1999-00 Budget,' Estimates Memorandum 1999/06, p. 2.

30. Ralph, op. cit., p. 731.

31. Ralph, op. cit., p. 20.

32. This figure is obtained by reading the graph contained in figure 25.1, page 748 of Ralph, op. cit.

33. Ralph, op. cit., p. 746.

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

35. Department of Finance and Administration, 'Costings of policy proposals for 1999-00 Budget,' Estimates Memorandum 1999/06, p. 2 and 12 (emphasis in original).

36. Ralph, op. cit., p. 703.

37. This assumes that the deductions from 2004-05 on are equivalent to a series that declines arithmetically for t reach zero in 10 years.

38. The New Business Tax System, Press Release No 58 of 21 September 1999 by the Treasurer, The Hon. P. Costello, MP, p.1.

39. A Strong Foundation-Discussion Paper, released by the Review of Business Taxation November 1998, Appendix A, p. 133.

40. Report of the Review of Business Taxation - A Tax System Redesigned; Section 7, p. 286.

41. Tax Reform and Community Sector Alliance (TRACSA) submission to the Senate Select Committee on a New Tax System.

42. Centre for Australian Community Organisations and Management, Australia's Non-profit sector, Working Paper Number 13, October 1994.

43. Business Review Weekly, 23 April 1999, p. 75

44. National Farmers' Federation, Farmers Relieved over Ralph CGT Decision, News Release 21 September 1999.

45. NSW Farmers Association, NSW Farmers say "Ralph Tax Review decisions better than expected", Press Release 21 September 1999.

46. ibid.

47. National Farmers' Federation, op. cit.

48. ustralian Bureau of Statistics, Agricultural Industries Financial Statistics, 1996-97, Catalogue Number. 7507.

49. Econtech, The Long -Term Effects of Tax Reform on Australian Industries, Prepared by Econtech for the Australian Bankers Association, Final Report 24 August 1999.

50. Review of Business Taxation, op. cit. 747-8.

51. Tax 2000 Overview, Australian Financial Review, 22 September 1999.

52. 'Australian Business welcomes business tax reforms', Media Release 21 September 1999.

53. 'Ralph Report: Industry Response', Statement by Heather Ridout, Media Release 21 September 1999.

54. Plastics and Chemicals Industries Association Submission on Reform of Business Taxation, April 1999.

55. Treasurer's Press Release, The New Business Tax System, 21 September 1999.
56. Association of Superannuation Funds of Australia, Media Release 21 September 1999, Ralph Outcome Largely 'Balanced And Positive.

57. The Australian, 24 September 1999.

58. Canberra Times, 22 September 1999.

59. Australian Prudential Regulation Authority, 'Table LI3: Life Insurance Share of Superannuation', Life Insurance Trends-June Quarter 1999, http://www.apra.gov.au.

60. Council of Small Business Associations of Australia, Response to Ralph Committee Options Paper, Submission No. 174.

61. Council of Small Business Organisations of Australia, 'Drought Breaks in Small Business Tax', Media Release, 21 September 1999.

62. Steve Lewis, 'Simpler tax system causes great relief', Australian Financial Review, 22 September 1999, p. 4.

63. 22 September 1999.

64. 22 September 1999.

65. Industry Commission, Research and Development: Report No. 44, 15 May 1995.

66. ibid., p. 598.

67. Alan Kohler, "Taxation Reform all Smoke and Mirrors", Australian Financial Review, 28 September 1999.

68. The Hon. Peter Costello, MP, Treasurer, interview with Mr Kerry O'Brien, 7:30 Report, 21 September 1999.

69. Ivor Ries, 'Ralph's Investment Wheel Of Fortune', Australian Financial Review, 25-26 September 1999.

70. Australian Society of Certified Practicing Accountants, 'Small Business Finds a Voice on Ralph', Media Release of 21 September 1999.

71. Tom Allard, 'Double Whammy of GST, CGT May Hit Assets Sell-Off', Sydney Morning Herald 28 September 1999.

72. Paul Cleary, 'Ralph Pushes Further CGT Cut', Australian Financial Review, 20 October 1999.

73. The figuring was performed on a separate spreadsheet and there may be minor errors due to rounding.

74. Department of Industry Science and Resources, The State of the Australian Automotive Industry, 1997.

75. Based on the input output figures for 'motor vehicles and parts etc.' Australian Bureau of Statistics Input-Output Tables 1994-95: Australian National Accounts, Cat No. 5209.0, 12 March 1999.

 

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