Are you still feeling lucky punk? Why Ken Henry’s hunch is right – we

should abolish dividend imputation and cut company tax to 19%

Nicholas Gruen

Presentation to Community Tax ForumSydney, 20th May 2009

Outline

1. Introduction 2. Our current situation “are we still feeling lucky?”3. The case for lower company tax

– In a closed economy – In an open economy

4. ‘Long clean lines of policy’– Alignment– Dividend imputation

5. Conclusion

Our Circumstances

Our Circumstances

Australia’s current account deficits have been around 6%Without compulsory super, New Zealand has been running even higher deficits for some time and is now on S&P watch for credit downgrade

We need to – Ensure we can attract the funds we need to make it through the

next few years– Maximise extent to which recovery is investment and net export

driven– Establish long term plans to increase savings

Tax is about choices

‘Long clean lines’ of policy are valuable, but also come with costs.Alignment of company and top personal taxDividend imputation improves neutrality between debt and equity, but comes at

cost of higher company rate

None of these issues can or should be decided in principleWe must choose the lesser of evils based on the evidence

Capital taxation

– Other things being equal it’s more economically costly than taxation on personal exertion

• The implicit tax on saving and investment compounds over time (the closed economy argument)

• Capital is more mobile than – even highly skilled – people (the open economy argument)

The closed economy argument

– Mankiw and Weinzierl’s ‘back of the envelope’ model– A simple neoclassical growth model of the US with plausible

parameterisation and 25% tax on labour and capital– In context of debates about extent of self funding of tax cuts

• Where are various taxes on the Laffer Curve?

– Conclusions are that in the long run• Capital tax cuts are nearly 50% self funding through higher saving and investment

compounding through time• Labour tax cuts are less than 20% self funding – through greater work effort

The closed economy argument

Additional issues strenthening the case for capital tax cuts• Positive externalities from capital investment• In an open economy, lower capital tax is also tax competition

But what about equity?• Capital tax cuts are generally regressive

The open economy argument:Tax and foreign investment

A substantial body of research considers . . . the effects of taxation on investment and on tax avoidance activities. . . . The first generation of these studies . . . reports tax elasticities of investment in the neighborhood of –0.6. [So] a ten percent tax reduction (for example, reducing the corporate tax rate from 35 percent to 31.5 percent) should be associated with six percent greater inbound foreign investment. More recent evidence suggests that foreign direct investment is even more tax sensitive than this.

Hines, J and Summers, L, 2009. “How Globalization Affects Tax Design”, NBER

Tax cuts and growth - empirical evidence

– Lee and Gordon (2005) • Strong negative correlations between company tax rates and economic

growth – 10 percentage point cut in the company tax rate increases per capita annual

growth by between 0.57 and 1.82 percent• Little or no correlation between top personal tax rates and economic

growth

– Hassett and Mather (2006)• Strong negative correlations between company tax rates and wages and • Little or no correlation between personal tax and wages (against their AEI

priors)

Djankov, Shleifer et al, 2008, NBER

Company tax and growth - empirical evidence

Company tax over time

Source: OECD, 2004

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Alignment: do it’s benefits outweigh its costs?

• Because companies are separate financial entities to their shareholders, anti-avoidance provisions are generally effective

• That’s why they’re often unpopular• Like undistributed profits taxation

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Alignment: do it’s benefits outweigh its costs?

Dividend Imputation

– We know its theoretical justification• To improve tax neutrality between debt and equity investment • To reduce double taxation of dividends

– But is it cost effective as a capital taxation expenditure?– It now costs over 1/3rd of company tax revenue

• ~ $20 billion– How much does it lower the cost of capital?

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Ken Henry: 23 February 2009

An open economy model affects the way one should think about our company tax arrangements, including dividend imputation.

Dividend Imputation in economic theory

Foreign investors are the marginal, more elastic investorSo they disproportionately determine share prices. In fact Australian policy has

• Extended domestic shareholders’ access to imputation credits– Superannuation – Refundability

• Restricted pass-through of imputation to foreign shareholders.

So the marginal (foreign) investor gets no imputation benefits. So foreigners don’t value credits in their bids for sharesSo a $20 billion tax expenditure doesn’t lower the cost of capital!

Dividend Imputation – the evidence

~ 80 percent of internal investment appraisals are done without regard to the value of imputation credits earned.

Most reputable ‘drop off’ studies suggest that the value of imputation credits on the markets is 50 cents in the dollar or less.The most sophisticated econometric study by Cannavan, Finn and Gray (2004) suggests something close to zero valuation.Recent econometric evidence suggests that the introduction of dividend imputation did not increase share prices (Ickiewicz, 2006)

Dividend Imputation – the evidence

Abolition of dividend tax credits on dividends paid to UK pension funds yielded the same result.

Credits under-valued and so were not reflected in share prices and did not lower the cost of capital.

Removing these tax credits produced substantial reallocation of ownership, but with second order effects on price. (Bond, Devereux and Klemm; 2005)

Recycling dividend imputation revenue as lower company tax

We could ‘cash out’ an inefficient tax expenditure for an efficient company tax cut.

Allows cuts of up to 11 percentage points (Hathaway and Officer, 2004)

Several European countries have cashed out their own dividend imputation for lower company tax

• Likely effectsAbolition of DI Sale of Australian equities to foreigners Second order’ price effects (Bond, Devereaux and Klemm,

2005).Lower company tax

Improved post tax return on foreign investment in Australian shares

Increased FDI Increased foreign demand for portfolio investment increases

share prices Lower cost of equity capital

Recycling dividend imputation revenue as lower company tax

– “The coefficient estimates suggest that a cut in the corporate tax rate by 10 percentage points will raise the annual growth rate by one to two percentage points” (Lee and Gordon)

– This would increase the payback well above Mankiw and Weinzierl’s result

– Or can be spent chasing lower company tax• Anti-avoidance and resource rent tax could also bring the rate

lower, or generate higher revenue

Recycling dividend imputation revenue as lower company tax

This lowering of company tax is progressive – because it only favours foreign suppliers of capital

Effective tax on Australian shareholders actually rises– Share price rises provide compensation for those whose

effective tax rate on dividends rises.

Equity

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Conclusion (i)

The economist’s job is to say “this or that, not both. You can't do both”. Kenneth Arrow

– Alignment and dividend imputation stem from worthy objectives

• They also have opportunity costs • Those costs exceed their benefits

• Swapping DI for lower company tax improves

– Efficiency – Growth– Equity – With foreigners paying

compensation to our (mostly high income) losers

Conclusion (ii)

What’s there not to like?