Tax cuts for companies are all the rage at the moment. Trump has got the USA all excited, and it’s spilling over to Australia.
But the impact of a company tax cut in Australia is completely different to its impact in the USA.
To understand the real impact of a company tax cut in Australia you need to understand two things: how Australians are taxed on dividends, and how we tax foreign shareholders. When you understand these two things, you will realise that a company tax cut in Australia is effectively a free-kick to foreign investors, with little (if any) positive impact for the domestic economy.
In Australia a company effectively ‘pre-pays’ tax for its shareholders (i.e. the people who own the company).
For example, if the company makes $100 profit it will pre-pay $30 of tax, leaving $70 of cash to distribute to shareholders. When the company distributes the remaining $70 cash to its shareholders, the shareholders will be taxed at their full marginal rate on the original $100 of company profit. But they will get a $30 ‘credit‘ for the tax already paid by the company, (called a ‘franking credit’).
So if the shareholder has a marginal rate of 47%, the shareholder will have a tax bill of $47 ($100 x 47%), but will get a credit of $30 for the tax already paid by the company, meaning that the shareholder only needs to shell out an additional $17 cash to make up the full $47 of tax. The net result is that the shareholder ends up with net $53 cash in their pocket ($100 less $47). This is irrespective of the company tax rate. If the company rate is reduced, it just means that the credit is also reduced, and the shareholder needs to pay more tax in their own name, (and vice versa). In the end, a reduction in the company tax rate does not cost the government anything so far as Australians are concerned!
If the shareholder is an Australian super fund, and the member is in pension phase, then the super fund’s tax rate will be nil. In this case, the super fund will receive $70 cash from the company, and a $30 credit on the dividend. Because the super fund’s tax rate is nil, the government will fully refund the credit of $30. This means that the super fund ends up with net $100 cash. This outcome is also irrespective of the company tax rate. A change in the company tax rate will not change the effective rate for the super fund (i.e. nil), and will not cost the government anything more, (or less).
Well, if the shareholder is a foreigner, and they receive a dividend that has a full credit attached, they pay no more tax in Australia. So if the rate of company tax in Australia is 30%, the foreign shareholder ends up with net $70 cash in their pocket (and we get $30). But if the company rate of tax is reduced to 20%, the foreigner ends up with net $80 cash in their pocket (and we end up with $20). Every reduction in the Australian company tax rate is a direct increase in the after-tax and final cash return to the foreign shareholder – and a reduction in the total tax received in Australia to fund our infrastructure.
So what benefits might a lower company tax rate really have?
A lower company tax rate does mean that the company has more after-tax cash to funds its working capital (in the short to medium term). If the company is growing, then generating some more cash after-tax to reinvest is a good thing. However, most companies at the moment are returning cash to shareholders because they are struggling to find worthwhile investments in which to apply their surplus cash.
A lower company tax rate may attract more foreign investment. Really? In the areas where we have a competitive advantage, (which are few and far between, e.g. mining, real estate, education and tourism – with the first two making up almost 50% of all direct investment), the tax rate on companies is hardly going to materially impact a foreign investment decision. These are also areas that are expensive from a public infrastructure perspective. Back in 2010 the RBA estimated that around 40% of listed equities were owned by foreign investors, with a disproportionately high representation in mining and infrastructure stocks.
What the government is not saying is that company tax makes up only around $64b of the total tax take (a big chunk of which will ultimately be refunded to super funds), while individuals pay around $192b. As we now know, self-funded pensioners are making $0 contribution to the tax take, (which may not be a bad thing, but is super generous).
So how is this different to the US?
The US operates what is known as a classical company tax regime. Larger companies pay company tax, and then distribute the after-tax cash to shareholders without a tax credit. The shareholders then pay tax on the after-tax cash at the rate applicable to dividend income. Under this scenario, a reduction in the company tax rate represents a permanent reduction in the total tax-take from company profits for all shareholders – domestic and foreign.
We are not advocates of higher taxes, (actually, the opposite). But, we are advocates of honest tax policy. So read ‘company tax cut’ as essentially a reduction in Australian tax on foreign investment. Full stop.
The information contained in this post is current at the date of editing – 6 July 2023.