News Weekly readers don’t need me to tell them that both sides of politics here in Australia spent most of last year and part of 2015 talking about tax “reform”. There was much talk and not much action.
Some kind of consensus came out of it – once the “special pleaders” took hold. Yes, they said with one voice, we need more tax revenue; as long it doesn’t come from me.
Like our businesses, companies in the United States want the rate of company tax (they call it corporate tax in the U.S.) cut. In the U.S. a clever academic agrees with them and has produced a plan for a new approach.
In December The Australian (good on them, no other media outlet picked it up) gave us a hint of it. Apparently the Republican Party and some Democrats like it. We don’t know about President Donald Trump, but it could help cut company tax, and that’s on his wish list.
Why didn’t I think of such a great approach to company tax? Sob!
Alan Auerbach of the University of California, Berkeley, alongside the Centre for American Progress (which is aligned with the Democratic Pary) and the Hamilton Project, is behind the plan. Auerbach has justified starting with a clean sheet of paper by observing that what the U.S. is doing now was conceived a hundred years ago. It is hopelessly inadequate for today’s world, even as a revenue raiser.
Tellingly, he reminds Americans that in 2010 corporate tax supplied only around 5 per cent of federal revenue, compared with 23 per cent in the 1960s; all this despite the U.S. having the highest corporate tax rate in the Western world.
Auerbach’s plan is radical. He doesn’t say so, but it really is not corporate tax at all. That’s fine by me. I have never liked the idea of taxing companies.
Put simply, Auerbach’s plan is a tax on a company’s revenue stream, after costs and wages have been deducted. Really a consumption tax (like our GST) collected at source, rather than at the point of sale. It would be much cheaper to collect, more effective, and impossible to avoid.
(If applied in Australia it would allow 1300 pages of our Tax Act defining eligible deductions to be trashed.)
Auerbach’s plan is supported by two basic propositions. First, the tax will apply only on a company’s business operations inside the U.S. The author calls it a “destination-based” tax. Second, unlike most company tax regimes in Western countries, it will not favour borrowing over equity investment as a means of funding operations. More later about why this is important.
A “destination-based” tax will apply only to domestic U.S. operations. Moreover, imports destined for incorporation into U.S.-produced goods will not be deductible for tax purposes; nor will profits on exports be taxed.
While a novel idea, it is not as complicated as it first appears. U.S. companies producing in the U.S. mainly for domestic consumption will be less likely to include imported content in goods and services made in the U.S. and destined for U.S. consumers. Likewise, it is bad news for U.S. companies based in the U.S. expecting to claim tax deductions on the imported content, sell the output in the U.S. and arrange for the profits to be taxed offshore at low rates. Trump will like this too.
U.S. companies exporting would benefit, however, since profit on exports would not attract U.S. tax.
The second part of the plan is even more ingenious and, arguably, more important. It is about how companies fund investment. At present the tax system favours borrowing over equity for funding for investment. For no outlay companies can borrow at no cost since the interest is tax deductible. Equity investment is only recoverable by means of a year-on-year tax deduction against a depreciation schedule.
Auerbach believes that the present arrangement tilts the tax regime in favour of borrowing. His plan makes the tax regime neutral in respect of how companies fund investment. Companies will be able to write off total equity investment, including investment in stocks, in the first year, instead of having to do so over the life of the project. Thus equity investment will be tax free over the life of the investment. At present such investments are only tax deductible according to a depreciation schedule over the life of the investment.
Borrowings, at present tax free, will be taxable under the proposed system; however, interest on borrowings will be tax deductible as they occur. Auerbach believes that destroying the advantage borrowings have over equity investment under the present arrangement is an important change. He believes that equity investment is a better choice for companies; certainly it is better for the economy. Overloading companies with debt tends to be destabilising for them, and for the economy as a whole.
This is especially so in times of crises, and was demonstrated to be so in the global financial crisis. Corporate debt overhang, coinciding as it did with a downturn in consumer demand, left business with serious cash-flow problems. The effects of these flowed on to the wider economy.
Whether by design or not, Auerbach did not deal with a more fundamental problem associated with the debt-funding option for business investment. If we look back over the last 30 years, we see that the shift from equity to borrowing as the preferred source of investment has changed the character of business in ways not necessarily beneficial for companies, for the economy, or for society as a whole.
Debt financing has changed the focus of business management and even of company ownership. Shareholding is now largely in the hands of arms-length investors with mostly short-term interests focused on the share price. Such ownership naturally leads to the appointment of chief executives for only short terms, with bonuses tied to quick lifts in the share price at the expense of longer-term considerations.
With this new breed of company ownership, the long-term health and the future of a company and its staff became incidental. Some of the malaise affecting Western economies (particularly unequal wealth distribution and insecure, low-paid jobs) is closely connected with this new sort of company structure, which relies heavily on debt financing.
Auerbach’s tax model, by tilting the balance of advantage back towards equity financing, would encourage companies once more to adopt a view of business management concerned with more than a short-term increase in the share price.
Incidentally, it may also help deal with some of the wider political and social problems our societies are at present wrestling with, to the extent that these problems are derived from the stresses associated with unemployment, low wages and job insecurity.
Auerbach quite properly has outlined how this system might be adjusted to deal with non-corporate business. He has also attempted to explain how the changes might impact on total company tax collections. Obviously these calculations cannot be considered definitive, and it is unnecessary to follow them to conclusion at this point.
However a general comment is appropriate. The U.S. is far and away the largest and most corporatised economy in the Western world. How it manages its economic affairs, including tax, impacts fundamentally on all Western economies, including Australia. Such is the weight of this impact that, if the U.S. adopts a totally new tax system, Western economies may have no option but to move in the same direction.
Impact on Australia
That being said, this writer considers he should try to assess how Australia might be affected. A few general comments are obvious – at least as they may apply to large Australian companies. For the moment it seems undesirable to speculate at what level any new tax might be set.
What seems obvious is that if the U.S. system leaves imports and exports out of its domestic tax calculations, we would have to do likewise. The same would be true for other Western economies. Trade with the U.S. and each other would be impossible otherwise.
The same would be true for the Auerbach proposals for taxing equity-financed investment as compared with borrowing.
But would the changes carry precisely the same advantages for Australian companies as Auerbach suggests they would carry for companies in the U.S.? We can’t know for sure because the circumstances are different. The corporate sector in Australia has much more foreign ownership than it does in the U.S.
Were we to follow the Auerbach plan and take exports and imports out of our tax equation, we can assume our foreign-owned corporate sector would be displeased. It would lose, for example, the benefit of transfer pricing (the practice whereby foreign-owned companies supply locally based subsidiaries with overpriced imports of goods and services to avoid local tax obligations).
This apart, there would be another fundamental problem for us – which we share with Europe and Japan. We all have consumption taxes. Ours is called a goods and services tax (GST). The U.S., at a federal level, has neither.
It has been observed that the Auerbach tax, whereby companies’ domestic cash-flow is taxed after costs are deducted is not a company tax at all but a tax on consumption, collected at source rather than at the point of sale, like our GST.
Taking up the Auerbach plan would mean embracing a system that, in effect, combines company tax with a consumption tax. Not necessarily a bad thing, but it would be complicated to manage the transition, not least because our GST revenue is collected expressly for the states.
But spare a thought for the European Union. The complications of this kind of tax change would simply add to the complications they are already finding it difficult to manage. All very exciting, if it comes to pass.