Brian Fallow: Fallout of Australian tax review will be felt in NZ

What changes, especially to business taxation, flow from the Australian tax review headed by Treasury Secretary Ken Henry will inevitably have ramifications here.

That imparts a more than academic interest to a radical proposal getting some attention across the Ditch.

At a conference last month held under the aegis of the Henry review, a hefty paper by Peter Sorensen and Matthew Johnson proposed a system that would largely shift the taxation of returns to capital from corporates to individual taxpayers.

The theoretical case for it, put crudely, goes like this. In a world where capital is mobile, investors, whether foreign or domestic, are only interested in how after-tax returns stack up competitively.

All else being equal - like the top line and the required after-tax return - the bigger the bite the tax man takes, the less is left from which to pay wages and other local costs. What looks like a tax on investors is really an indirect tax on those local suppliers.

As Sorensen and Johnson put it: "Under perfect capital mobility the burden of a source-based capital tax levied by a small open economy is fully shifted on to the domestic factors of production such as labour and land.

"Since the source tax only falls on domestic investment, investors can always escape the burden of the tax by moving capital abroad, so capital will flow out of the domestic economy until the pre-tax return on investment has risen by the full amount of the tax."

They argue this results in capital shallowing, which lowers the productivity of less mobile or immobile factors like labour and land, whose owners have to accept lower wages and rents. They point to empirical evidence that supports this theoretical conclusion.

But they are not advocating the abolition of company tax altogether.

There is an important distinction between the normal return on capital and what in the jargon are called "rents" - profits over and above the going market rate of return on capital.

The analysis above only applies to taxes on the normal return, Sorensen and Johnson say. If investors can earn location-specific rents only by investing in a particular country - perhaps because that is where some natural resource or customer base is - its government can tax those rents at source without risking capital flight.

So what they propose is a system called ACE under which corporates are allowed to earn a normal return on equity without paying tax on it, and are only taxed on profits in excess of that.

Instead dividends and capital gains, as they accrue, would be taxed in the hands of the shareholder.

One benefit claimed for this system is that it would deal to a distortion in the current system: the divergent taxation of debt and equity funding, where interest is deductible but returns to equity are taxed.

The world, after all, has been dealt a pretty harsh lesson over the past couple of years in the merits of equity and the perils of excessive leverage.

If the change to corporate taxation was all that happened, the impact on government revenue would be harsh, so the second leg of the Sorensen/Johnson plan is a more rigorous taxation of capital income at the personal level.

Dividend imputation would go. Capital income would include interest and rental income, dividends and accruing capital gains, and imputed returns (perhaps along the lines of McLeod's risk-free return method) on capital invested in non-corporate businesses.

Capital income would be taxed at a flat rate - they suggest 20c in the dollar - rather than at the marginal rate the taxpayer pays on his or her labour income. This dual income tax system is used in Nordic countries.

They would also apply it to imputed rentals on the family home.

That addresses another longstanding distortion. Part of the return to investing in owner-occupied housing is the rent you avoid paying. For neutrality and base-broadening reasons the 2001 McLeod review wanted it brought into the tax net.

But from talk-back radio land to the higher floors of the Beehive, the reaction was predictably negative. McLeod's package of carefully thought-out reforms was dead in the water.

The price we are now paying for that knee-jerk reaction is the debt legacy of the mother of all housing bubbles and a tax system which will increasingly struggle to fund what we expect the state to provide.

When it comes to economic reform the Australians tend to proceed more gingerly, more pragmatically and more successfully.

It remains to be seen whether the Henry review will back something as radical as the Sorensen/Johnson model. Henry, by all accounts, has not been giving much away.

Even if it does, it is a separate question whether the Australian Government will pick up the recommendation.

It might suffer the same fate as the McLeod review.

Even if the Australian Government goes for it, it would still have to get it passed by a bicameral Parliament.

And even if the model is attractive as a destination, there is still the question of how do you get there from here, and how quickly. The transition issues would be daunting.

So the risk that we may have to scramble to adjust to radical reform along these lines in Australia may be small. But it is not zero.

Sorensen and Johnson reckon their model would be revenue-positive for the Australian Government. The lower tax take at the corporate level would be more than offset by an increase in the personal tax take.

We can't assume that the same would apply here.

Broadly speaking a shift from source to residence-based taxation is an unwelcome development from a New Zealand point of view. We have chronically lousy - indeed negative - household savings rates and are abjectly reliant on importing investment capital from the rest of the world.

Taxing the returns to that capital in the hands of the investor (there) rather than at source (here) tends to be revenue-negative from the Government's point of view.

In addition a shift in the tax burden from corporates to individuals is less attractive when the population is as footloose as ours. New Zealand has a particularly large diaspora, with 14 per cent of the overall New Zealand-born population, and 24 per cent of the skilled, living overseas.

Finally, Deloitte's data on our 200 largest companies (excluding banks) indicates the foreign-owned ones have been twice as profitable, in terms of after-tax returns on equity, as the New Zealand-owned ones over the past 10 years.

That suggests deep cuts to corporate taxation would be a windfall to foreign investors.