Company tax a deadweight issue that splits the parties

By BRIAN FALLOW

Whether to cut company tax is one of the issues over which political views are sharply divided.

National and Act are promising company tax cuts, saying they would be liberating and stimulatory for the economy - claims that Labour has been treating with scepticism.

The dogmatic assertions of politicians and lobby groups aside, there is some independent research that suggests:

* There are hidden "deadweight" costs to taxing the income from capital and they are not trivial.

* Reducing the tax burden by targeted concessions and exemptions that make holes in the tax base is likely to increase those deadweight costs; broad base, low rate is the way to go.

* Despite a comparatively high statutory company tax rate, the effective tax rates on business investment in New Zealand compare well with international standards.

Deadweight costs arise when the imposition of a tax changes relative prices, skewing the choices people make.

For example, tax beer more than wine and people may end up drinking more wine and less beer than they would if their choices were not distorted by tax.

Tax the income from labour and you affect how people divide their time between work and leisure.

In the case of taxing the income from capital, the distortions are most likely to take the form of skewing investment decisions, in ways that reduce efficiency and economic growth.

The Treasury commissioned a study by Canadian economists Erwin Diewert and Denis Lawrence to quantify the deadweight losses from taxing income from capital. They had carried out a similar exercise on taxing labour and consumption in 1994.

Their econometric modelling found that the marginal excess burden of company tax 30 years ago was around 11 per cent. In other words the deadweight loss associated with the last dollar of company tax raised was equivalent to 11c.

The figure climbed sharply in the mid-1980s, peaking at 30 per cent in 1987 before falling back sharply to 6 per cent following the major tax reforms of the late 1980s.

But it increased to around 13 per cent by the mid-1990s and has been relatively stable since then.

"This puts the production loss for capital tax at a similar level to the marginal excess burdens for labour and consumption in our first study," Diewert and Lawrence say.

But they qualify that conclusion by pointing out that they have only modelled the loss of production arising from company tax.

They say it does not take account of any deadweight costs falling on households because of the effects that taxing the return on capital have on their saving and spending decisions over time.

Overseas studies have suggested that the deadweight costs in capital taxation are higher than for labour because capital is more mobile and more responsive to tax.

"This is especially likely to be the case for a small open economy such as New Zealand trading in a world of ever-increasing capital mobility," Diewert and Lawrence say.

Deadweight costs rose in the Muldoon years as rates increased and more and more distortions in the form of tax incentives were introduced.

But they only shot up markedly when the economy was opened up, through CER and other measures, and capital was freer to respond to the cacophony of signals it was getting from the tax system.

The sharp fall in deadweight costs in the late 1980s was only partly the result of tax reforms.

At the same time inflation was being brought under control. Because tax is levied on nominal incomes, high inflation introduces major distortions and therefore deadweight costs.

But even with the effect of inflation allowed for, there was a significantly wider tax wedge in the 1970s and 1980s than there has been since then. The tax wedge is the gap between the company's required or break-even rate of return before tax, and the after-tax return to investors.

The tax reforms of the late 1980s did not just reduce the company tax rate from 45c (briefly 48c) to 33. Crucially they also broadened the tax base by eliminating all sorts of exemptions and concessions like accelerated depreciation.

John Creedy, a principal adviser in the Treasury's tax policy branch, says the trouble with exemptions is not only that they are distortionary, but to raise the same amount of tax you have to increase the tax rate on what is not exempt.

"And the excess burden goes up with the square of that. So you are making things doubly hard. It strongly reinforces the broad base, low rate strategy."

His colleague, Peter Wilson, draws these lessons from Diewert and Lawrence's work: "Excess burdens exist. They are big. And governments can do something to make them smaller."

The debate doesn't just have to be about the level of Government spending, Wilson says.

"You can raise the same amount of tax in different ways and you can reduce it in different ways.

"[The study] tends to suggest that tax reductions which narrow the base can come with high hidden costs. Tax reductions through rate reductions might have a lower cost."

Advocates of a lower company tax rate commonly point to the fact that Australia's rate is now 30c in the dollar, 3c lower than New Zealand's.

But when looking at the tax impact on business investment, the statutory tax rate is only one factor in a complex equation.

The effective tax rate also depends on what depreciation regime applies, and therefore what kind of assets that companies invest in.

And it depends on how the investment is financed: debt or equity?

If foreign capital is involved further complications arise: what withholding taxes are imposed on interest or dividends? Are there offsetting tax credits in the investor's home country?

A study by Peter Goss of Ernst & Young, for the Ralph tax review in Australia, calculated a set of effective tax rates that takes account of these variables and makes apples-with-apples comparisons between different asset classes in different countries.

The conclusions cited in the McLeod tax review show New Zealand comparing well with most of the other eight countries considered.

The effective tax rate on investment in plant, for example, was 17 per cent, undercut only by Ireland and Singapore.

But that work was based on 1998 tax regimes.

Since then Australia has cut its company tax rate from 36c to 30c, offset by changes to its depreciation regime.

That is likely to have improved Australia's relative position, Goss says, although as far as he knows his work has not been updated to reflect them.

The McLeod report said that moves like Australia's were likely to put downward competitive pressure on the company tax rate over time.

It recommended cutting the tax rate for foreign investors in "greenfields" projects to 18 per cent in order to stand out from the international crowd.

It said that the current average effective tax rate for non-residents was somewhere between 9.25 and 20 per cent.

Officials have advised against McLeod's recommendation, but Finance Minister Michael Cullen intends to seek public comment before making a decision.

* In Forum tomorrow, Rob McLeod, chairman of Ernst and Young, and Alasdair Thompson, chief executive of the Employers and Manufacturers Association (Northern), give their views on company tax.

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