Saturday, November 29, 2008

TAXING TIMES: Could Ken Henry be thinking really big?

It's crunch time at the Henry Tax Review.

The Prime Minister's hand-picked five-person team is in the final stages of preparing the consultation paper it will release in December setting out the lines of thought that have emerged from the hundreds of submissions it has received and consultations it has held since August.

After that it'll spend an entire year honing down those lines of thought, expanding those that will work work and discarding that that will not until it reports in December 2009.

The good news is that many of the ideas that will work are actually quite simple. The inquiry's Chair, Treasury Secretary Ken Henry scared us a bit earlier this month when he talked about the myriad ways in which Australia taxes fencing wire and our 125 different taxes - "more than there are northern hairy nosed wombats".

These good ideas may be simple, but they are also disturbingly big.

None bigger than destroying one of Labor's most important tax measures in order to axe the company tax rate.

Dividend imputation was pushed through the Labor caucus only by the force of the Treasurer Paul Keating more than 20 years ago. He sold the change by asking it to imagine two small shopkeepers - perhaps an Italian or Pakistani couple in a working class area, according to a recent biography. If the shopkeepers formed a company their profits would be taxed twice - once at the company tax rate and then again at the full personal tax rate when they was distributed as dividends...

"If that fair?" Keating is said to have asked, and then told caucus that if double taxation wasn't fair for small shopkeepers it wasn't fair for anyone.

So from 1987 almost alone in the world, Australia taxed the corporate profits received by Australians only once. If a company had already paid tax on the profits it was distributing, its Australian shareholders (but not its foreign ones) could get a credit to set against their income tax.

Much of the rest of the world followed Australia. The UK already had such a system, but has since abolished it as has Ireland. They found it complicated and not particularly appreciated.

Appreciation matters. Nick Gruen of Lateral Economics points to a study that finds Keating's gift to be so little appreciated by Australian shareholders that it is "unable to reject the hypothesis that companies with dividend imputation do not attract any share price premium".

Many companies simply don't bother. They'd rather minimize their tax, and they know that Australians are about as likely to invest in them without dividend imputation as with.

The shareholders they need to impress are the ones from overseas - the so-called "swing" shareholders with investments in every country in the world to choose between who can really move a share price. Yet they are excluded from dividend imputation.

What they get instead is a 30 per cent headline corporate tax rate. About standard or not, it looks unattractive compared to other countries' headline tax rates.

Our system of imputation prevents them from getting a tax cut - a massive cut that would bring the corporate tax rate down to 19 per cent.

That's what Dr Gruen reckons would be possible if dividend imputation was axed. It costs more than $20 billion a year.

And he says the cut in the company tax rate could be even bigger. If cutting the rate brings in more foreign investors as it is likely to, it'll make it cheaper for Australian firms to raise money, boosting their profits and possibly funding further cuts in the headline rate.

All this without costing the Treasury a thing.

Who's going to mind? Well the Australian shareholders enjoying imputation credits are likely to be upset. But less so if Doctor Gruen explains his thinking to them. He believes the tax cut would lift foreign direct investment in Australian companies by almost one-quarter. That's right, almost one-quarter. Its the sort of thing that happened when Ireland and Britain abolished their imputation schemes to fund corporate tax cuts. Ireland in particular was flooded with foreign capital.

What would this do to Australian share prices? Nick Gruen believes it'll push them high enough to compensate the Australians investors who will miss out on their imputation credits. They'll get higher share prices instead. And back a decade ago Australia halved its rate of capital gains tax, didn't it?

Well actually, it didn't. Australia halved only the headline rate of capital gains tax and recouped much of the loss by removing the inflation discount. But it was the headline rate that mattered. All manner of Australians began gearing up to invest. Which is partly Dr Gruen's point. Headline rates matter. Australia is denying itself a 19 per cent corporate tax rate and the flood of money it might bring for no particularly good reason.

It's also denying itself a much simpler tax system.

Gruen has persuaded the Committee for the Economic Development of Australia of the merits of the change and also the government's Innovation Review of which he was a member.

It found that switching from dividend imputation to a lower tax rate looked "extremely promising from the perspective of promoting entrepreneurialism, productivity, investment and economic growth".

It reported that the equity issues were "surprisingly mild for such a large change."

Who's left to object such an apparently good and simple idea? Two of the members of the Henry Review, Dr Ken Henry and Professor Greg Smith helped introduce dividend imputation while working on tax at the Treasury in the mid 1980's. But that's unlikely to matter much. If they were bright enough to recognise a good idea two decades ago, they'll be bright enough to assess whether there's a better one now.

The Tax Office likes dividend imputation as an "integrity measure". It keeps (some) companies honest in reporting profits. But many more don't bother with imputation.

And managed trusts. Many owe their livelihoods to offering mum and dad investors dividend imputation and its benefits. They began fighting such a change the day Ken Henry was asked to chair the Review.