Smarter to cut personal income tax, not corporate

You might not remember the “underpants gnomes” from the satirical cartoon South Park. These fictitious creatures had a shonky business plan: Phase 1 was “collect underpants”, Phase 3 was “profits”. But when pressed by the character Kyle about Phase 2, how the collected underpants would actually lead to profit, the gnomes couldn’t explain but pressed on regardless.

It’s a bit like the government’s plan to cut corporate tax. Phase 1 is cutting the company tax rate to 25 per cent by 2026 and Phase 3 is higher wages. Phase 2 is unclear. Is it “capital deepening” or “investment”, or some sort of weird, unenforceable social contract that businesses will raise the wages of workers out of the goodness of their heart? Voters seem suspicious of all of them.

Businesses don’t pay workers higher wages out of empathy or kindness. Economics assumes self-interest, and wages only rise if businesses have to pay their workers more. It’s the invisible hand. The recent wage ­increases and bonuses that some large firms have paid in the US, following a cut in the US federal rate from 35 per cent to 21 per cent, are about politics as much as economics.

The government should see the Senate’s rejection of the company tax cut as a way out of a sticky situation, a way to devote all the revenue losses pencilled in for cutting company tax to cutting personal income tax. Cutting personal income tax is a tangible, direct way to lift wages, and would be far more popular. In an era of stagnating wage growth it’s the easiest, perhaps only, way for federal government to lift real wages. By contrast, cutting corporate tax would take many years to filter through to workers’ pay packets, when the effect would be difficult to isolate.

Workers in Australia have endured ­almost a decade of bracket creep or rising ­average tax rates, while companies, facing a flat rate of 30 per cent, essentially have not. Cutting tax on wages would leave households with more money to spend on goods and services, helping lift consumption, which has been an economic weak spot. ­Attracting and keeping workers in Australia, especially as travel costs decline, is as important as attracting foreign investment.

Cutting corporate tax should be a lower priority than cutting personal tax.

None of this is to say the government’s plan has no merit. But top economists are divided about the extent of the benefit. It ­depends heavily on assumptions. Even those in favour of the reform rely on modelling that shows quite small benefits, which would be swamped by other factors. The Treasury analysis estimates GDP would rise by 1.2 per cent in the long run, and gross national ­income, a better measure of prosperity, a little less. The income measure strips out ­income flowing abroad.

Peter Swan, an eminent finance professor at UNSW, and a renowned conservative, has recently argued that the entire benefit of cutting company tax flows to foreigners — who have already decided to invest here at present tax rates — and leads to higher personal income tax. The money to fund government services has to be made up somewhere.

For Australian taxpayers, because of dividend imputation in operation since 1987, company tax is a prepayment of personal ­income tax. “President Trump still has a long way to go to match Australia’s imputation system by a further tax reduction from 21 per cent to zero!” says Swan. “The government is right to target tax cuts but wrong to single out corporations already enjoying effectively zero corporate tax rates.”

Swan also says the assumption the “marginal investor” is foreign — that new investments are necessarily funded by foreign investors alone — is extreme and flawed. Cutting their tax rate won’t induce enough inward investment to make up for the lost tax revenue. Investment in Australia is domi­nated by Australians, who effectively pay no corporate tax. Superannuation funds, for ­instance, have many billions available to ­invest in new business projects.

The government has made it clear personal tax cuts are on the agenda. But the ­requirement to achieve a budget surplus in 2021 leaves little room to move. The budget has improved only a little bit. UBS, an investment bank, reckons the government could afford a tax cut of $10 billion and still achieve a surplus. For workers on incomes up to $85,000 that would be a tax cut of about $17 a week — not a lot. Indeed, any tax cut will partly be gobbled up when the Medicare levy increases 0.5 percentage points next year bringing the cut down to $12.

There are other problems with cutting the corporate rate. The gap between the top personal tax rate and corporate rate would rise, sharpening the incentive for avoidance and evasion. This is no small problem.

And our corporate tax rate, 30 per cent, might not even be as high as it seems. The US Congressional Budget Office, which has no axe to grind in domestic Australian politics, concluded last year our effective company tax rate, the one which applied to “marginal investments”, was 10.4 per cent. That was far lower than the effective rates in the US, Britain, Germany and other major countries.

There are, alas, as many different rankings of “effective tax rates” as there are economic models spitting out different impacts. It’s important to be wary of economic models - they have a dreadful track record. At least the Trump tax cuts will provide a grand experiment in cutting corporate tax.

The other problem is government spending. Cutting taxes is much easier than cutting spending. The future budget surpluses are built on a sudden slowdown in spending growth in the early 2020s, which is unlikely to materialise if history is any guide.

Spending is a better indicator of the size of government than taxation because all spending must ultimately be paid for, either now or in the future. And if interest rates ­increase, as they are showing signs of, the cost of funding the deficit will rise too. Cutting tax and spending is a good idea but it’s best to target limited political capital on tax cuts with certain and tangible benefits.