Most people don’t understand what company tax is intended to do in Australia’s tax imputation system. The idea of imputation is to avoid taxing the same income twice. When a firm earns profits it is taxed on those profits at the company tax rate of 30%. If some of the after-tax profits are distributed as dividends to shareholders then the intention is not to tax this income a second time when it reaches the shareholder. Hence if the shareholder’s marginal tax rate is 49% they get a tax credit equal to the tax paid by the company of 30% and hence only pay 19% tax. The income is overall taxed at the taxpayer’s marginal tax rate it is just that the firm is regarded as pre-paying the taxpayer’s liability of 30%. Under John Howard’s sensible ruling if the taxpayer’s marginal tax rate was only 20% then they can claim a rebate of 10% since the tax on that amount of dividends was already paid by the company.
Some economists argue that shareholders should be double-taxed on dividends – both when the income is in the hands of the firm and, subsequently, when it is in the hands of the shareholders. Joe Stiglitz, for example, in his text “Publlc Economics” argues that, typically, not all profits are paid out as dividends to shareholders but can be instead retained and use to augment the capital assets of the firm without being subject to tax. Of course if these capital assets are increased and the capital value of the firm increases, a shareholder will be liable for capital gains tax on this appreciation and/or for normal taxes on any increased dividends that result. That capital gains taxes are often lower than income taxes suggests that this provides a means for firms and hence shareholders to escape the tax net. My own view is that capital gains taxes are often unduly subsidized and that, in any event, firms should be obliged to pay out a high proportion of their earnings as dividends. Firms should need to go to capital markets to gain extra capital resources rather than to simply grab the earnings that belong to the firm’s owners, the shareholders.
Diverting profits into retained earnings does mean that such retentions are taxed only at the corporate tax rate of 30% rather than the generally higher marginal tax rate of private shareholders. It does not mean that such retentions escape tax entirely. If there is concern about such effects then you might wish to impose an extra charge on such retentions but such effects would seem to be small.
Generally, the imputation view accepts the logic that corporate profit taxes should be set at zero for domestic shareholders with the only tax liability being that incurred when shareholders receive dividends when they are taxed normally as income. The slight twist in the Australian use of imputation is that foreign shareholders do not receive imputation credits. This can be justified pragmatically on the grounds that doing this snares income paid to these foreign shareholders that would otherwise be lost to the ATO.
Ignoring double tax agreements between countries the upshot of this is that cutting the corporate tax rate has no direct effect on domestic shareholders in the sense that, for a given $1 of dividend income, they will pay exactly the same tax rate equal to their personal tax rate. Foreign shareholders will, however, gain increased returns. The claim by Treasury and other groups is that, because capital is highly mobile internationally, this will lead to increased investment in Australia thereby increasing productivity and therefore wages.
The counterclaim to this proposition is that is that in many mainly foreign-owned parts of Australian industry – such as the mining sector – firms avoid their tax liability anyway by using transfer pricing or other means to evade taxes. If that is true completely then foreign shareholders will gain no loss or benefit from a reduction in the Australian corporate tax rate. Profits will continue to leave the country and evade tax liability. But the ATO is vigorously pursuing such transfer pricing deals and firms engaging in such activities face huge potential back-tax claims and penalties. The more reasonable assumption is that foreign owned firms will face lower reasons to engage in potentially costly tax-minimization strategies if corporate taxes are lower anyway. At the margin conditions are more favorable to them paying their correct tax bills to the ATO if the average tax rate is lower.
What is my view? Generally my sympathies lie with the Coalition in its attempt to reduce corporate tax rates particularly since the US has cut its high corporate tax rates significantly. This should increase foreign investment to Australia which I believe is a better factor of production to import than labour. Bringing in capital should boost wages whereas admitting 200,000+ immigrants (with the current immigration quotas) each year will depress wages. Bringing in capital too will not increase house prices and will leave our cities less congested and more livable.