Budget 2016: Company Tax Cuts – Catalyst for Growth or Waste of Money?

One of the “centrepieces” of the Federal Government’s 2016 Budget is a 10-year plan to lower the company tax rate. Unfortunately, partly due to a gaffe by Mr Turnbull on Sky News, much of the commentary has focused on the  cost rather than the merits of the policy.

The plan is as follows. From July 1st this year there will be an immediate cut from the current rate of 30% to 27.5% for firms turning over between $2 million and $10 million. Over the next four years the upper threshold will progressively rise to $100 million. It will eventually apply to all firms by 2023-24, and then finally in 2026-27 it will drop to 25% for all firms.

A cut in the company tax rate has long been anticipated—the Henry Tax Review recommended it way back in 2010, and both sides of government have previously said they were committed to it. Like the villagers in the Aesop fable, The Boy Who Cried Wolf, a lot of us had stopped believing it would ever happen. Indeed, if the Coalition government is not re-elected, it probably won’t happen, since both Labor and the Greens have apparently decided to launch a ‘class warfare’ campaign in response to the Budget.

It is the job of the opposition and the media to hold the government to account on issues such as transparency and fiscal responsibility, but as one commentator has pointed out, requesting the forecasted cost of a policy over 10 years is quite absurd. There is so much uncertainty involved, particularly in regards to this policy, that such a forecast is unlikely to be worth the paper it’s printed on. And Treasury does not have a good track record with even 6-month forecasts in recent times.

But cost aside, we need to ask: is a company tax rate cut a good idea?

The unapologetically left-wing think tank, the Australia Institute recently released a report that argues the answer is no.

The report’s conclusion is based on a number of findings.

First, there is no correlation between company tax rates and economic growth rates of OECD countries (and in fact, there is a positive relationship between living standards and company tax rates).

Second, time-series analysis of Australian macroeconomic indicators shows that the gradual increase of the company tax rate between 1960 and the late 1980s—from 40% to just under 50%—and the gradual reduction to the current rate of 30% both seemed to have no effect on the economy. Indeed, the economy performed better when the high tax regime was in place.

However, the conclusion that a cut would not improve the economy based on these findings is problematic. As the report notes, there are many other variables that must be considered when comparing countries, and the existence of a correlation in Australia between high tax rates and good economic performance does not mean high tax rates lead to good economic performance.

Further, these findings still provide no evidence against the argument that a company tax cut will lead to “jobs and growth,” as the Treasurer claims. Indeed, an argument such as this, which needs to take so many factors into account, is difficult to provide evidence for or against.

A recent, peer-reviewed journal article has provided some evidence.

The article first discusses the two empirical challenges involved: changes in tax policy are not random—they are influenced by many factors, including economic conditions—and even if they were random, it is not possible to observe counterfactual outcomes, as is necessary for a true scientific experiment.

One way that economists attempt to overcome these challenges is by seeking out what are called ‘natural experiments’—occurrences that by chance happen to resemble random assignment of some ‘treatment’. In the case of this article, the authors were able to exploit the fact that US states who share borders tend to have similar economic conditions. Provided that a tax change doesn’t lead to firms shifting operations interstate—which can be tested—then bordering states could be used to observe counterfactual outcomes.

The study looked at 140 increases and 131 cuts in 45 states going back to 1969. Its main findings are that, historically, increases in corporate tax rates have a negative impact on employment and wages, while cuts have fairly little impact unless they occur during a recession. A 1% reduction in corporate tax during a recession was found to cause around a 1% increase in wages, and a 0.6% increase in employment.

These findings make intuitive sense. Investment decisions are unlikely to be significantly altered unless tax changes or economic conditions make the investment more risky or less profitable. A tax increase reduces potential profit, and while a tax cut increases potential profit, it is unlikely to be a large enough increase that the business would not have gone ahead with the investment anyway—unless economic conditions also made it less attractive. A tax cut during a recession works as a nudge to businesses to go ahead despite their trepidations.

Again, a word of caution is in order. The authors note they are hesitant to extrapolate their findings to the potential effects of corporate tax changes at a federal level, since their study only looked at the effect of tax changes on employment and wages. However, this means that the positive effect of a tax cut on the economy is probably understated, since the observed increase in wages and employment is likely caused by increased investment, which also affects economic growth through other avenues, such as increased capital income.

Their findings are also fairly consistent with studies on the effect of federal-level corporate tax cuts, which generally find a moderate-to-high positive effect on GDP, implying a positive effect on wages and employment, as well.

Other favourable evidence comes from Ireland.

A government report examining the economic impact of Ireland’s famously low tax rate looked at data from 26 European countries and found that corporate tax has a ‘strong negative effect’ on where multinational firms decide to invest. The report argues that their highly competitive tax rate has been necessary for Ireland to address the economic limitations of their ‘peripheral geographical location’.

It also cites research by the OECD which used data on 21 OECD countries over the period 1971-2004 and found corporate income taxes to be the ‘most growth-damaging form of tax’, when compared to taxes on personal income, consumption and property.

Each of these studies are relevant to Australia’s current situation, for the following reasons.

First, much of the recent tax debate in Australia has rightly focused on how to address an increased need for funding of services that are predominantly the responsibility of state governments, such as health and education. Many argue that an increase in the GST is crucial to deal with this issue, while others convincingly argue that an increase in property tax would also be effective.

If we need more tax revenue to fund health and education, we should be looking at these taxes, since they are more efficient and less damaging to growth. And if a lower company tax rate leads to higher growth, then it will also increase the revenue take from these taxes, as well as from personal income tax.

Second, while our growth rate is currently keeping its head above water, some economists are predicting a recession by 2017. Evidence suggests that cutting company tax at a time of limited growth leads to more enhanced results, and is therefore an effective way to help the economy out of a hole.

Third, one of the Government’s arguments for cutting the rate is that it’s too high relative to the rates of our Asian neighbours. As the rest of Asia grows, we need to look at ways to make ourselves unique in the region, besides the fact that we have a lot of iron ore in the ground.

Australia has no choice but to transition away from being a resource-based economy. To do this we must begin to rely on new areas of the economy for growth, and generating growth in new areas requires investment and job growth in those areas. The evidence suggests that cutting company tax may be one way to do this, but the extent to which the results will be positive is not clear. This is perhaps why the Government’s plan is such a cautious one—the uncertainty may have them worried that a lack of results will leave them with too much of a revenue hit.

However, the evidence also suggests that less of a delay may mean the cut will have a greater effect, due to the relatively poor state of the economy.

Further, if the government is banking on attracting foreign investment, then they may want to consider a greater cut in company tax, and a greater reliance on revenue from more efficient sources of tax, such as property and consumption.