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So much to gain for so little pain

By Nicholas Gruen - posted Friday, 20 October 2006


How often have you heard that aligning personal and company tax rates is some touchstone of “real reform”? Of course it would be nice to do, but at what cost?

Not only does cutting the top personal tax rate focus tax reform where it gives us the least growth dividend. (If we’re cutting personal tax, money spent lower down the income scale generates more growth by getting more people to work.) Alignment also keeps our eyes off a bigger prize.

Economic theory suggests lowering company tax generates more growth than lowering personal tax. So does a bit of empiricism - whether it’s from casual observation or a careful look through the trusty “econometriscope”.

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Economic theory says taxes on investment returns discourage saving and investing and that this effect compounds hugely over time - that it depresses productivity, wages and growth.

That’s why a plausible economic model suggests that cutting company tax eventually generates more than twice as much growth as personal tax cuts returning nearly 50 per cent of its revenue cost back to government as increased growth swells tax receipts.

And that’s before you count the way company tax cuts would increase foreign investment. The econometrics agrees with the theory. Two scholars from the free market American Enterprise Institute investigated the correlation between income and company taxation and wage rates. It turned out that lower company rates increased wages - confirming their expectations. But something else confounded their expectations - lower personal taxes don’t correlate with higher wages.

Another academic study found that lower company tax strongly increased growth - suggesting that that a ten percentage point cut in company tax would increase per capita growth by at least 0.5 per cent per annum. They found virtually no relationship between top marginal personal tax rates and growth.

Now add this example to the econometrics for an overwhelming case against alignment. Ireland’s company tax rate is 12.5 per cent - around 30 percentage points below top personal rates. And Ireland has doubled the next best developed country’s growth - our own.

Alignment is always sold as an anti-avoidance measure. “Who’d pay 45 per cent tax when they could pay 30 per cent?” But you can’t enjoy a company’s money without it being paid to you as dividends - and when it is guess what? You pay tax on it.

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If we’re concerned about the remaining tax deferral opportunities non-alignment creates we should deal with them specifically with anti avoidance measures - like those we abolished in 1987 when we (fleetingly) managed alignment. But tackling avoidance by foregoing the huge benefits of company tax cuts is using a sledge hammer to crack a nut.

We also hear that cutting company tax advantages the rich. In fact to the extent that company taxes reduce our wages we all pay them. But even ignoring this, company tax doesn’t tax the wealthy these days because dividend imputation credits shareholders with the company tax paid by their company.

Back in 1987 the introduction of dividend imputation certainly looked like “real reform”. It was big and bold - with those “long clean lines” that Paul Keating liked in his policies - and his decor. It neutralised the tax treatment given to buying shares compared with lending a company money.

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About the Author

Dr Nicholas Gruen is CEO of Lateral Economics and Chairman of Peach Refund Mortgage Broker. He is working on a book entitled Reimagining Economic Reform.

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