Australia’s corporate tax is said to be very successful, raising substantial revenue, and there has been little debate about it over the past few years. The most obvious starting point in any tax debate is question why a particular tax is levied at all. The case for the corporate tax is less obvious than many would think.
Three reasons can be given for imposing corporate tax: its desirability, its necessity, and its convenience. While all three reasons are plausible, they are not necessarily convincing. The desirability of corporate tax arises primarily from the ability to tax foreigners. It is entirely plausible to argue this is desirable, but the motive of taxing foreigners needs be tempered by awareness of the cost this form of taxation imposes on the domestic economy, and also by the desire to attract foreign investment.
The second argument in favour of the corporate tax is based on its necessity. This argument holds that the corporate tax serves as a “backstop” to the personal tax system, and generally serves to avoid distortions in the overall tax system.
The logic underlying this argument is that the solution to economic distortions due to a high personal tax rate is to have a high corporate tax rate. There are two interrelated arguments here. The first is that corporate tax is necessary to prevent individuals from organising their personal affairs through the corporate form to avoid personal income tax.
It is not clear, however, that this is big a problem. For example, Nicholas Gruen suggests that “The ease with which a taxpayer can reduce their effective personal tax rate through incorporation is frequently overstated”. Gruen makes the argument that incorporation, at best, defers personal tax payments, but does not allow individuals to avoid personal taxation. This suggests the personal tax system has few leakages. Consequently, the personal tax system may not need to have a backstop.
The second argument on the necessity of corporate income tax is closely related yet less plausible. This argument recognises that taxation distorts the economy. Consequently, to minimise these distortions it is necessary to tax everything. Joel Slemrod refers to this as being a “folk theorem”. Further, he describes this as being “the most informal argument of all” supporting corporate income tax.
He concedes that a lot of formal economic theory on taxation (known as optimal tax theory) seems to suggest something like the folk theorem. But formal theory does not support corporate tax in small open economies. In his empirical analysis, Slemrod finds no evidence supporting the folk theorem, but does suggest his evidence is consistent with the backstop theory.
The convenience argument for corporate tax is largely self-explanatory. Corporate taxation is a source of easy revenue for government. The costs of corporate tax to government are low, it is politically popular, the incidence is uncertain, and corporations themselves do not vote (though many of their stakeholders do). The fiscal illusion and lack of democratic accountability associated with corporate taxation makes it very convenient to impose.
The arguments in favour of corporate tax need to be weighed against the costs of imposing it. The excess burden (or deadweight cost) of corporate tax is that it causes resources to be misallocated. There are three separate sources of inefficiency that can be identified.
First, corporate taxation leads to a misallocation of resources across the corporate and non-corporate sectors of the economy. Jane Gravelle argues that this distortion has received most attention in the academic literature. There is a large US literature that addresses the extent of this type of deadweight loss from corporate tax. Unfortunately, the empirical estimates of corporate tax’s deadweight costs vary from 5 per cent to over 100 per cent of revenue raised.
Second, corporate income tax reduces economic efficiency, productivity, and growth over time. Ireland has demonstrated this point very well by dramatically lowering corporate income tax rates, yielding substantial economic benefits.
Finally, corporate income tax distorts the debt-equity financing choices of corporations and the dividend decision. In principle, the dividend imputation system in Australia should reduce the debt-equity distortion (at the expense of having high dividend payout ratios) and reduce the double taxation of corporate income.
The (unofficial) Treasury view of Australian corporate tax is set out in a 2004 paper by James Kelly and Robert Graziani. They argue the role of company income tax is to tax the income of Australian residents and to act as a withholding tax on Australian-sourced income for foreign investors. This is a combination of the folklore theorem and the argument that corporate tax is a backstop to the personal tax system.
As I have argued, this is a weak justification for corporate income tax, yet Kelly and Graziani write as if these arguments were beyond question or doubt. Indeed, they present them as being self-evident.
In 2008-09, the corporate tax is expected to raise $73.5 billion, making up about 34 per cent of income tax revenue. The Australian corporate tax take is high by international standards. Given the costs associated with the corporate tax and the uneasy arguments that sustain corporate taxation, government should be considering large-scale reform of corporate taxation rather than simply dismissing call for tax reform as special pleading.