Government Senators’ Report
Summary
The Government’s objective is to simplify and improve Australia’s taxation
system. Reform of the taxation system, including business taxation, will produce lasting
benefits for the Australian economy. It will help create an environment for increased
economic growth, more jobs and improved opportunities for saving and investment.
Reforms to the personal tax system, which have recently been enacted, will provide
incentives to work and save.
It is also important for the tax system to provide a sustainable revenue base so that
governments can deliver social services and provide public goods. The reforms that the
Government is making to the indirect tax system will provide a secure and growing source
of revenue to the States that will allow them to allocate additional funding for services
such as health and education.
In relation to business tax, the Government has announced that it will implement the
majority of the recommendations of the Review of Business Taxation that was chaired by Mr.
John Ralph AO and documented in the Review’s Report (‘the Ralph Report’).
Those reforms will take Australia into the next century with a modern, competitive and
fair taxation system. Importantly, the Report recommended a package of changes that will
be revenue neutral. A key element of the terms of reference set by the Government for the
Review was that its recommendations were to be revenue neutral. It is therefore
unfortunate that the main focus of the Committee’s hearings was on whether the
realisation assumptions concerning the reduction in capital gains tax were appropriate and
the extent of the opportunity to convert income to capital. The overall objectives of
business tax reform, including the major benefits that would come from the
Government’s reform package, were not adequately addressed. Furthermore, the capital
gains tax measures are but one part of a comprehensive package of reform.
Nevertheless, the evidence presented to the committee did not undermine the
appropriateness of the Government’s assumptions regarding the realisation of capital
gains flowing from the changes. This is a difficult area of revenue estimation and the
evidence presented merely illustrated what was known before the committee began, and was
outlined in the Ralph Report, namely that there is a wide range of views on this issue.
For this reason the approach adopted by the Review, upon which the Government’s
response is based, has not relied on only one study to determine the likely realisation
response, but has taken into account the results of a large number of studies. This is
clearly the appropriate approach to follow. As to the issue of converting income to
capital, the evidence presented clearly indicated that the allowance contained in the
Government’s response is appropriate. While some witnesses talked about the
possibilities for arbitrage, little evidence was presented as to how this could occur,
especially given the requirement for the 12-month holding period and the fact that there
are effective anti-avoidance measures in the legislation.
The benefits of tax reform
Mr Reynolds made the point in his evidence that it was unfortunate that the committee
focussed excessively on the likely realisations from the reduction in capital gains tax
without adequately considering the overall impact of the reforms to business tax:
It is important to recall that the main objective of the business tax reforms is to
provide Australia with a modern, competitive and fair tax system. One that will create the
environment for achieving higher economic growth. It is relevant that witnesses appearing
before the committee who were critical of a particular measure in the package still
endorsed the overall benefits to the economy of the business tax reforms. For example,
Professor Krever stated:
Yes, I was a consultant to the report. Taking off my consultant’s hat and sitting
back in an academic’s hat and as director of a tax research institute, I think the
overall package has a lot of very positive benefits for Australia. As a package, many
elements are going to bring a lot of benefit in terms of introducing neutrality and
economic efficiency into the Australian tax system and a lot of welcome gains as a result
of that.
The fact that the business tax reforms are but part of the Government’s overall
design of a new tax system was picked up in Mr Murphy’s evidence when he said:
The RBT business tax measures are based on a cut in the company tax rate to 30 per
cent, costing $3 billion. This means that the RBT is a small change compared with ANTS. It
is basically shifting around $3 billion worth of revenue between different industries
rather than $24 billion, so you would expect the effects on the industry pattern of
economic activity to be a lot less, and indeed they are.
The Government’s full tax reform package has now been announced, along with the
implementation dates for all measures. It is simply incorrect to say that the package is
incomplete in terms of scope and timing.
The Ralph Report acknowledged that, while achieving higher levels of economic growth
was the overarching objective motivating its deliberations, the behavioural responses
(which will lead to higher economic growth) are extremely difficult to estimate. Against
this background, the Review adopted what it termed as ‘a conservative judgement about
the likely growth dividend’, while also adding that ‘the collective judgement of
the Review is that the national dividend will be significantly greater…’. In
terms of the impact of the expected growth dividend on revenue the Ralph Report stated:
Mr Ralph also indicated during the committee’s inquiry that the Review adopted a
conservative approach in estimating the revenue that would come from increased compliance
and greater integrity in the tax system as a result of the Report’s recommendations,
which have been adopted by the Government. For example, Mr Ralph noted:
The reason why I feel extremely comfortable with the position we have reached in
relation to revenue neutrality is that I believe that we have taken a conservative
position generally - I think I have a natural inclination to go that way - and many of the
integrity benefits will come. I suspect that, even with schemes that are going on that we
do not know about, if you move to a structure that essentially ties your tax system very
closely to commercial reality and tracking very close to the principles of financial
accounting, you actually close off opportunities.
The clear view of the Business Coalition of Tax Reform (BCTR) in its submission to the
committee was that the overall package of tax reform measures announced by the Government
would produce a surplus of revenue above the benchmark chosen for revenue neutrality. In
coming to this view the BCTR noted that the Review had adopted a conservative approach,
deliberately erring on the side of caution in favour of the revenue. They identified that
this conservatism had the following dimensions:
- while a core thrust of the business reform package is to improve integrity, very little
revenue from the reduction in opportunities to evade or avoid tax has been factored into
the estimates;
- the gains to revenue from behavioural responses to tax changes tend to be understated
while the losses to revenue from behavioural changes tend to be overstated;
- the Review built into its revenue projections a growth dividend which is acknowledged to
be conservative; and,
- the Review did not include a specific estimate for the revenue saved from a reduction in
compliance costs, despite its anticipation of substantial reductions in compliance costs.
The BCTR not only concluded that the Review of Business Taxation was overall likely to
be revenue positive, it went on to identify where the extra revenue could be
‘spent’.
Capital gains tax reform
The main focus of the Senate inquiry was on whether the reduction in the capital gains
tax would result in extra realisations. Just as it is unfortunate that there was not
sufficient consideration to the overall benefits of the business tax reform package, it is
also unfortunate that due consideration was not given to the benefits that will be derived
from the reform to Australia’s capital gains tax regime. This issue was, however,
referred to in Mr Ralph’s evidence to the inquiry, along with that of Mr Reynolds,
and was also covered in an information paper submitted by the Business Council of
Australia (BCA).
The Ralph Report noted that a major motivation for reform of the capital gains tax
arrangements was the desire to increase the international competitiveness of Australian
business and to encourage greater investment by Australians. In particular, the Report
stated that reducing capital gains tax would encourage a greater level of investment. Mr.
Ralph indicated in his evidence to the committee the importance of having an
internationally competitive headline capital gains tax rate. As he noted, people look
first at the headline rate before they decide whether or not a country is worth investing
in. If the headline rate is attractive, then the investors will look more carefully at the
investment.
The information paper prepared by the BCA concluded:
- if the reforms to capital gains tax are adopted by the Parliament, resources will tend
to be redirected into more productive investments, investment portfolios will be more
actively managed and both corporate saving and investment will rise;
- as a result of the base broadening measures, including the removal of significant
barriers to the realisation of assets, there is every reason to expect the proposed CGT
regime will result in more tax being paid on capital gains rather than less; and
- against the benchmark of the former capital gains tax arrangements, none of the
arguments against the proposed capital gains regime on the grounds of equity presents a
convincing reason to forgo the economic benefits that can be anticipated with confidence
to flow from that regime.
Mr Reynolds concluded his evidence to the committee with the assessment that:
I think what you are proposing to do on capital gains tax is the single most important
tax change in Australian history. One of the reasons is the reason you are speaking of:
that it brings you out of the mining business, which I greatly respect, into the age of
the knowledge industry. Rather than sending your people to Silicon Valley, you will be
bringing some of Silicon Valley to Australia.
Increased realisations of capital gains
As noted, the efficiency gains that will flow from the reforms to the capital gains tax
regime, and the resulting impact this will have on investment, economic growth and in turn
revenues, should be the main consideration. Nevertheless, the focus has been on the extent
of the increase in realisations of assets if the tax rate on capital gains is reduced.
Estimating a likely behavioral response to a measure is always difficult, but this is
compounded if there are data limitations. Due to the lack of historical capital gains tax
data, there are no Australian studies to indicate what impact a change in the tax
treatment of capital gains might have on taxpayer behaviour. To overcome this limitation,
it has been necessary to draw on the experience of the United States - a country with a
long history of capital gains taxation and changes in capital gains tax rates. While a
large number of studies have been undertaken on the US experience, there is no agreement
as to the likely long term behavioural response from a change in capital gains tax. This
was acknowledged in the Ralph Report.
However, a common conclusion of nearly all the studies of the American capital gains
tax data was that a lower rate of tax will lead to an increase in realisations of capital
gains, at least in the short term. Factors which will influence the extent of the increase
in realisations will be the size of the reduction in the capital gains tax rate and the
extent of the ‘lock-in’ effect.
The Australian Stock Exchange (ASX) noted in its submission to the committee that these
points are accepted by US commentators, even those who recommend a cautious approach to
capital gains tax reform. The ASX referred to the following quote from the US Citizens For
Tax Justice:
Despite the wide disparity in empirical estimates of the behavioral response of
individuals to changes in the capital gains tax rate, most researchers are in agreement in
at least three areas: that whatever the response may be, it is likely to be greater in the
period immediately after a tax change than several years down the road; that taxpayers
respond to marginal rates rather than say, average rates; and that this response should
vary with the absolute level of the marginal rate.
The likelihood of a very significant increase in realisations in the period following
the reduction in capital gains tax was accepted by many researchers, even those who
questioned the long term response adopted by the Review. For example, Professor Alan
Auerbach stated:
The Treasury noted in its evidence to the committee that the magnitude of realisations
in the short term is likely to be very large because of the large build-up of unrealised
gains. Australia has had the one capital gains tax regime for nearly 15 years. In
contrast, the United States has increased and decreased its capital gains tax rate, which
has probably led to increased realisations while unrealised gains continued to increase in
Australia.
Hence, it is clearly likely that the reduction in the capital gains tax will lead to a
significant increase in realisations in the short term. Professor Krever said there would
be an ‘enormous’ short-term realisation effect, the Burman and Randolph study
quoted by Dr Gravelle indicated that there would likely be a ‘huge’ revenue
windfall in the short-term, while Professor Auerbach said that the responsiveness of
capital gains was quite large in the short term and referred to the fact that realiastions
had exploded in the United Sates following the Tax Reform Act of 1986 when investors
sought to take advantage of the lower rate.
Consequently while there is some debate as to the long term impact on realisations of a
reduction in capital gains tax, the evidence and opinions presented to the committee
clearly pointed to a very significant impact in the short term. Thus concerns as to
whether the realisation estimates adopted by the Ralph Report may bring into question the
overall revenue neutrality of the package are perhaps more about the likely impact on
revenue a number of years after the changes.
This is relevant given that the confidence interval around any revenue estimates is
lower the longer the time period involved. But even in the short term, the magnitude of
the possible difference in revenue coming from different assumptions about the likely
realisation response must be kept in perspective. For example, a lower (higher) short-term
elasticity response compared with that used by the Review may see revenue reduced
(increased) by $200-300 million. Yet the average error margin around budget year revenue
projections is 2 per cent of total taxable income, which translates into an error margin
in excess of $3 billion dollars. This error margin increases significantly the longer the
time period. The conclusion is that we should avoid false precision when attempting to
make judgments about the accuracy of any revenue projection.
That said, the evidence presented to the committee did not undermine the
appropriateness of the long-term elasticity of capital gains realisations used by the
Ralph Review. A number of witnesses presented a different view, but this only confirmed
what was known when the Review considered this issue, namely that the research and
literature is divided as to how large will be the long-term realisation response to a
change in capital gains tax rates.
The position put to the committee was whether the studies by Professor Auerbach, Dr
Gravelle and Burman and Randolph were more accurate than the average of the 11 studies
examined by Reynolds (he examined 13 but excluded two, including the Burman and Randolph
study which said there was a 95 per cent chance that the long-term elasticity was
somewhere between zero and one) which had an average long run elasticity of minus 0.9.
This was the same as the long run elasticity adopted by the Review and is also the same
elasticity used by the US Treasury.
There was some questioning as to whether it was appropriate to use US data on
realisation experience given the difference in tax rates in the US and Australia and other
aspects of the taxation system. For example, Mr Reynolds in evidence to the Committee
noted that the US official elasticity estimate of minus 0.9 was based on US tax rates
which were considerably lower than Australian tax rates. He indicated that at Australian
tax rates the elasticity would be more like minus 1.5 to 2.0 at the higher end of the
range and that minus 0.7 to 0.9 would be at the lower end. It was also noted by a number
of witnesses that allowance must be made for the removal of indexation. The ASX estimated
in its submission to the committee that after allowing for indexation, the reduction in
the maximum capital gains tax rate was in the order of 36 per cent to 24.25 per cent. This
was relevant when considering US studies. For example, some of the recent studies in the
US examined likely realisation response from an effective maximum CGT rate of 20 per cent
to 15 per cent. The realisation response from a CGT rate of around 36 per cent (allowing
for indexation) would clearly be significantly larger than a rate reduction from 20 per
cent.
Those criticising the minus 0.9 elasticity used by the US Government claimed it was
based on dated research, with Dr Gravelle questioning the value of cross-section studies
as opposed to time series studies. However, Mr Reynolds pointed out to the committee that
only one of the studies which he examined was a cross-section study and he eliminated that
one in drawing his conclusions.
Consequently the evidence presented to the committee merely illustrated that this is a
difficult area to estimate and that there are a range of views. Against this background
the approach taken by the Ralph Report of considering all the studies rather than relying
on just one or two is clearly appropriate and the uncertainty (in both directions)
surrounding the revenue estimate for the CGT changes is no greater than that for other
measures.
Allowance for CGT arbitrage activity
The evidence presented to the committee did not undermine the appropriateness of the
Government’s allowance for a total loss of revenue of $500 million across five years
from arbitrage activities, particularly the conversion of income into capital.
The views expressed that the allowance was too low were just that, views, and were not
supported by evidence. Some witnesses indicated that there was a large incentive to
convert income to capital, and Professor Evans presented scenarios of the potential loss
to revenue if 2 per cent of PAYE income was moved into capital. However this was merely
an assumption and no evidence was presented that this would occur. This point was
addressed by Mr Simpson, who has had over 30 years as a tax administrator:
I would say, ‘ Well if you can do it, why stop at 2.5 per cent?’ but the
other question is, would it ever get to 2.5 per cent? Pay-as-you earn comes essentially
from ordinary Australians. We have a 12–month rule for favourable capital gains tax.
These ordinary Australians really need some income to live on.
Then you get into questions like, ‘If they are going to convert pay-as-you earn
into capital, what are they going to use to live on? They have to have income, they have
to have cashflow.’ If you get into arrangements whereby perhaps loans are arranged or
whatever else for them to live on, you start really running into approaching contrived
avoidance arrangements. That would be something I am sure the tax office would look very
closely at.
Mr Reynolds also noted in his evidence to the committee that there was very little
evidence of people converting income into capital.
Now as for converting income into capital gains, the challenge that I keep putting in
my paper is that, first of all, I look for evidence in the United States and we cannot
find it. Secondly, I look at the theorists who talk about that and they cannot explain how
you do it. If we knew how to convert income to capital gains - if it were that easy - then
it is kind of surprising Australia ever collected any income tax prior to 1985 - when in
fact it collected quite a lot - because people could convert everything into capital gains
and not be taxed at all.
The Treasury advised the committee that the 12-month holding rule would address many of
the possible avenues of converting income into capital.
It was also pointed out to the committee by the Australian Taxation Office (ATO) that
there are already robust anti-avoidance measures that would address contrived schemes to
convert income to capital. As Mr Fitzpatrick from the ATO told Senator Conroy regarding
the application of the general anti-avoidance rules in the income tax legislation,
‘Part IVA is proving to be an effective mechanism to curb anti-avoidance
activity’.
In the interchange between Mr Fitzpatrick from the ATO and Senator Cook on the
strengthening of the general anti-avoidance rules announced by the Treasurer on 11
November, it is inappropriate to claim that Mr Fitzpatrick said that it was
‘unclear’ whether the proposed new anti-avoidance rules would apply to
arrangements which seek to exploit differences between tax rates on capital gains and on
other income. Mr Fitzpatrick was referring to the fact that the Government is to
strengthen the general anti-avoidance rule rather than introduce a measure specifically on
the conversion issue. To quote the comments of Mr Fitzpatrick in full:
I think the changes announced yesterday are more to the effective operation of the
anti-avoidance provision, but certainly it extends to the concept of tax benefit. To what
extent that would have an effect on the arrangements to convert income to capital is
unclear. As Dr Preston said, it certainly would not do any harm, and it would help the
operation of the anti-avoidance provision. The anti-avoidance provision presently, as it
is interpreted by the courts and certainly since the High Court looked at in Spotless, is,
as I said last time, a fairly effective measure to counter arrangements which seek to
exploit the law in its intended operation.
On the basis of the evidence presented to the Committee it is clear that the allowance
the Government has made for a possible loss of revenue from arbitrage activity is
appropriate.
In his evidence Mr. Fitzpatrick observed that claims about opportunities to convert
income into capital were ‘somewhat exaggerated’.
Concerns that the scrip-for-scrip rollover relief could possibly lead to tax avoidance
where private entities are involved, can be mitigated through the imposition of
appropriate conditions on eligibility for relief. It is also relevant that the Government
has announced that there would be a review of the effectiveness of this measure after its
introduction.
Conclusion
The emphasis of the Inquiry has been misplaced.
Too little attention has been given to the fact that the total package of business tax
measures as proposed in Tax reform, not a new tax, a new tax system and those
recommended by the Ralph Review are significantly revenue positive against the revenue
generated by the current legislation and practices. The revenue estimates associated with
the reform of Australia’s capital gains tax regime, which will significantly increase
the incentive to invest and save, are robust. There are always uncertainties associated
with revenue estimates. The important point is that the Review’s recommendations on
the whole are revenue neutral, at a minimum, and they will contribute to increased
economic growth, more jobs and a rising standard of living for all Australians.
Grant Chapman
Senator for South Australia
Brian Gibson
Senator for Tasmania
|
