APPENDIX C

Consultancy Report – Professor Peter Dixon

Company taxes, Depreciation allowances and Capital gains taxes: some effects of Ralph

by Peter B. Dixon and Maureen T. Rimmer*

Centre of Policy Studies, Monash University

Paper prepared for the Senate Finance and Public Administration References Committee: Inquiry into Business Taxation Reform

November 15, 1999

1. Introduction

The Ralph Report contains many detailed recommendations. Here we consider three of them:

the proposal to reduce the company tax rate from 36 per cent to 30 per cent;
the proposal to eliminate accelerated depreciation allowances; and
the proposal to halve the rate of capital gains tax while at the same time eliminating indexing and averaging.

We think it is reasonable to consider these three recommendations in isolation because their implementation does not depend on the implementation or non-implementation of the other recommendations.

Potentially, the most important route by which implementation of recommendations (1) – (3) could affect the Australian economy is via post-tax rates of return on investments in Australia by foreigners and by residents. If implementation of the recommendations leads to an increase in post-tax rates of return, then we would expect an increase in investment. This would lead to changes in the rates of growth of GDP, employment, wages, exports, imports and many other economic variables.

In section 2 we describe a typical investment project in the Australian economy. Then in section 3 we report the effects of the Ralph proposals on the present value of this project to different types of financiers. In section 4 we consider windfall gains and losses that may be created by the Ralph proposals. Sections 5 and 6 report implications for Government revenue and for the macro economy. Our main findings are listed in section 7 together with concluding remarks.

2. A hypothetical investment project in Australia

To work out what implementation of recommendations (1) – (3) would do to post-tax rates of return, we consider a simple project. This hypothetical project lasts 100 years. It requires an outlay of $2 in year 0 and subsequent capital injections of similar size in real terms in years 20, 40, 60 and 80. With inflation of 2 per cent a year, these subsequent capital expenditures are $2.97[=2*(1.02)20], $4.42[=2*(1.02)40], $6.56[=2*(1.02)60] and $9.75[=2*(1.02)80]. For working out depreciation allowances we assume that half of capital outlays are depreciable.

We assume that the project produces a pre-tax profit in year 1 of $0.079022, growing each year by 4 per cent. We adopt a faster rate of profit growth (4 per cent) than the rate of inflation (2 per cent) to reflect on-going productivity improvements. In the absence of taxes, our hypothetical project would have an internal rate of return of about 6 per cent.

In Table 1, we have set out the pre-tax characteristics of the project algebraically, allowing the starting point to be any year t (rather than the fixed year 0). We recognize real growth in Table 1. If the project starts in year t, t 0, then we assume that the real size of the project is inflated (for t > 0) or deflated (for t < 0) by the factor (1+g)t where g is the real rate of growth of investment (assumed to be 3 per cent). Adjustment for real growth is not important in our present value calculations in sections 3 and 4, but plays a role in the revenue calculations in section 5.

From the point of view of deciding whether or not the project will be financed, it is the expected post-tax rate of return to potential financiers that is important, not the pre-tax rate of return. The post-tax rate of return depends on the pre-tax characteristics of project together with taxation rules and the characteristics of the financier.

We consider the three potential financiers: (a) an Australian resident buying shares in a company; (b) an Australian resident providing funds to a partnership or other non-corporate business, and (c) a foreign resident buying shares or otherwise providing funds to a company. The assumptions that we have made in moving from pre-tax returns to post-tax returns are discussed below and listed in Table 2.

Assumption 1: company tax rates

These are relevant only if the project is run via a company [cases (a) and (c)]. In both these cases we assume under Ralph that the company tax rate will be reduced from 36 per cent to 30 per cent in one step. We ignore the Ralph recommendation that the reduction be made in two stages: from 36 to 34 and then from 34 to 30.

Assumption 2: marginal income tax rates for individuals

Many share-holding individuals have a higher marginal tax rate than 30 per cent. On the other hand, the marginal tax rate of Australian superannuation funds is only about 15 per cent. We think that 30 per cent is a realistic average of the marginal tax rates of potential holders (both resident and non-resident) of Australian shares.

Assumption 3: capital gains tax

We ignore the provisions for averaging. In the current system these have allowed some taxpayers to reduce their capital gains taxes. Under Ralph, averaging will be eliminated. By ignoring this, we are over-estimating the attractiveness to potential shareholders of the Ralph proposals. We have also ignored asymmetries between the treatment of realized capital gains and realized capital losses in years 1 to 99 of our hypothetical project. This is legitimate because our examples do not involve realized capital losses.

Assumption 4: depreciation allowances

The current tax law allows different rates of depreciation for physical assets of different longevity. For example, short-lived assets can be expensed (i.e. entirely depreciated in their first year) whereas long-lived assets can be fully depreciated over about half their life. In our hypothetical project, capital is long-lived (20 years). We have assumed that under the current system it is depreciated over 10 years whereas under Ralph it would be depreciated over 20 years. For simplicity, we have assumed straight-line depreciation schedules.

Assumption 5: dividend policy and treatment of retained projects

Reductions in rates of company and capital gains taxes as proposed by Ralph are likely to increase the attractiveness to shareholders of retained profits. Nevertheless, we have ignored links between tax changes and dividend/retention policy. If time were available for further work, it would be interesting to build such links into our numerical examples.

Assumption 6: discount rate

We assume that the interest rate for both Australian and foreign investors is 6 per cent. This gives them a post-income-tax rate of interest of 4.2 per cent. Consequently, in calculating present values of income streams for foreign and domestic investors, we use a discount rate of 4.2 per cent, i.e. we assume that investors value equally $100 today and $104.2 to be received in one year.

Assumption 7:dividend imputation

We assume that all dividends are fully franked, except possibly those in year 100. For year 100, we assume that dividends are franked only to the extent of the balance in the dividend franking account. In the early years of the project, the franking account for our particular project may be negative, especially if there is accelerated depreciation. We assume that the project is embedded in a large organization which makes up negative balances for this project from positive balances generated from other projects.

3. The present value of the project to different types of financiers

(a) An Australian resident buying shares in a company

Line 1 in Chart 1 is drawn assuming maintenance of the current business tax system. It shows the present value of the project [value in year zero] to an Australian resident who owns the project via shares in a company. The calculations have been done under different assumptions about the year in which the shareholder sells the project. For example, the present value of the project to the shareholder if he or she sells it in year 1 is $2.45. If sale is delayed to year 20, then the present value is $2.49. We assume that the sale price in any year is the present value in that year of the remaining income stream from the project to an Australian shareholder who retains his or her shares to the end of the project's life. The increase in present value [value in year zero] of the project for later sale dates is explained by the delay in incurring capital gains tax.

From the current system we move in Chart 1 to the Ralph system in three steps. In line 2 we show the present value of the project in the current business tax system without accelerated depreciation. The removal of the accelerated depreciation reduces the present value of the project to the Australian shareholder by about 4 per cent for any year of sale. Rapid depreciation increases the after-tax profits of a company early in the life of the project. This is valuable to shareholders if the company retains profits, investing them on behalf of the shareholders. In effect rapid depreciation allows the company to delay the time at which its shareholders must pay tax on the earnings of the company.

In line 3 of Chart 1 we show present values of the hypothetical project without accelerated depreciation and with lower company tax rates. The difference between lines 2 and 3 shows that lowering the company tax rate has a very minor positive effect on the present value of the project (less than half a per cent).

In the early years of the hypothetical project, depreciation is quite high (even without acceleration) relative to the project's before-tax income. Thus the company tax payable for the project is low, and is not changed significantly by a reduction in the company tax rate. For example, if the company tax payable in year 1 were zero because before-tax profits were matched by depreciation allowances, then variations in the company tax rate would have no effect on the company tax payable. However a reduction in the company tax rate reduces the benefit to shareholders of dividend imputation. Under our assumption that deficits in the project's franking balance can be covered by surpluses from more mature projects in the company, a reduction in company tax rates can reduce the present value of a new project. In Chart 1, this negative effect of reducing the company tax rate is slightly outweighed by the more familiar positive effect arising from an increase in the quantity of retained earnings that the company can invest on behalf of the shareholders.

The insensitivity of the present value of a project to a shareholder with respect to movements in the company tax rate is further illustrated in Table 3. There we consider a simpler example than that in Tables 1 and 2. The project in Table 3 lasts for two years and earns $100 in each year. In the first panel of results showing the initial situation with accelerated depreciation, the depreciation allowance in year one is $80 leaving a taxable profit of $20. The company tax rate is 36 per cent so that the company tax is $7.2 and the after-tax profit is $92.8. We assume that half of the after-tax profit ($46.4) is distributed as dividends and half is retained. The shareholder not only receives a dividend of $46.4 but with full franking the shareholder also receives a tax reduction of $4.4, making a total benefit of $50.8. The tax reduction is worked out according to the formula:

tax payable = tax payable on grossed up dividends less tax deemed to be paid by the firm on behalf of the shareholder,

that is,

tax payable = [46.4/(1 - 0.36)]*[0 .30 - 0.36] = -4.4 .

The firm is left with negative tax credits associated with the project of $18.9 calculated as:

tax credits = company tax less tax allowances given to the shareholder,

that is,

tax credits = 7.2 - [46.4/(1 - 0.36)]*0.36 = -18.9 .

We assume that these negative tax credits are covered in year one by positive credits available from other projects. In year two, we assume that dividends are not fully franked, allowing the tax credit account can be balanced at zero. With retained earnings invested at 6 per cent, before tax profits in year two are $102.8 [ = 100+ 0.06*46.4]. There is no depreciation allowance in year two so that company tax is $37.0 [ = 0.36*102.8] leaving an after tax profit of $65.8. We assume that all of this is distributed together with the retained profits from year one making a total dividend of $112.2. Under the assumption that the firm balances the project's tax credit account, the shareholder's tax liability on the year two dividend is calculated as:

tax payable = [112.2+ 37.0 - 18.9]*0.30 - [37.0 - 18.9] = 21.0 ,

leaving the shareholder with a net benefit of $91.2. The present value of this benefit discounted at 4.2 per cent [the shareholder's post-tax interest rate] together with the benefit from year one gives a present value of $138.3 from the project. Similar calculations in panels two and three of Table 3 show that the present value to the shareholder of the project falls to $137.7 with the elimination of accelerated depreciation and remains at this level with the lowering of the company tax rate from 36 per cent to 30 per cent.

Returning to Chart 1, we see that the move from line 3 to line 4 shows the effect of the changes proposed by Ralph in the taxation of capital gains. These are particularly valuable to shareholders who plan to sell their shares early in the life of the project. The advantages of the proposed changes in capital gains taxes are muted to later sellers by discounting (tax reductions in the future are worth less than tax reductions in the present). The advantages are also muted by inflation (the Ralph proposal involves a switch from the taxation of real capital gains to nominal capital gains).

Overall, the move from line 1 (the current system) to line 4 (Ralph) involves reductions in the present value of the project, especially for late sellers. Thus we could expect Ralph to reduce the attractiveness of the project to Australian share investors.

(b) An Australian resident providing funds to a partnership or other non-corporate business

Chart 2 is similar to Chart 1 except that now the lines refer to the present value of the project to an investor in a partnership. Line 1 shows present values under the current system, line 2 shows present values when accelerated depreciation is eliminated and line 3 shows present values without accelerated depreciation and with lower capital gains taxes. There are only three lines in Chart 2 (rather than four as in Chart 1) because the proposed reduction in company tax rates is irrelevant for non-corporate businesses.

The results in Chart 2 are broadly similar to those in Chart 1. This is not surprising. The main difference between the corporate and non-corporate structures in our calculations is the company tax. Movements in this tax had only a minor effect in Chart 1.

As was the case for corporate shareholders, we find in Chart 2 for non-corporate investors that the implementation of the Ralph proposals will reduce the attractiveness of the project, especially for investors who plan to retain their holdings in the project for the long term.

Line 1 in Chart 3 shows that the present value of the project to a foreign shareholder declines as we consider later selling dates. In Charts 1 and 2, later selling dates had the advantage of delaying the payment of capital gains taxes. This no longer applies in Chart 3 because we assume that foreign investors do not pay capital gains taxes. However this does not explain why line 1in Chart 3 slopes down.

At any time during the life of the project, the future income stream is worth more to resident shareholders than to foreign shareholders. This is because resident shareholders benefit from dividend imputation and foreign shareholders do not. Thus a foreign shareholder can realize a gain (free from Australian capital gains tax) reflecting the difference in the values of the project to foreign and resident shareholders. The present value of this gain [value at year zero] is continuously eroded the longer the foreigner delays the sale of his or her shares to a domestic resident. This gives line 1 in Chart 3 its negative slope.

As in Charts 1 and 2, the elimination of accelerated depreciation in Chart 3 significantly lowers the present value line (the move from line 1 to line 2).

From the point of view of foreign shareholders, the reduction in company taxes confers a significant advantage (the move from line 2 to line 3). With lower company taxes, dividends can be higher. For domestic shareholders the advantages of higher dividends are largely lost through lower imputation credits. This does not apply to foreign shareholders who cannot use imputation credits.

The advantage of lower company tax rates to foreign shareholders increases with the year of sale (the gap between lines 2 and 3 widens). As mentioned earlier, the company tax rate is largely irrelevant to domestic shareholders and therefore largely irrelevant to the price they are willing to pay for the project. Thus if the foreign shareholder sells the project at an early date, the company tax rate becomes largely irrelevant to the present value of the project. However, if the foreign shareholder retains the project for a considerable length of time, then he or she benefits from reduced Australian company taxes via increased dividends.

For some foreign shareholders changes in the company tax rate in Australia may affect their tax liability in their home country. Thus in Chart 3 we may have exaggerated the advantage to foreign shareholders of the proposed reduction in company tax rates. Insufficient time was available for us to investigate this issue fully. However, we think that for most foreign investors in Australia the change in their home tax liability resulting from changes in Australian company tax rates would be small.

Even ignoring the possibility of changes in home tax liability, the increases in the present value of the project to foreign shareholders from the proposed reduction in the company tax rate are outweighed by the decreases from the elimination of accelerated depreciation. Thus, in common with resident shareholders and resident investors in non-corporate structures, foreign shareholders would find the attractiveness of the project reduced by implementation of the Ralph changes.

Summary

Chart 4 summarizes the main results from Charts 1 to 3. If investors have a 5 year horizon, that is they expect to sell the project in year 5, then Chart 4 indicates that the Ralph proposals will reduce the present value of the project to the three classes of investors by between 1.5 and 3.1 per cent.

4. Windfall gains and losses

Changes in Australia's business tax system will effect not only incentives to invest (indicated by effects on the present value of new projects) but will also create windfall gains and losses for owners of existing projects. These windfall gains and losses can be evaluated by looking at the effects of changes in business taxes on the present value [the value in year zero] of existing projects of different ages.

In Chart 5 we consider projects of the same nature as those considered in the previous sections. However we assume that they have already been in existence at time zero for 1, 2, ..., 10 years. We have standardized these projects so that they have the same initial real outlays and real profits. We assume that the initial owners of the projects sell them in year 5, realizing a capital gain. Subsequent owners hold until project termination.

Chart 5 shows that Ralph provides a windfall gain to resident owners of projects less than 5 years old and windfall losses to all foreign owners and to resident owners of projects that have been in existence for 5 years or more.

The key to this result is the Ralph reduction in capital gains tax. This is a windfall gain to resident owners of comparatively recent projects. We have assumed that these investors are about to realize a capital gain on which they will now be taxed at a lower rate than they initially anticipated. For foreign owners and for resident owners of older projects the capital gains tax is, under our assumptions, largely irrelevant. For these owners the Ralph proposals will generate a windfall loss via the elimination of accelerated depreciation allowances. The windfall loss will be particularly sharp for owners of non-corporate projects. Owners of corporate projects receive some compensation for the elimination of accelerated depreciation from the cuts in company taxes.

5. Revenue calculations

To calculate the implications for Government revenue of the Ralph proposals, we need to make assumptions about investment in the past, present and future. For this paper we have assumed that investment expenditure in each year consists of projects of the type analyzed above. In each year investment is identical apart from inflation of 2 per cent a year and real growth of 3 per cent a year.

Under this assumption we find that the Ralph proposals would lead to an increase in the average rate of taxation of capital income. The increase would vary across income earned in projects financed in the three ways considered in the previous sections. Our calculations suggest an increase in taxation revenue over the next 20 years of between 1and 3 per cent of capital income. This is consistent with our finding in section 3 that the Ralph proposals would reduce the present value of investment projects by percentages in a similar range.

6. General equilibrium effects simulated in the MONASH model

Charts 6 and 7 show results from the MONASH model for the effects of increasing taxes on capital income by two percentage points [from 20 per cent, for example, to 22 per cent]. We assume that the Government uses the revenue from the extra taxation of capital income to make a general reduction in income taxes. Thus our simulation can be interpreted as showing the effects of an increase in the rate of tax on capital income, of the magnitude we think will follow from Ralph, balanced by a reduction in the rate of tax applying to labour income.

The short run results from MONASH depend on our labour market assumption. In Chart 6 we assume that there is stickiness in real after-tax wage rates. Under this assumption, cuts in the tax rate on labour income reduce the cost of employing labour [the real before-tax wage rate]. This generates a short-run increase in employment and GDP. There is a short-run increase in capital despite the increase in capital taxation. This is explained by capital scarcity arising from increased employment.

In the long run, we assume that wages adjust so that employment returns to its forecast level. With no long-run effect on employment, Chart 6 shows a long-run reduction in the capital stock with an associated reduction in GDP. The reduction in the capital stock reflects the need to generate higher pre-tax profits per unit of capital to compensate for the increased taxation of capital income.

In Chart 7 we assume that there is stickiness in real before-tax wage rates. Under this assumption, cuts in the tax rate on labour income no longer reduce the cost of employing labour. Thus in Chart 7 there is no short-run stimulation of employment. In the long run the situation in Chart 7 is similar to that in Chart 6.

7. Summary and concluding remarks

To reach firm conclusions about the likely effects of the Ralph proposals we would require considerably more time than the 10 days allowed for the preparation of this paper. We would need to consider many different types of projects and to specify typical projects for different industries. On the basis of the work that we have been able to complete, our tentative conclusions are as follows:

the proposed cuts in company taxes will have a very minor positive impact on the attractiveness to Australian residents of investment projects in Australian companies but will have a greater positive effect on the attractiveness to these investments to foreigners;
the proposed elimination of accelerated depreciation allowances will have significant negative effects on the attractiveness of investments in Australia to all classes of financiers;
the proposed changes in the capital gains tax will increase the attractiveness of investments in Australia to Australian residents but not to foreigners;
in total, the impact effect of the Ralph proposals will be a reduction in the attractiveness of investment projects in Australia to all classes of financiers;
the Ralph proposals will generate windfall gains to owners of recently established projects and windfall losses to owners of long-established projects;
the proposals amount to increase in the rate of taxation of capital income accruing to all classes of financiers; and
increases in the rate taxation of capital income balanced by decreases in the rate of taxation of labour income will have little long-run effect on employment and will generate long-run declines in Australia's capital stock and GDP. The short-run effects depend on the labour market. If wage bargains are made in real after-tax terms, the reduction in taxes on labour income would generate a short-run increase in employment. If, on the other hand, wage bargains are made in real before-tax terms, the short-run employment implications of the substitution of capital taxes for labour taxes are slightly negative.

We think that it would be technically feasible to make a detailed and convincing quantitative analysis of the Ralph proposals. However, given our resources this would take us at least 3 months. It is unfortunate that present-value calculations of the type reported here were not made available to the Ralph Committee and to the Senate Inquiry by the Treasury. The Treasury has much greater resources than we do for making detailed calculations and much easier access to relevant data.

Table 1. Characteristics of project starting in year t

Initial outlay in year t 2*(1+p₁)t(1+g)t

made up of

depreciable assets (1+p₁)t(1+g)t

non-depreciable expenses (1+p₁)t(1+g)t

Capital injections in year t+d 2*(1+p₁)t(1+g)t(1+p₁)d , d=20, 40, 60, 80

made up of

depreciable assets (1+p₁)t(1+g)t(1+p₁)d, d=20, 40, 60, 80

non-depreciable expenses (1+p₁)t(1+g)t(1+p₁)d, d=20, 40, 60, 80

Before-tax profits in year t+s 0.079022*(1+p₁)t(1+g)t (1+p₂)t+s , s=1, ...100

p₁ is the general rate of inflation, assumed to be 2% in our numerical examples,

p₂ is the rate of growth of profits, assumed to be 4%,

g is the real rate of growth of investment, assumed to be 3%.

The project is terminated after 100 years. Ignoring tax considerations, the internal rate of return of the project is about 6%.

Table 2. Tax, Dividend, Retention and Interest Assumptions

Current System Ralph Proposals

1. Company 36 per cent 30 per cent

taxes in all years from year 1 onwards

2. Marginal income tax 30 per cent

rate of both Australian

residents and foreigners

3. Capital gains taxation 30 per cent 15 per cent

on real realized gains on nominal, realized

gains

4. Depreciation allowance 10 per cent a 5 per cent a year

year for 10 years for 20 years

5. Dividend policy and Companies distribute half of post-company-tax

treatment of retained profits profits as dividends and finance capital injections

from retained profits. The balance of retained profits

is invested at 6 per cent. The final balance is returned to shareholders in year 100. In non-corporate

structures, all profits are distributed to the owners and

the owners finance capital injections from their own sources.

6. Discount rate for residents 4.2% [=6*(1 - 0.3)]

and for foreigners

7. Dividend imputation All dividends are fully franked

Table 3. Present value calculation for a two year firm

	Initial situation		Eliminate accelerated depreciation		Cut company tax rate
	Year 1	Year 2	Year 1	Year 2	Year 1	Year 2
FIRM
Project profit	100.0	100.0	100.0	100.0	100.0	100.0
Interest	0.0	2.8	0.0	2.4	0.0	2.5
Before tax profit	100.0	102.8	100.0	102.4	100.0	102.5
Depreciation	80.0	0.0	40.0	40.0	40.0	40.0
Taxable profit	20.0	102.8	60.0	62.4	60.0	62.5
Company tax rate	0.36	0.36	0.36	0.36	0.30	0.30
Company tax	7.2	37.0	21.6	22.4	18.0	18.7
After tax profit	92.8	65.8	78.4	79.9	82.0	83.7
Dividend	46.4	112.2	39.2	119.1	41.0	124.7
Retained earnings	46.4	0.0	39.2	0.0	41.0	0.0
Tax credits	-18.9	0.0	-0.5	0.0	0.4	0.0

SHAREHOLDER
Dividend	46.4	112.2	39.2	119.1	41.0	124.7
Tax rate	0.3	0.3	0.3	0.3	0.3	0.3
Tax	-4.4	21.0	-3.7	20.3	0.0	24.0
Benefit to shareholder	50.8	91.2	42.9	98.8	41.0	100.7
Present value at 4.2%	138.3		137.7		137.7

GOVERNMENT
Tax received	2.9	58.0	17.9	42.8	18.0	42.7

Chart 1. Present value of a new project in a company to an Australian shareholder