Tax working group: The corporate tax rate

The Tax Working Group has released their report, as you all already know.  The recommendations are as expected, so its not particularly exciting in that sense.

However, there are some issues I would like to discuss – lets start with the idea that we “urgently need to cut the corporate tax rate” if Australia does.

Currently there is talk that, if Aussie cuts the corporate tax rate to 30% we need to do the same immediately.  We are told this as if it is a self-evident truth, and told that if we don’t all investment will head to Australia.  This is a touch over the top.

In Australia and in New Zealand there are a whole bunch of “potential investments” that offer varying rates of return.  Now, New Zealand is a small open economy, so we have access to all the credit we want from overseas – as long as the rate of return on that credit (adjusted for risk) is equal to the global rate of return.  So the “supply curve is perfectly elastic”.

A higher corporate tax rate in New Zealand reduces the profitability of investment, which in turn implies that the rate of return for each project is lower.  As a result, a higher corporate tax rate (in a sense) shifts the demand for capital to the left.

As a result, when setting the tax what matters is the “elasticity of demand” for capital investment in New Zealand – not the tax level in Australia.

Will a higher corporate tax rate reduce investment, yes.  It does so by preventing “marginal” projects from occurring – those that offer the lowest benefit.

But it must matter somehow!

The corporate tax rate overseas matters insofar as it changes the “global rate of return” on investment – so if all other countries cut their corporate tax rate, the required rate of return would be higher.  As a result, foreign tax arrangements do impact on what rate of return we have to achieve to get foreign investment.

However, the welfare impact of the tax, and whether we should cut the corporate tax rate depends on the elasticity of demand for investment – it is not a fact that we should attempt match Australia’s tax rate.

6 replies
  1. Andrew Coleman
    Andrew Coleman says:

    Hi Matt

    There is a different perspective on these matters. A large fraction of investment is funded from the reinvested profits of firms. Thus factors that change firm profitability will change investment. If you tax firms more highly, they have fewer profits for reinvestment. Thus
    (a) if Australia has a lower corporate tax rate than NZ, it may have more investment in industry. Moreover, the most profitable firms will expand at a faster rate than the less profitable firms, leading to a “slow elimination of the least fit” evolutionary dynamic.
    (b) NZ firms may choose to locate in Australia as a way of preserving their profits and thus investing more and expanding more quickly.

    Of course this argument depends on the effective rate of tax, not the headline rate of tax. Jurisdictions with lots of tax deductibility exemptions etc which lead to low effective average corporate tax rates are likely to do well in these circumstances.

    According to the excellent Australian Tax Working Group paper, “Taxing Capital income – options for reform in Australia” (by Sorensen and Johnson)in 2004 corporate taxes as a fraction of total taxes were higher in NZ than any other OECD countries….except for Norway and Australia. So perhaps we shouldn’t be looking as closely at Australia as the rest of the OECD, where effective rates of corporate taxation are quite a lot lower.

    As an aside, and as someone with only a very loose attachment to the working group (I attended one session) I find it strange that the group appears to have ignored the possibility of dedicated social security taxes. Australia and NZ are the only two OECD countries not to have them. For this reason capital income taxes as a fraction of total taxes are higher in Australia and NZ than anywhere else in the world (Australian ranked 1, NZ 2), and taxes on labour (as a fraction of the total tax take) are lower than almost anywhere (Australia ranked 3 to bottom, NZ ranked 2 to bottom, Korea 1). We are noticeably different here, but no-one in the TWG seemed to think that this was worth examining. These taxes normally only apply to labour income, and thus mean the incentives to save and invest are not distorted as much as capital income is less highly taxed.

    Andrew

  2. Matt Nolan
    Matt Nolan says:

    @Andrew Coleman

    Hi Andrew,

    Very true, good comment.

    “So perhaps we shouldn’t be looking as closely at Australia as the rest of the OECD, where effective rates of corporate taxation are quite a lot lower.”

    I see this part as key, as it is the global tax situation that helps establish the equilibrium risk adjusted rate of return which will lead to investment.

    “For this reason capital income taxes as a fraction of total taxes are higher in Australia and NZ than anywhere else in the world (Australian ranked 1, NZ 2), and taxes on labour (as a fraction of the total tax take) are lower than almost anywhere (Australia ranked 3 to bottom, NZ ranked 2 to bottom, Korea 1).”

    When it comes to looking through tax policy I expect to see the following steps:

    1) Look for taxes that increase efficiency,
    2) Once that’s done, try to establish a tax system that treats all factors equally,
    3) Once that’s set, adjust relative tax rates based on elasticities,
    4) Once that’s done, think about equity (in essence this should occur separately through the welfare system).

    I get the feeling that, outside of the land tax discussion, the third point sort of got lost. I lack of willingness to engage on this point could be behind the lack of discussion on a social security tax.

  3. steve
    steve says:

    you are also assuming away distance, add transaction and transport costs to the mix and you get a different set of results. once location is included it is the global rate of return, as observed from NZ. It is the as observed part that is hugely affected by the Australian corporate tax rate. In fact because of the increased transport costs and transaction costs (related to distance) for a firm based in NZ, our corporate rate should be even lower than Aus to have the same observed global rate or return.

  4. Matt Nolan
    Matt Nolan says:

    @steve

    “you are also assuming away distance, add transaction and transport costs to the mix and you get a different set of results. once location is included it is the global rate of return, as observed from NZ”

    Yes. The rate of return required for capital to come to NZ is higher. But, it is still a flat supply curve.

    “In fact because of the increased transport costs and transaction costs (related to distance) for a firm based in NZ, our corporate rate should be even lower than Aus to have the same observed global rate or return.”

    This does not necessarily follow. We aren’t trying to set it up so that the implied rate of return is the same as other countries per see – we are trying to raise income for our nations preference for government spending at the lowest cost.

    In reality, if the “demand for capital” is sufficiently different in NZ, then our corporate tax policy should be different.

    Sorry for the delay replying, I missed the comment earlier and only found it again when I was looking up corporate tax on google 😛

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