Bigger breaks for smaller business will come at a cost

Treasurer Joe Hockey’s surprising transformation into the ghost of Wayne Swan in this year’s Federal Budget has brought about some welcome tax breaks for a swathe of businesses at the smaller end of town. From 1 July 2015 businesses with an annual turnover of less than $2 million (coincidentally the Budget Papers suggest there are somewhere around 2 million of these) will receive a 1.5% tax cut (from 30% to 28.5%) if they are incorporated, or a 5% tax discount (up to a maximum of $1,000) where the business is not operated through a company (for example, where the business is operated as a sole tradership or partnership, or through a trust).

In addition such businesses will be able to obtain an immediate tax deduction where they buy capital items (such as vehicles, machinery, plant and equipment) each costing less than $20,000 from now through to 30 June 2017. Start-up small business will also be able to immediately expense legal and professional fees related to the start-up rather than write them off for tax purposes over five years.

And finally there are generous subsidies available for small businesses who take on new employees in the business, as well as new and more comprehensive capital gains tax roll-overs to allow small businesses to change the form in which they operate (for example from a sole trader to a trust) without adverse tax consequences.

So far so good. But, as ever, the devil is in the detail, and a lot of detail is still missing from the Budget Papers. What is certain is that the welcome tax breaks will come at a cost.

In the first place Treasury is likely to be aware that the new concessions will lead to gaming of the system – invoices for capital items just above $20,000 will be split so that a larger item will be divided into component items each coming in at less than $20,000; tax planning strategies will be implemented to ensure the 5% discount is maximised even when it may not strictly be available; and the incentive of a lower rate of tax may cause some individuals currently taxed as employees to seek ways to transform themselves so that they can take advantage of self-employed status.

In order to counter such moves, the legislation will be riddled with so-called integrity measures, further complicating the already overly complex tax system. Complexity causes the costs of complying with tax obligations to increase.

And, as the Budget Papers note (based upon research published in Australian Tax Forum in 2014 carried out by colleagues and myself), small businesses are disproportionately hurt by compliance costs. Whereas the largest businesses suffer tax compliance costs of $2 per $1,000 of turnover, and for medium businesses that cost is $12, the very smallest businesses face tax compliance costs of $90 per $1,000 of turnover. Those tax compliance costs, and their regressive impact, will inevitably increase as a result of these measures.

The existence of a two rate tax system for small business will also act as a disincentive for those businesses approaching the $2 million threshold to continue to expand and grow. At a turnover of $1.9 million and a taxable profit of $190,000 a small company faces a tax rate of 28.5% and a tax liability of $54,150.

If that turnover increases to $2.1 million, with a taxable profit of $210,000, the tax liability (now at 30 per cent) increases to $63,000. The company therefore pays additional tax of $8,850 and has encountered a marginal tax rate of 44.25% on the extra profits of $20,000 (figures courtesy of PwC). A similar analysis would apply to unincorporated businesses, potentially curtailing expansion plans.

There are also problems relating to the fairness of the measure. A fundamental criterion by which tax systems should be judged is the notion of horizontal equity – my dollar of income is taxed in much the same way that your dollar of income is taxed. The new lower small business rate not only drives a wedge between the tax rates of the employed and the self-employed; at certain levels of income it also provides the unincorporated self-employed businessperson with a lower tax benefit (for example the maximum $1,000 when business taxable profits are $100,000) than her incorporated counterpart (who would save $1,500 on $100,000 taxable profits).

Finally, we should beware the lessons of history. Some of these measures reflect something of a return to the past, and the signs from the past are not entirely encouraging. Instant asset write offs have featured in previous Budgets and have not lasted long.

We have also had a poor experience in recent years with the Entrepreneur’s Tax Offset, which attempted to do much the same thing as the small business tax rate and discount, albeit at a lower level. That particular offset proved remarkably difficult to calculate and to police, and was finally put out of its tortured and miserable existence in 2012.

Tax cuts are always welcome (at least to those who receive them), even if they are likely to lead to increased complexity and unfairness, and even if history tells us that fiddling with the tax system in this manner is not always effective.

But the lucky small business recipients of the Treasurer’s largesse should perhaps also hope that the monetary benefit that comes their way keeps them ahead of their financial losses as a result of bracket creep; and that it more than compensates them for the additional tax they will have to pay on their digital downloads of films, music and books as a result of the imposition of the so-called Netflix tax.

Chris Evans has received funding from the Australian Research Council and the Institute of Chartered Accountants in Australia for research into tax system complexity in Australia.