Untangling the debate on bracket creep, corporate tax rates and negative gearing

Much of the current tax debate is mangled by poor analysis and misconceptions. Let’s consider three topics: “bracket creep”; corporate tax rates; and negative gearing.

The fact that inflation, more precisely wages growth, pushes individuals into higher marginal tax brackets has been advanced as the rationale for a variety of tax proposals. But the unacknowledged elephant in the room is the simple, rational, response to bracket creep – index the tax scales.

That is, if inflation was 5% over the past year and the 37% marginal tax rate previously started at an income threshold of $80,000, that threshold would be increased to $84,000 (that is, an increase of 5%).

It is legislatively and administratively simple. A low inflation environment makes this the ideal time to implement such a beneficial change which can counter profligacy of future governments, should high inflation return and induce higher tax revenues from bracket creep.

That one is simple. The real issues in the corporate tax rate debate, where many advocate lowering the rate, are more subtle – and missed by most of those advocates. Under our dividend imputation tax system, company tax payments are offset by lower investor tax payments when earnings are paid out as franked dividends to Australian investors. For such investors, lowering the company tax rate has (subject to a few caveats) no effect on their after tax returns from investment.

Who would benefit? Foreign-owned companies for one, for which the after-tax returns from Australian operations are increased (assuming they haven’t structured affairs to avoid tax anyway). That might induce more of them to establish or expand operations in Australia – although it should be stressed that our corporate tax rate, while above that of some Asian neighbours, is below that of a number of advanced countries. So arguments that our corporate tax rate is “uncompetitive” do not obviously cut the mustard.

Other beneficiaries would include private Australian companies owned by wealthy individuals on (hopefully) high marginal tax rates. For them, there are significant tax benefits from retaining earnings in the company rather than paying franked dividends.

Doing so avoids the extra tax payable at the personal level (after allowing for franking credits) due to their marginal tax rate exceeding the company rate. Instead retention of earnings (and franking credits) generates capital gains which may eventually be taxed at the concessional capital gains tax rate. So lowering the company tax rate would benefit these wealthy individuals (and does nothing for small private companies struggling to make a taxable profit).

A third set of beneficiaries might be Australian companies – but the source of any such presumed benefit is subtle. A benefit would arise if the cost of equity capital was reduced through a lower company tax rate.

As explained above, there is unlikely to be any such effect from a change in the required rate of return of Australian investors. Foreign investors might lower their required rates of return, but that is, at least, debatable.

Of course, one doesn’t need to lower the company tax rate to achieve this – a rebate of tax on dividends paid to foreign investors would achieve the same outcome. And the political resistance that would undoubtedly occur in response to such a proposal should indicate that relying on this argument for reducing company tax is untenable. And remember, our company tax rate is in the middle of the pack for advanced economies.

Finally, negative gearing. There is nothing wrong with negative gearing itself (although fraught with risk due to leverage). The problem is that there are undesirable tax benefits associated with it, arising from claiming current tax deductions for interest paid on financing an investment on which tax on returns will be deferred and at a concessional rate.

The solution? Removing concessional capital gains tax (or at least returning to full taxation of real capital gains) is part of the solution. But it is only part – because deferring tax payments until realisation of the asset sale implies a lower effective tax rate.

It would not be feasible to tax capital gains as they accrue, given the adverse cash flow consequences for investors. However, we could use a variant of the tax treatment of companies with carry forward tax losses, which are compounded up at the government bond rate to keep their real value until usable.

Quarantining currently deductible interest costs on negative gearing to offsetting income earned on the investment, plus carry forward of additional unused interest costs is one way to go. When the investment is eventually sold, or when income exceeds interest expense, those accumulated unused costs could be claimed for tax purposes.

This is not administratively complex, would be fairer for other taxpayers who ultimately pay for the concessions, and might reduce incentives for excessively leveraged investments.