Neil Warren and Richard Eccleston

This week saw the publication of a discussion paper on the reform of the federation. This document and next month’s Council of Australian Governments leaders’ retreat are timely given that most agree the commitment to tax and federalism reform seems to be flagging.

Not only is GST revenue growth slowing, but the prospect of the Commonwealth freezing (in real terms) special purpose grants to the states after 2017 will result in commonwealth funding to the states dropping from 28% of federal spending in 2001 to a projected 21% by 2024 – cost shifting on an unprecedented scale.

Although NSW and Victoria are presently benefiting from a short-term fiscal reprieve courtesy of their spectacular and equally unsustainable housing booms, the longer-term outlook for all states remains bleak.

Clearly, something will have to give.

Tuesday’s discussion paper raised the possibility of a commonwealth takeover of key state responsibilities such as funding public hospitals as an alternative. While this would restore balance to the federation there is little enthusiasm for such courageous reform in Canberra.

As a result of the emergence of this ‘fend for yourself federalism’, state governments will need to develop efficient and sustainable strategies to fund key public services into the future.

Increasing the rate or broadening the base of the GST have been the most widely discussed responses to this challenge. However, advocates of a revamped GST are increasingly thin on the ground.

Not only does the Labor Party, most premiers and the community sector remain opposed to increasing its rate, but tax experts are increasingly of the view that the GST will never be the growth tax many had hoped.

As the discussion paper points out, personal income tax is Australia’s largest and most robust tax with clear potential to fund state governments. Moreover, according to Treasury it’s almost as efficient in economic terms as the GST.

From a political perspective, it’s more progressive than a GST and should be more palatable to those concerned about equity considerations.

In practical terms, there are numerous precedents for income tax sharing in federal systems. Such arrangements exist in Canada, the US and Germany.

The fact that any new state income tax levies could be harmonised with the existing federal tax and administered by the Australian Tax Office would minimise administrative and compliance costs.

Given these benefits, its unsurprising that Tuesday’s discussion paper argues that allowing states and territories to access the personal income tax base could be a central element of a broader reform package.

Proposals to share the income tax base across the federation have real merit; however, there are a number of design issues which have to be carefully analysed.

The first question is whether the states and the Commonwealth should enter into a simple revenue sharing agreement whereby the states get a fixed percentage of personal income tax revenue. While this would give the states access to a growth tax it would do little to improve political accountability.

A more ambitious model would involve granting the states the power to set their own income tax levy or surcharge on the federal income tax base.

Such a regime would improve accountability and allow state governments to set state income tax levies based on local preferences and demand for services.

Despite improved accountability, allowing the states to set their own income tax rates has significant distributional implications which have hitherto been ignored in the Australian debate.

Quite simply, a per capita revenue from any residency-based state income tax levy would vary considerably between states because both income and employment levels vary across the states.

The bottom line is that wealthier states would benefit more from such a regime compared with poorer jurisdictions.

Our analysis suggests that a 3.2% income tax levy on income above $37,000 could raise $10 billion for the states and territories. However, the distribution of such a levy favours wealthier jurisdictions whereas poorer states would have to exert a greater tax effort to raise equivalent per capita revenue.

One way of representing the magnitude of these distributional consequences is by considering the income tax levy that different jurisdictions would have to impose to raise the same per capita revenue.

For example, Western Australia would have to impose a levy of 2.1% to raise its per capita share of a $10 billion levy. In contrast, this figure for poorer states such as Tasmania and South Australia would be 5.0% and 4.3% respectively.

What is clear is the design details of income tax sharing models as outlined in this week’s federalism discussion paper need to be analysed and debated in the coming months. The future of our federation depends on it.

Neil Warren is a professor in the school of taxation and business law at UNSW Business School. Richard Eccleston is a professor and director of the Institute for the Study of Social Change at the University of Tasmania. A version of this post appeared in The Australian.

John Taylor

In an ideal accounting world with a comprehensive income tax, all increases in a taxpayer’s stock of wealth in a given accounting period would be taxed at the end of that period.

If your investment property’s value went up in one year, for example, you’d pay tax on the increase at the end of that year (on an accruals basis). Likewise, all decreases in wealth would be deductible on the same basis.

Australia, like many countries, varies from this ideal by only taking capital gains and losses into account for tax purposes (CGT) when they are realised.

This model results in tax-induced distortions in investor behaviour. Capital gains and losses on assets are not given the same tax treatment as gains and losses on economically equivalent investments.

It’s the reason negative gearing is so popular. You get the deduction each year but don’t pay tax on the increase in the value of the asset until you sell it.

Two key distortions flow as a result of Australians only being taxed when they realise the gains on their assets. First, in the absence of an adjustment for inflation, inflationary rather than real gains are taxed.

Second, there’s a deferral advantage from having the gain on an appreciating asset taxed some time in the future as compared with investing in an asset which produces an annual return which is taxed each year.

Australia’s current tax law exacerbates the deferral distortion by: not taxing gains on pre-CGT assets; not taxing gains on a taxpayer’s main residence; and by discounting gains derived by individuals, trusts and superannuation funds.

One way to fix this distortion would be to continue to tax capital gains on all assets on a realisation basis, with an adjustment for inflation, but give no discount.

At the same time, there could be an additional compensatory tax on realisation. This would provide equal tax treatment with an investor who derived and was taxed on the same gain periodically over the same term as the owner held the asset.

For these ideas to be pursued systematically to their logical conclusion the following changes would also need to be implemented:

Prospective taxation of capital gains on all pre-September 20, 1985 assets and main residences by allowing a cost of market value at the date of introduction of the changed system; and regarding death as a realisation event with a rollover where the beneficiary is a spouse or dependant.

This approach would reduce the tax distortions affecting savings and investment decisions, resulting in a more efficient allocation of resources. The use of a broader base would provide revenue for a general lowering of tax rates.

It would also neutralise negative gearing as an investment strategy, since it only works because the interest deduction is allowed in the current year while tax on the capital gain is deferred until realisation (and then given a discount for individuals, trusts and super funds).

Amending taxation in this way would also increase vertical equity as capital gains are currently concentrated in the asset owning segment of the population. It would simplify tax legislation by removing more than 170 provisions presently in the Income Tax Assessment Act.

The proposal would also open up a more radical possibility – only taxing individuals and not taxing entities such as companies, trusts or superannuation funds. Distributions from companies, trusts and superannuation funds to individuals, and capital gains and losses on interests in these entities, would still be taxed at the individual taxpayer level.

Abolishing entity level taxation would be a radical response to profit shifting by multinationals. It would be expensive and would have to be phased in over time. Ideally, existing bilateral tax treaties with at least Australia’s trading and investment partners would have to be reworked.

Abolishing entity level taxation would represent a significant shift to taxing income (in the broad sense of “gain”) where individual investors reside.

Removing entity level taxation would enable further significant simplification of tax legislation by the repeal of whole divisions dealing with such matters as debt and equity rules, thin capitalisation, dividend streaming, franking credit trading and so on.

John Taylor is a professor and head of the school of taxation and business law at UNSW Business School. A version of this post appeared on The Conversation.

Fiona Martin

A recent decision of the Federal Court has highlighted that although using charities in Australia for tax avoidance purposes is not common, it can happen.

In February 2015, the Federal Court awarded the highest monetary penalty ever handed down against a taxpayer. The amount was $1.5 million. The court awarded civil penalties to the Australian Taxation Office (ATO) against Stephen Arnold, Leaf Capital and Donors Without Borders because they attempted to exploit the tax system by generating deductions for gifts to overseas charities to which their clients were not entitled.

In essence the arrangements, which dated back to 2009 and 2010, were that donors would enter into an agreement under which they paid 7.5% of the cost of certain drugs to be used in the treatment of HIV/AIDS in Africa.

These drugs were held in a warehouse in the UK. The balance of the purchase price of 92.5% was not payable until 50 years later. This meant that an initial outlay of $150 would technically enable a donor to claim a tax deduction of $2000.

A further issue at play was that these pharmaceuticals were never actually delivered to the African charities noted in the agreements with the donors.

In delivering his judgment, Justice Edmonds noted at least five grounds why the scheme was not available under the law, including that there was no actual delivery of the pharmaceuticals to the charities concerned at the relevant time and that the purchasers only paid 7.5% of the grossly inflated price of the drugs, yet claimed tax deductions of 100%.

Not only was there significant tax avoidance occurring in this series of arrangements but the judge also felt there was real immorality and a lack of any sense of contrition in the scheme promoters.

In coming to his conclusion Edmonds said: “Specific deterrence is a significant factor where, as here, the contraventions involved deliberate wrongdoing, sustained denials of contraventions and lack of remorse.”

He went on to state that “the penalties need to be substantial enough to persuade potential promoters that it is not worth the risk of whether a tax exploitation scheme will escape the detection by the Commissioner”.

But have these tax avoiders learnt their lessons? Interestingly, they had tried the same scheme in Canada in 2009. At that time, Canada’s equivalent of the ATO, the Canada Revenue Agency, had revoked the registration of the entity involved in the scheme on the grounds that the amounts claimed for the costs of the drugs were grossly inflated.

Yet, the Donors Without Borders website is calling for public support, claiming that almost $7 million worth of medicine was donated and delivered to sub-Saharan Africa in 2010, and that the ATO is trying to stop life-saving goods from reaching those suffering in Africa, being “more concerned about tax deductions than saving lives”.

This case is an incredibly blatant example of the use of charities and charitable giving for tax avoidance purposes. The perpetrators were probably caught because they were so flagrant.

But until 2012, it is quite possible that there were many more of these types of schemes going on. The ATO was the only government entity with the power to withdraw the privileges of tax deductibility of donations to organisations. Yet overseeing charities is not its main role nor is it its main area of expertise.

But the good news is, that since late 2012, Australia has had the Australian Charities and Not-for-profits Commission (ACNC). This federal government entity is charged with educating and regulating the charities and not-for-profit sector.  Like any such organisation is it not infallible.

However, unlike the ATO, it does have staff that is experienced and knowledgeable about charities and not-for-profits. It has the power to investigate and deregister entities such as Leaf Capital.

And the ACNC’s additional powers of registration of charities, and the public scrutiny that this allows, may also mean that these types of entities may be caught and weeded out much earlier that has happened with the Leaf Capital case.

The future of the ACNC has been in doubt since the 2013 federal election saw a change in government to a Liberal/National Party Coalition. Under the stewardship of Kevin Andrews as minister for social services, the Coalition initially mandated the abolition of the ACNC.

In late 2014, the Social Services portfolio was given to Scott Morrison and he indicated that he was not interested in pursuing the abolition of the ACNC. The latest development is the May 2015 federal Budget which has allocated funding for the commission until 2019.

This is particularly welcome as the not-for-profit sector has come out strongly in favour of the work the ACNC is doing.

Fiona Martin is an associate professor in the school of taxation and business law at UNSW Business School.

Chris Evans

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 July 1, 2015, businesses with an annual turnover of less than $2 million (coincidentally the Budget Papers suggest there are somewhere around two 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 $1000) 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 June 30, 2017.

Start-up small businesses 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 that take on new employees, 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 presently 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 on 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 $1000 of turnover, and for medium businesses that cost is $12, the very smallest businesses face tax compliance costs of $90 per $1000 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%) increases to $63,000.

The company therefore pays additional tax of $8850 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 $1000 when business taxable profits are $100,000) than her incorporated counterpart (who would save $1500 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 is a professor in the school of taxation and business law at UNSW Business School. A version of this post appeared on The Conversation.

Richard Holden

It seems it’s open season on tax deductions. Everyone from the Grattan and Australia institutes to the Australian Council of Social Service and the Australian Labor Party have concluded that the way to repair our budget deficit is to remove any tax deduction they can find.

Concessional superannuation taxation, dividend imputation, lower taxes on capital gains: all a boondoggle for the rich.

The whole public discussion around the matter is completely off the rails. There is way too much focus on who we tax and not nearly enough on how we tax.

The reason any tax deduction is allowed – including the ones mentioned above – is to remove distortions from the economy. Setting all taxes equal on all things actually tilts the playing field in favour of certain behaviours over others, such as consumption versus saving or debt versus equity.

Take capital gains tax. Australia, like every other advanced economy, taxes capital gains at a lower rate than ordinary income. Why? Because before money can be invested you have to earn it, and pay income tax on it.

So if we tax the investment earnings generated from saving at the same rate as well, people balancing the decision between consuming and investing will be much likelier to consume – the tax system is tilting the playing field in favour of consumption.

This is bad for saving, investment, growth and jobs. It is not a matter of ideology, it is a matter of primary school-level arithmetic.

This is a proposition so obviously right that even the intellectual du jour of the Left, the great French economist Thomas Piketty, agrees with it.

But in the context of the Australian discussion this policy is seen as deeply unfair – after all, those “tax breaks” go to wealthy people. Ya-huh: they are the ones saving and investing.

Dividend imputation is another case in point. The Murray and Henry reviews questioned the continued case for dividend imputation – comments echoed by a series of foot soldiers on those reviews such as former Treasury secretary Martin Parkinson and business figure Carolyn Hewson.

The two finest treasurers in Australian history, Paul Keating and Peter Costello, were apoplectic, and rightly so. (OK, Keating was apoplectic and Costello just distressed, but you have to factor out the baseline.)

Dividend imputation simply stops double taxation and avoids artificially subsidising debt over equity (since interest payments are tax deductible). What on earth is it being questioned for?

The sketchy argument offered by advocates of abolition is that it favours investment in domestic over foreign equities. The subtext is that it looks like a big pot of money to go after. After all, people received A$30 billion in deductions last year. Can’t we abolish imputation, take that money and run back to surplus?

Actually, no. And on that point, we should be incredibly wary of statements – all too commonly made – such as, “if we abolished X tax concession we would raise $Y billion”.

Whenever I hear someone say this I am reminded of the French expression that roughly translates as “and if my grandmother had wheels she would be a bicycle”.

Yes, maybe if people didn’t change their behaviours and tax arrangements it would raise that much. But if there is one universal principle that economists have established it is that people respond to incentives.

Change the tax incentives and people will change their behaviours. Governments never claw back so-called tax expenditures through policy changes — and they often create a lot of unintended (or unthought through) consequences in the process.

The central goal of any good taxation system is to raise a given amount of revenue in the least distorting way. Distortions change behaviours, shrink the economic pie, and make everyone worse off in the end.

Distributional concerns and equity are vitally important. The right way to address those concerns is through the transfer system. Transfers such as the family tax benefit, unemployment benefits and the aged pension are the right tools to use to address equity. Tax the wrong way and it reduces the growth engine that makes those transfers possible.

The bottom line is this: we should tax for efficiency and redistribute for fairness. That is unlikely to be the most popular bumper sticker at the next election. But it is a very sound guiding principle for tax policy.

There is far too much discussion about who we tax and not nearly enough about how we tax. We have wound back the clock on public debate about taxation to the pre-Keating era.

That’s more than a shame, it’s really dangerous.

Richard Holden is professor of economics at UNSW Business School. A version of this post appeared in The Australian.

Jeffrey Knapp

In the week after Easter, the Senate inquiry into corporate tax avoidance took evidence from a selected number of multinationals, including Google, Microsoft, Apple, Glencore, Adani and News Corp.

The inquiry didn’t pull these company names out of a hat. Rather, the companies have a reputation for engaging in aggressive corporate tax minimisation strategies. The inquiry asked them to explain the complex (legal) accounting and corporate structures they have used to minimise the tax they pay in Australia.

News Corp’s use of such strategies came to my attention after the Australian Taxation Office (ATO) took issue with related party transactions that created billions of dollars of foreign currency losses in Australia with offsetting foreign currency gains in Bermuda.

The ATO challenged the legitimacy of the deductions for these losses but was defeated in a final court case in July 2013. News Australia Holdings emerged with a tax refund of A$623.8 million together with interest of A$215 million.

In light of this case, I decided to calculate how much income tax the News Australia group has paid in the past decade. I obtained the annual financial reports of News Australia Holdings Pty Ltd for all years since its incorporation covering the 10-year period 30 June 2005 to 30 June 2014.

This publicly available information from our corporate regulator, the Australian Securities and Investments Commission, set me back A$380.

In Australia, checking the corporate accounting disclosures of billion dollar multinationals is a very costly exercise. It feels as if the government prefers the financial affairs of these companies not be publicly known.

According to my calculations, the net cash outflow of News Australia Holdings for corporate tax over 10 years amounted to A$326.4 million, or just 4.7% of operating cash flows before tax. On Easter Monday, my calculations appeared in Fairfax Media print and online publications.

Last week, News Australia CEO Julian Clarke sat at the Sydney Senate inquiry hearing and described my calculations as “absolute nonsense”, “hopelessly wrong” and “does not make any sense”.

I was publicly discredited before senators and afforded no right of reply – but that’s politics.

Given the choice of being transparent and chastened about its previous tax avoidance activities or discrediting an academic critic, News Australia can be expected to pursue the latter course of action.

My calculations covered a 10-year period, News Australia representatives presented their calculations which covered five years. They did not disclose the corporate taxes paid over 10 years. They did not explain why my calculations were wrong.

News Australia’s calculations appear to be internally inconsistent. Some amounts agree to the financial reports of the holding company while others do not. Their calculations also conflate corporate tax and withholding tax and omit the financial effect of the tax refund received in late 2013.

In the moment of my discrediting at the Senate hearing, it occurred to me that I shouldn’t have to be a lone voice on the corporate tax paid by News Australia.

If the information was genuinely available in the public domain, then anyone – including a senator – could do the sums and a public consensus view would inevitably arise.

At the same time of this revelation, I felt indirectly confronted by the effects of two persistent public messages about tax and responsibility.

The first is the “debt deficit disaster” slogan – a mantra that has been repeated in parliament for the past 12 months. This slogan has been the predominant political discourse intended to train individual taxpayers into accepting paying more tax or receiving fewer benefits in future.

The central tenet of the debt deficit disaster slogan is that mugs with wages and salaries but without access to Bermudan wealth transfers have to pay more for doctor visits, education, petrol or something else and expect less when they retire.

There has been a somewhat different echo coming from our federal parliament for businesses and corporations: “cut red tape”.

This slogan suggests that regulations stymie business activity, regulations are an unnecessary impost on companies, or regulations are for fools and don’t really matter.

The red tape slogan conveys the message that regulations are bad, therefore it is reasonable for businesses to avoid corporate tax, avoid public transparency and accountability, and avoid disclosures wherever possible. If it can somehow be construed as legal to avoid the regulations, then avoid them.

The central tenet of that slogan for business and companies is that corporate taxpayers can do less and take more. Only a corporate mug would not participate in this avoidance game.

The red tape slogan encourages loopholing, legal form over economic substance, and paying off an industry of avoidance advisers so as to get ahead in corporate tax and accounting affairs.

Unsurprisingly, the debt disaster slogan has failed to gain traction with the general public because the red tape slogan is its corollary. Most individuals I know have no problem helping out mates when times are tough but companies actively avoiding the country’s tax and accounting requirements are not mates.

The real problem is not the debt deficit disaster: it is disclosure. Individual wage and salary earners should not have to pay more or receive less until there is better disclosure of multinational financial and tax affairs.

How is it possible that parliamentarians have little idea about how much corporate tax multinationals are paying and need to call an inquiry to find out? It is beyond ridiculous.

These same multinationals have spent the past decade paying advisers to help them to avoid corporate tax and avoid accounting standards.

The requirements for related party disclosures and other tax relevant disclosures are treated with contempt. For example, paragraph 13 of AASB 1054 Additional Australian Disclosures is routinely ignored:

An entity shall disclose the amount of imputation credits available for use in subsequent reporting periods.

This is not rocket science. Everyone knows that sunlight is the best disinfectant. It is surely time to shine the light on the financial and tax-related information of multinationals.

These companies should be required to prepare general purpose financial statements every year that include details of all subsidiaries, full disclosures of related party transactions and balances, as well as a breakdown of the corporate taxes paid in Australia and other jurisdictions.

These general purpose financial statements should be freely available for public scrutiny rather than priced out of circulation through exorbitant government fees and charges.

The debt and deficit will continue until the worst of all the disasters is first attended to: the disclosure disaster.

Jeffrey Knapp is a lecturer in the school of accounting at UNSW Business School. A version of this post appeared on The Conversation.

John Taylor

The federal government has floated the idea of lowering the corporate tax rate – arguing the present rate of 30% is not internationally competitive.

The rationale is that globalisation makes capital perfectly mobile and the marginal non-resident investor in Australian companies will go where corporate tax rates are lowest.

At the same time, the government’s Re:Think tax discussion paper identifies some problems with Australia’s dividend imputation system (albeit recognising some of its advantages).

Under the present system, franking credits provide little or no benefit to non-resident investors in Australian companies – because the franked portion of a dividend paid to non-residents is exempt from Australian dividend withholding tax but does not generate a tax offset for them.

The relatively high corporate tax rate is said to deter foreign investors while the dividend imputation system does nothing to attract them.

Cutting the corporate tax rate across the board would be very expensive, although the cost may dissipate over time if the rate cut produced greater economic activity.

Importantly, the cut in the rate would apply to all companies, not just those with non-resident shareholders.

The revenue cost would be mitigated by a change back to a classical system of corporate-shareholder taxation – where corporate profits would be taxed twice.

For closely held domestic companies, a cut in the rate would encourage companies to retain profits as would a move away from dividend imputation towards a classical system or other forms of corporate-shareholder taxation.

Again, the revenue cost would be mitigated if we removed the 50% discount on capital gains, but this would also encourage profit retention unless capital gains were taxed more heavily than ordinary gains to compensate for the advantages of deferral.

If the problem lies in having a competitive tax rate for non-resident investors in Australian companies, why not have a solution targeted at those investors?

Why don’t we extend tax offsets on franked dividends to non-resident investors? The technical reason is that, for many resident taxpayers, tax offsets on franked dividends are refundable.

The prospect of giving refundable tax offsets to non-resident shareholders probably does not have a lot of political appeal – but it would be a less expensive way of giving these investors in Australian companies an internationally competitive corporate tax rate.

The extension of franking credits to non-resident shareholders would reduce the effective Australian corporate tax rate for non-resident investors in Australian companies in a targeted way.

Australia presently imposes withholding tax on the unfranked portion of dividends paid to non-resident investors.

Where the non-resident comes from a country with which Australia does not have a double tax treaty (DTA) the rate is 30%. Where the non-resident comes from a country with which Australia has a DTA the rate can vary between 0%, 5% and 15% depending on the level of investment and the particular DTA.

Currently, Australia exempts the franked portion of a dividend from withholding tax.

Where the non-resident shareholder resides in a DTA country, Australia could provide a targeted reduction in the effective Australian corporate tax rate that applied to the non-resident shareholder by imposing withholding tax on the franked portion of the dividend while allowing a proportion of the franking credit to generate a refundable tax offset for the shareholder.

Because of withholding tax rates in DTAs, to produce an even effective Australian corporate tax rate for investors from all DTA countries the proportion of the tax offset allowed would need to fall with the withholding tax rate.

For non DTA countries, we should continue our present policy of exempting the franked portion of the dividend from withholding tax and not allowing tax offsets. Generally we do not have DTAs with very low-taxed countries or with countries that are not significant trading and investment partners.

If the Australian corporate rate remained at 30%, extending tax offsets for franking credits to non-resident shareholders tapering down as the level of withholding tax decreased would reduce their effective Australian corporate tax rate.

For example, to produce a very competitive 15% effective corporate rate for non-resident investors Australia could, while maintaining its corporate rate at 30%, provide a full tax offset of where a 15% withholding tax applied, a two-thirds credit where 5% withholding tax applied and a half credit where a 0% withholding tax applied.

In all cases the effective Australian corporate tax rate for a non-resident shareholder would be a very competitive 15% at a lower revenue cost than under an across-the-board cut in the corporate tax rate and the benefits of dividend imputation would be preserved for resident shareholders.

John Taylor is a professor and head of the school of taxation and business law at UNSW Business School. A version of this post appeared on The Conversation.

Dale Boccabella and Kathrin Bain

The tax “conversation” Treasurer Joe Hockey is hoping to kick off has quickly moved on to a discussion about the goods and services tax (GST).

Last month’s tax discussion paper reminded us that Australia’s GST rate of 10% is one of the lowest among developing countries, and only just more than half of the OECD average.

It may therefore be tempting for government to take the “easy” approach of increasing the GST rate, which would require less legislative change than making various changes to the GST base.

However, it’s imperative Australia fully debates the GST base broadening issue before reaching for the relatively simpler option of increasing the GST rate on the present base.

A rate increase on the present base would put us in (or at least move us towards) the same category as countries such as the UK, which have a relatively narrow GST base with high rates. It would also run counter to the widely accepted tax mantra of “broaden the base and lower the rate”.

For many reasons, a “narrow base, high-rate GST” is poor tax design. For example, the distortions to production and consumption decisions are magnified because of the greater difference(s) between the taxed and non-taxed items.

In addition, inequities are compounded based on consumers’ spending patterns. It would also put us on the path to replicating the discredited wholesale sales tax, which was replaced by the “superior” GST.

GST systems are designed to tax private final consumption expenditure (PFCE). But if only a portion of PFCE is taxed, the whole point of a consumption tax is significantly undermined or compromised.

In 2012, Australia’s GST applied to 47% of PFCE. This is lower than the OECD average of 55%. New Zealand’s GST is a stand out, with 96% of PFCE taxed; it is seen as a model to aspire to.

The big untaxed items in Australia’s GST are basic food, financial services (financial services have a nominal amount of tax on them), health, medicines, education, aged care, childcare and water and sewerage.

Each of these has its own reasons as to why they originally were not fully included in the GST base. The inclusion of all these items would move Australia well up into the 90% bracket of PFCE coverage, a very desirable position.

Basic food was excluded due to equity grounds. While health and education have a small equity aspect, the main reason was the challenge of dealing with both private providers (where there is a price signal) and public providers (where there is no price signal).

Given the differing rationales for the original exclusion of each category, it is very unlikely one policy measure (outside or inside the GST) can address all concerns. That means that significant broadening of the GST base is likely to require a number of targeted solutions.

However, the regressive effect of a flat-rate tax applying to more categories of PFCE is a recurring theme. When items are exempted from the GST base, all consumers, regardless of income level, receive the benefit of the exemption.

The tax discussion paper highlights that while lower-income households spend a higher percentage of their income on GST-exempt items, in dollar terms, it is higher-income households that receive the most benefit from GST exemptions.

For this reason, subject to the comment below, compensation through the direct transfer (social security) system is the best method of delivering compensation for the regressive effect of broadening the GST base, rather than dealing with the regressive effect through concessional treatment within the GST base.

The problem with compensation is that many voters (and many politicians) do not have faith in future governments maintaining the level of compensation over the long term.

This distrust was at the heart of the Australian Democrats insistence that basic food be excluded from the GST.

Perhaps the solution lies in a “lock-in mechanism”. There is no doubt the GST rate and base lock-in mechanism has been very effective as a political check on the federal parliament acting contrary to it.

This is in spite of the fact the lock-in mechanism is legally meaningless.

A lock-in compensation mechanism would necessarily be very different to the GST rate and base mechanism. It is very likely a compensation mechanism would not be legally effective because our federal parliament cannot generally bind future parliaments.

But given the political sensitivities around the GST and the categories of PFCE listed above, there is every reason to think that a lock-in compensation mechanism could be politically effective.

Dale Boccabella is an associate professor and Kathrin Bain is a lecturer in the school of taxation and business law at UNSW Business School. A version of this post appeared on The Conversation.

Richard Holden

If you want a recipe for a really bad public policy debate, combine the following ingredients: taxes, government spending, children’s welfare, gender equity and jobs.

However, there is one simple answer to the debate on childcare in Australia. Taxation.

The Productivity Commission has now delivered its long awaited report on the matter. Its answer? It’s all terribly complicated. According to the commission, we need sliding scales and means tests, carve outs and exemptions. It’s all a balancing act that can only be performed by a bureaucrat’s Excel spreadsheet.

I’m not convinced. It’s much simpler than that. Just make it tax deductible.

The reality is that childcare subsidies are not very complicated. We don’t need big, thick reports to get to the right answer. And we can do away with most of the agonised commentary as well.

So let’s take a deep breath and get back to first principles about childcare subsidies.

Why does the government subsidise some things and not others? Two reasons. The first is dignity. We believe that everyone who lives in Australia should have a basic level of human dignity.

So we provide a basic level of services for health, education, housing and other things. And so we should. It’s part of what makes Australia a great country. In some cases, this will also include the provision of childcare. For disadvantaged parents, affordable childcare can be essential to the ability to earn a basic living.

Existing policies on childcare also reflect this understanding, though rising costs may be putting access of this kind under pressure.

The second reason government subsidises things is because free markets – though great – don’t always get everything right. In the language of economics, sometimes there are “externalities”. Government subsidies are a way of “internalising” those externalities – a way of preserving the magic of the market, but getting the price signals right.

And so it is—or at least should be—with childcare. The market, left to its own devices, would provide too little and parents would consume too little childcare.

Why? There is a swathe of evidence – such as that from Nobel prize-winning economist Jim Heckman – that quality early childhood care has particularly large benefits for disadvantaged children.

Formal childcare can be essential to addressing the needs of disadvantaged children in ways that mean they also require less support from society later in life. This is the whole idea behind “head start” or early intervention.

Affordable childcare is also important to supporting job-market participation by parents, and particularly women. This has important gender-equity implications, which society as a whole should care about.

But it also has critical economic implications in terms of job-market participation and overall workforce productivity. Remember that G20 pledge Tony Abbott (correctly) made?

With taxes on income and a free market for childcare, parents rationally under-consume childcare. The playing field is tilted in favour of them doing more of it themselves because they are not taxed on the labour they provide in taking care of kids, but have to pay in after-tax dollars for market-based childcare.

Tax deductibility of childcare levels the economic playing field. Case closed.

There may be good arguments – based on dignity and the needs of disadvantaged children – for providing childcare subsidies. Those subsidies should also keep pace with changes in the costs and structure of the industry in ways that may warrant some form of government Excel spreadsheet.  But the key challenge on childcare is about economic participation.

In this context, we subsidise childcare not because it’s like healthcare, or a basic right, but because income taxes distort people’s decisions about how much time to spend at work versus at home.

Those  income taxes are vital for a whole range of reasons, but when they distort other decisions – such how much to give to charity – we fix it by making things tax deductible. And that’s precisely what we should do with childcare.

There is, of course, a complicated set of questions about who should provide childcare, and standards and accreditation. Sometimes, we might have good reason to want to insist that children be cared for in a formal setting: there are strong arguments for the educational and social benefits of formal daycare.

These benefits may also be especially important for disadvantaged or socially isolated children. In other contexts, we might think that parental flexibility, or individualised care, is more important.

But just because the government pays for (part of) something doesn’t mean they need to set up a separate agency to oversee how it is provided. In most cases, we think that parents are well placed to decide how best to spend any subsidy, or tax-deduction, they receive for childcare.

Anyone who has children knows that caring for them is a joy, a privilege, and a responsibility freely taken up. Work is also important. It gives people another sense of purpose, affords the dignity of providing for oneself and a family, and produces tax revenue for the government.

How to balance those things is perhaps the greatest challenge a working parent ever faces. The choices can be wrenching at times. But for government, the answer is simple:

Make childcare tax deductible. Provide a subsidy for those who earn below a certain income. Then stop.

Richard Holden is a professor of economics at UNSW Business School. Twitter: @profholden

Dale Boccabella and Kathrin Bain

Under Australian law, changes to the GST are said to be not permitted unless the states agree to the changes. In reality, the GST lock-in mechanism is legally meaningless and unenforceable, though it may still hold political weight.

Section 11 of the A New Tax System (Managing the GST Rate and Base) Act 1999 provides that:

“the rate of the GST, and the GST base, are not to be changed unless each State agrees to the change”.

Similarly, section 1-3 of the GST Act states that:

“the Parliament acknowledges that the Commonwealth will maintain the rate and base of the GST in accordance with the Agreement on Principles for the Reform of Commonwealth-State Financial Relations endorsed at the Special Premiers’ Conference in Canberra on 13 November 1998”.

These legislative provisions and the Intergovernmental Agreement are referred to as the GST lock-in mechanism.

The legislative GST lock-in mechanism is contained in Commonwealth pieces of legislation. Despite the fact that the GST revenue collected is distributed to the states, these pieces of legislation are not Acts of state parliaments. Accordingly, it is the legislative power of the Commonwealth that is relevant when determining whether the GST rate and base can be modified contrary to the lock-in mechanism – that is, without state agreement.

The Commonwealth Constitution grants the Commonwealth Parliament the right to make laws in respect to taxation. Section 1 of the Constitution states:

“the legislative power of the Commonwealth shall be vested in a Federal Parliament, which shall consist of the Queen, a Senate, and a House of Representatives”.

There is no mention of any other body (for example, state governments) having any power in relation to Commonwealth law-making.

The current GST lock-in mechanism is in conflict with section 1 of the Constitution, (which vests the legislative power of the Commonwealth solely in the Commonwealth Parliament) because it purports to grant a veto power to the states in regard to the GST, and is therefore constitutionally invalid.

In order for a GST lock-in mechanism to be valid, section 1 of the Constitution would need to be amended to include a grant to the states of a veto power over Commonwealth GST legislation. Such constitutional change could only be achieved by way of referendum.

In spite of the above, the Commonwealth government has a signed agreement (the Intergovernmental Agreement) with the states that contains the lock-in mechanism. Since the legislative provisions are invalid, does such an agreement provide an alternate avenue for enforcement of the lock-in mechanism? It depends whether the government has the authority to enter into such an agreement.

The key factor in addressing this is whether the executive under the Constitution (that is. the government) has the authority to enter into such an agreement.

Section 61 of the Constitution gives the government the power (and effective responsibility) to implement and maintain the Constitution and the laws of the Commonwealth. The GST lock-in part of the Intergovernmental Agreement is attempting to circumvent a central pillar of the Constitution – that is, the sovereignty of the legislative branch of the Commonwealth government – by granting a veto power over certain areas of its legislative competence to the states.

If the High Court enforced the GST lock-in mechanism, it would be sanctioning a change to the Constitution without requiring use of the referendum process (that is, contravening the Constitution rather than maintaining it). The High Court will not do that.

Overall, neither the legislation nor the Intergovernmental Agreement would legally prevent the Commonwealth government from changing the GST rate or base. However, this does not mean that the Commonwealth government won’t seek the approval of the states before making any such changes.

Laureate professor Cheryl Saunders has stated: “Agreements that have no legal effect either as contracts or through legislation, nevertheless may be significant as a form of ‘soft law’, effectively guiding executive action, often complementing the operation of legislation and sometimes affecting the interests of third parties.”

Indeed, consulting the states has been the practice in regard to the numerous amendments to the GST since its introduction. From a political point of view, the Commonwealth government of the day would need to consider the inevitable community backlash it would receive if changes were made to the GST despite state opposition.

Therefore, while the GST lock-in mechanism is unenforceable, the Commonwealth government (regardless of political party) may still feel obliged to comply with it. It must also be remembered that the Senate is a central part of the Commonwealth Parliament, and therefore must approve any legislation passed by the House of Representatives before it becomes law.

Dale Boccabella is an associate professor and Kathrin Bain is a lecturer in the school of taxation and business law at UNSW Business School. Solicitor Bruce Gordon also contributed to this article. A version of this post has appeared on The Conversation.