Brian Fallow: Few gains with company tax cuts

COMMENT

Finance Minister Michael Cullen is not ruling out a cut to the company tax rate.

But he would not bet on it.

Other parties are filling the air with "me too" calls for a lower corporate tax rate.

Cullen, however, prefers targeted tax relief which will benefit at least some sectors of the business community.

The depreciation regime is to be changed so as to allow faster depreciation on shorter-lived equipment, such as computers, at the same time as imposing slower rates of depreciation on buildings. The net cost to the revenue (or benefit to taxpayers) would be upwards of $200 million.

Cullen also signalled last month that he is prepared to scrap the capital gains tax on superannuation schemes and actively managed unit trusts. That would remove a longstanding and investment-distorting anomaly, hitherto thought too fiscally costly to remove.

He has hinted next year's Budget may also include sweeteners to encourage workplace savings.

Forthcoming changes to the fringe benefits tax regime would also have a revenue cost.

In all, he says these measures are expected to cost more than $500 million.

A cut in the company tax rate from 33c in the dollar to 30c would cost a bit more than $600 million - if companies' taxable incomes stayed at the level they were at in the year ended June.

That is a quite a big if.

Cullen argues that much of the $900 million increase in the tax revenue from companies in the 2003/04 year is cyclical and could evaporate as the economy slows.

For a battling small business owner, the case for a company tax cut is simple enough. Any dollar the tax man takes is a dollar not available either to reinvest in the business or pay out to its owners.

A company cut, the argument goes, would increase investment and create jobs.

No doubt it would. The hard questions, though, are how much and at what cost?

The economy has managed to grow more than 20 per cent during the past five years despite the 33 per cent company tax rate.

An extra $600 million, which firms might or might not reinvest, is comparatively small beer in the context of an economy in which business spends more than $20 billion a year in capital expenditure (excluding buildings).

As a source of capital, it needs to be put alongside the $80 billion or so the banks have on loan to the business sector at the moment.

It is not obvious then that it would make a big difference to levels of business investment.

This form of tax relief would be of more use to foreign shareholders than New Zealand ones.

The reason is that company tax for New Zealand shareholders is only a withholding tax. The final rate of tax they pay on their share of a company's profits is determined by their personal marginal tax rate, which for the top 10 per cent of taxpayers is 39c in the dollar.

A lower company tax rate would mean smaller imputation credits attached to dividends and a greater chance of taxpayers facing a tax bill at the end of the year.

The wider the gap between the top personal and company rates, the greater the chances investment decisions will be made for tax reasons, which is inefficient, and the greater the effort put into tax planning.

And the more retained earnings are used as a means of sheltering income from the tax man, the stronger the case for a capital gains tax to catch it on the way out, so to speak.

New Zealand is a rarity among developed countries in not having a capital gains tax.

"If we had the Australian capital gains regime and Australian payroll tax regime we could probably more than halve our company tax rate," Cullen said on Tuesday in response to parliamentary questions.

He might have added that when the Australians cut their company tax rate to 30Ac the revenue cost was largely offset by base-broadening measures such as a tougher depreciation regime, which served to increase the amount of income subject to the tax.

The bigger question is what the opportunity of cutting the company tax rate would be, that is, what other forms of tax relief it would crowd out.

The cost would be about the same as scrapping the top personal tax rate, which would arguably be a more efficient way of letting small business owners keep more of the fruits of their enterprise.

A company tax cut would reduce the scope for adjustments to the thresholds at which higher income tax rates kick in.

Raising the threshold for the 33c rate from $38,000 to $43,000 would cost around $450 million. That would at least keep someone on the average wage on the right side of what is a steep increase in marginal tax rates.

The overarching question in all this is how much scope there is for tax relief.

Cullen told Radio New Zealand's Morning Report that the $500 million plus in targeted measures he has signalled did not leave a lot more wriggle room in the short to medium term.

That is, of course, a matter of opinion and increasingly a minority opinion among the political parties.

The Government had an operating surplus of $7.4 billion in the year to June 2004 or more than 5 per cent of GDP - healthy by any standards.

It was boosted by a downward revaluation of future liabilities to ACC claimants and retired public servants. Excluding those revaluations (which go up and down with interest rates), the operating surplus was $6.6 billion.

But that figure does not reflect money the Government spends on capital items, including student loans and contributions to the New Zealand Superannuation Fund. It includes all of the state-owned enterprise profits, even though the Crown receives only part of them in cash dividends.

After adjusting for all of those items, the bottom line cash surplus left to reduce debt was only a few hundred million dollars. Most years, the Government still has to borrow money, despite reporting operating surpluses.

Cullen's yardstick of fiscal virtue is to see the level of gross Crown debt continue to decline, not necessarily in dollar terms but as measured against the size of the economy.At the moment it is $35 billion, or 25 per cent of GDP, down from 35 per cent of GDP in 1999.

The Government's long-term goal is to reduce it gradually to below 20 per cent by 2015.

That is a less aggressive debt-reduction target than in the past.

"We have reached now, by any reasonable international standards, a prudent level of debt," Cullen says.

But it is important to keep a "downward bias" in the debt targets, he says, because the risks and uncertainties are such that if you are not aiming to reduce the debt ratio the outcome is likely to be that it goes up.

New Zealand owes the rest of the world about $109 billion (net of what it owes us). It is almost all private-sector debt.

That level of external liability relative to the size of the economy is high by international standards.

It is a source of vulnerability for the economy, as National leader Don Brash in a former life used to warn us and the ratings agencies regularly still do.

We pay a price for that level of international indebtedness in higher interest rates - about 1 percentage point, year in, year out, says Reserve Bank research.

But the reason the credit rating is not lower and the risk premium built into interest rates is not higher is that the Government accounts, by contrast, are a model of prudence, discipline and thrift.

We mess with that part of the New Zealand story at our peril.