Company tax-cut doubters ignore economic dynamism

Nokia phones, Kodak cameras and the Netscape browser once dominated their markets. But they withered because they failed to respond fast enough to changes in society and technology.

These examples, and many others, show the best businesses respond quickly to opportunities by innovating and investing.

New opportunities will open up with a cut in company tax, and perceptive businesses will see the cut’s potential to encourage growth.

A static view says the tax cut is just a gift to large business or foreigners. But in such a static world, Nokia, Kodak and Netscape should still dominate their industries. That is a fantasy world where businesses don’t respond to a changing environment.

Yet a static view has formed a common argument against the company tax cut. It has been claimed that the cut will provide a windfall to existing businesses (an argument that effectively ignores the imputation system); or a windfall to existing shareholders, including foreigners; or a windfall to foreign governments. Or somebody has searched out a handful of businesses that won’t respond to the tax cut.

This all misses the point: the benefits of the tax cut are entirely about dynamic effects, not what happens to existing operations. If businesses don’t respond to tax rates, then it doesn’t matter whether the company tax is 0% or 100%.

So estimates of the dynamic responses are essential, and these have been provided in modelling by Treasury, Independent Economics and KPMG. The Independent Economics assumptions about tax avoidance have been criticised, but that doesn’t invalidate the other results, which show substantial benefits of the tax cut.

The Treasury modelling finds that the increase in yearly national income ($11bn) is more than 2.6 times the net revenue cost ($4.2bn) — and the increase in income includes the revenue cost.

Some sleight of hand can obscure these benefits; for example, the benefits can be converted into growth rates: Treasury has wages set to grow by 0.05% per year over 20 years. But both costs and benefits must be compared in exactly the same way. On this basis, the reduction in tax revenue growth for all governments is 0.04% per year over the same 20-year period. Noting that total wages are significantly larger than total taxes, this seems an advantageous trade-off. Similarly a total revenue cost over 10 years should be compared with a total benefit over 10 years.

These modelling results assume a dynamic economy, where there is increased investment due to the tax cut. There are plenty of ways to critique the models as being unrealistic, but a model, by definition, simplifies from reality. And some of these assumptions mean that the model underestimates the benefits of the tax cut.

In particular, the assumption of no unemployment means the increased jobs from the tax reform are substantially understated. The models also appear to omit the benefit caused by increased investment from retained earnings. In addition, the tax cut may actually reduce inequality, because much more of the benefit goes to wages than existing shareholders (particularly according to modelling by Janine Dixon), with share ownership concentrated among the rich.

All these issues seem to be missed in the criticisms of the modelling.

But even setting aside the modelling, we can focus on the strong evidence from the real world.

Shadow Assistant Treasurer Andrew Leigh, in a 2010 article for the Australian Financial Review, promoted evidence that “most of the impact of a corporate income tax rise falls on workers”, with a tax hike (or cut) of 10 percentage points leading to a decline (or increase) in wages of 6-10%. Similar results are in many studies of real world evidence surveyed by the Centre for Independent Studies.

The growth in wages is a result of substantial increases in investment, which are also revealed in many real-world studies — including a paper by Simeon Djankov and others in 2010 finding that the corporate tax rate has a “large adverse impact” on investment and entrepreneurial activity, and evidence cited in the Henry Tax Review that a one percentage point increase in company tax would lead to a decline in foreign direct investment by 3.72%.

Of course, we could disregard all this evidence of the dynamism of economies. But then we are living in a static world where mobile phones are still dominated by Nokia, cameras by Kodak and web browsers by Netscape. Not a world we recognise.

Greg Lindsay is Executive Director, and Michael Potter is a Research Fellow, at the Centre for Independent Studies