Peter Martin has a bit of a scoop this morning from a Canberra tax conference where apparently it has been revealed that:
A WORKING group set up by the Treasurer, Wayne Swan, is planning a shake-up that would see most companies pay no corporate tax and a smaller number pay a much higher rate of “super tax” on profits clearly above the odds.
…The nine-person working group, set up by Mr Swan after the tax summit, is examining a proposal known as Allowance for Corporate Equity, which would apply no tax to the portion of corporate profits necessary to get a reasonable return on equity. Most companies – especially manufacturers – fail to meet that hurdle and would pay no corporate tax.
Banks and mining companies make a much greater return on equity and so would be liable for the super tax on the excess portion of their earnings.
A working group member, John Freebairn from Melbourne University, told the conference the super tax rate could be as high as 40 or 50 per cent. He nominated McDonald’s and KFC as examples of companies able to make larger than normal profits because of the power of their brands.
“How are they going to get those profits from Australians without doing it in Australia?” he said. Good tax design said that if something couldn’t move, it should be taxed. Mining of Australian resources could also only be done in Australia.
The secretary of the ACTU, Jeff Lawrence, also on the business working group, told the conference the union movement would accept it on the condition the total company tax take did not fall. Another member, the Business Council, has spoken in favour of the idea.
Asked whether the change would be practical, Mr Heferen said it had been implemented in a number of countries although not on the scale of the GST.
“Belgium has one, Brazil and Italy had it, Latvia has it,” he said. ”But from what I can gather none have done it for the reasons we think it is useful … to attract capital and boost labour productivity.
This is certainly a radical idea. And in theory it would make a dramatic difference to the houses and holes economy in which the only major industry sectors that enjoy any profit growth are finance and mining, the ASX8 as it were.
So basically, it’s a tax on companies with high return on equity (ROE). At first the concept stirred up my libertarian passions. Why should successful companies be taxed more just because they are better at turning equity into profit? Such injustice! However, that’s a debate for a weekend musing after a few CC and cokes. From an investor’s perspective, the idea would have significant implications for listed companies. It also raises several questions.
What will the return threshold be?
The article hints at the threshold being considered, with the statement “Most Australian companies would pay no tax on their earnings”. I predict the threshold would lie between 7% and 12% given the sorts of ROE I’ve seen when examining listed companies.
I imagine the official calculation would be based on a risk free rate (like a government bond) plus a certain percentage to allow for business risk. I also imagine they’d want to fix it (rather than let it float with the risk free rate) in order to provide certainty and simplicity for business.
What is reasonable?
How will the “reasonable return on equity” value be calculated? Will it be a blanket % applied to all industries, or will it be industry-specific? This matters because the typical return on equity (ROE) for BlueScope is very, very different to a company like Seek. BlueScope has very large capital assets (e.g. blast furnaces), which inflates its equity base and puts their typical ROE in the 5 – 10% range (during the good times). Seek’s business is based on electronic systems and human capital. As such it has relatively little equity compared to BlueScope but is far more profitable, so ROE sit’s in the 50 – 60% range. Under a blanket %, a company like Seek would see it’s tax bill increase substantially.
What is included in equity?
Will equity include intangible assets such as goodwill and IP, or will it be based on net tangible assets or physical capital only? If the former, then companies would have an incentive to inflate their intangible values (and hence their equity levels) in order to reduce their ROE and tax bill. If the latter, what happens to companies with negative intangible assets? A company whose liabilities are larger than their physical capital would have a negative return on capital – how is that taxed under the new scheme?
Impact on debt levels
A positive development I can see coming from the ROE tax system would be a reduction in the appetite corporate for debt. Currently, companies can inflate ROE by loading up on debt to fund their business. The debt doesn’t show up in equity but typically adds to earnings (assuming the return on debt is higher than the interest rate). If companies wanted to avoid paying tax, they may choose higher capital levels over higher debt levels because their tax bill would be lower for the same amount of earnings. This would encourage more conservatism and help avoid debt-induced collapses.
Increase in awareness of return on equity
The fact the tax is based on ROE would bring the metric more into focus for equities investors. This can only be a good thing in my opinion. If investors were watching ROE (as opposed to easily-gamed metrics like earnings per share), then they would not have paid the ridiculous prices they did for ABC Learning prior to its collapse. Same goes for the current share prices of some low-ROE ASX stocks.
A boon for manufacturing?
Whilst the concept would at first seem like a good thing for manufacturers because of their low ROEs, the fact still remains that no company in Australia pays tax when it makes a loss. And making a loss is quite a common occurrence for our manufacturers. An ROE-based tax may reduce the tax burden in the good times, but it doesn’t change the fundamentals of a company that consistently fails to be profitable.
Post Script: Increased Tax Revenue Volatility
Taking more tax from fewer, more-profitable companies will make the company tax base more volatile. It’ll be rivers of gold during a boom, but during a bust those super-profitable companies will pay less or no tax. At about the same time as government expenditure increases due to welfare and stimulus – not a good scenario. This will be most evident in the mining companies – anyone remember what coal prices were in the early 2000’s?
Other unforeseen consequences
I have no doubt a change this radical would have other consequences, especially around company structures, M&A activity and remuneration. Would high-ROE companies go chasing stable, low-ROE companies to reduce their overall ROE and hence reduce their tax level? Is this a good thing? Would it unfairly punish online start-up businesses, which can have very little in the way of equity at the start but (relatively) high profits – making their tax bill quite onerous. This would seem counterproductive given the government’s commitment to the NBN and all things digital. Would we see an increases in remuneration levels, as it may be a better use of capital to retain staff through high wages than have high-ROE earnings taxed at 40 or 50%?
Despite my philosophical misgivings, it’s agood thing ideas like this are being considered. Tax reform is never finished. There could be several positive outcomes from an ROE-based tax, however the devil is always in the detail and the sting comes from the unintended consequences. Hopefully this is more than a thought bubble and some serious debate will ensue.
As an aside, it’s a little sad to hear that most Australian companies would not pay tax under the scheme. That speaks volumes about our ability to generate decent returns for shareholders – tax or no tax. That, in turn, raises the really important question about the power of those that are making big profits and what they would do if such a proposal became live.