Living standards and well-being are generally high, though challenges remain in gender gaps and in greenhouse-gas emissions, and further challenges arise from population ageing.
Low interest rates have supported aggregate demand but are also ramping up risk-taking by investors and driving house prices and mortgage lending to historical highs.
A fall in house prices and or demand could have significant macroeconomic implications. Specifically, the market may not ease gently but develop into a rout on prices and demand with significant macroeconomic implications.
Macrofinancial indicators underline the threat from the housing market, with house prices and related indicators (house indebtedness, bank size), pointing to continued vulnerability. Any impact will most likely be through aggregate demand than financial instability.
They advocate tight macroprudential measures, improved housing supply, and reducing banks’ implicit guarantees by developing a loss absorbing and recapitalisation framework.
They support a cut in company tax, and an expansion of the GST, switching from transaction taxes (like stamp duty) to land taxes.
They say the economy is now rebalancing following the end of the commodity boom, supported by macroeconomic policies and currency depreciation. The strengthening non-mining sector is projected to support output growth of around 3% in 2018 and spur further reduction in the unemployment rate.
Improving competition and other framework conditions that influence the absorption and development of innovation are key for restoring productivity growth.
Innovation requires labour and capital markets that facilitate new business models. Productivity growth could be boosted through stronger collaboration between business and research sectors in R&D activity.
Australia’s adjustment to the end of the commodity boom has not been painless. Unemployment has risen, and there are increasing concerns about inequality.
In addition, large socioeconomic gaps between Australia’s indigenous community and the rest of the population remain. Developing innovation-related skills will be important for the underprivileged and those displaced by economic restructuring, and can help reduce gender wage gaps.
Externally, Australia, as always, is exposed to the vagaries of global commodity markets and this might include a renewed plunge in prices (or, positively, a strong resurgence). Australia’s iron ore production is among the lowest cost in the world and therefore comparatively insulated from such developments, however its coal sector is relatively more exposed as its production is distributed across the cost curve. Interaction of downside scenarios is likely to exacerbate the negative macroeconomic outcomes.
For instance, a negative external shock could lift unemployment sharply which would result in significant fall in consumption and rising mortgage stress and falling house prices. The economy is well positioned to handle shocks. The speed and strength of the rebalancing processes in response to the end of the commodity boom auger well for the economy’s shock-absorbing capacity. In addition, Australia has more reserve capacity for monetary and fiscal stimulus than many other OECD economies.
The Howard government, when flush with revenue, made a bad tax decisions which continue to haunt current policy makers. It removed the tax on the retirement phase of superannuation, this has been partly resolved by current government’s recent changes. But the Howard government also replaced the full taxation of real capital gains with concessional treatment of capital gains (only 50% of gains taxed). This remains as a tax avoidance loophole which both parties acknowledge but are reluctant to act upon.
The reason is straightforward. Assets put into superannuation in the accumulation phase and held until the retirement phase, can then be sold with no, or minimal, capital gains tax payable. This a major incentive to put assets into super and hold them until the retirement phase.
Without further changes to superannuation taxation, this is simply going to worsen the social problem of the well-off adopting tax minimisation strategies by piling as many assets into super as possible. Remember, it will still be possible to contribute up to A$100,000 per annum as non-concessional contributions.
Consequently, the well-off could easily build up a pool of assets of several million dollars or more, which when sold in retirement will still get very, very, favourable capital gains tax treatment under super.
If superannuation assets in retirement are under the A$1.6 million cap, no tax will be payable on capital gains from sales of assets. If assets are above the cap, the tax rate applied to capital gains is 10%.
For example, an asset costing $100,000 and held for 15 years, increasing in price at an average of 7% per annum would be sold for $276,000. If in super, tax payable would be $17,600. If outside of super, on the top marginal tax rate (including levies) of 49%, the tax payable would be $43,096.
If the concession on capital gains tax was reduced (without addressing the concessionary rate in super), the incentive would be even bigger. For example, if the concession was reduced to 25%, tax payable on the capital gain outside of super would be $64,644, an even larger gap to the tax payable in super of $17,600.
Putting $100,000 per annum into super for 15 years with an average 7% capital gain per annum generates a portfolio worth $2.7 million. The capital gains tax savings on this being in super, rather than outside, are more than $1 million!
So, what are the consequences if a brave government elects to reduce the concession applied to capital gains tax? If they make no changes to super tax arrangements there are at least two likely consequences.
First, there is increased incentive for individuals to set up self managed super funds to exploit these tax arbitrage or minimisation loopholes.
Second, despite taxation of earnings on retirement income balances over the A$1.6 million cap, maximising non-concessional contributions into self managed super funds will remain attractive, to take advantage of the difference in capital gains tax rates on assets inside versus outside super – to the detriment of future government budgets.
The consequences for self managed super funds incentives to borrow (via non-recourse arrangements involving trusts) to purchase assets such as property are unclear. As described on one adviser’s website:
Such borrowing will enable trustees to acquire assets over and above the assets that can be obtained from contributions. The caps on contributions can therefore be “overcome” by such borrowings.
However, it is doubtful that there are tax arbitrage benefits from using leverage to purchase assets via super (because higher marginal tax rates mean higher tax deductions for interest on borrowings outside of super).
For reasons of social equity, any general changes to the capital gains tax rate will also need to address capital gains tax within super. Admittedly there is already a lower concession in the case of super (two-thirds of gains are taxed versus one-half).
But that means taxing capital gains in super at only a 10% rate, leaving strong incentives to thwart higher capital gains tax by locating assets within super. Failing to reduce the capital gains tax concession in super would be likely to undo a substantial part of the effectiveness of any general changes the government has already made.
Author: Kevin Davis, Research Director of Australian Centre for FInancial Studies and Professor of Finance at Melbourne and Monash Universities, Australian Centre for Financial Studies
Eight years after the global financial crisis (GFC), economic growth remains weak in many rich nations. Australia has been an exception to the malaise, but growth has slowed as the mining boom winds down.
Business investment is vital to economic growth and to lifting living standards, but a new Grattan report explores why Australian business investment is plummeting. Australia is now experiencing its biggest ever 5-year fall in mining investment, as a share of GDP. Non-mining business investment fell from 12% to 9% of GDP after 2009 and remains unusually low. Why is it low, and what should we do?
The shift to services has reduced investment
Most of the gap in investment between today’s non-mining investment rate and that of the early 1990s is due to long-term structural changes in the economy.
The non-mining market sector slowly became less capital intense, it shifted towards capital-light services, and it shrank as a share of GDP. Together, these factors have reduced non-mining business investment by almost 2% of GDP since the early 1990s. In the chart below, the decline in investment needed to offset “capital consumption” reflects declining capital intensity across the non-mining economy.
These declines are benign. Many non-mining industries now require less capital per dollar of output than they did in the past, because equipment is better and cheaper, in part thanks to the rise of China as a manufacturer. The shift to capital-light services largely reflects households choosing to spend more of their income on these services as their incomes grow.
The role of output growth
A less benign factor, slow output growth, has cut non-mining investment by about a percentage point of GDP compared to 1990, and about two percentage points since the boom years of the mid-2000s, when above-trend growth and buoyant financial conditions drove very strong investment. The role of growth can be seen in the chart above.
In turn, output has grown more slowly for two reasons: slower potential output growth, and a widening gap between actual and potential output.
The potential growth rate of the economy has declined in recent years. The International Monetary Fund (IMF) estimates that potential GDP is now growing at just over 2.5% a year, about a percentage point below its pace between 1995 and 2004.
Potential growth (the rate of output if all resources are being used efficiently) has declined mainly because productivity growth has slowed and the working-age population is growing more slowly. Productivity growth was exceptionally weak between 2004 and 2010. It recovered in recent years, but remains weaker than it was in the 1990s and early 2000s. The working-age population is growing more slowly, mainly because of a decline in net migration since its peak in about 2012 and, in part, because the population is ageing.
In addition, actual growth has been a bit slower than potential in recent years. The IMF estimates the gap between actual and potential output to be about 1.7% of GDP, though it is difficult to estimate with much precision. Several pieces of evidence suggest that actual output is below potential. Inflation is relatively weak and there is some spare capacity in the labour market. The capital stock is ample given the current level of output: office vacancy rates are high, while business capacity utilisation is close to its long-term average.
Transition from the mining boom may have made it difficult for the economy to operate at potential. As mining investment falls, demand for construction, in particular, weakens. In theory, as the terms of trade and mining investment decline, the real exchange rate and other prices can change to maintain full employment. But in practice, slow output growth is common after mining booms, perhaps because businesses and workers take some time to reassess their opportunities.
What next?
Looking ahead, if output growth remains subdued, the current level of non-mining business investment may be the “new normal”. If the economy continues to rebalance, non-mining investment is likely to increase. There are encouraging signs that non-mining investment responds to the exchange rate and other aspects of the business environment in the medium term: it has begun to pick up in NSW and Victoria. Output could even grow above potential for a few years, as the IMF and RBA both forecast. But investment is not likely to return to the levels of the mid-2000s.
Is a company tax cut the answer?
The government has proposed cutting the company tax rate from 30% to 25%, largely on the basis that the competition for mobile capital has intensified (see chart below). That would attract more foreign investment and could increase total business investment by up to half a percent a year. But such a cut would also reduce national income for years and would hit the budget. Committing to a tax cut before the budget is on a clear path to recovery risks reducing future living standards.
Other company tax changes could help. An allowance for corporate equity would make currently marginal investment projects more attractive, though highly profitable firms would pay more tax.
Accelerated depreciation would encourage investment, as would moving from today’s model to a cash flow tax. Both of them help firms to reduce tax paid at the time they make investments. But they would hit the budget hard in the early years, and would have to be phased in slowly.
An allowance for investment (for example, permitting firms to claim over 100% of depreciation) would support new investment without giving tax breaks on existing assets, but may be costly to administer, as firms could be tempted to relabel some operating expenditure as capital expenditure.
Government should ensure any company tax changes are offset by other tax increases or spending cuts.
What else should policymakers do?
Government stimulus and interest rate cuts can encourage business investment if there is spare capacity in the economy. Australia does have some spare economic capacity. But there are constraints on both arms of macroeconomic policy. The RBA is reluctant to cut interest rates from their already low levels, as it is concerned about risky lending. Public debt has grown (though it is still not high by international standards), though bank balance sheets remain large compared to GDP, limiting the scope to expand public sector debt.
Monetary policy should remain supportive, and tough prudential standards can help limit risky lending. There may be modest scope to build more public infrastructure, if governments can improve the quality of what they build.
Broader policies to support economic growth would also lead to more and better private investment. They include reducing tax distortions, boosting labour participation, encouraging competition, improving the efficiency of infrastructure and urban land use, tightening regulatory frameworks, and more reliable climate policy.
No single policy is a silver bullet, but together, they can help make better use of Australia’s existing assets and make new investment more attractive.
Author: Jim Minifie, Productivity Growth Program Director, Grattan Institute
Superannuation industry groups are warning the federal government to keep Australia’s $2 trillion retirement savings system away from addressing the nation’s housing affordability problems.
Earlier this week Federal Treasurer Scott Morrison said the government is likely to address housing affordability in its May Budget, and there have been several suggestions about how to deliver the best outcome.
New South Wales Minister for Planning and Housing, Anthony Roberts, recently mentioned the idea of unlocking superannuation for first home deposits.
Industry Super Australia believes the idea is bad policy as it could reduce retirement savings and drive up housing prices while doing nothing to address supply.
ISA chief economist Stephen Anthony said: “In the housing affordability debate, the focus should be on land release, regulation and tax subsidies that fuel investment in existing property rather than new buildings. Allowing first home buyers early access to their super will set back a retirement income system that is still struggling to fully deliver.”
Anthony also said the proposal is inconsistent with the federal government’s objective of super, being “to provide income in retirement to substitute or supplement the age pension.”
The Australian Institute of Superannuation Trustees (AIST) also warned against using superannuation to tackle the nation’s housing affordability challenge.
“The superannuation industry shares concerns about housing affordability for the young but superannuation is not the silver bullet,” AIST chief executive Tom Garcia said.
“Superannuation is about saving for retirement. It’s not a savings pool to be used for any other purpose as the government has made clear in its own proposed objective for super.”
Morrison said in a radio interview with Ray Hadley that he’s had good discussions with senior NSW government ministers about housing affordability issues for a long time.
“It is a big challenge particularly for people here in Sydney and particularly people down in Melbourne. Whether it is in Queensland or other places, particularly South East Queensland there are real challenges there. We want to look at ways that we can improve that situation. It is not just for people who are looking to buy their first home,” Morrison said.
If re-elected, the Western Australian Liberal government will cut stamp duty for downsizing seniors by up to $15,000.
The discount will apply to new and already-established homes, and will affect more than 4,000 eligible seniors aged over 65 years, according to a statement from the Liberals Western Australia.
Eligible seniors will pay no stamp duty on property worth up to $440,000, and the tax will be roughly halved on a property worth $750,000. The initiative, which will be introduced for two years from the start of 2018, will include a requirement for the senior to sell their existing home.
The policy will also give a duty concession of up to $10,000 for vacant lots.
Premier Colin Barnett said, “It is important to support seniors in choosing housing that better suits their needs.”
Seniors Minister Paul Miles said, “Our actions will not only bring major benefits to seniors and their families, they will directly support jobs – whether it be the tradies building new houses, or the professions involved in the sale of established homes.
The Barnett government already has policies in place to stimulate the languishing WA property market, including the First Home Owner Grant Scheme and Keystart.
The Real Estate Institute of Western Australia and the Council on the Ageing welcomed the release of the Barnett campaign policy.
REIWA President Hayden Groves said he was thrilled the Barnett Government had committed to easing the burden of transfer duty for seniors if re-elected on 11 March.
“Transfer duty creates a significant barrier for seniors over 65 on fixed incomes who are looking to change their lifestyle or down size,” he said.
“The cost of transfer duty on a median house price of $520,000 is $18,715, which is almost equivalent to the entire annual standard aged pension of $20,745.40.”
“The $15,000 concession the government have committed to will make a substantial difference to those seniors looking to ‘right size’ into more suitable accommodation,” he said.
COTA WA CEO Mark Teale said one in three voters in WA are over the age of 60 and seniors make up 19 per cent of WA’s population.
“Our members, many of whom are on a fixed income, find the existing transfer duty arrangements to be a major barrier to ‘right sizing’, so this announcement is very positive news,” said Teale.
REIWA analysis estimates the policy reform could release 21,000 homes onto the market, making it easier for West Australians to “trade-up”.
“While the concession would cost the state government $303 million from the 21,000 senior households ‘right sizing’, the resulting trade-up activity would generate additional transfer duty revenue in the order of $393 million, leaving a net surplus of $90 million,” said Groves.
Ben Myers, Executive Director – Retirement Living at the Property Council of Australia, said the downsizing incentive for senior Western Australians will have broad-ranging benefits and should be examined by other states.
The peak body for retirement and seniors living has conducted its own research which shows that “downsizing to a smaller home can extend people’s capacity to live independently, delaying or reducing their need for formal care or support,” according to Myers.
Myers said the policy with “ensure senior Australians have housing choice and can downsize at low cost” but also has the benefit “of freeing up housing stock for first home buyers.”
The Turnbull government’s signature economic policy at last year’s election was a 5% cut in the company tax rate, over a ten-year period, at a cost to revenue estimated to be in excess of A$48 billion. As the government itself has conceded, this now stands very little prospect of being passed by the Senate.
However, there is one element of the government’s proposal which appears to enjoy almost universal political support – the idea that “small” companies should get a tax cut. The only disagreement among the Coalition, Labor and the Greens on this score is how small a company should be in order to be deserving of paying a lower rate of tax.
From the standpoint of good economic policy this is surprising. There has been a lively debate for a while among economists as to whether cutting company tax rates will boost economic growth, employment and real wages – and the extent to which this theory is supported by evidence. But there is no evidence at all to support the notion that preferentially taxing small businesses will do anything to boost “jobs and growth”.
Advocates of tax and other preferences for small businesses often argue that small businesses are the “engine room of the economy” – because, for example, 96% of all businesses are small businesses, or because small businesses employ more than 4.5 million people.
According to the latest available ABS data, small businesses (defined as those with fewer than 20 employees) employed just under 45% of the private sector workforce in June 2015. Despite this, small businesses accounted for only 5.2% of the increase in private sector employment over the five years to June 2015.
By contrast, large businesses (defined as those with 200 or more employees) employed less than 32% of the private sector workforce in June 2015 – but they accounted for more than 66% of the increase in private sector employment over the five years to June 2015.
Employment and employment growth by size of business
ABS Australian Industry (8155.0) 2014-15, Author provided
Similarly, a smaller proportion of these small businesses engage in any of the four categories of innovation which the ABS recognises in its annual survey of business innovation than of medium or large businesses.
ABS, Summary of IT use and innovation in Australian businesses (8166.0), 2014-15, Author provided
So on the basis of the available evidence, a policy which sought to encourage employment creation and innovation via the use of preferential tax treatment would surely preference large businesses, rather than small ones.
What sort of businesses create jobs and growth when tax is reduced?
An alternative approach, which would be much more likely to have positive effects on employment, investment and innovation, would be to tax new companies at a lower rate.
New businesses are of course likely to be small, at least initially. Confining preferential tax breaks to new businesses – for example, by prescribing that a lower tax rate is only available to a business for the first (say) three years after its incorporation – focuses the assistance on those businesses which are actually likely to innovate, and to create jobs. This is instead of dissipating it on the much larger number of businesses who have no desire, intention or ability to do either.
Preferentially taxing new businesses is therefore much more likely to achieve the stated goals of boosting jobs and growth, and of encouraging innovation, at much lower cost.
In addition to this, preferentially taxing new businesses avoids the perverse incentives that inevitably arise when the eligibility for some form of preferential treatment is determined by a business’ size. This is frequently demonstrated by the reluctance of businesses to put on an extra worker when doing so would render them liable to pay state payroll tax.
Of course, there would need to be compliance measures designed to forestall “rebirthing” of companies in order to prolong access to tax preferences intended to benefit new companies, but that would not be difficult to provide.
The Coalition’s support for a preferential tax rate for small businesses appears to owe more to its long-standing, almost religious, belief that there is something inherently more noble or worthy about owning and operating a small business, than there is about managing or working for a large one (or a government agency). Also that this belief should be reflected in the tax system, rather than basing it on any evidence that taxing small businesses at a lower rate than large ones will have any positive impact on economic or employment growth.
Why Labor and the Greens should support this view is much more of a mystery.
Author: Saul Eslake, ice-Chancellor’s Fellow, University of Tasmania
So what can be done? Donald Trump is being encouraged by leading House Republicans – led by Kevin Brady, chairman of Washington’s tax-writing Ways & Means committee, and speaker Paul Ryan – to introduce a Destination-Based Cash Flow Tax, or DBCFT. This tax plan has been pushed forward by leading Berkeley economist Alan Auerbach and scholars at the Oxford Centre for Business Taxation.
It sounds complicated – and has an awful acronym – but there is something in this plan that offers an alternative.
The DBCFT doesn’t go after a firm’s profits in the normal sense, as the current corporate tax regime does. Instead of taxing corporate income (revenue minus costs) it taxes sales at their point of destination or consumption.
Another key part of the new tax is that monetary flows across a multinational corporation’s international network of subsidiaries (that would include tax haven locations) are border-adjusted. This means that export sales, for example Ford selling cars overseas, would be excluded from a firm’s tax base, but imports, such as the purchase of raw materials from abroad, would be included. What this boils down to is that the tax looks like an export subsidy, and at the same time, an import tax. In many ways therefore it looks like a backdoor attempt to improve the US’ large current account deficit – which formed a major part of Trump’s presidential campaign.
Trump on the campaign trail.EPA/LARRY W. SMITH
Radical Change
The House Republicans highlight several key attractions of this new and radical tax.
They argue that it would allow the US to reduce its federal corporate tax rate to around 15-25% – from 35% currently – which would bring it in line with China and much closer to the UK. The hope is also that it will deter firms from stashing profits in tax havens, and minimise the role of aggressive transfer pricing manipulation – the practice of buying and selling goods between divisions of the same multinational as a means to reduce the corporate tax bill. It should also deter firms from relocating their legal domicile to countries like Ireland and Bermuda – so called corporate inversions.
Current tax arrangements offer companies an advantage if they raise money through debt. However the DBCFT would have the effect of removing that incentive by eliminating deductions for interest payments. This means in theory that firms would be more likely to favour stock markets when raising capital. There is a potential twin advantage here: lower debt ratios would make the US economy more resilient in the face of external shocks, while equity markets are given a further boost.
The theory seems appealing, but the truth is, nobody really knows if it will work. It might not even be compliant with the World Trade Organisation (WTO). This is a step in to the unknown; there could be multiple unintended consequences. Not since the early 20th century, when bilateral tax treaties between countries were introduced, has there been such sweeping reform to international taxation as this policy change would initiate.
Progressive?
There is an argument that the new tax could have a progressive outcome. Because payroll costs could also be deducted from its calculation, this should shift the tax burden more firmly on to shareholders, and away from workers. Concerns with the existing system are that workers end up paying a fair chunk of the corporate tax bill, through lower wages and benefits.
However, consumers might not get off lightly. The DBCFT may well have the effect of increasing consumer prices on imported goods, leading to higher energy and food prices. This would disproportionately hurt the poor, meaning the tax’s progressive credentials might not bear scrutiny.
In order for the tax to work, proponents argue that the dollar will have to appreciate in value to offset the effects of the border-adjustment. This is because exports are tax free but imports incur tax. Hence US exports will appear more attractive to foreign consumers and imports will appear more expensive to US consumers. But whether exchange rates will move is an open question, as ever.
Consumer power?EPA/ANDREW GOMBERT
This really is a highly contentious and ambitious proposal for tax reform. The US’ international competitors – and of course tax haven locations – may see it as a hostile move. It will encourage firms from abroad to locate their production in the US. On the other hand, proponents argue that the policy is “incentive compatible” – in simpler terms, it will force other countries to adopt a similar policy. This would, in effect, dismantle the standard tax haven business model and send shockwaves throughout an industry that specialises in tax avoidance.
That is an intriguing prospect, but interest groups such as the Tax Justice Network in the UK would argue that the key to a better functioning corporate tax regime is for countries to be more open with one another in terms of information exchange for tax purposes. This would include multinational companies reporting their financial statements on a country by country basis instead of consolidating them. Countries would then be able to clearly define their corporate tax base and decide themselves what tax rate to levy.
The EU is currently discussing the introduction of a Common Consolidated Corporate Tax Base to partially achieve this. This would not eliminate the tax havens, but it may go a long way towards enhancing transparency, leading to greater scrutiny of the world’s biggest multinational enterprises and changing their behaviour in terms of profit shifting.
In some ways this is the longer, harder road. The appeal of the Republican proposal would be to force the issue, but it is desperately hard to predict, or manage, the consequences if this tax is enacted.
Author: Chris Jones, Senior Lecturer in Economics, Aston University
While the market, and various pundits and economists have been mostly focused on the still to be disclosed details of Trump’s infrastructure spending aspects of his fiscal plan, “one of the least talked about but possibly most important tax shifts in the history of the United States” is, according to DB, House Speaker Paul Ryan’s and President-elect Trump’s “border tax adjustment” proposal.
This is part of the “Better Way” reform package and also figures prominently in the writings of senior Trump administration officials.
What is it?
Put simply, the proposal would tax US imports at the corporate income tax rate, while exempting income earned from exports from any taxation. The reform would closely mirror tax border adjustments in economies with consumption-based VAT tax systems. If enacted, the plan will likely be extremely bullish for the US dollar. What’s more, it would have a transformational impact on the US trade relationship with the rest of the world. Consider the below:
A “border tax adjustment” would, roughly speaking, be equivalent to a 15% one-off devaluation of the dollar. Imports would be 20% more expensive, because corporates would have to pay the new 20% corporate tax rate on their value. Exports would be roughly 12% “cheaper”, because for every $33 of earnings earned from $100 of exports (we use the 33% gross margin of the S&P), there would be a 12% tax cost ($33 earnings*35% current tax rate) that would no longer be imposed on corporates. Taking the average impact on the prices of exports and imports is equivalent to a 15% drop in the dollar.
A border tax adjustment would be very inflationary. The price of exports doesn’t affect the US consumption basket so would have no impact on CPI. However, the cost of imports would go up by 20%, which based on a simple relationship between import PPI and US inflation would be equivalent to a 5% rise in the CPI. Corporates may of course choose to absorb part of the rise in import costs in their profit margins. But either way, the order of magnitude is large.
A border tax adjustment would be very positive for the US trade balance. Similarly to the dollar calculations, a border tax adjustment would be equivalent to an across the board import tariff of 20% and an export subsidy of 12%. Keeping all else constant and applying standard trade elasticity impact parameters to an average of the two estimates results in a more than 2% drop in the trade deficit equivalent to more than 400bn USD, or equivalently, an almost complete closing of the US trade deficit.
In other words, should the “border tax proposal” pass, it would not only send inflation soaring, while eliminating the US trade deficit – a long-time pet peeve of Trump – it would also be the trade-equivalent of a 15% USD devaluation, even as it leads to an offsetting surge in the actual value of the dollar.
To be sure, there are uncertainties related to all estimates above. First, there is a question mark on whether a border tax adjustment based on a territorial corporate tax system (as opposed to VAT) would be allowable under WTO rules. The question is highly complex, but senior Trump advisers have stated they would be willing to take the issue to the WTO.
It is also not clear what types of goods the new tax would cover – the broader the coverage the bigger the impact and vice versa.
Second, the impact on trade highlighted above should be considered an upper bound, as the post-crisis responsiveness of current account balances to relative price shifts has proven to be much lower.
Still, it is hard to argue that such a fundamental shift in tax treatment of US exports and imports would not have a material impact on trade relations and flows with the rest of the world. More importantly, Saravelos argues, the second-order impact of “re-shoring” may be more material given that US corporate activity has been disadvantaged due to the current unfavorable tax treatment of offshore profits.
* * *
Taking all of the above into account, the academic literature is unambiguous in its conclusion that the dollar should rally strongly in the event a “border tax adjustment” is put in place. An appreciating dollar would be a natural response to an improving US trade balance and the competitiveness gains achieved by the shift in the relative prices of exports over imports. In extremis, the dollar would rally by 15% to fully offset the price changes caused by the tax. This analysis is partial however, with the knock-on consequences on the Fed, US corporate off-shoring and global trade relations likely making the impact even more material.
Deutsche Bank concludes that combined with potential changes to the treatment of unrepatriated earnings, “the proposed changes to the US corporate tax code could be one of the most important shifts in US tax and international trade policy in a generation.”
We wholeheartedly agree with DB’s assessment in this particular case.
“The Great Distortion.” That’s what The Economist, in its cover story of May 2015¸ called the systematic tax advantage of debt over equity that is found in almost every tax system.
This “debt bias” is now widely recognized as a real risk to economic stability. A new IMF study argues that it needs to feature more prominently on tax reform agendas; it also sets out options for how to do that.
Debt bias: Why we should (still) worry
The IMF’s recent Fiscal Monitor shows that global debt levels have risen to a record 225 percent of world GDP. And high corporate debt poses significant economic stability risks—especially in the financial sector: no one needs any reminder of the enormous damage from distress and failure of large financial institutions.
Since the global financial crisis, many governments have strengthened policies to mitigate excessive corporate borrowing, notably by tightening regulatory capital requirements for financial institutions.
That’s good. But most tax systems continue to do exactly the opposite: they allow interest to be deductible, but not the costs of equity finance, and so encourage corporations to finance themselves through debt rather than equity. Chart 1 clearly shows that this tax discrimination in favor of debt is still widespread.
In advanced economies, the tax bias has increased debt ratios in nonfinancial corporations by, on average, 7 percent of total assets (about 15 percent of GDP). Our new results find that, despite their special status, financial institutions show a very similar response. Debt bias thus amplifies financial and macroeconomic stability risks—and the effect is too big to keep ignoring.
What can be done?
There are two broad ways to mitigate debt bias: limit the tax deductibility of interest, or provide a deduction for equity costs. There is now plenty of experience with both.
Limiting interest deductions
Some 60 countries have some form of limitation on interest deductibility. The details of the rules on these limitations vary greatly—and those details matter.
39 countries apply the limitations only to “related-party” debt (between affiliates within a multinational group). New analysis reported in our paper finds that (as one might expect) these rules have no discernable impact on firms’ borrowing from unrelated parties—which is what gives rise to stability concerns.
21 countries have rules applicable to all debt, related party or not. On average, these rules do reduce the external debt-to-asset ratio by around 5 percentage points—a significant effect.
Limitations on interest deductibility thus can work, but only if they cover all forms of debt.
Allowing a deduction for equity
Several countries—Belgium, Cyprus, Italy, and Turkey—have introduced an allowance for corporate equity (ACE). This retains the deduction for interest but adds a similar deduction for the normal return on equity.
Economists tend to like the ACE: it neutralizes debt bias and also eliminates tax distortions to investment. And the allowance continues to win over policymakers: Switzerland will soon introduce it, the Danish government has recently proposed its adoption, and the European Commission included it in its recent proposal for a common corporate tax base in the European Union.
And the ACE works. Chart 2 reports new evidence on the effect of the Belgian allowance on corporate debt ratios in nonfinancial firms (left) and banks (right), relative to a synthetic control group of companies in other countries.
The impact is significant and large: the debt ratio in Belgium is almost 20 percentage points lower than in the control group for nonfinancial firms and almost 14 percentage points lower than in the control group for banks.
The main hesitation about the ACE is the potential revenue loss. We find that if the allowance were given to all equity, corporate income tax revenue would fall by 5-12 percent (Chart 3, left panel).
But governments can reduce the revenue cost while preserving the efficiency gains from the ACE by giving it only in respect to equity added after some base year—as is done in Italy and Switzerland and has been proposed in Denmark and by the European Commission.
This reduces the first-year revenue cost to about 1 percent of corporate income tax revenue (Chart 3, right panel). In the financial sector, moreover, the allowance might be granted only for equity above what is already required due to minimum regulatory capital requirements, which would further reduce the fiscal costs.
No better moment
Since the global crisis, debt bias has become much more widely recognized as a real macroeconomic concern. Governments have taken some steps to fix the distortions it creates.
But the issue has not gone away, and in the financial sector, tax policies (which encourage debt finance) and regulatory policies (which do the opposite) continue to be fundamentally misaligned. In our view, debt bias needs to figure more prominently in countries’ corporate tax reform agendas. The approaches discussed here have proven effective, and they can be tailored to countries’ circumstances. The revenue impact is currently muted by low interest rates. There will be no better moment than now to address the “Great Distortion” once and for all.
Macrofinancial indicators underline the threat from the housing market, with house prices and related indicators (house indebtedness, bank size), pointing to continued vulnerability. Any impact will most likely be through aggregate demand than financial instability.
Improving competition and other framework conditions that influence the absorption and development of innovation are key for restoring productivity growth.
Australia’s adjustment to the end of the commodity boom has not been painless. Unemployment has risen, and there are increasing concerns about inequality.
Externally, Australia, as always, is exposed to the vagaries of global commodity markets and this might include a renewed plunge in prices (or, positively, a strong resurgence). Australia’s iron ore production is among the lowest cost in the world and therefore comparatively insulated from such developments, however its coal sector is relatively more exposed as its production is distributed across the cost curve. Interaction of downside scenarios is likely to exacerbate the negative macroeconomic outcomes.
