Allowance for Corporate Equity

[nwoodman]

Interesting changes being entertained for the Australian Tax Code

 

"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."

 

http://www.canberratimes.com.au/news/national/national/general/business-tax-could-be-cut-to-nothing/2382561.aspx

 

 

The usual commentators are starting to work themselves into a lather

http://www.businessspectator.com.au/bs.nsf/article/banks-super-profits-tax-australia-gillard-governme-pd20111207-par9x?opendocument&emcontent_gottliebsen&src=msp

 

 

 

 

[oddballstocks]

This is big, I wish other countries would consider this as well.

[Rabbitisrich]

Sounds like a weird subsidy for inefficient and/or cyclical businesses. Maybe a low sustainable rate of return is a sign that less money should head in that direction.

[nwoodman]

It is an interesting concept.  I haven't done a lot of reading on it yet but there are some interesting papers available off the internet

 

http://www.imf.org/external/pubs/ft/wp/2006/wp06259.pdf

 

"the idea of an ACE is to address this difference in the treatment of debt and equity by allowing firms to deduct a notional interest rate on their equity as well. Specifically, the ACE or the notional return is defined as the product of the end of last year’s equity stock, Et-1, with a notional interest rate iˆ . The notional interest rate should be defined as the risk free nominal interest rate because the tax advantages are certain. It could be approximated by the rate on government bonds."

 

The author goes on to list some of the advantages of ACE:

 

• Most obviously, the ACE system ensures neutrality for financing choices. Firms will
  thus be indifferent between debt and equity finance, at least regarding the corporate
  tax implications.
   
  
• More generally, the ACE system is neutral to investment. Therefore no tax is charged
  on marginal projects, as for such projects the notional return will exactly match the
  pre-tax profits. Hence any investment that would be worthwhile in the absence of tax
  remains worthwhile when taxed.
   
  
• The method of tax depreciation is irrelevant under an ACE system. Any increase in
  depreciation in early years, will reduce the stock of equity and hence the ACE in later
  years, which exactly offsets in net present value terms any benefit from earlier
  depreciation
  

 

The system is also unaffected by inflation. Any increase in monetary profits that is

due to inflation will be offset by a higher notional return, as the notional interest rate

will also be higher as a result of inflation. Indexation is therefore unnecessary.

 

The ACE thus achieves far more than just equal treatment of debt and equity finance, and

from the list of properties above, it would appear to be such a great system, that it is a puzzle

as to why not more countries have implemented it. There must clearly also be some

drawbacks, and the following are among the main ones:

 

• Because of the narrower tax base, a higher tax rate needs to be set if the same amount
  of revenue is to be collected. This could be harmful in the presence of tax competition
  for mobile economic rents.
  
• There may be doubts as to whether other countries will accept corporate tax payments
  under an ACE system as a basis for double tax relief.
  

 

 

 

 

 

[twacowfca]

It's an anti productive change that is proposed.  Under the proposal, the most productive companies will be taxed at a relatively higher rate.  Thus, investment will be curtailed in those fields that contribute the most to the progress of society.

[nwoodman]

It's an anti productive change that is proposed.  Under the proposal, the most productive companies will be taxed at a relatively higher rate.  Thus, investment will be curtailed in those fields that contribute the most to the progress of society.

 

You may well be right, however in the Australian context it might help to reduce  the hollowing out of the economy. At the moment it is all house and holes (banks and mining). The ROE's especially in the banking sector are abnormally high due to the government providing a backstop. In fact most high ROE's in Australia are either result of natural endowment or anomalies such as government implied guarantees that are gimmees.

 

Anyway, the current countries that have partly implemented the policy are hardly banner economies at the moment ;)

[oddballstocks]

It's an anti productive change that is proposed.  Under the proposal, the most productive companies will be taxed at a relatively higher rate.  Thus, investment will be curtailed in those fields that contribute the most to the progress of society.

 

The flip side is currently a company that can't make their cost of equity because of labor costs would leave the country and look for a location with cheaper labor.  Under this proposal it might remain possible for those companies to remain which would help keep up employment. 

 

I think capital will always flow to high return companies regardless of the tax situation.

[rmitz]

I haven't actually read about this yet, but while interesting in a theoretical sense, this feels like a loophole that someone could fly a fleet of 747s through.

[twacowfca]

It's an anti productive change that is proposed.  Under the proposal, the most productive companies will be taxed at a relatively higher rate.  Thus, investment will be curtailed in those fields that contribute the most to the progress of society.

 

The flip side is currently a company that can't make their cost of equity because of labor costs would leave the country and look for a location with cheaper labor.  Under this proposal it might remain possible for those companies to remain which would help keep up employment. 

 

I think capital will always flow to high return companies regardless of the tax situation.

 

Yes, short of confiscatory rates, but the flow to the most productive uses will be retarded nonetheless.  When there are high returns in seemingly nonproductive uses, distortions are almost always caused by government supported policy, monopolies, oligopolies, occupational licensure, and regulations that have unintended consequences.