FOR the government to finance needed public services it needs to raise revenue from taxation. The costs of tax stem not from the money it raises - because at least that can be put to good use - but the key economic decisions it changes.
In theory the government could raise much of its revenue from taxes that perfectly correct for external costs of one kind or another, and this could do away with these distortions. But the detailed information needed to set such taxes is, in practice, not available.
And efficiency is not the end of the story. A tax's perceived fairness is a crucial determinant of its social acceptability, and therefore its capacity to remain part of the policy fabric. So we must seek to raise the revenue we need at the lowest possible cost, while recognising that some cost is unavoidable - and the way we do that must be seen as fair.
Moreover, the challenges of an ageing population, even with expenditure restraint, will place further pressure on revenue. Given the many worthwhile things that we citizens will probably want governments to do more of in future, raising the tax revenue needed at the lowest cost to public wellbeing will become increasingly important.
Business and personal tax are often regarded as separate domains, yet they are intimately related and the interrelationship has become more important and complex over time.
The introduction of dividend imputation in 1987 meant investment income would no longer be double taxed for domestic investors. Their tax rate would become simply their marginal rate on personal income. However, capital gains realised by individual taxpayers have received a 50 per cent concession since 1999, which provides an incentive to convert income to capital gains where possible.
Other structures complicate matters further. One of the largest and most rapidly growing is superannuation. While capital income such as dividends would otherwise be taxed at marginal personal rates, superannuation contributions are taxed at a flat 15 per cent rate, earnings are generally taxed at 15 per cent and most benefits paid out over age 60 are tax free. Accordingly, a super fund investing in a company and then receiving franked dividends would be entitled to a refund of 15 per cent, and can then drive its earnings tax to zero.
Superannuation funds own roughly 30 per cent of the ASX. Given the refundability of franking credits, it's not surprising that super funds demand the distribution of fully franked dividends. This is great for shareholders in the short term, but a challenge for companies because it eats into retained earnings that may otherwise be used to finance investment. The tax-free treatment of superannuation investment returns during the retirement phase adds another twist, with potential implications for business decisions.
Many small businesses have a trust structure combined with a company and possibly a self-managed super fund that allows them to effectively manage their taxes. For example, income could be derived as labour income, or paid out as a dividend and routed through the trust, or reinvested to build up the capital value of the business and, perhaps, rolled over into the self-managed super fund when the business is sold.
Complex? Certainly is. Despite rules to contain profit shifting, multinationals also have some latitude about where to locate their profits - and here tax is likely to be a, if not the, primary driver.
It is now easier than ever to move funds between jurisdictions at little cost and to recharacterise financial assets from debt to equity or vice versa. Australia, and many other countries, treats debt and equity differently for tax purposes. One of the problems is we do not all define them the same. And Australia has added a further quirk. Our taxation of financial arrangements regime provides the capacity for financial institutions to account for tax on an accrual basis, not a realisation basis. More arbitrage opportunities.
Intangible assets such as brands, intellectual property, customer lists, internal processes, and copyrights are becoming increasingly important. As these assets have no fixed physical form it is much easier to relocate them to low-tax jurisdictions than it is to relocate people or machinery. For example, Pfizer and Microsoft have relocated a considerable part of their R&D to Ireland while Shell's central brand management is located at its Swiss affiliate, which charges royalties to operating subsidiaries worldwide.
How should Australia's tax system respond to these global pressures? OECD work has suggested that for the average OECD country a change in the tax mix away from income taxes and towards potentially less mobile and distorting bases would have economic benefits. Tax reform that envisages a sustainable rebalancing of tax bases would need to gain community acceptance. This would be a difficult process. Raising taxes or making any individual tax less progressive usually meets strong community resistance.
Since many people consider progressivity to be the most important measure of the fairness of the system, any such change would require a long and carefully designed transition path.
Among other options we might consider is a different base for corporate tax. What is suggested is a destination-based tax, which would be levied where the sale to a final consumer is made. This tax would be a source-based tax that would make border adjustments that eliminate the incentives for companies to shift location or earnings to other countries. Such a system may seem quite remote from our current situation but we should not underestimate the power of structural change in the global economy to shape policy in new and unexpected ways.
Future governments will need to strike a new balance between raising sufficient revenue and lowering the economic costs of taxation. By speeding up the process of globalisation with its associated pressures and opportunities, the Asian century makes the case for ongoing tax reform more compelling. While reducing the efficiency costs of the tax system is clearly a worthy goal in any circumstances, the unfolding developments in Asia increase the need to make genuine progress.
Rob Heferen is the executive director in charge of revenue at the Treasury and a member of the Treasurer's business tax working group. This is an edited text of his F. H. Gruen Lecture, Tax Policy Challenges in a Changing World, delivered at the Australian National University.