Taxing Times

The Government release of Re:think, its tax discussion paper, is a welcome development, designed to kick-start the conversation with the community on a range of reform options designed to achieve a simpler and streamlined tax system capable of meeting the growing needs of an ageing population. 

In this post, I discuss some of the areas raised in Re:think which are of greatest interest to equity investors: how important income and consumption taxes are to Australia's tax take in a global context, the prospect of the growing drag from bracket creep on household disposable incomes (discretionary retailers), the outlook for the GST (supermarket retailers), the efficacy and viability of the dividend imputation system (high yielders with predominantly domestically oriented operations), the sustainability of the concessional tax treatment of superannuation (asset managers), and the risk associated with companies that have low effective tax rates.

The great divergence

Although Re-think does not consider the outlook for government spending, the conversation about the viability of Australia's tax system cannot be disentangled from trends in expenditures.  After growing in line with government outlays during the credit boom, tax revenue dropped sharply during the financial crisis and although it has recovered since then, it hasn't kept up with the path of government spending (see chart). 

Australia's ageing population will make it increasingly difficult for governments to reduce the growth in their spending.  The burden will thus fall on governments to reform the tax system to reduce its sensitivity to the economic cycle so that downturns are not associated with a large and persistent divergence between spending and tax revenue.  The federal Government collects around 80% of Australia's total tax revenue, mainly from taxes levied on individuals and companies, while state and territory governments collect 15% of tax revenue, largely through payroll taxes and stamp duties (see chart).

Australia's aggregate tax burden - 27% of GDP - is low by the standards of other developed economies, which reflects the overall size of government and the fact that Australia is one of the few countries that does not levy specific social security taxes.  Much of the media reaction to Re:think has been around Australia's excessive reliance on corporate and personal income tax, and what this might mean for the politically sensitive Australia's Goods & Services Tax.  Income tax levied on individuals accounts for 40% of total tax revenue and corporate taxes account for another 20%.  The combined contribution from these two sources is second only to Denmark (see chart). 

But the heavy reliance on corporate and personal income tax reflects Australia's low consumption tax take and the  fact that Australia does not levy a social security tax.  Social security contributions across the OECD represent a significant source of revenue, accounting for one quarter of tax revenue in developed countries.   Australia's consumption taxes generate around 27% of total tax revenue, below the OECD average of 32% (see chart).

The GST - Politically Hot Potato

The GST is Australia's main consumption tax which applies a rate of 10% to a range of goods and services. The rate is around half of the OECD average and the base is narrow, applying to only 47 of the consumption basket (see chart). 

The GST base has narrowed over time because Australians are increasingly spending a bigger slice of their budgets on health and education that are exempt from the GST (see chart).  Going forward, Australia's ageing population will likely further reduce the GST base.  Fresh food is also GST exempt.  Any efforts to broaden the base to capture fresh food would clearly have negative implications for food retailers Woolworths and Wesfarmers, although the effect on profitability would be partly ameliorated by government efforts to compensate low income earners.

But Re:think acknowledges that GST reform is a politically hot potato.  The Commonwealth Government collects the GST on behalf of the states and territories and all the revenue raised by the GST is provided to the states and territories.  Thus any change to the rate or base would require unanimous support of the state and territory governments.  Comments from the Prime Minister and Treasurer today confirm that any efforts to reform the GST would also be conditional on broad political consensus for change.  If the Shadow Treasurer's - Chris Bowen's - comments on the 730 Report tonight are any guide, support from the ALP is not forthcoming at this time (nor any time soon).

Bracket creep - A drag on discretionary retailers

Australia's tax system is progressive because higher marginal tax rates are levied at higher income levels.  Because the tax or income thresholds are not indexed, they remain fixed and do not keep up with inflation or wages.  So over time, income earners will find that they face higher marginal tax rates as their salaries grow beyond the tax thresholds.  This effectively leads to bracket creep which erodes the value of tax cuts.  At present, the second highest marginal rate of 37% is levied at gross incomes of $80,000 pa, while the top marginal rate of 45% applies to gross incomes above $180,000. 

Currently, average full time weekly earnings is around $75,000 which is associated with a marginal rate of 32.5% for each dollar earned above $37,000.  Based on the government's estimates, a full time employee is projected to move into the second highest tax bracket of 37% by 2016-17 (see chart).  In the absence of cuts to marginal rates or adjustments to income tax thresholds, bracket creep promises to be a drag on discretionary spending at a time when profitability for the discretionary retailers is little changed from a decade ago.

Rethink-BracketCreep.jpg

Target - Savings in superannuation?

Among saving vehicles, bank deposits attract the highest marginal tax rate followed next by foreign shares and property, while superannuation attracts the lowest tax rate because contributions are taxed at a flat concessional rate of 15% out of pre-tax income (see chart).  The flat concessional rate, when combined with the progressive income tax system, produces regressive outcomes.  That is, high income earners effectively receive the largest tax benefit from the superannuation system.  The discussion paper acknowledges the problems of distribution and fairness that the superannuation system gives rise to.

Thanks to the growing concerns of rising income inequality across many developed countries - including Australia - there is a growing risk that the tax breaks that Australia's superannuation system offers the wealthy will increasingly come under intense scrutiny, particularly from a government with little philosophical attachment to a system of forced saving.  While such changes would carry negative implications for Australian based asset managers, ironically they would be expected to be met with stiff opposition from the ALP, which was the party that launched superannuation in the early 1990s. 

But any measures designed to reduce the size and scope of superannuation tax concessions accruing to high earners and the wealthy would likely garner support from the cross benchers in the Senate.  Stocks that would be most adversely impacted are the pure play asset managers (BTT, MFG, PPT, PMC) and the major banks, all of which have significant wealth management operations.

Dividend imputation - Not in the firing line thanks to an ageing population

Any proposed changes to Australia's dividend imputation system is likely to arouse interest amongst institutional investors, particularly at a time when high yielding stocks with defensive cash flows have delivered strong performance for over three consecutive years.  The discussion paper draws attention to the costs to tax revenue associated with a full imputation system, which Australia has had in place since 1987.

But Re:think also addresses some of the key advantages of imputation.  First, it ensures that there is no double taxation of income earned by Australian shares owned by Australian resident shareholders.  Second, it supports the integrity of the business tax system because imputation does not encourage Australian companies to avoid tax; tax avoidance by Australian companies reduces their ability to pay unfranked dividends.  Third, imputation imposes an important source of discipline on CEOs since it encourages companies to pay out dividends rather than retain profits and discourages forays offshore, which have tended to be value destructive on balance over the sweep of the past three decades. 

Given the demographics of ageing, I doubt that this or any future government will tamper with the tax treatment of corporate payout that effectively encourages companies to cater to the growing influence of those approaching retirement age, and their preference for dividends over capital growth.

Regulatory risk surrounding corporate income tax set to grow

Corporate income tax is levied at a rate of 30% on all taxable income earned by companies, which is higher than the OECD average of 25% (see chart).  Re:think discusses the mobility of capital and the fact that Australia's relatively high corporate tax rate potentially deters foreign investment in Australia.

Despite the high corporate tax rate, Australian resident shareholders effectively pay a lower tax rate on their dividends than other country shareholders thanks to imputation.  Moreover, it is not entirely clear just how much of a deterrant to foreign investment is associated with Australia's high corporate tax rate.  After all, the corporate tax rate levied in the United States is amongst the highest in the OECD at close to 40%.

Indeed, there is a case for lifting the corporate tax rate.  First, after peaking at a record high of 25% during the credit boom, the corporate tax take as a share of economy wide profits has fallen to 17.5%, below its long run median (see chart).  Second, the mining boom saw a reduction in effective tax rates due to the growing depreciation and amortisation expenses associated with the construction of mining and LNG projects.  The size of this effect is already diminishing however, as mining and energy companies have increasingly deferred or permanently shelved new investment projects.  Third, the politics of growing income inequality across most developed countries - which has found a credible voice in French economist Thomas Piketty - means that a lift in the corporate tax rate is politically more feasible than other alternatives. 

Beyond a lift in the corporate tax rate, a number of companies with low effective tax rates would be exposed to measures that seek to raise the corporate tax burden, including: CGF, FXJ, QBE, COH, IPL, SEK and CSR (a full list of exposed stocks is available on request).  Infrastructure companies - some of which receive a net tax benefit due to their large depreciation and amortisation charges - should be insulated because governments are unlikely to implement reforms that discourage infrastructure investment.