RDP 2018-07: The GFC Investment Tax Break 3. Background on the Tax Break

In this section we make the theory outlined in Section 2 more concrete by providing further detail on the tax break and Australia's business taxation rules.

For equipment investment committed to between 13 December 2008 and the end of 2009, businesses could make an extra, immediate, tax deduction equal to a proportion of the value of the asset. This extra tax deduction did not affect the standard tax depreciation deductions for the asset, so allowed businesses to make deductions exceeding 100 per cent of the value of an asset over its life. The extra tax deduction was immediate in the sense that it could be deducted in the current tax year. The official title of the investment tax break was the ‘Small Business and General Business Tax Break’. Notably, the tax break applied only to equipment investment, and provided no benefit for building investment.^[7]

When the policy was first announced in December 2008, the tax break afforded all businesses an extra deduction of 10 per cent (Swan 2008). Subsequent government announcements over the first half of 2009 made the tax break more generous, until it reached its final form in mid May 2009 (Swan 2009a, 2009b). The final form included differentiated deductions for small and large businesses, with small businesses afforded a 50 per cent deduction, and large businesses being afforded a 30 per cent deduction for investments committed to before 30 June 2009 and a 10 per cent deduction for those committed to during the second half of 2009.

The time-series profile of bonus deductions is shown in Figure 1. While the final rates announced in May 2009 applied retroactively to earlier investment, it is the rates that businesses thought to be applicable in each period that would have governed their behaviour, and so we focus on the rates as announced.

The legal definition of a small business, and thus eligibility for the higher rate of tax break, is complicated. Under the relevant law, a business qualifies if any of these conditions are satisfied:

• revenue in the previous financial year was less than $2 million;
• revenue in the current year is likely to be less than $2 million (as judged at the start of the year), provided revenue in at least one of the two previous years was less than $2 million; or
• revenue in the current year is less than $2 million (measured at the end of the current year).^[8]

Businesses that do not meet any of these criteria are considered to be large businesses and are therefore only eligible for the lower rates of bonus deductions.

Table 1 presents hypothetical tax deductions for a $100,000 piece of equipment capital under normal rules and varying rates of tax break. Under the normal depreciation rules, a business is allowed to deduct 20 per cent of the value of its investment, or $20,000, in each year of the effective life of the item. Assuming the marginal tax rate of the business is constant at 30 per cent, this equates to a reduction in tax payable of $6,000 per year. Using a reasonable discount rate, the present value of these deductions is around $88,000, or 0.88 of the purchase price (this is Z). The present value of tax benefits is around $26,000, or 0.26 of the purchase price (this is τZ).

The tax break changed this sequence of deductions and tax benefits only in the first year. With an extra deduction equivalent to 10 per cent of the value of the item, a business can make a $30,000 deduction in the first year, which translates to a tax benefit of $9,000. With 50 per cent bonus depreciation, the tax benefit in the first year is $21,000, $15,000 higher than under normal depreciation. The tax break increases Z from 0.88 under normal rules to 0.98 with a 10 per cent deduction, and to 1.38 with a 50 per cent deduction.

How do these tax benefits flow through to the owners of businesses with different legal types? For owners of unincorporated businesses, the tax benefits are exactly as shown in Table 1, with 30 per cent replaced by the relevant marginal tax rate of the owner(s). Table 2 outlines the benefits of the investment tax break for a company owned (solely) by a resident shareholder and a company owned (solely) by a non-resident shareholder. The hypothetical company makes $200,000 in net profit and receives an extra $20,000 deduction from the tax break. The key point is that the resident shareholder receives no increase in after-tax income, while the non-resident shareholder receives a benefit.

This example shows how different assumptions about the residency of shareholders, and therefore about the value of γ, can lead to very different conclusions about the effect of the tax breaks on companies' costs of capital. The common assumption in computable general equilibrium models, which are often used in modelling the effects of tax changes on macroeconomic outcomes, is that Australia is a price-taker in capital markets. This means that the cost of capital is set by foreign investors who receive no benefit from the imputation credits. That is, γ is effectively equal to zero. Examples of this approach include Dixon and Nassios (2016) and Kouparitsas, Prihardini and Beames (2016).

This assumption makes sense in the context of these papers, though it does contrast with recent empirical evidence from Swan (2018). It requires perfect international capital mobility, which might be the case over the long horizons examined in these papers. Moreover, much of the investment undertaken in Australia is done by large listed companies, who frequently have a significant proportion of non-resident shareholders, and so assuming γ is equal to zero might be reasonable when trying to model aggregate macroeconomic outcomes.

For our purposes, however, the assumption that γ is equal to zero is unlikely to be appropriate. We study small companies with revenue around the $2 million threshold. Tax data indicate that these companies are almost exclusively owned by Australian residents, who get full value from the imputation credits. It is unlikely that capital markets are so complete that the cost of capital for these companies is wholly determined by non-resident investors. This is particularly true over the short horizon we consider. For these reasons, we think that it is reasonable to assume that the value of γ in the user cost equation is close to 1 for our sample.

In this case, there will be no change in the user cost of capital for companies as a result of the tax break. For this reason, we interpret any significant response from companies as evidence that the investment tax breaks operate through other, non-standard, mechanisms. As a corollary, we also expect companies to respond less strongly to the tax incentives than (similar) unincorporated businesses, who benefit both from a lower cost of capital and these non-standard mechanisms.

The key non-standard mechanism that we suggest is financial constraints on companies' investment decisions, which may be particularly relevant for the small companies we consider. Such constraints may include very high costs of external finance, or the inability to access such finance. As a concrete example, the extra cash available as a result of the tax break could make a range of investments feasible by lowering the amount of external finance required. The same story could be told for companies relying entirely on internal finance: the extra cash available could make it possible to finance some additional investment using their own internal resources.

Footnotes

The tax credit applied to depreciating assets for which deductions were available under Subdivision 40-B of the Income Tax Assessment Act 1997. This subdivision captures most equipment investment. Building investment is generally dealt with under another section of the Income Tax Assessment Act 1997 (the capital works expenditure rules). [7]

See Section 328-110 of the Income Tax Assessment Act 1997 as in force 29 May 2009; <https://www.legislation.gov.au/Details/C2009C00226>. [8]