Taxing earnings – the great distortion
written by Robert Deutsch CTA *
Is it just me or are there others out there who find the debate about lowering the corporate tax rate to 27.5% (ultimately to 25%) somewhat perverse in view of the fact that the top marginal tax rate is sitting at almost 50%?
Let’s look at the tax effect on the last $200,000 of taxable income of each of three fictitious taxpayers:
- News Today Pty Ltd – the owner of an outer-Melbourne newsagency
- Bob Build – a respected architect
- Amy Land – a real estate investor.
News Today derives taxable income of $200,000. Assuming it is accepted that it carries on a business (1) and its turnover is less than $10m, it qualifies for the reduced corporate tax rate of 27.5%. This would give rise to tax of $55,000.
Bob Build earns $380,000 in 2016-17 in taxable income and will consequently pay tax on the top $200,000 of $94,000 (inclusive of the Medicare levy).
Amy Land purchased real estate in Sydney’s inner west for $1m in May 2014 and sells it in August 2016 for $1.2m. Tax at her marginal rate on the discounted CGT rate of half of the capital gain, namely, $100,000, will arise. Thus, in broad terms, tax of $47,000 (including the Medicare levy) would arise, assuming she has other income of $180,000.
Table 1 summarises the tax paid by the three fictitious taxpayers:
My point here is that individual tax rates on earned income (see Bob Build) are disproportionately and absurdly high relative to both the company tax rate (see News Today) and certain types of passively derived income (see Amy Land).
This is a massive distortion in a system which seems to work the wrong way around. We heavily tax, almost to the point of penalising, the earning capacity of individuals, but lightly tax companies (which may, in some cases, be involved with far less productive activities than comparable individuals) and unearned income derived by individuals.
Is it not time to revisit this issue with the intent of reducing the top marginal tax rates, rather than focusing so heavily on the company tax rate?
This argument is even stronger when one considers that, when it comes to distributed profits to domestically based individuals, company tax operates effectively as a pre-payment of income tax. This follows from the fact that company tax currently operates on the basis that 27.5% is effectively withheld by the company. That 27.5% tax is then imputed to the individuals who receive any distributions, with an adjustment either by way of top-up tax being paid by the individual (if his or her marginal tax rate is more than 27.5%) or a refund being received.
Thus, if the individual has other income of $180,000, the additional tax on the $145,000 distributed by News Today will be $39,000. In other words, the ultimate effect is that tax will be imposed at a global rate of 47% (27.5% at the corporate level and the additional 19.5% at the individual level).
If the individual has no other income, tax of $63,632 would be payable less the $55,000 already paid by the company (i.e. $8,632 in extra tax). This is a total tax rate of 31.8%, with 27.5% being collected at the company level and 4.3% at the individual level. (2)
Thus, on profit fully distributed to local shareholders, the advantage of holding through a company washes out. That is not the case for profit retained by the company.
In the circumstances, while there are undoubtedly positives in having lower corporate tax rates, which The Tax Institute wholeheartedly supports, it is the absurdly high personal income tax rates (which are set to go even higher under Labor) that really need our legislator’s most immediate attention.
- How this is to be interpreted is as yet unclear, but a newsagency business will undoubtedly be treated as a business.
- This assumes, for convenience, that the franking rate and the company tax rate will be the same – as a result of some odd recent legislative changes they will not be the same. That, however, is a story for another day!
* Robert Deutsch is The Tax Institute’s Senior Tax Counsel. This article was first published in the September issue of the Institute’s member-only Taxation in Australia journal.