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The Australian Economic Review, vol. 53, no. 4, pp. 463–481 DOI: 10.1111/1467-8462.12385
Replacing Corporate Income Tax with a Cash Flow Tax
Ross Garnaut, Craig Emerson, Reuben Finighan and Stephen Anthony*
Abstract 1. Governments have been Cutting
Corporate Income Tax Rates
We design a parsimonious cash flow tax for
Australia and estimate revenue effects. It This paper sets out an alternative approach to
allows immediate deduction of all capital corporate income taxation that aims to reduce
expenditures, denies deductions of interest or remove the main weaknesses of the
payments, and compensates negative cash established approach. The authors see it as a
flows at the same rate and time as it taxes change that would generate large benefits for
positive cash flows. It allows taxpayer timing long‐term economic growth, and involves
choice on implementation over 10 years. It has relatively small disruption to established
incentive effects comparable to lowering the administration of the corporate tax laws. It
corporate income tax rate to zero. It removes happens to be useful to the current macro‐
distortions that artificially favour debt over economic circumstances.
equity, short‐ over long‐term investments, rents A corporate taxation model for the twenty‐
over competitive returns, large, established first century has to take account of a number of
over small and new businesses, and conven- realities: greater mobility of capital, giving rise to
tional over innovative investments. It closes an international ‘race to the bottom’ in taxation
international tax evasion loopholes. Its spur to rates to attract and retain investment; increasing
investment and timing of revenue impacts international payments for management and
favours implementation in recession. intellectual property fees in deductions from
assessable income; increasing opportunities for
tax avoidance and evasion through transactions
across international borders; an expansion in
the proportion of rent and decline of competitive
returns on capital in corporate income; a decline
in the competitive position of national against
multinational corporations arising out of the
former's more limited opportunities for tax
* Garnaut: The University of Melbourne, Victoria 3010 avoidance and evasion; a declining national tax
Australia; Emerson: Victoria University, The Australian compliance culture; and growing resentment of
National University, Australian Capital Territory 2600
Australia and RMIT, Victoria 3000 Australia; Finighan:
‘globalisation’ arising out of multinational
London School of Economics, London WC2A 2AE United enterprises’ tax avoidance and evasion.
Kingdom; Anthony: Industry Super Australia, Victoria 3000 Public concerns about these matters have
Australia. Corresponding author: Garnaut, email . The authors acknowledge helpful and to growing mistrust of market exchange.
suggestions from colleagues at seminars at the Melbourne
Economic Forum, the Committee for Economic Development
Over the last decade or so governments
of Australia and the Faculty of Business and Economics at the have been cutting their rates of corporate
University of Melbourne, and from an anonymous referee. income tax, ostensibly to attract foreign
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research,
Faculty of Business and Economics
Published by John Wiley & Sons Australia, Ltd464 The Australian Economic Review December 2020
investment to their jurisdictions or to hold for investment of mobile capital compared to
onto foreign investment when competitor existing corporate income taxation schemes.
countries cut their tax rates. The economic When applied in a single country, its effect on
justification given is that capital is mobile investment incentives is comparable to that of
internationally and will gravitate to countries a corporate income taxation rate of zero—so
with low corporate income tax rates. In this removing the international ‘race to the
competitive race to reduce corporate income bottom’. It removes an important distortion
tax rates, less emphasis is placed on the base in traditional approaches to taxation: the
of the corporate income tax, despite its artificial promotion of debt over equity, which
capacity to exert at least as much influence has adverse consequences for financial effi-
on after‐tax returns on competitive investment ciency and national economic stability. By
as the tax rate. abolishing the distinction between recurrent
The empirical evidence on the effect of and capital expenditure, it removes a disin-
corporate income tax rates on investment centive to long‐lived and capital‐intensive
decisions is not compelling. The case is often investment that is a feature of the current tax
argued from a model that assumes unrealis- system. It removes and reverses a bias in the
tically that there is perfect competition in all current taxation system that favours low‐risk
relevant markets. Even in competitive situa- investment and does not support innovation. It
tions, other considerations are highly influ- removes major contemporary avenues for
ential on investment decisions, including the large‐scale avoidance and evasion of corpo-
tax base, sovereign risk, the independence rate taxation. It avoids one important source
and transparency of regulatory and legal of inequality in the distribution of income in
systems, foreign exchange restrictions, work- developed countries. Introduced in a deep
force skills, and geographic location. recession—as it would be in Australia in
Nevertheless, governments remain under 2020–21—its revenue impact would be ex-
pressure to reduce their corporate income pansionary, with the reduction of revenue
tax rates. This is problematic for financial withdrawn automatically over time.
stability, for the continued supply of public Like any change in taxation arrangements,
goods that are essential for the efficient moving to the proposed system would impose
operation of the economy, and for equitable some deadweight costs. By allowing tax-
income distribution. payers a choice over a decade of the year of
The rigorous application of economic transition from the old to the new system, we
principles has led us to search for systems of would minimise disruption. Second, the
taxation that have low incidence on returns on proposed denial of deductions for royalties
capital operating in a competitive market, and on foreign intellectual property—an important
high incidence on economic rent. feature of our proposal that could be intro-
This paper suggests a major change in duced into the conventional corporate tax
approach to taxing corporate income. It regime as well—might be seen as reducing
proposes changing the corporate tax base, incentives for global innovation. We judge
from a conventional view of income to cash that this effect will be negligible and
flow. This increases the incidence of the tax more than offset by increased incentives for
on economic rent, and reduces the incidence innovation in Australia.
on competitive or ‘normal’ returns on invest-
ment. It improves the trade‐off between the
amount of revenue collected and the amount 2. Rent Taxes and the Ideal of Neutrality
of welfare‐enhancing investment. in Taxation
Our proposed cash flow tax is relatively
simple to administer, applying familiar and If the objective is to maximise national
well‐tested measurements of the taxation base. income, taxes should not affect investment
It has a strongly positive effect on incentives decisions; that is, taxation should be neutral.
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business
and EconomicsGarnaut et al.: Replacing Corporate Income Tax 465
There is a general exception to the would support a positive investment decision
neutrality principle where a tax corrects for in the absence of taxation. A higher rate of
negative spillovers from an investment standard corporate income taxation would
decision—such as water pollution and carbon make it harder for investors to achieve their
emissions. In the absence of defined spil- ‘hurdle’ rates of return. A country that applies
lovers, taxes that distort investment decisions a higher standard taxation rate will lose out in
result in deadweight losses to society. competition for investment in competitive
It is in the nature of economic rent that its sectors of the economy with another country
taxation does not reduce incentives for applying a lower tax rate to investments that
investment. The search for neutrality in have exactly the same commercial parameters
taxation is in the first instance a search for before taxation in the two countries.
economic rent as the tax base. In contrast, a two‐sided cash flow tax (with
Investors make decisions based on the negative and positive cash flows being
expected net present value (ENPV) of an augmented or taxed at the same rate) does
investment proposal. The net present value not change the sign of the ENPV of an
(NPV) of an investment is the value of future investment; if the proposed investment has a
positive cash flows minus future negative cash positive ENPV before tax it will maintain a
flows discounted to the present at an appro- positive ENPV after tax.
priate interest rate. The ENPV of a possible There is one significant exception to the rule
investment is the weighted average of possible that a two‐sided cash flow tax will not affect
NPVs, with the weights being determined by decisions on whether to commit to an invest-
the probability of each possible outcome. ment. Different investors have different atti-
Tax neutrality is generally achieved when tudes to risk and losses. Investors are generally
an investment offering a positive ENPV understood to be averse to risk and to loss
before tax maintains a positive ENPV after (Tversky and Kahneman 1991; Hwang and
tax. Corporate income tax renders sub‐ Satchell 2010), and will value an investment
marginal any investment that is expected to with a lower spread in returns more than one
achieve before tax no more than the normal with higher spread, even if they have the same
return on investment obtainable in competi- ENPV. Investor risk‐aversion has long been
tive markets (and some investments with well understood to have negative consequences for
above normal returns). It does this in two overall investment and the severity of down-
ways. First, it requires investors to deduct turns (Keynes 1936; Zeira 1990; Castro,
their capital expenditures not immediately but Clementi and MacDonald 2004). The taxation
over time in accordance with legislated of positive cash flows and compensation of
depreciation schedules, ensuring the NPV of negative cash flows at the same rate compresses
those deductions is less than the NPV of the the probability distribution of expected after‐tax
actual expenditures. Second, it allows only outcomes; that is, it makes investments less
incomplete deductions for losses, which risky. A two‐sided cash flow tax may therefore
especially disadvantages small, innovative affect investment decisions positively, by redu-
businesses.1 Corporate income taxation is cing risk. This particular source of non‐
applied to the normal or competitive return neutrality of a two‐sided cash flow tax has the
to capital. As a result, an investment that potential to raise incentives to invest and gross
yields a positive ENPV before tax at a national income (GNI) above levels in the
discount rate reflecting a normal return may absence of taxation.
yield a negative ENPV net of the standard In some circumstances, rent taxation can
corporate income tax. reduce economic distortions. To the extent that
For an investment to qualify, the EPNV of not all expenditure or money or effort on
an investment in a competitive part of the lobbying for policy change is a deductible
economy therefore must be expected to earn a expense, it reduces the returns on rent‐seeking
before‐tax return in excess of that which behaviour. This may raise economic output by
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business
and Economics466 The Australian Economic Review December 2020
reducing the amount of resources dissipated in future productive innovation. It is not accu-
economically unproductive rent seeking rately described as rent. Investment that
(Tullock 1980; Krueger 1974), or reduce the generates quasi‐rent is not discouraged by
negative impact of regulatory distortion to the two‐sided cash flow tax proposed in this
protect firms from competition. paper. Investments to generate future income
Hence an appropriately designed cash flow are reimbursed at the same rate at which
tax is nearly neutral and to the extent that it is revenues from the innovation are taxed.
not neutral, it is non‐neutral in desirable ways. Economic rent arises whenever the pre-
It is neutral with respect to whether invest- sence of high profits in an economic activity
ment ENVP is positive or negative, because fails to induce expansion of supply to reduce
its tax base is the economic rent component of prices and profits to normal or competitive
corporate income. It is non‐neutral in reducing levels. The restriction on entry may arise
investor risks associated with economically because production requires a specific re-
valuable investment, and reducing payoffs for source, the supply of which cannot be
economically unproductive rent‐seeking. augmented by investment. Examples include
Beyond its contribution to economic wel- urban and agricultural land and mineral
fare through increased incentives to produc- resources. Land and mines that can produce
tive investment, rent taxation reduces the valuable product at lower costs than others, or
impact of a rapidly growing and economically which are favourably located, cannot be
unproductive contributor to rising inequality. reproduced through investment. The restric-
A large and growing presence of rent tends to tion may arise because there are over-
increase income and wealth inequality, owing whelming economies of scale that make it
to the narrow ownership of the scarce assets impossible for a newcomer to compete—as in
that attract rent. Unlike standard progressive a network, or an economic activity where
taxation of personal income, rent taxation is lowest cost scale of production is very large
progressive without adversely affecting in- compared with the size of the market. They
centives for participation in economically may arise because incumbents earn excep-
valuable activity. tionally high returns because they happen to
have established an oligopolistic position in
3. Types of Rent the market and are prepared to invest part
of those returns in predatory behaviour to
Economic rent is payment to a factor of protect their market power. The restrictions
production in excess of the minimum required may exist because government law or regula-
to attract it to, and hold it in, the activity in tion blocks new entrants. Different sources of
which it is engaged. In the case of firms, rent rent can interact with and reinforce each other.
is profit above that which is necessary to Some but not all restrictions that allow rent
attract the economically optimal amount of to persist are economically inefficient.
investment into an activity—returns in excess Inefficient rent may be the result of regulatory
of the supply price of competitive capital. barriers to competition that serve no public
Rent is the return in excess of ‘normal profits’. interest. Others arise from privately created
Rent persists because competition in the monopolies that are in a position to maintain
supply of a particular good or service is and to exercise market power. It is in the
imperfect or, in some cases, non‐existent. public interest to eliminate these inefficient
One apparent source of economic rent is sources of rent by removing barriers to
the temporary excess profit that occurs competitive entry, or by actively promoting
following changes in economic equilibria, competition.
which takes time for competition to erode— There are several types of rent that emerge
the phenomenon that Marshall called quasi‐ from restrictions that increase economic effi-
rent (Marshall 1890). This cannot be taxed ciency. One category results from exclusive
away without risking under‐investment in ownership of a specific land or mineral resource.
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business
and EconomicsGarnaut et al.: Replacing Corporate Income Tax 467
There is a sense in which the absence of large economies of scale include some manu-
competitive access to the resource is the result facturing activities (e.g., Diewert and Fox 2008;
of government action—through the defining Angeriz, McCombie and Roberts 2008;
and enforcement of private property rights. In Romero and McCombie 2016). Examples of
the absence of this restriction on competition, the two together include electricity transmis-
private incentives would lead to overall sion, gas pipeline and telecommunications
investment in the use of the resource in excess hardware systems. Duplication of investments
of levels that maximise the value of output. in a natural monopoly may waste resources—
For example, cost‐minimising exploitation of while the absence of competition allows the
an alluvial gold deposit may allow maximisa- owner of the established assets to maintain high
tion of economic value with 1,000 workers prices and profits at the expense of community
employed over 10 years, with half of the value welfare.
of output accruing as mineral rent to the Some activities generating efficient rent can
owner of the resource. A free‐for‐all in a gold be subject to regulation of activity or price to
rush may see the same or a lesser quantity of increase total economic value. Whatever the
gold being mined and revenue achieved with source of rent, and however rent may be
4,000 miners working for 5 years. The constrained by regulation, rent can be subject
equivalent of 10,000 worker‐years of labour to taxation without sacrifice of economic
would have been wasted. This is one example value.
of the general phenomenon of ‘the tragedy of
the commons’. 4. The Prevalence of Rent
Access to urban land is a special case.
Planning regulations are necessary to restrict The share of rent in GDP has varied widely in
investment to levels that maximise economic the course of modern economic development.
value. In the absence of planning restrictions, The rent of agricultural land was at the heart
there is likely to be over‐development of of classical economics (Ricardo 1817) and the
favourable sites, to the point where total economic and political systems from which it
economic value is diminished. Here a judi- grew, with agricultural land comprising around
cious balance has to be struck between the half the wealth in Western Europe in the early
public interest in full use of the resource, and nineteenth century (Piketty 2013). The rent of
the public interest in avoiding dissipation of private ownership of slaves contributed a large
value in overcrowding. proportion of US income at that time, and the
A second category of efficient rent results capital value of slaves constituted about half of
from government protecting private use of all wealth in the southern states by the mid‐
intellectual property resulting from scientific nineteenth century (Piketty 2013). Mineral rent
or technological or intellectual or artistic has been the main source of income in some
creation. The restriction increases incentives resource‐rich countries since the beginnings of
for economically productive investment in the modern economy, and was important
innovation, at the same time as it restricts the globally in the immediate aftermath of the oil
value generated from access to each creation. price leaps in the 1970s. Rent from the
As with urban planning, a judicious balance concentration of private ownership of business
between competing sources of value is assets was at the centre of the great fortunes of
necessary for economically optimal outcomes. late nineteenth and early twentieth century
A third category of efficient rent is ‘natural America, and its reduction the policy focus of
monopoly’, associated with ownership of a President Theodore Roosevelt (Morris 2001).
network, or a physical asset with overwhelming In the decades from the late twentieth to the
economies of scale, or the two together. early twenty‐first century, rent has expanded
Examples of network monopolies are provided its share of total income. Rent on urban land
by the main information technology and social has grown in parallel with the populations
media platforms. Examples of overwhelmingly and economic predominance of large cities.
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business
and Economics468 The Australian Economic Review December 2020
Its importance in many countries now rivals that increased by 52 percentage points since 1980.
of agricultural land in early nineteenth century The increase in G7 countries ranges from
capitalism. The United States, and increasingly around 30 to almost 150 percentage points.
China, have seen growth in rent from monopoly Ingles and Stewart (2018, p. 20) refer to
control of new intellectual property and from the various Australian and US estimates suggesting
natural monopolies of information technology the normal return on investment represents
networks. Vast new fortunes in the developing between 30 and 60 per cent of the corporate
world have come disproportionately from return, with various rents constituting the
private control of natural monopoly utilities remainder. Murphy (2018, Table 2, p. 6)
and natural resources. In Australia, a high and, estimates that 41 per cent of Australian corporate
over recent decades, an increased proportion of income tax revenue is from rent.
incomes has emanated from rent‐heavy sectors,
notably mining, urban real estate, information 5. Cash Flow Taxes as Rent Taxes
technology, financial services and large‐scale
retailing. An early version of a cash flow tax was
In the United States, where the macro proposed by E Cary Brown (Brown 1948).
and micro evidence base is developing most The Brown Tax compensates investors for
rapidly, a range of recent economic ana- negative cash flows at the tax rate and taxes
lyses has identified an increasing propor- positive net cash flows at the same rate. The
tion of rent in income from the early 1980s. two‐sided Brown Tax cannot change the sign
From 1980 to 2016, returns in excess of of the ENPV of a potential investment from
normal profits as a share of GDP have positive to negative.
grown between four and five fold In a Brown Tax, financing costs are not
(De Loecker and Eeckhout 2017, 2018; deductible expenses. Consequently, the Brown
De Loecker, Eeckhout and Unger 2020). Tax cannot distort financing choices between
See similar findings in Kurz (2017), Dixon debt and equity, whereas corporate income tax,
and Lim (2017), Barkai (2016) and Díez which allows for interest deductions, favours
et al. (2018). This was the central focus of debt over equity. The Brown Tax is based on
Olivier Blanchard's Presidential Address to annual cash flows. It allows the immediate
the American Economics Association in deduction of capital expenditures, whereas
2019 (Blanchard 2019).The rise in rent corporate income tax allows for capital expen-
accompanies increases in market concen- ditures to be written off over time in accordance
tration, especially in banking, healthcare with legislated depreciation schedules.
and ICT (US Council of Economic In years when cash outflows exceed cash
Advisors 2016; Autor et al. 2017). The inflows, producing negative cash flows, the
US economy has bifurcated into an abun- government pays to the investing company an
dance of firms with low returns and a amount equal to the negative net cash flow
narrow band of firms with super‐profits: multiplied by the rate of Brown Tax. This
returns for firms that were in the top 10 per feature makes the Brown Tax a two‐sided tax.
cent by profitability rose from 20 per cent While the Brown Tax is efficient in its
per annum in the mid‐1980s to around 100 neutrality and elegant in its simplicity, the
per cent per annum in recent years. Rent obligation of the government of the day to
has become more persistent: the odds of a make cash payments to companies may not be
super‐profitable firm still being super‐ politically acceptable in some circumstances.
profitable 10 years later have doubled since An alternative cash flow tax is the Resource
the 1990s to 85 per cent (Furman and Rent Tax (RRT) proposed by Garnaut and
Orszag 2015). Clunies Ross (1975) and further developed by
The pattern of growing rent is present in Emerson and Garnaut (1984) and Garnaut and
many countries. De Loecker and Eeckhout Clunies Ross (1983). Rather than the govern-
(2018) find that global average mark‐ups have ment making cash contributions to negative net
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business
and EconomicsGarnaut et al.: Replacing Corporate Income Tax 469
cash flows as they occur, the RRT provides for apply to all Australian mining income. The
them to be carried forward at a risk‐adjusted RSPT would allow negative net cash flows to
interest rate to be offset against future positive be carried forward at the Commonwealth
net cash flows. This accumulation rate is the bond rate for offsetting against future positive
risk‐free long‐term government bond rate plus a net cash flows. If the investment was aban-
risk premium designed to raise the accumulation doned at some time in the future when
rate to the investor's hurdle rate—or supply price accumulated cash flows were negative, the
of investment. In taxing jurisdictions where government would make a payment to the
sovereign risk is high, and if the particular investor equal to the negative accumulated
investment is considered highly risky, the supply value multiplied by the tax rate. This payment
price of investment will be high. The accumula- made the RSPT to some extent two‐sided—to
tion rate will need to be correspondingly high if the extent that the government's commitment
the discouragement of investments that would be to make the future payment was credible, and
attractive in the absence of tax is to be avoided. that the Commonwealth bond rate corre-
The RRT is, therefore, a one‐sided tax; sponded to the opportunity cost of capital
it shares in positive NPVs but not in during the period in which the negative cash
negative ones. It can change the sign of flows were being carried forward.
the ENPV of an investment from positive to Following the Australian Government's
negative and therefore is not strictly neutral. announcement of the RSPT in the 2010
However, it is more nearly neutral than Budget, the Minerals Council of Australia
corporate income tax and most other taxes (MCA) invested heavily in an advertising
in practical application around the world campaign aimed at defeating the tax. Many of
(see Garnaut and Clunies Ross 1983 for its criticisms did not have an analytic basis.
comprehensive comparisons). One did. Businesses were being expected to
An operating example of the RRT is the rely on government‐legislated assurances that
Petroleum Resource Rent Tax (PRRT) intro- negative net cash flows carried forward would
duced by the Australian Government in 1987 be the subject of a cash refund from a future
for application to offshore petroleum devel- government. Since this accumulation process
opments. The initially legislated accumulation could be conducted over decades, rational
rates for the PRRT were, for exploration investors would take account of the risk of
expenditure, the long‐term bond rate plus these deductions being disallowed through
15 percentage points, and for other expendi- amending legislation. It is reasonable to doubt
ture the long‐term bond rate plus 5 percentage whether a future government would be certain
points. These and other features of the PRRT to honour a distantly preceding government's
were reviewed in 2017 and the accumulation commitment to provide large cash refunds on
rate for exploration was reduced to the long‐ unsuccessful investments.
term bond rate plus 5 percentage points. The Following the 2010 election, the Australian
rate of the PRRT is 40 per cent. The data Government abandoned the RSPT, introdu-
required for assessment of PRRT is essentially cing in its place in 2012 the Minerals Resource
the same as that required for application of the Rent Tax (MRRT) at the rate of 22.5 per cent.
corporate income tax. It can therefore rely on This took the form of the PRRT, with special
established tax law and practice—now aug- arrangements for historical deductions. The
mented by two decades of application of the coverage of the MRRT was limited to iron ore,
PRRT itself. coal and natural gas. An historical cost base
A 2010 review of Australia's tax system for existing projects was negotiated with the
chaired by then Treasury Secretary Ken Henry mining industry, with the effect of wiping out
(Australian Treasury 2010) recommended a expected liability for MRRT for a number of
hybrid of the Brown Tax and the Resource years ahead. As deductions from the cost
Rent Tax for application to mining income. Its base began to approach exhaustion for
Resource Super Profits Tax (RSPT) was to some companies, the incoming Australian
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business
and Economics470 The Australian Economic Review December 2020
Government following a 2013 election Nassios (2018) in Australia, and Altig et al.
scrapped the MRRT. (2001) in the United States.
Another approach to rent taxation is the One of Murphy's modelling runs replaces
allowance for corporate equity (ACE). It the corporate income tax with the ACC while
adjusts the normal corporate income tax base retaining full dividend imputation. He obtains
by deducting an allowance calculated as a a gain to consumer welfare of $18 billion but
normal, competitive rate of return multiplied at a cost to revenue of $26 billion. A more
by the equity value of the company. In this modest proposal involves reducing the
way, the ACE seeks to exempt from tax the corporate income tax rate from 30 per cent
normal, competitive returns on investment, to 25 per cent and introducing a rent tax at the
taxing only economic rent. The ACE tax rate rate of 8 per cent on the financial sector only.
would need to be high in order to collect the Murphy estimates that, when the effects of the
same amount of revenue as the existing change have fully flowed through the
corporate income tax that it would replace. economy, this proposal would collect the
The ACE is a variant of a general rent tax same amount of revenue as the established
proposed by Boadway and Bruce (1984), corporate income tax at a rate of 30 per cent,
which has become known as the allowance with a welfare gain of $5.4 billion. Murphy's
for corporate capital (ACC). Instead of estimates of the gains rely on an assumption
allowing a deduction for a return on equity, that there would be substantially less tax
as with the ACE, the ACC allows a deduction avoidance by multinational corporations at
for a return on debt and equity combined, but lower rates of corporate income tax. There is
interest payments are not deductible. no empirical or analytic support for this
Recognition of the increasing role of assumption. More generally, Murphy advo-
economic rent in corporate income and its cates a corporate income tax rate of 20 per
perverse effect on economic efficiency and cent, a financial services rent tax and major
equity in income distribution has led in recent changes to the dividend imputation system.2
times to the proliferation of suggestions for While Murphy estimates the impacts at a
alternative approaches to taxing rent. For point in time after economic adjustment to the
example, Collier (2018) has argued for higher new regime, Dixon and Nassios track the path
taxation on incomes of large enterprises and of the adjustment over time. Dixon and
of residents in large cities as a way of Nassios track the effects of reducing the
concentrating taxation more heavily on rent. corporate income tax rate to 25 per cent.
We see larger gains and smaller losses in They take into account the welfare losses to
seeking an increase in the incidence of Australian nationals from giving foreign
taxation on economic rent through an appro- investors a windfall gain on their pre‐
priately designed cash flow tax. existing Australian investments made in the
Discussion of and experience with alter- full expectation of a 30 per cent corporate
natives leads us to favour the efficient and income tax rate. Dixon and Nassios conclude
elegant two‐sided Brown Tax. that the reduction of the tax rate would lead to
a fall in national income.
6. Previous Modelling of Rent Taxes Based on their own tax design analysis and
Murphy's modelling, Ingles and Stewart
Various efforts have been made to model the (2018) suggest various options, including
fiscal and macro‐economic effects of substi- combining corporate income tax at a lower
tuting rent taxes for corporate income tax, or rate with a tax that denies interest deduct-
of reducing the corporate income tax rate ibility and ultimately replacing the corporate
while introducing a rent tax at a low rate. income tax with a rent tax.
Prominent among these are the computable Altig et al. (2001) simulate five possible
general equilibrium (CGE) modelling exer- cash flow tax reforms in the United States.
cises of Murphy (2018) and Dixon and Some of these variants have properties that are
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business
and EconomicsGarnaut et al.: Replacing Corporate Income Tax 471
improbable in the Australian and indeed the certified cash loss could be made available for
US context, such as the removal of progres- offset against any cash flow tax payable by
sive taxation or the application of the tax to any entity. The taxpayer would be permitted
housing wealth. Each of the five cash flow to sell the certified amount to another
taxes is expected to raise investment and company for offset against its own current
national income. The variants closest to our cash flow tax liabilities. The private sector, the
model provide the highest national income Australian Securities Exchange (ASX) or the
and wage gains, of three to six percentage ATO could create a market for such offsets,
points over 13 years, with gains continuing to which would trade at face value minus
grow into the future. By broadening the tax transaction costs.
base, they also allow for the lowest capital
income taxation rates. The models lack details
appropriate to the contemporary Australian 8. Specific Design Issues
context, including the treatment of intellectual
property and services, mechanisms of invest- 8.1 Treatment of the Financial Sector
ment expensing, and international tax arbit-
rage, and are, of course, modelled using US Our analysis of the treatment of financial flows
economic data. under a cash flow tax follows the structure laid
out by the Meade (1978) Committee on UK tax
7. Replacing Corporate Income Tax with a reform, which has since become conventional.
Cash Flow Tax The Committee drew a distinction between
flows resulting from real transactions and those
We propose replacing the corporate income from purely financial transactions. Following
tax with a form of cash flow tax that has the Meade Committee notation, take R as real
two‐sided character of the Brown Tax. The inflows and R̅ as real outflows, and F as
cash flow tax would have as its base net cash financial inflows and F̅ as financial outflows (see
flows, being taxable revenues (excluding any Table 1, from Auerbach et al. 2017). The two
interest income) less non‐financing cash out- standard options for structuring the tax base are:
lays (operating costs plus capital expenditure,
but with no allowance for interest or other An R‐base, taxing real inflows net of real
financing costs). The accounting data for outflows only: R − R̅
revenues and expenditures would be exactly
the same as for corporate income tax and the An R + F‐base, adding financial inflows and
PRRT, so that established case law would deducting financial outflows: (R + F )
apply. No distinction is drawn between capital – (R̅ + F̅ )
and recurrent expenditure.
For typical capital‐intensive projects, net Choosing between these options has
cash flows in the early years will be negative. proven challenging for past specifications
Negative cash flows could also arise late in the of a cash flow tax. The R+F‐base has the
life of a project when large capital expenditure advantage of taxing the rent of financial
is required for refurbishments or dismantle- institutions, but imposes prohibitively com-
ment of ageing assets such as oil and gas plex tax accounting requirements on busi-
platforms or, possibly, in years of low prices nesses and may encourage perverse profit
and sales revenue. In years when negative net deferral (Auerbach et al. 2017; see Poddar
cash flows are recorded, we propose that an and English 1997; Zee 2005 for some
amount equal to the negative net cash flow untested approaches to simplification). The
multiplied by the tax rate be certified by the R‐base, on the other hand, may substantially
Australian Taxation Office (ATO) and rebated simplify tax calculations compared to the
to the taxpayer. If political judgements existing corporate income tax and may even
weighed against a straightforward rebate, the be automated for many smaller businesses
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business
and Economics472 The Australian Economic Review December 2020
Table 1 Components of R , R̅ , F and F̅ in R and the border between real and financial flows for
R+F‐Base Taxation financial firms.
Inflows Outflows
Non‐financial firms will face incentives to
disguise some real flows as financial flows. As
Real items suggested in Auerbach et al. (2017), quasi‐
R 1 Sales of goods R̅ 1 Purchase of materials financial transactions, such as delayed pay-
R 2 Sales of services R̅ 2 Wages and salaries ment schemes, would be treated as real flows.
R 3 Sales of assets R̅ 3 Purchase of fixed Non‐financial firms engaged in limited but
assets
substantial financial activities over a specified
R R̅
Financial items threshold may be obliged to submit tax returns
F 1 Increase in any forms F̅ 1 Decrease in any forms for the cash flow tax and FSIT.
of borrowing of borrowing
F 2 Decrease in any forms F̅ 2 Increase in any forms
of lending of lending 8.2 Countering Base Erosion and Profit
F 3 Decrease in cash F̅ 3 Increase in cash Shifting
F 4 Interest received F̅ 4 Interest paid
F 5 Decrease in holding of F̅ 5 Increase in holding of
foreign shares foreign shares
Multinational corporations shift profits to tax
F F̅ havens or to lower‐tax jurisdictions through
inflated related‐party interest payments (from
artificially high gearing or artificially high
interest rates, or both); transfer pricing
(US President's Tax Reform Panel, 2005), between related parties for sales (including
but excludes financial flows from its through dedicated marketing hubs in low‐tax
coverage. jurisdictions); and inflation of technology and
We propose avoiding these problems by management fees to affiliates. Global digital
combining an R‐base cash flow tax for all corporations are famously adept at using
except financial firms, with separate provisions technology and management fees to shift
for the taxation of financial firms. For simpli- profits to low‐tax or zero‐tax jurisdictions.
city, we propose taxing financial firms under A cash flow tax removes tax avoidance
the existing corporate income tax regime, but problems arising from artificially high gearing
with the immediate expensing of investment. and high interest rates for loans from related
Taxable income for financial firms would be parties by excluding financial transactions
interest received minus interest paid, plus fees, from its base.
minus current costs and capital expenditure. We propose removing problems from
This modified corporate income tax—the technology and management fees paid to
Financial Sector Income Tax (FSIT)—is similar foreign affiliates by allowing no deduction
to the Financial Activities Tax, or FAT, for imported services, unless the taxpayer
proposed by IMF staff (Claessens, Keen and demonstrates that they relate to current
Pazarbasioglu 2010; Keen, Krelove and expenditure on goods and services directly
Norregaard 2016), and the Financial Services required for the sale to the Australian
Tax proposed by Henry's Future Tax System taxpayer. For foreign investment in research
Review (2010). Our proposal would require no and development, the presumption is that
changes in data collection compared to the earnings from sales to Australia are an
existing corporate income tax so it can be economic rent—except to the extent that
readily implemented. they require specific expenditure on adapta-
The FSIT would be applied at the same rate tion to Australian conditions. This is unlikely
as the cash flow tax. A single rate across all to cause any reduction in global research and
activities removes one potential incentive to development, given the small proportion of
disguise financial flows as real flows, and vice expected early sales to Australia in the
versa, hence reducing the burden of enforcing technology firms’ plans for investment.
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business
and EconomicsGarnaut et al.: Replacing Corporate Income Tax 473
Payments for Australian technology and standard corporate income tax to a cash flow
other services would be deductible as in the tax. We have not included this extension of
current corporate income tax, but with im- the proposal in our revenue estimates.
mediate expensing of all expenditure on
research and development. Immediate expen- 9. Arrangements for Transition and
sing with provision for compensation of Effects on Revenue
negative cash flows at the tax rate would be
highly encouraging of Australian investment We propose phasing in a cash flow tax while
in research and development. Existing incen- simultaneously phasing out the existing cor-
tives for Australian research and development porate income tax under an ‘irrevocable
have their justification in externalities and switch’ scheme.
should not be affected by the changes in An irrevocable switch scheme enables any
taxation. taxpayer to elect in any year in the first
An anonymous referee has commented that 10 years of the new tax system to immediately
the proposal for denying deductions for and fully switch from corporate income tax to
imported services that are not directly related cash flow tax. If there has been no prior
to sales to Australia could be introduced into election, the switch would occur after the
the existing corporate tax system, indepen- 10th year.
dently of the shift to the cash flow tax. That We envisage the FSIT applying to financial
would cause the existing corporate tax to raise institutions from the beginning of the transi-
more revenue than it does now. While that is tion. The FSIT is more favourable to banks
true, the treatment that we propose for than the established corporate income tax.
imported services sits more comfortably For this scenario we model the revenue
within the logic of a rent tax than a standard impact of the reform with a 30 per cent tax
corporate income tax. However, we have no rate. We take as the 10‐year transition period
objection to a reader choosing to see our 2020–21 to 2029–30.
proposed reform as a package of two reforms: Summary outcomes under each option for
the shift to a cash flow case for corporate the final year of the transition period are
taxation; and the proposed treatment of presented in Table 2. The results relate to
deductions for imported services. The revenue Australian companies with aggregated annual
effects of the proposed reforms are then the turnover above $25 million. The methodology
revenue effects of the package. Within this underpinning the calculations is provided in
package, the denial of the deductions for the Appendix.
imported services unless there is a direct link By moving to a cash flow base, taxable
to provision of the services in Australia would income is increased by $128.2 billion in
account for about $12 billion of the $162 2029–30. If the cash flow tax rate were
billion contributed by the Cash Flow Tax in maintained at 30 per cent, the increase in tax
2029–30. The denial of the deductions for collection above the existing corporate in-
imported services would account for about come tax is an estimated $37.5 billion.
$73 billion of the $1,180b contributed over The transition path of the estimated tax
the decade 2020–21 to 2029–30. payable under the irrevocable switch scheme
An anonymous referee has commented that over the period 2020–2021 to 2029–30 is
our paper is directed to corporate income presented in Figure 1. By the year 2029–30
alone, and not to business income, and the revenue for the cash flow tax is estimated
suggested that we should spell out how other to be $179.1 billion and the revenue from
business income would be treated. There corporate tax $141.6 billion. Our modelling
would be additional efficiency gains in assumes 50 per cent of companies switch in
extending the proposal to all business income. the first year while the rest switch in the 10th
That is an appropriate focus of future effort by year. This assumption is based on likely
a government committed to changing the corporate responses to the opportunity to
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business
and Economics474 The Australian Economic Review December 2020
Table 2 Estimated Taxable Income and Tax Revenues in 2029–30
30% Tax rate
Taxable income Diff. to Tax payable Diff. to
(2029–30) company tax (2029–30) company tax
Tax scheme Transition scheme $ million $ million $ million $ million
Existing 546,324 141,645
company tax
New cash flow Irrevocable switch, 674,561 128,237 179,095 37,450
tax with FSIT immediate CAPEX
deduction
Source: ISA Analysis with data from ATO, ABS, S&P Capital IQ and Ruthven Institute.
increase the present value of deductions by period, and increase them later by larger
taking them earlier. We expect that business amounts.
investment would be much larger under the Under the irrevocable switch scheme,
cash flow tax, but we have modelled future higher levels of capital expenditure are
revenues on the basis that there is no change assumed in the first 2 years of the transition
in levels of investment. Higher investment period, resulting in negative revenue out-
would reduce taxation revenues early in the comes before recovering and overtaking
Figure 1 Irrevocable Switch and Corporate Income Tax, Revenues by 2029–30 (30 per cent tax rate for cash
flow tax)
Source: ISA modelling with data from ATO, ABS, S&P Capital IQ and Ruthven Institute.
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business
and EconomicsGarnaut et al.: Replacing Corporate Income Tax 475
projected revenues from the company tax in Cross‐checking of our estimates reveals that
the third year. The pattern of capital invest- most of the estimated revenue gain is
ment under the scheme is depicted in Figure 2. attributable to taxable entities with interna-
The spending profile shows significant front‐ tional dealings. These estimated revenue
loading in the early years as companies take gains come from privately held companies
advantage of immediate deductions of their —international branches of foreign‐owned
investment expenditure. and Australian‐owned enterprises. The pro-
In our estimates of additional tax revenue posed approach reduces revenue leakage
under the cash flow tax, we have endeavoured to associated with transfer pricing surrounding
use the best available public data. We have global supply of capital, intellectual prop-
sought to overcome the apparent behavioural erty and conventional physical supply
bias in publicly available data sources collated chains.
by the ATO embedded in the ATO's Material problems that arise around transfer
International Dealings Schedule, which experts pricing by consolidated operations include:
have told us may tend to understate taxable
income reported in Australia.3 Our approach (i) contract production of factory‐less goods
has also been sense‐tested by professionals with (for example, Apple does not produce
deep experience in international dealings. We iPhones in Australia but charges the
believe our projections are conservative, since branch office for the intellectual
they do not account for second‐round efficiency property);
gains that are likely to increase productive
investment and other economic activity (ii) the creation of special‐purpose entities
and hence contribute to larger revenues (as where intellectual property is parked by
identified in Altig et al. 2001). foreign affiliates (for example, Ireland, a
Why are the estimated revenues from tax shelter, saw GDP jump by 26 per
taxing rent via the cash flow tax larger than cent in 20154 because of a one‐off sale of
from the standard corporate income tax? a special purpose entity); and
Figure 2 Assumed Profile of Capital Expenditure under the Irrevocable Switch Scheme
Source: Derived from ABS Cat.5206.0.
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business
and Economics476 The Australian Economic Review December 2020
(iii) use of debt by large capital importers to and incentives to invest in activities that would
reduce Australian income.5 raise Australian output and incomes. It would
remove taxation on normal profits—the expected
10. Preferred Transition Approach income of firms operating in a competitive
environment. This would include most small
Companies that had incurred large amounts and medium‐sized businesses.
of debt in the period prior to the introduction The cash flow tax would substantially
of the cash flow tax, and have low expecta- increase incentives for investment—or rather,
tions of capital expenditure in future, are remove powerful disincentives inherent in the
likely to opt to remain in the corporate standard corporate income tax for investment
income tax system for as long as possible, in capital‐intensive, long‐lived and more risky
enabling them to claim deductions for investments.
interest paid. Companies with big investment The cash flow tax would encourage
plans during the early years of the transition investment in innovation, including, but not
will have an incentive to switch to the cash only, through research and development.
flow tax, enabling them to immediately It would do this by compressing the prob-
expense all eligible capital investment. Still ability distribution of expected outcomes
other companies might opt into the cash flow of investments—unsuccessful investments
tax during the middle of the transition, would be compensated at the cash flow tax
having claimed interest deductions on prior rate. The recoupment of ‘tax losses’ at the tax
investments for corporate income tax pur- rate from early years of negative cash flows
poses and looking forward to obtaining the would also support the financing of innova-
benefits of immediate expensing of new tive investments, including those requiring
capital expenditures under the cash flow research and development.
tax. Firms incurring or expecting to incur The cash flow tax would systematically
negative cash flows as a result of recession favour small businesses in comparison with
are likely to opt for immediate transfer to the their treatment under the standard corporate
cash flow tax. income tax. They are much more likely to
Financial companies would be subject to a attract tax losses because of the competitive
FSIT from the beginning. This is the existing environment in which they operate and the
corporate income tax regime, but with im- greater likelihood that their losses will never
mediate expensing of investment. be recouped under established arrangements.
The cash flow tax would remove incentives
11. Conclusions to distort financing structures to avoid tax, by
artificially inflating reliance on debt. This is
We have formed and tested the view that likely to contribute positively to efficiency.
replacing the corporate income tax with a cash The removal of artificial encouragement to
flow tax with the design set out in this paper debt financing would make the economy less
would contribute substantially to efficiency vulnerable to financial crises.
and economic growth, and to a more equitable The cash flow tax would remove or greatly
distribution of the tax burden. It would protect reduce the main opportunities currently used
the Australian fiscal system from the con- for avoiding and evading Australian corporate
temporary ‘race to the bottom’ in international income taxation—artificially high interest
rates of taxation of corporate income, and it payments and foreign technology and man-
would remove a number of distortions in- agement fees.
herent in the current system of corporate It would also remove a large, systematic
income taxation. bias in favour of foreign and larger enterprises
The cash flow tax would substantially improve against Australian‐owned and smaller enter-
the trade‐off between the amount of tax collected prises in the current corporate tax system,
© 2020 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business
and EconomicsGarnaut et al.: Replacing Corporate Income Tax 477
through removing opportunities for avoidance ATO, which has access to more up‐to‐date
and evasion that are generally more readily data and a better understanding of the impact
available to foreign and larger enterprises. of recent international tax compliance
The cash flow tax would be more equitable, initiatives.
because its incidence would be larger on high We are confident that the various benefits to
incomes, as a result of the concentration of economic efficiency and economic growth
ownership of corporations earning large outlined above would lead to a substantial
amounts of economic rent. increase in investment, productivity and
The cash flow tax would reduce incentives incomes. There would be a decisive shift in
for rent‐seeking pressures on government to the tax burden toward enterprises generating
introduce laws and regulations that reduce income from rent with little new investment,
competition. It may therefore contribute to and away from businesses prepared to make
economic efficiency, output and incomes in large commitments to new investments. The
two ways: by reducing the waste of resources increased incentives for investment would be
in rent‐seeking behaviour; and by reducing especially strong in the competitive parts of
deadweight losses from regulatory distor- the economy, where small and medium‐sized
tions as a result of rent‐seeking pressure on businesses are dominant.
government.
Finally, the introduction of the cash flow Endnotes
tax now would be highly expansionary, at the
time when the economy needs stimulus of 1. Presently, businesses making losses can carry them
demand. With taxpayers free to choose when forward for seven years at zero interest only. With
they move to the new tax, those with large deductions less than the NPV of expenditures, this is a
disincentive for investment. More significantly, small
investment plans would shift to the new businesses are less likely to survive long enough to
regime and be more likely to make larger benefit from loss deductibility. This inefficiently dis-
and earlier investments. Companies, espe- courages small business from pursuing positive‐ENPV
cially small businesses, incurring losses now innovations.
in the pandemic recession would receive 2. Murphy (2018), p. 32.
partial reimbursement for those losses. These 3. The aggregate company tax data presented by the
sources of loss to the revenue are advanta- ATO in its Australian Taxation Statistics publication
geous now on macro‐economic policy and associated detailed table presents the most detailed,
grounds. The macro‐economic stimulus would line‐by‐line, breakdown of the contributions of various
be automatically withdrawn as operatingosses revenue and expenditure items to reported company tax
payable. However, for international dealings, the
fall as the economy moves out of recession summary table which aggregates all information
and early recipients of tax offsets for early presents only a partial summary of the entirety of all
investments qualify for smaller deductions in transactions engaged in by entities. This gives
later years than they would have done. taxpayers an opportunity to filter what they report and
We have designed the proposed cash flow scope to understate their tax payable from overseas
transactions. Also, there is no arithmetic check‐sum for
tax to be relatively easy to implement, the incomplete set of international dealings that are
drawing mainly from concepts and data that reported by an entity back to the company tax return.
are required in assessment of the current Therefore, we believe the international summary
corporate income tax and Petroleum Resource reported by the ATO will tend to systematically
understate the tax payable by entities. Evidence for
Rent Tax. We have introduced transitional
this is the fact that collectively, international corpora-
arrangements that would avoid sudden and tions have constantly run multi‐billion dollar losses
large changes that detract substantially from year after year. Our projections incorporate an adjust-
the expectations of established businesses. ment factor to reflect the recent enhanced enforcement
The best publicly available data has short- activities by the ATO in international dealings.
comings, and we look forward to our 4. OECD 2016, Irish GDP up by 26.3% in 2015? viewed
estimates being improved by bodies like the 13 November 2018 .
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