House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Minister for Small Business, the Hon Bruce Billson MP)

Chapter 2 Regulation impact statement - Small business company tax cut

Background

2.1 The Australian economy is in transition and faces significant structural challenges due to both domestic and international factors. Mining investment is now detracting from GDP growth. The switch to broader-based growth driven by activity in non-resource sectors is occurring, but perhaps more slowly than is desirable.

2.2 Below trend economic growth is leading to spare capacity in the labour market and increasing unemployment, particularly youth unemployment. Economic growth has been below its long run average in 5 of the past 6 financial years, weighing on job creation and contributing to a gradual upward drift in unemployment.

2.3 Low interest rates, a falling Australian dollar and real wage adjustment over time are expected to support employment and encourage business growth over the longer term.

2.4 There have been some positive signs the required adjustment is underway, including job advertisements showing a slight upward trend in recent months ^[1] .

2.5 However there is a risk of the adjustment being a protracted one, particularly given businesses remain reluctant to invest and take on new workers absent stronger sustainable demand. ^[2] Investment in the non-mining sectors continues to be subdued, ^[3] and small businesses have responded by scaling back the level of their capital spending. ^[4] Longer-term capital expenditure plans have also been revised down significantly in the non-mining sector, notwithstanding solid growth this year.

2.6 The Government committed to introducing a 1.5 per cent small business tax cut from 1 July 2015 in the Coalition's Policy for Small Business. ^[5] On 2 February the Prime Minister announced a small business and jobs package would be announced in the 2015-16 Budget.

The problem

2.7 Incorporated small businesses make an important contribution to the Australian economy. They, along with unincorporated small businesses, account for the vast majority of the active private businesses in the country and represent large shares of its employment and value added.

2.8 There are currently around 780,000 incorporated small businesses or over 30 per cent of the 2.3 million small businesses in Australia (defined as having less than $2 million turnover). According to the Australian Bureau of Statistics, small businesses provide around 43 per cent of non-financial private sector jobs in Australia and around one third of non-financial output in 2012-13. ^[6] The small business sector has the potential to contribute strongly to national growth and competitiveness, including providing greater employment opportunities. Small businesses have the advantage of being adaptable and flexible, able to respond profitably to changing circumstances. Studies indicate that it is small businesses that are often the entities that test and pioneer innovative ideas and business practices which are critical to future economic growth, job prospects and improved living standards.

2.9 However, while small companies play a significant role in the Australian economy, they also face a unique set of operational challenges, and as a consequence typically have higher failure rates than those for larger companies. A comparison of the outcomes of the National Australia Bank (NAB) survey of large companies, with the Sensis survey of small businesses undertaken by the Reserve Bank suggests that conditions for small business have been weaker than for larger businesses since the global financial crisis in 2008-09. ^[7]

2.10 One issue is regulatory costs; incorporated small businesses face higher proportional regulatory costs than larger companies due to their inability to take advantage of economies of scale in understanding and complying with regulation.

2.11 The other main issue for small companies is access to finance. Funding for small businesses is essential to facilitate productivity growth and job creation. Improving small business's access to finance was a Government election commitment. ^[8]

2.12 The tax rates which apply to Australian companies are above the Organisation for Economic Co-operation and Development (OECD) average ^[9] and may be discouraging investment. The higher a company's tax rate, the less retained earnings the company will have for reinvestment. Reducing tax rates would allow incorporated small businesses to retain more of their earnings, allowing them to invest more and expand their business activity. Modifying the tax system to better encourage new small business investment could enhance productivity over time through capital deepening.

Case for government action / Objective of reform

2.13 While it is businesses which create jobs, there is a clear role for Government to address impediments and create the right conditions for Australian small businesses to grow and become more productive, creating more jobs. With the economy facing below-trend growth, the Government's objective is to stimulate small business growth and employment, through reduced tax and regulatory barriers.

2.14 The Australian economy is in transition. The declining terms of trade and the ageing of the population are placing downward pressure on income growth. Small businesses are a key driver of Australia's economy, underpinning growth and innovation and providing jobs for millions of Australians.

2.15 Small businesses are typically more vulnerable to shocks and changes in economic conditions than larger businesses. This makes it particularly important that, during this period of economic transition, the policy settings support small business growth and innovation. This proposal will deliver lower taxes to incorporated small businesses to help them grow.

2.16 Providing incorporated small businesses with a reduced rate of company tax will permit them to retain more earnings for investment. Investment is important as it leads to existing output being produced at a lower cost (capital deepening) and new and improved ways of doing business (innovation), which improves the amount of output produced for each unit of input, including labour (productivity). As a result, higher investment can lead to higher employment and wages over time. However, given the small size of these companies, the overall macroeconomic impact is unlikely to be as significant compared to a broader tax cut to all companies.

Policy options

Option 1: No policy change

2.17 Under this option, no new actions would be taken by the Government and existing policy settings would be relied upon.

Option 2: Company tax cut for incorporated small businesses

2.18 The Prime Minister announced at the National Press Club, that 'at the heart of our small business jobs package will be a small business company tax cut on July 1 - at least as big as the 1.5 per cent already flagged' to apply from the start of the 2015-16 financial year.

2.19 Under this option, a company tax cut of 1.5 per cent would be provided to incorporated small businesses (defined as those companies with turnover of less than $2 million) for income years beginning on or after 1 July 2015. This is consistent with the Government's election commitment to provide small business with a 1.5 per cent tax cut, as outlined in the policy document, Coalition's Policy for Small Business. ^[10]

Cost benefit analysis of each option / Impact analysis

Option 1: No policy change

2.20 This option involves no new actions by the Government and relies on existing policy settings. Consequently, it would introduce no new impacts on businesses, community organisations or individuals. At the same time, it would not address the issues identified in the Problem section.

2.21 As noted in the background, low interest rates, a falling Australian dollar and real wage adjustment over time can be expected to support employment and encourage business to growth over the longer term, along with increasing infrastructure investment and already announced measures to reduce regulation and red tape burden to make it easier to do business. However, a long, drawn out adjustment process would have substantial social costs, as identified in the Problem section.

Option 2: Company tax cut for incorporated small businesses

(a) Company tax rate reduction for small business

2.22 A corporate tax cut targeted to small businesses (defined as incorporated businesses with aggregated turnover less than $2 million) beginning on or after 1 July 2015.

2.23 This proposal would create a two-tier company tax system whereby:

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the whole of a company's taxable income would be subject to a tax rate of 28.5 per cent if its aggregated turnover is below a $2 million threshold; or

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the whole of a company's taxable income would be subject to a 30 per cent rate if its aggregated turnover is equal to or above a $2 million threshold.

2.24 The maximum amount of franking credits a small incorporated business can attach to its dividends in a year - its franking cap - will not be reduced along with the tax rate. The franking cap for small businesses will stay the same as for large businesses.

Benefits

2.25 Providing incorporated small businesses with a reduced rate of company tax would improve small business cash flow and assist them to grow and to compete more effectively with larger businesses. It is estimated that over 780,000 companies could potentially benefit from this proposal.

2.26 Being a tax-based assistance measure, the financial benefit for individual companies will be proportional to the amount of tax they pay. The benefit will be more significant for eligible companies with higher taxable profits.

2.27 Reduced tax payable by small businesses will allow them to retain more earnings for reinvestment. Investment is important as it leads to existing output being produced at a lower cost (capital deepening) and new and improved ways of doing business (innovation), which improves the amount of output produced for each unit of input, including labour (productivity). As a result, higher investment can lead to higher employment and wages over time. While a cut in the company tax rate will not immediately benefit the majority of small to medium enterprises that are not operating in a company structure, they are likely to benefit, to some extent, from the economy-wide benefits that flow from the cut. However, given the small size of these companies and average reduction in tax paid, the overall macroeconomic impact is unlikely to be large.

2.28 The benefit of this measure should not be assessed in isolation but considered as part of the small business package. Small businesses may be eligible for more than one of the different proposals, dependent on their level of taxable income or whether they are incorporated or unincorporated.

2.29 Keeping the maximum amount of franking credits a small incorporated business can attach to its dividends in a year the same as large companies while the tax rate decreases means shareholders in dividend paying incorporated small businesses would be better off. Shareholders could receive franking credits in excess of the tax rate applicable to these companies, providing there are enough franking credits in these companies' accounts, (recognising that companies may not fully distribute their taxable income in any year). This would effectively reduce the shareholders' overall tax paid regardless of their marginal tax rate.

Costs

2.30 Revenue loss for government in the short term is estimated to be in the order of $1.45 billion over the forward estimates (-$250 million in 2015-16 and -$400 million per annum from 2016-17 to 2018-19). However, the ongoing loss may be reduced in the long term to the extent that higher business earnings and employment as a result of the tax cut increases government revenue.

2.31 Keeping the maximum amount of franking credits a small incorporated business can attach to its dividends in a year the same as large companies comes at a cost to revenue as the Government is providing franking credits in excess of the tax rate applicable to incorporated small businesses. As a result, some shareholders will pay tax at less than their marginal tax rate on dividends.

2.32 It is expected there will be an initial compliance cost for businesses and their accountants/tax advisors/tax agents in learning about and understanding the change, and implementing it into their accounting systems. However, the model is largely based upon the existing company tax system. This one-off adjustment cost is estimated at $35 per company, or $30 million in total.

2.33 A widening of the differential between company and personal tax rates might provide an additional incentive for high income individuals to structure their services through incorporation to get the tax benefit, therefore incur additional compliance costs in doing so. Aggressive tax planning might also lead to subsequent revenue losses. If unincorporated businesses restructured to take advantage of the lower tax rate, they would incur initial costs of incorporation and ongoing costs to satisfy corporations act requirements. This risk may be lowered if a separate proposal to provide assistance to unincorporated businesses is also adopted.

2.34 A company crossing the threshold between the lower and higher tax rates will be subject to an additional tax liability on the taxable income under the threshold that was previously assessed at the lower small company tax rate. This tax 'cliff' could be a disincentive to growth and, while it would not be very large in most circumstances, it adds to the existing disincentives within the system to grow above the small business turnover threshold.

2.35 In addition, businesses that are close to the threshold could attempt to actively delay recognition of income and/or bring forward deductions in order to fall under the small business threshold and be eligible for the lower tax rate. However, such behavioural responses are likely to be uncommon as only a small number of companies would be close to the threshold in a given year. Those companies close to the threshold, estimated at around 5,500 companies, will have some compliance costs associated with determining their tax position which is estimated at $35 per company or $200,000 in total.

2.36 It is expected that the taxpayers and their tax agents will have very minimal ongoing compliance cost because system changes required are expected to be a one-off change.

2.37 Medium and large companies will not incur any costs from the change as their tax outcomes are unchanged.

2.38 The ATO will initially have significant administrative costs in applying the two-tier company tax system, which should decrease over time as issues are settled and system changes are put in place.

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Adjustments to ATO systems may be required.

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The ATO might devote greater efforts to police the boundary (threshold) and relevant integrity rules, but this is limited to a small proportion of taxpayers in the population

2.39 The assessment is that the potential compliance cost impact to be medium overall comprising a medium implementation impact and a low ongoing compliance cost relative to the affected group. The table below gives the dollar costing of these estimates.

2.40 The measure is subject to the normal compliance cost offset requirements, which require that any additional compliance costs be fully offset by compliance cost reductions elsewhere. The increased regulatory costs are offset by the regulatory cost reductions associated with a proposal to align the legal frameworks for personal and corporate insolvency practitioners.

Net Benefit

2.41 This proposal would potentially benefit over 780,000 small incorporated businesses. However, being a tax-based assistance measure, the benefit will be proportional to the amount of tax a company pays. This measure will benefit tax paying incorporated small businesses by improving their profitability and competitiveness, which ultimately can lead to higher employment and wages over time.

5. Consultation

2.42 The tax proposals have been informed by targeted consultation with tax specialists outside government, including the Board of Taxation (the Board), on an in-confidence basis. Descriptions of the tax measures being considered were provided to Board members out-of-session for discussion at the Board's March 2015 meeting. A follow-up teleconference was also held with the small business tax experts of the Board. The purpose of the teleconference was to provide Board members with the opportunity to provide more detailed feedback on the options identified for improving the way that small businesses and their owners are taxed.

2.43 The feedback from the Board was that a tax cut would be warmly received, and would send a positive message that the Government is doing something for small business. The Board questioned whether the suggested amount would make a significant difference to eligible companies as it would have a minimal impact on cash flow. Other issues raised by the Board mostly were around the complexities of applying a small business threshold. The Board recommended a turnover rather than an income test which was adopted.

2.44 The scale and turnover issues were considered in the policy development process. While larger tax cuts would be favoured by industry in isolation, larger tax cuts would have come at the expense of the other small business assistance measures such as accelerated depreciation. High turnover, low margin businesses may criticise a turnover test as it does not take account of profit margin variations, but such a test is robust because it is less exposed to manipulation than an income test.

2.45 The Treasury also consulted with the ATO in order to identify any implementation issues, integrity concerns with the proposals, or any potential flow-on impacts they might have within the broader tax framework.

2.46 The limited consultation on the proposals reflects the cabinet-in-confidence nature of the decision making process. However, it should be noted that the proposed tax options have already been the subject of, and informed by, extensive consultations undertaken as part of previous policy processes.

2.47 To inform the 2014 Board of Taxation Review into Tax Impediments Facing Small Business, the Board encouraged broad participation by writing directly to stakeholder groups and holding consultations with 48 stakeholder groups as well as further targeted consultations with experts on specific issues. The review recommendations were also informed by the 43 written submissions received. As this was a fast-track review the Board did not issue a discussion paper. The review recommended increasing the small entity tax threshold, increasing the Fringe Benefits Tax minor and infrequent threshold and extending CGT roll-over relief for small business, noting that these issues were commonly raised in the submissions received.

2.48 The Business Tax Working Group (Working Group) was established by the former government following the Tax Forum held in October 2011. The Working Group released a Discussion Paper that sought views from stakeholders and received more than 80 submissions. The Working Group concluded that there would be benefits from a lower company tax rate and that Government should continue to reduce the tax rate as fiscal circumstances permit. This is also consistent with the findings of the Australia's Future Tax System ^[11] review.

2.49 Since the Budget announcement of the Government's small business package, the Council of Small Business Australia (COSBOA) the peak industry body, expressed its support for the package noting the 'budget inclusions for small business have been designed to boost confidence, boost cash flow and boost the economy'; and that the package 'provides the lowest tax rate for small business since 1967'.

2.50 As the implementing legislation is to be introduced as a 2015 Winter T Bill, there will not be time for the release of exposure draft legislation. This is not considered an issue as the legislation is expected to be relatively straightforward as it is essentially a rate change.

6. Option selection / Conclusion

2.51 The preferred option is to provide a company tax cut of 1.5 per cent to incorporated small businesses (defined as those companies with turnover of less than $2 million) for income years beginning on or after 1 July 2015.

2.52 While larger tax cuts would be favoured by industry, larger tax cuts at the expense of the other small business assistance measures is not considered the optimal policy mix.

2.53 The Government must balance the benefits of a tax rate cut against the other forms of industry assistance such as accelerated depreciation. If this measure was introduced in isolation rather than as part of the proposed small business package, the net benefit would be less due to it exacerbating potential distortions to taxpayer behaviour near the turnover threshold. The reduction in net benefit would result from the additional compliance and administrative costs associated with restructuring and aggressive tax planning that some businesses may choose to incur in response to the proposal.

7. Implementation and evaluation / review

2.54 Legislation is required to implement the proposed two-tier company tax system. As the Government has set the start date as 1 July 2015, the small business company tax cut needs to be a Winter T Bill and enacted by 30 June 2015.

2.56 The design of the legislation is expected to be relatively straightforward largely relying on current models in the tax system.

2.57 The ATO would be responsible for administering the tax rules applying to incorporated small businesses. The ATO and Treasury are experienced in implementing this type of reform.

2.58 The benefit of this measure should not be assessed in isolation but considered as part of the small business package. Similarly, the design issues that have the potential to cause difficulty, such as the use of a turnover rather than and income threshold and the tax cliff threshold need to be monitored as part of the total small business regime as these conditions already apply to other benefits received by small businesses. The ATO will monitor compliance of small businesses and unintended behavioural changes resulting from the small business test. It will advise Treasury if any problems are identified so remedial action can be considered, if appropriate.