RDP 9011: Inflation and Corporate Taxation in Australia 1. Introduction

For much of the past decade, Australian corporate behaviour was influenced by a tax system which contained important biases favouring debt-financed asset acquisition. Of particular importance were two features of the tax system which have subsequently been reformed: the treatment of capital gains (which were untaxed prior to 1985), and the double taxation of dividends prior to the introduction of dividend imputation in 1987. Other distortions arising from the interaction of the tax system with inflation were also important.

The aim of this paper is to review the effects of these distortions and to consider the extent to which they have been removed by the 1985 and 1987 reforms.^[1] The paper begins by reviewing some facts on Australian corporate financial structure in the 1980s, noting in particular the growth of leverage and of takeover activity. It then presents a formal analysis of the pre- and post-reform tax systems in order to assess their effects on corporate financing decisions and on the allocation of investment spending. The paper will argue that:

• aggregate leverage of the corporate sector roughly doubled during the 1980s, but does not appear to have increased recently;
• the growth of leverage was strongly encouraged by the pre-imputation tax system, although this direct tax bias towards debt has now been removed;
• the non-taxation of capital gains created a strong bias towards asset acquisition. This was reduced but not eliminated by the introduction of the real capital gains tax;
• there are a number of distortions arising from the interaction of inflation with the tax system which have not been overcome by recent tax reforms. In particular, under the present tax system, inflation erodes the real value of depreciation allowances and hence penalises investment in plant and equipment. Also, the interaction of inflation with the tax treatment of nominal interest receipts and payments probably exerts an influence on real interest rates and the real exchange rate; and
• the incorporation of inflation into nominal interest rates increases the time needed to break even which may discourage investment in general and longer term projects in particular.

The above conclusions are consistent with Macfarlane's (1989, 1990) observations about the role of tax-inflation interactions in encouraging the boom in corporate borrowing and asset acquisition during the 1980s, although it seems clear that the tax system was not the only factor at work. They also support Freebairn's (1990) view that inflation continues to distort corporate incentives under the present tax system.

Footnote

A related paper by Willmann (1990) provides detailed calculations of the amounts of tax involved. [1]