RDP 9205: Measuring the Cost of Capital in Australia 4. International Comparisons

Given the variety of estimates presented for the cost of capital in Australia, one should be wary of claims that that Australia's cost of capital is definitely above or below that prevailing overseas. In particular, it would be hard to draw conclusions that Australia's taxation regime is either over-generous or is stifling investment by its effect on a solitary measure of the cost of capital. Furthermore, there may be valid reasons for a higher cost of capital in some countries. For example, developed countries may face a higher cost of capital than developing countries, perhaps reflecting higher effective tax rates. But the higher cost of capital may be balanced by a higher standard of publicly-provided infrastructure.

The Department of Finance (1987) argues that Australia may suffer a relatively high cost of access to international financial markets due to a balance of payments constraint that occurs if an increase in investment is expected to result in an increase in overseas borrowings and imports that outweigh any increase in export earnings. They also suggest that the existence of an Australian risk premium on equity funds may be due to the mix of investment projects undertaken in Australia (more specifically, the predominance of energy-related investment which commands a high cost of funds around the world). They suggest that this distortion may take the form of a risk premium paid on the cost of funds but no evidence of this is provided. The Australian Manufacturing Council (1990) also suggests the existence of a risk premium resulting from the price volatility of imported investment capital arising from the instability of Australia's commodity-based currency. Richards (1991) finds some tentative evidence of an Australian risk premium by estimating a version of the International Asset Pricing Model. Irvine (1991), on the other hand, provides long-run evidence to the contrary, suggesting that the cost of funds in Australia is similar to that in the rest of the world.

Some economists from the Bureau of Industry Economics essentially follow the E/P ratio methodology, used in McCauley and Zimmer (1989), to estimate the cost of funds and the cost of capital for Australia, the U.S., the U.K., Germany, and Japan.^[24] They estimate the cost of capital for various types of investments (equipment, factories, and R&D projects), recognizing that the cost of capital varies for different assets because of different tax and depreciation treatments. Their work indicates that the cost of funds for Australia has increased from a relatively low level in the late 1970s to be among the highest of the countries studied during the 1980s (though they acknowledge that there is a great deal of uncertainty surrounding their estimates). The high cost of funds reflects a relatively high cost of equity and a relatively low after-tax cost of debt. The BIE suggest that the high cost of equity may reflect the combined effect of a comparatively volatile commodity-based economy, possibly inadequate equity markets, and sustained high inflation rates. Australia has had a relatively low after-tax cost of debt, reflecting relatively high rates of inflation and corporate taxation so making the deductibility of nominal interest payments more valuable. BIE note that with inflation now at the lowest rate for 30 years, the situation has changed markedly for both the cost of debt and the cost of equity. The removal of 5/3 depreciation for machinery and lower rates of plant depreciation in Australia have acted to increase the cost of capital. The reduction in the corporate tax rate from 49 to 39 per cent provided an offsetting influence.

The OECD (1991) present an international comparison of a variety of measures of the cost of capital. Australia had a high cost by some measures but when the comparison was done on the return to a personal investor on the top marginal tax rate (and so incorporated the effect of dividend imputation), the cost of capital in Australia was below the OECD average.

Footnote

See Bureau of Industry Economics (1991) and Archinal et al (1992). [24]