In its May 2015 budget, the Commonwealth Government announced a number of tax concessions for small business. On the assumption that many small business operators are swing voters, the concessions were judged politically attractive, with bipartisan support. However, for an economy struggling to boost lagging productivity, tax concessions that drive employment and investment for just one segment of the business sector will result in significant costs to the Australian economy.
Tax concessions explained
Under the rubric of 'Growing Jobs and Small Business', the Commonwealth Government budget proposed four sets of tax concessions for small businesses with an annual turnover of less than $2 million a year (Budget Paper No.2, Revenue Measures, Treasury).
To reduce tax burdens on small business, the company tax rate was reduced from 30% to 28.5%, with the 30% franking rate retained for income distributed as dividends, and a discount of 5% on business income received from an unincorporated business. These lower tax rates are estimated to cost revenue about $1 billion per year.
The extended accelerated depreciation rules enable small businesses to deduct from taxable income the purchase cost of capital assets valued at less than $20,000 rather than claim depreciation. Relative to the previous depreciation (15% for the first year and then 30% in following years), immediate write-off can reduce the present value cost of eligible investments and effectively provides an interest-free government loan.
More generous rollover relief for capital gains taxation, and an extension of fringe benefit taxation for portable electronic devices, involve relatively small concessions.
Long term costs outweigh small short term benefits
There is certainly potential for lower effective tax rates for small businesses to encourage higher levels of investment, employment and production. The higher after-tax return will shift some marginal investment options from the category of not financially viable to worthwhile, and the lower tax rate means larger available internal cash flow to fund increased investment. It is even possible that we will also see a boost to 'animal spirits' which can augment the investment stimulus. But, in practice not all small businesses will benefit from the tax concessions, particularly those which record negative or zero taxable income in particular years, or, indeed, over extended time periods.
The small business tax exemptions distort the efficient allocation of limited resources, add to tax complexity and invite costly gaming behaviour from business trying to fit the eligibility criteria. The revenue cost has adverse second round effects on government fiscal policy.
By providing tax concessions to small business rather than to the business sector at large, we are encouraging the reallocation of investment, employment and production from standard-taxed large businesses to concession-taxed small businesses. As a result, some investment, employment and production are reallocated from society higher returns in the large business to relatively lower returns in the small business sector. This loss of efficiency does not happen when small and large businesses face a common tax rate.
There are no well-documented market failure reasons for providing a different set of taxes for small versus large businesses. Both large and small businesses invest in plant and equipment, develop new products and better production methods, create jobs and generally contribute to economy-wide wealth. Some individual businesses in both the small and large sectors reduce employment, and some fail.
The 'less than $2 million a year turnover' definition of a small business eligible for the tax concessions is arbitrary. Why not $1 or $5 billion, or an employment level or taxable income level? This arbitrary level adds to tax administration and compliance costs, and invites costly game playing. Many businesses with an average turnover around the $2 million mark will be uncertain about their eligibility given the several sources of volatility of turnover from year to year. Some, in order to access the concessions, will deliberately hold back expansion. Others will reorganise themselves to increase the chances of being below the turnover threshold, with additional costs to both the taxpayer and tax administrator.
Ultimately these concessions have to be funded from somewhere. Funding sources could include; higher other taxes, such as failure to index the personal rate schedule, resulting in higher average tax rates on all employees and a lower consumption expenditure capacity: lower government expenditures on, for example, education and infrastructure to increase national productivity; or, larger government deficits which contribute to higher interest rate >expenses, including for small business, and higher future taxes.
The politically attractive tax concessions to small business appear beneficial in the short term but the long term economic costs of such an initiative are high and all Australians will bear the brunt.