Criticisms of the present system
16.16. Separate systems are sometimes criticised for involving ‘double taxation’, since shareholders are required to pay personal income tax on company profits that have already borne company tax. But what is basically important is the total amount of levy a particular kind of income bears, not the number of taxes by which that amount is collected.
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16.17. Whether the separate system taxes company profits fairly depends upon whether or not it leads to the shareholder paying tax on his share of the profits at the marginal rate of personal income tax appropriate to his income if it included the whole of his share of the profits. The amount of tax paid, by the company and shareholder, in respect of the shareholder's interest in company profits depends upon the proportion of company profits distributed, the rate of company tax, and the shareholder's marginal rate of personal income tax. The manner in which these influences operate is shown in Table 16.B. In this table, assuming a company tax rate of 47½ per cent, the rate of tax paid by a shareholder on company profits can be compared with his marginal tax rate, for various levels of shareholder's income and various levels of retention by the company. In this calculation, all retained profits are presumed to bear tax at 47½ per cent: in the long term these may contribute to a capital gain in the value of the company's shares, and to the extent that they do any such gain will not have incurred personal income tax. Only the distributed portion of profits will bear the personal income tax as well. Thus if a company retains half its profits after payment of company tax, a shareholder on a personal marginal rate of 66.7 per cent will in effect pay only 65 per cent on his proportion of the company's before-tax earnings. But had his marginal rate on personal income been 15.4 per cent, his full share of profits would have been taxed at 51.5 per cent.
| Shareholder's notional income (a) | Shareholder's marginal rate of personal income tax (b) | Combined company / personal tax expressed as a percentage of company profits, assuming proportion of profits retained is: (c) | ||||
| $ | per cent | 0 per cent | 25 per cent | 50 per cent | 75 per cent | 100 per cent |
| 2,000 | 15.4 | 55.6 | 53.6 | 51.5 | 49.5 | 47.5 |
| 5,000 | 33.3 | 65.0 | 60.6 | 56.3 | 51.9 | 47.5 |
| 12,000 | 48.2 | 72.8 | 66.5 | 60.2 | 53.9 | 47.5 |
| 50,000 | 66.7 | 82.5 | 73.8 | 65.0 | 56.3 | 47.5 |
(a) Including an attribution of company profits before tax according to his shareholding. (b) On final increments of income as shown in previous column; 1973–74 rate scale. (c) The company tax rate is taken as 47½ per cent, the 1972–73 public company rate. The personal tax rate is as shown in the second column, implying that the amount of company profits attributable is modest enough to be wholly taxable at the one marginal rate.
16.18. Table 16.B indicates more generally the way in which over-taxation of a shareholder on company profits is related to the shareholder's total income and the retention policy of the company. At all income levels, the effective tax rate is lower the greater the proportion of profits retained, although the tax saving from retention (both relatively and absolutely) is greater the higher the individual's income. At the same time, the amount of over-taxation, for a given retentions policy, is greater (both relatively and absolutely) the lower the individual's income: indeed, for high-income individuals, high retention results in under-taxation.
16.19. Thus the combined conpany / personal income tax borne by shareholders paying marginal rates of personal income
tax of less than 47.5 per cent will in all cases exceed those marginal rates, but whether this is true of
higher-income shareholders will depend upon what distributions are made. The system is clearly inequitable. In low
income ranges, it discriminates against those who invest relatively more of their savings in equity shares; in very
high income ranges, it probably discriminates the other way. It discriminates between individuals on the same incomes
with identical
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savings according to the different distribution policies of the companies whose shares they
hold. It substantially defeats the general progressivity of the income tax.
16.20. It fails also, in several distinct ways, when the test of efficiency is applied:
- (a) The over-taxation of the profit entitlements of some shareholders creates a bias against their doing business in corporate form, although the under-taxation of other shareholders creates the opposite bias. Admittedly, the former bias may inhibit the use of company organisation for income splitting purposes; but even if the discouragement of income splitting is proper, the over-taxing of company profits is not an appropriate way of going about it. The Committee believes that tax law should, as far as possible, be neutral in its effect on the choice of a form of business organisation.
- (b) The separate system favours retention of profits, as retained profits bear income tax only at the company level. The addition of a capital gains tax, as proposed by the Committee, will not fully correct this distortion, since capital gains tax applies only on realisation and thus may be indefinitely deferred. Whether the distortion is a ground for criticism depends on the view that is taken of company self-financing through retention of profits, compared with financing by resort to the market. In terms of general economic policy and ignoring the financial strain that high rates of inflation can impose on active businesses, a case can be made for companies distributing all their profits over a period and relying upon the market for acquiring more capital, though innumerable reasons can be suggested why it might be thoroughly imprudent for them to distribute fully each year. This would imply that it would be desirable to reconstruct the tax in such a way as to replace its present bias against full distribution with one in its favour. But in view of the great diversity of kinds of business conducted in the company form, the variations in the annual fortunes of companies, the variations in pressure to retain or distribute to which managements are subject and possible large discrepancies between accounting, economic and business definitions of profit, any attempt to do this may create serious problems in practice. On the whole, therefore, the Committee concludes that neutrality is the best practical test.
- (c) The separate system is clearly not neutral as between equity and debt financing. Company income going in payment of interest on debt is not taxed at the company level, but only under the personal income tax in the hands of the lender. As indicated in Table 16.B, this produces a bias in favour of investment in debentures and other fixed-interest securities for all low-income shareholders and a bias in favour of equity investment in high-retention companies for high-income shareholders. It creates pressure to increase the gearing of debt finance to equity and fixed-interest capital raising may become more difficult for less well established ventures with few assets that can be offered as security. It tends to divert the savings particularly of low-income individuals away from equity investment, and to create a gap in the flow of Australian funds to developmental enterprises requiring equity capital. The gap may then be filled to a greater extent by overseas investors than is felt desirable on general grounds.