Tax Change in the USA: Major impact for Australian policy makers and business leaders

| 2Tax Change in the USA: Major impact for Australian policy makers and business leaders

US President Donald Trump has promised change and says major tax reform is one of his top priorities. With a Republican controlled Congress for at least two years, he also has an open path that just might allow that change to happen. However where that path will lead remains unknown; not just in the detail of the tax changes but also in their consequences for the global economy.As with any change, Australian business leaders must prepare to adapt their strategies and operations to the emerging opportunities and challenges. They should also now be prepared to participate more fully in Australia’s tax reform debate.As always, Australian policy makers must respond to the likely new global environment if Australia is to be resilient and competitive in this uncertain and changing world. And now, the tax changes in the USA provide yet another reason for Australia to urgently move on its own tax reform process. In this paper we outline some key issues that should be considered by Australian policy makers and business leaders.

| 3Tax Change in the USA: Major impact for Australian policy makers and business leaders

Tax reform is a top priority for the President and the US Congress. President Trump listed middle class tax relief as one of the early priorities for his Administration.During his campaign, Trump outlined a tax reform plan that included proposals to lower the corporate and individual tax rates, as well as other changes. More recently, he has stated his intent to put forth a comprehensive framework for tax reform.

In early 2016, the Republican members of the House of Representatives released a pro-growth Blueprint for Tax Reform (Blueprint). The Blueprint proposes lowering tax rates and perhaps in its most innovative feature, moving the current corporate income tax system toward a destination-based cash flow tax.

Republican senators also have proposals under development and plan to introduce draft laws during 2017. A big question that remains unanswered with respect to the Senate is whether any Democrats will participate in the drafting of a Senate tax reform plan. If Democrats do not participate and do not support the plan, it could be passed on a party-line vote. This process, referred to as reconciliation, will have an impact on the substance of the reform.

While the details of the President’s campaign tax plan and the Blueprint are not identical, directionally they are similar. It is not clear that the Senate, the other party in this three-way negotiation, will propose a similar plan.

We set out the details of the President’s and House plans in the following page.

While the details remain to be seen, some key features that many think may be part of any final tax reform plan include:

• Lower corporate/business tax rates

• Lower individual tax rates

• Elimination of many deductions, exclusions and credits

• Possible limitations on interest deductions

• Move toward a territorial system and a mandatory transitional tax to encourage accumulated foreign earnings to be repatriated to the USA and

• Provision(s) to encourage economic activity within the US

US tax reform

| 4Tax Change in the USA: Major impact for Australian policy makers and business leaders

The table below summarises the key features of the Trump campaign plan and House Republican Blueprint

Trump campaign plan House Republican Blueprint

Top corporate tax rate (now 35%)

15%, corporate AMT eliminated 20%, corporate AMT eliminated

Top pass-through rate (now 39.6%)

15% rate within the personal income tax system for pass-through entities that want to retain profits within the business

25%

Taxation of future foreign earnings

In September 2015, proposed immediate worldwide taxation, repeal of deferral; unclear if he still supports

• Territorial, 100% exemption for dividends paid from foreign subsidiaries

• Border tax adjustment mechanism

Mandatory tax, untaxed accumulated foreign earnings

10% 8.75% for cash/cash equivalents, 3.5% otherwise, payable over 8 years

Cost recovery Expensing for manufacturers 100% expensing of tangible, intangible assets except land

Interest Manufacturers electing to expense capital investment lose the deductibility of corporate interest expense

No current deduction will be allowed for net interest expense

Other business provisions Calls for them to generally be eliminated, except for research credit

Calls for them to generally be eliminated, except for research credit and LIFO

Individual rates (now 10%, 15%, 25%, 28%, 33%, 35%, 39.6%)

12%, 25%, 33% 12%, 25%, 33%

| 5Tax Change in the USA: Major impact for Australian policy makers and business leaders - The heat is getting turned up!

It is hard to predict precisely what the impact of the US tax reform will be. However the issues summarised should be considered by anyone trying to understand the implications of the potential US tax reform.

• The President has said that his tax reform will be designed to boost the US domestic economy – supporting growth and jobs. The lower tax rates should, at least in the short–to-medium term, work in this direction.

• If it is part of the final tax reform bill, a border adjustment tax regime could (at least initially) favour US domestic businesses. From what we know so far — and very few details are available - imports into the USA will be fully taxed while exports from the USA will not be subject to tax under such a taxing regime. Further, only costs of production from sources in the USA would be deductible. Any inputs sourced from offshore would be denied deduction for USA tax purposes.

• Supporters of the border adjustment tax say it will:

• encourage companies to produce goods and services in the US by raising the cost of imports and lowering the cost of exports

• increase federal revenues to offset the lost revenue from cutting the corporate tax rates, and

• serve as a key component of an overall plan to boost wages, jobs and the US economy in a fiscally responsible manner.

• Critics of the border adjustment tax say it will:

• be complex to implement

• negatively impact US retailers and other large importers

• impose a disproportionate burden on low-and middle-income families who spend a large share of household income on imported goods

• potentially violate World Trade Organisation rules, and

• risk retaliation against US exports by other countries

• The medium to long term impact of the tax reform proposals are much more difficult to predict. Some commentators have predicted that the increased stimulus could lead to higher interest rates in the USA. This monetary effect could dampen the longer term stimulatory effects of the tax changes.

• Commentators have also predicted that there will be a significant strengthening of the US dollar as a result of the tax policies. This will effectively make exports from the USA more expensive for foreigners and imports to the USA cheaper for US consumers. While this potential currency effect could mitigate the regressive nature of the changes mentioned above, it would also work against the intended US domestic stimulatory effect of the tax changes.

• The longer term effects on the trade policies of the USA and its major trading partners has also been questioned. Will the border adjustment tax lead to “retaliatory” law changes by the major trading partners of the USA? Will this in turn lead to greater protectionist policies that could impact the global economy?

Impact of US tax reform

| 6Tax Change in the USA: Major impact for Australian policy makers and business leaders

Change is coming to the USA tax system. The timing and detail are not yet certain. But it is likely that the tax changes could have significant long term effects on the global economy that are hard to predict.

The US tax changes create challenges for Australia’s policy makers and business leaders.

They place even greater importance on Australia’s own reform agenda. We think policy makers in Australia should urgently reinvigorate their efforts in this area.

Reserve Bank of Australia Governor, Philip Lowe listed the current micro economic policy challenges in his 9 February 2017 speech1, broadly:

• reinvigorating productivity growth

• capitalising on the opportunities from the economic development of the Asian region. “But it is a competitive world out there, and other countries see these opportunities too.”

• providing adequate high-quality infrastructure

• spending restraint - “ensuring that our public finances are on the right track… by rebuilding our fiscal buffers. This too is a challenging thing to do, particularly given the additional demands being placed on government.”

• a competitive corporate tax rate – “we need to make sure that our tax system is internationally competitive. One example of this complication is in the area of corporate tax, where there is a form of international tax competition going on in an effort to attract foreign investment. Like other countries, we face the challenge of responding to this.”

Our corporate tax rate does not position us as an attractive place to work, invest and save. After the US tax reforms go through our corporate tax rate will go from being substantially below the US rate to substantially above that rate.A competitive tax rate should enhance growth by increasing investment, productivity and incomes. A number of reports and studies have supported this view.

What does this mean for Australia?

1 http://www.rba.gov.au/speeches/2017/sp-gov-2017-02-09.html

| 7Tax Change in the USA: Major impact for Australian policy makers and business leaders

The Henry Review commissioned by the previous Labor government considered this issue and reported2:

Australia’s company income tax rate, which currently stands at 30 per cent, is high relative to other comparably sized OECD countries. The average rate for small to medium OECD economies is currently around 25 per cent.3

Reducing taxes on investment would increase Australia’s attractiveness as a place to invest, particularly for foreign direct investment. Reducing taxes on investment, particularly company income tax, would also encourage innovation and entrepreneurial activity. Such reforms would boost national income by building a larger and more productive capital stock and by generating technology and knowledge spill overs that would improve the productivity of Australian businesses and employees.4

The IMF February 2017 Country Report 17/42 for Australia stated5

“The [Australian] authorities welcome the IMF’s confirmation of the current timetable to return the budget to surplus and note only small differences in path profiles. The authorities have a strong commitment to supporting jobs and growth through boosting infrastructure, innovation and investment while also rebuilding fiscal buffers ... Private investment will be encouraged through a lowering of the corporate tax rate - starting with tax

reductions for small businesses - while average wage earners will remain in lower tax brackets longer through adjustments to the personal income tax thresholds.“

The Australian Chamber of Commerce and Industry (ACCI) release of February 20176 had this to say:

“The company tax rate impacts on international perceptions of doing business in Australia. What happens to our economy and jobs if investors, both Australian and international, pass us by due to the risk of low rates of return on their capital investment? … “We cannot put our head in the sand as countries compete for investment by lowering their tax rates. We risk being stuck in 2001, when we last lowered our company tax rate across the board.”

But the needed tax reforms are not just about lower tax rates. We need to consider our tax incentive and more general business tax settings as well - especially for innovation, for R&D and for capital investment. This is especially the case if the US reshapes its tax incentives in favour of new capital expenditures made in the US.

Australia also needs to ensure it is seen as welcoming foreign investment. The operation of the new Diverted Profits Tax has raised major uncertainty for many internationally oriented companies operating from and in Australia. These uncertainties need speedy clarification.

Tax reform in Australia has failed over the recent past. The tax policy debate has been negative, cynical and divisive. It needs to be more holistic and focused on the national interest.

2 Australia’s Future Tax System: Report to the Treasurer, December 2009 (released on 2 May 2010) – refer Final Report: Part 2 - Detailed Analysis - Volume 13 Ibid, page 1634 Ibid, page 1495 IMF Country Report No. 17/42: Australia 2016 Article IV consultation6 https://www.acci.asn.au/news/no-risk-budget-company-tax-cut-analysis-shows

| 8Tax Change in the USA: Major impact for Australian policy makers and business leaders

Australia’s business leaders should get a head start on the likely effects of the US tax reforms by:

• monitoring the likely US tax changes as they coalesce into real tax reform bills

• assessing the impact of the tax reforms on interest rates and exchange rates and more generally on the global economy

• modelling the potential effects on their business. In particular the effect on the following matters should be assessed:

• global investment decisions

• funding decisions including the location of debt and the mix of currencies

• global supply and value chain structures including the location of operations

• considering how they can better participate and contribute to Australia’s tax reform debate by helping policy makers understand the implications of the US tax reforms on Australian business

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