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Report Published On Australian Financial System

by Mary Swire,, Hong Kong

10 December 2014

A major inquiry has concluded that several aspects of Australia's tax regime lead to distortions in its financial system, and has identified potential solutions that could feed into the Taxation White Paper process.

The Financial System Inquiry was set up by Treasurer Joe Hockey in December 2013. Headed by David Murray, the Inquiry was asked to report on the consequences of developments in the financial system since the 1997 Financial System Inquiry and the global financial crisis. On the tax front, the Inquiry was tasked with examining the taxation of financial arrangements, products, or institutions, and with identifying the extent to which these impinge on the effective and efficient allocation of capital by the financial system.

In its final report, the Inquiry notes that the financial system may be larger than it would otherwise be because goods and services tax (GST) is not levied on most financial services. In addition, households could be over-consuming financial services because, while financial services providers that do not charge GST still have to pay GST on inputs, they cannot claim input tax credits. These providers then pass this cost on to consumers in the form of higher prices. On the other hand, the report suggests that businesses could be under-consuming financial services. It attributes this to the fact that, because GST is embedded in prices charged to firms, but not charged explicitly, they cannot claim input tax credits.

The Inquiry also concluded that the case for retaining the dividend imputation mechanism, introduced in 1987, is now less clear than in the past. The report states that the benefits of dividend imputing may have declined as Australia's economy has become more open and connected to global capital markets. In addition, imputation provides little benefit to non-residents that invest in Australian companies, and, in the case of investors subject to low tax rates, the value of imputation credits received may exceed the tax payable, impacting on the Treasury. The Inquiry observed that, to the extent that dividend imputation distorts the allocation of funding, a lower company tax rate could reduce such distortions.

The interest withholding tax (IWT) regime was likewise a cause of concern for the Inquiry. The report warns that the unequal treatment of non-residents' repatriated income from Australian investments may affect the funding decisions of Australian entities, and place Australia at a competitive disadvantage internationally. It says that lower, more uniform withholding rates could help reduce such distortions, but stresses that the Government would need to consider the potential implications for tax avoidance of any future reforms. In the case of financial institutions, different funding mechanisms are subject to different IWT rates. The Inquiry concluded that, by cutting the relevant IWT rates, the Government could reduce funding distortions, provide a more diversified funding base and, more broadly, reduce impediments to cross-border capital flows.

The Murray Inquiry also found that the tax system treats some forms of saving more favorably than others. For instance, interest income from bank deposits and fixed-income securities are taxed relatively heavily, making them less attractive as forms of saving and increasing the cost of this type of funding. The report notes that a more neutral tax treatment could increase productive investment opportunities. In addition, it points out that reducing capital gains tax concessions for assets held longer than a year would lead to a more efficient allocation of funding in the economy.

In the case of the superannuation system, the Inquiry concluded that the tax concessions available are not sufficiently well targeted to achieve the adequate provision of retirement income. In turn, this raises the cost of the superannuation system to taxpayers, and increases the inefficiencies arising from higher taxation elsewhere in the economy. Moreover, barriers are introduced to the provision of "whole-of-life" superannuation products, as earnings are taxed at 15 percent in the accumulation phase, but left untaxed in the retirement phase. The report claims that aligning the earnings rate between accumulation and retirement would reduce costs for funds, foster innovation in whole-of-life products, facilitate a seamless transition to retirement, and reduce opportunities for tax arbitrage.

Treasurer Joe Hockey told a press conference that the Inquiry's observations "will be fed into a separate consultation process leading up to the Taxation White Paper in 2015." He did, however, emphasize that "these are independent observations and do not represent Government policy."

TAGS: tax | investment | business | tax avoidance | tax incentives | interest | financial services | capital markets | retirement | goods and services tax (GST) | Australia | tax credits | tax planning | tax rates | withholding tax | tax reform | services

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