Government's Tax Cut For Small Businesses: Analysis And Impacts

Details of the tax cut for small business owners

Question:

A  report on the government’s tax cut for small businesses. 

In the federal budget of 2015, the government announced the tax cut for small business owners. The prime minister confirmed that the tax cut will be 1.5% for the small business owners in Australia, whereas the big business owner will not receive any kind of tax deductions. This tax regime opted by the government has various consequent microeconomic and macroeconomic effects. In this report we look into the details of the tax cut for the small business owners and how the businesses, consumers as well as the entire economy benefits from it. We also look into the negative effects or the distortions that can be created by such a regime. The significant effects of the tax cut are mostly on the increased investment and output of the businesses which in turn increases employment and consumption, thus influencing economic growth. The tax cut also creates distortion such as allocation of labor or wealth effect making business owners not reach their potential productivity. The tax cut benefits and distortions are explained by income or wealth effects, substitution effects, increase in aggregate demand, rise in employment, rise in prices and wages, increasing productivity and all together affecting economic growth. We look more into these details in the following sections. 

The budget change adopted by the government of Australia includes tax measures specifically for small businesses. Small businesses are defined in the tax system as an entity which carried on a business with an aggregate annual turnover of less that $2 million. As per the budget the reduced tax rate had been a boom for small business owners making them grow bigger at the same time. Previously the government had cut the tax rate from 30% to the rate 28.5% for businesses with the turnover accounting for less than $2 million. This year the tax rate has been further cut to 27.5% (Chang, Chung & Burke 2016, Ref 15). At the same time this change had also increased the scope for small businesses having a turnover of less than $10 million. Such a tax cut implies advantages for a huge sector of people. There are approximately 870,000 businesses which employ about 3.4 million Australians, and all of these people will enjoy a reduced tax rate (Appendix I). Approximately 60,000 businesses which employ about 1.5 million belong to the bracket of $2 to $10 million and their tax rate reduced by 2.5%. Apart from this government has also extended its last year’s tax deduction of business equipment under $20,000 which was introduced the previous year to businesses under a turnover of $10 million. On the other hand there are the big business owners who do not enjoy any kind of tax cuts. But big businesses can also be estimated to access lower tax rates eventually. This can happen as the government moves with an incremental process. It first slowly increases the sizes of businesses which can access reduced tax rates of 27.5% and then eventually reduces the tax rates for all businesses to 25%. If this happens, then the threshold increases from $10 million to $25million in the year 2017-18, followed by $50 million in 2018-19 and $100 million in 2019-20. Hence, by 2020, approximately 4.9 million people which constitute of more than half of the total employees in the country will be working in companies and paying lower tax rates of 27.5% until 2026-27 when all business shall access tax rate of 25%. Hence these changes related to the tax cuts of the small businesses, directly and indirectly has impacts on the different sections of the society which includes, the business owners, workers, consumers and also the government. The mutual collaborated impact of all these effects has positive impacts on the economic growth. (Appendix I) (Chang, Chung & Burke 2016, Ref 15)  

Positive and negative implications of the tax cut

The cut in tax rates of small business owners has several macroeconomic and microeconomic effects. The tax cut is tended to act as an encouragement for the small business owners which are important for jobs and economic growth in the country. It is focused on increase in spending by encouraging businesses to spend more on capital and equipment from the tax savings and increase the growth of businesses (Mankiw, 2003, Ref 9).  As economic growth increases, employment will rise as the businesses increase production with increase in overall consumption and aggregate demand (Mankiw, 2003, Ref 9). The lower tax rate has impacts on both individuals and businesses through income and substitution effects (Pindyck 2009, Ref 1). A lower tax rate raises the post tax reward for saving, working and investing. The higher post tax rewards induces more work effort along with savings and investments through substitution effects (Pindyck 2009, Ref 1) which is what exactly the government intends to do. There are a number of components through which the tax cut helps in boosting the economy. We shall look into these components each at a time.

If we consider investments, then a reduction in tax rate of small business owners reduces the cost of capital for firms making marginal investment projects more profitable (Varian, 2010, Ref 2). These increased investment opportunities increases both domestic investment and foreign direct investment (Lypsey & Chrystal 2011, Ref 6). Investment being a component of GDP, in the short run it boosts demand and rise in investment shall increase the GDP. An increase in GDP is an indicator of positive economic growth (Samuelson & Nordhaus 2010, Ref 3) .

Reduced tax rates of small business owners also induce them to hire more workers. Wages of workers also increase which allows them greater consumption and acts as an income effect (Sen 2007, Ref 5). Hence, tax cut increases demand for labor by firms, which in turn increases wages and overall employment. Increase in wages increases both consumption and savings of the workers via positive income effect. Lower tax rates also influence productivity growth. If there is improvement in technology or innovations in one period there occurs increase in productivity growth in the next period. Induced by lower tax rates and efficiently using tax savings small businesses come up with innovative ideas and technology with greater research and development and shall positively affect growth in next period increasing productivity. As firms increase productivity and can produce more output for the same proportion of input it raises the GDP growth rate. (Lundeen 2015, Ref 13)

The cut in tax rates of small business owners also has effects on prices of the goods and services of these businesses. As with reduced tax rates the cost of capital decreases, the lower cost of capital along with high returns can result in lower prices charged by these businesses to consumers. The extent of these firms to pass the reduction in the burden of taxes also depends on how easily the consumers can switch to goods by these corporate firms from goods of other non-corporate or foreign entities. The reduction in price also depends on how open the economy is. The more the economy is open there occurs less reduction in prices. Market power of the firms also plays a significant role deciding how much prices can be reduced. Firms with high market power can significantly affect on changes in prices. As prices fall, domestic consumption increases which reduce demand for imported goods and increase demand for exports. As household consumption increases along with an improvement in Australia’s trade balance contributes in increasing the GDP.

The scope of the tax cut and its beneficiaries

The microeconomic and macroeconomic effects mentioned above are likely to positively affect the receipts. As investment, employment and demand increases it brings forth stronger economic growth which shall generate tax revenues that will offset the proportion of revenue lost in tax cuts. As the additional investment projects get completed, it will boost profits that will lead to additional corporation taxes. Higher consumption will also generate higher VAT and excise duty receipts. Increase in wages and employment shall also increase income tax and insurance contributions. Hence, the revenue lost is easily recouped via the taxes generated.

We shall now turn towards the not so bright aspects of the cut in tax rate of small business owners. The positive effects do stand a chance of not taking place due to the market distortions and highly depends upon the market share of these small business owners. The efficiency and strength of entrepreneurial motives also decide how much the tax cut provision given to such businesses shall in any way help the economy. The confidence of consumers and business owners on the market conditions also stand as an important factor. There had been many economists and scholars who believed that the company’s tax cut will barely make any difference in the economy. As the chief economist Saul Eslake of Bank of America Meryl lynch (Appendix II) tells that it might be possible that there will occur a surge in spending because of small asset purchases but it can be just characterized as a short term stimulus to the economy. The chief economist also go on to say that that majority of business investment is done by large businesses and not small businesses but as it is seen that big businesses do not receive any tax cut. We move ahead to see some of the distortions or inefficiencies of such a policy. (Hutchens 2015, Ref 10)

The reduced tax rates for small businesses is justifiable on efficiency grounds if there exists evidences that this will create spillover effects to the rest of the economy which is not completely covered by these entities. The special tax arrangements can distort choices of the business owners regarding the business organization structure and decisions regarding the types of expenditures. Economic inefficiency can also be a result of such a regime if it interferes with the market with consequences like allocation of resources to such small inefficient businesses than large efficient ones. (Swaboda 2015, Ref 16) 

Another distortion of such a regime is associated turnover based threshold of the small businesses biased towards high margin actions. For instance there may be a business which sells large amount of goods and services like a retailer for generating profit may account for a much larger turnover than a firm delivering a costly professional service and generating the same level of profit. Hence the lower tax rate to small business owners reinforces such a bias. The tax cuts also have positive income or wealth effects but these effects induce the individual to feel wealthier reducing his/her incentive to work more, save and invest. It also acts like a disincentive for accelerating further business growth as the businesses approaches a threshold of $2 million aggregate turnover. (Swaboda 2015, Ref 16) 

Conclusion:

Hence we saw the plausible effects both negative and positive of such a tax cut policy for small business owners. The most crucial impact economists are interested in is the effect on the economic growth. The biggest question arises that whether in any way the tax cuts on these small businesses will have any crucial positive impact on the economy. According to Grattan Institute’s Director John Daley (Appendix II), this tax cut won’t have much impact at all on the economic growth. He says, the 1.5% tax cut on the small businesses along with the instant asset write-off may assumed to be boosting the economic growth by 0.2% in the policy’s operation in second year equating to just $3.6 billion of economic activity in an economy of $1.6 trillion, whereas, at its first year of operation economic growth will be as small as by 0.06% of GDP or smaller.(Hutchens 2015, Ref 10 ) Thus, the tax cut on the section of small business owners shall have very negligible on the economy as a whole considering that economic growth is driven by large businesses, implying that government should not just cut tax rates for small business owners achieving short term economic growth but to all firms to boost the economy for a longer term. 

References:

1. Pindyck, R, Rubinfeld, D & Mehta, P 2009, Microeconomics, Pearson, South Asia
2. Varian, H 2010, Intermediate microeconomics, Affiliated East-West Press, New Delhi
3. Samuelson, P& Nordhaus, W 2010, Economics, Tata McGraw Hill, New Delhi
4. Mankiw, G 2007, Economics: principles and applications, Cengage Learning, New Delhi
5. Sen, A 2007, Microeconomics, Oxford, New Delhi
6. Lipsey, R & Chrystal, A 2011, Economics, Oxford, New Delhi
7. Sowell, T 2010, Basic economics, Basic books, USA
8. Hall, R & Lieberman, M 2010, Economics: Principles and applications, Cengage learning, USA
9. Mankiw, G 2003, Macroeconomics, Worth publishers, New York.