A wing and a prayer

Alan Kohler earlier this year argued that the 2011-12 Budget was based on a “wing and a prayer” partly because of heroic assumptions on company tax revenues:

That includes a 36 per cent increase in company tax receipts. Bear in mind that this year’s number is out by 10 per cent from the forecast published just six months ago.

In my opinion this kind of growth in company tax could have been achievable but now it must be in grave doubt.

The RBA Statement on Monetary Policy yesterday showed that corporate profits as a percentage of GDP have been falling.

Company tax receipts to GDP are the function of two ratios: (All figures here are for non-public corporate Gross Operating Surplus)

Let’s go through these one by one.

Nominal GDP growth will be lower than expected in 2010-11 but the RBA is predicting higher growth in 2011-12 than Treasury did in the budget. So nominal GDP will be about the same in the crucial surplus year, 2012-13, providing that terms of trade effects are also not impacted by the economic slowdown.

Gross operating surplus as a percentage of GDP is shown over time below. It was 24 per cent of GDP in 2009-10 and in the first two quarters of this financial year was just over 25 per cent. As the RBA has pointed that ratio has dropped, to 22.9 per cent. Let’s say thought that the GOS / GDP recovers after the floods to 25 per cent of GDP which would be its highest ratio on record.

It’s the ratio on the left though that is the absolute key. As the Treasury has pointed out repeatedly since the GFC there is a lag between the growth in profits and the receipts of company tax. As Treasury pointed out in the 2010-11 budget:

As a company returns to profit, a prior year’s loss will appear in tax assessments the following year, but will not affect revenue until the balancing payment is due in the year following the tax assessment year. This delay forms a significant part of the general lag between profits and revenue. (p. 5-9)

In that budget Treasury were assuming quite a rapid removal of prior year losses, from just under 10 per cent of taxable income in 2010-11 to just under 6 per cent in 2012-13. After the 1990s recession a similar fall in prior year losses took 4 years rather than 2 to acheive. As you can see in the graph below, there was a blip in 1994-95.

If we suffer a similar blip in prior year losses in 2010-11 or 2011-12, the Government’s forecasts for company tax revenue will be impossible to achieve. With the slowdown in economic activity, particularly in the non-mining sector, this is a distinct possibility.

Prior year losses impact on the company tax / GOS ratio, as even if they are making a profit companies can effectively defer tax as they write down their deferred tax assets. This is shown below where the GFC caused a dramatic fall in the company tax / GOS ratio to 17%. Assuming that the current slowdown has no impact on the level of nominal GDP in 2010-11 and 2011-12, and assuming a 25% ratio of GOS / GDP, the government needs the company tax / GOS ratio to recover to 20% in 2011-12 and 2012-13 to hit their company tax targets.

This was going to be challenging already because although 20% does not look historically optimistic, Treasury has noted that the increase in this ratio in the mid-2000s came during period of higher profits from the mining boom without a lot of investment and hence deductions. The situation is different now with heavy mining investment on the way:

While mining investment did increase during the boom of the last decade, the increase in mining GOS was not accompanied by a commensurate increase in the capital stock. By contrast, the current mining boom is expected to be associated with a substantial increase in investment by the mining sector … This increase, which underpins higher levels of deprecation expenses, means that depreciation is projected to grow faster than GOS for the whole economy across the forward estimates. Depreciation expenses relative to GOS are projected to increase even faster in the mining sector than the economy as a whole. (2011-12 Budget, p. 5-13)

If the tax / GOS ratio is one percentage point lower in the next two years, the government is facing a $4.3 billion hole in 2011-12 and a $4.2 billion hole in 2012-13. The surplus in 2012-13 is projected at $3.5 billion in the budget.

Remember all of this assumes that our GDP rebounds and that our terms of trade and company profits hold up. Even on the rosiest of assumptions, the government’s surplus promise is looking empty.

One other thing, the government is reducing the company tax rate to 29% in 2012-13 for small businesses making all of this even more challenging.