If you get the feeling that the profits some big businesses make are far more than they deserve – exorbitant, in fact – you’re not wrong. “Super profits” are something economists are well aware of, though they rarely say much about. And they prefer to call it “economic rent”.
Economic rent has nothing to do with what you pay to live in someone else’s house. And it’s money you receive, not money you pay. Why economists call it “rent” is lost in the mists of the history of economic thought. Maybe they just like using jargon other people don’t understand.
But in one of the reports the Productivity Commission has produced for the economic roundtable, it wants to make sure we all understand economic rent. Why? Because it wants to partially replace the present company tax with a tax on companies’ “net cash flow”. And the great advantage of this new tax, we’re told, is that it taxes companies’ economic rents, not their ordinary profits.
When a company considers setting up a business, it needs to earn a certain rate of return – that is, an after-tax profit after allowing for all its direct costs. The after-tax return is the company’s shareholders’ reward for investing their savings in the business rather than, say, lending it to someone.
And for the company to stay in the business, the rate of return it receives needs to be at least as great as what it could earn by moving to some other industry. Economists call this its “opportunity cost”.
But here’s the point: if the company’s after-tax return exceeds its opportunity cost, the extra bit is its economic rent. This rent is a sign the company’s profits are bigger than they need to be.
Sometimes these extra profits are temporary. Other businesses see how much moolah is being made, enter the market and, in the process of getting their share, bid down prices and profits. So, competition has removed the economic rent.
Often, however, the economic rent is lasting. This can be because the existing business has a special advantage other firms can’t share or copy. They’ve got the best location or have cornered the market in some other way. (Or, of course, they may have persuaded the government to grant them some special advantage other firms or industries don’t get. This, by the way, is why economists call businesses that ask for government favours “rent-seekers”.)
For Australians, note that economic rent is common in mining. Some minerals are in high demand, but limited global supply. Some mines are better located, or have deposits that are higher quality or nearer the surface.
Note, too, that pop stars and film stars also receive economic rent. Some of them earn far more than others because they have more charisma or a bigger following. (Please don’t tell my boss, but even I make a bit of rent. I’d do this job for a lot less than I’m paid. And nor could I make as much in some other occupation. So why doesn’t the boss pay me less? I guess because he’s worried some rival editor might offer me more.)
In other words, there are many companies and individuals earning economic rent that we can’t do much about. The commission sees this as a problem because the ability of some businesses to charge higher prices than necessary reduces the economy’s efficiency and causes living standards to be lower.
Which brings us to company tax and taxes generally. Economists worry that imposing taxes on certain activities distorts people’s behaviour. Taxing companies’ profits, for instance, may discourage them from expanding – or setting up in the first place.
So how widespread is economic rent? The commission says that modelling undertaken for its inquiry estimates that 54 per cent of the company income tax base takes the form of economic rent. This is up from an estimate of 41 per cent in 2018.
Taxing individuals’ incomes may (repeat, may) discourage them from working as hard. And taxing the purchase of some goods and services but not others may encourage people to buy stuff that’s not what they would prefer.
See where this is leading? We often need higher taxes to cover increased government spending and stop the government’s debt getting too big. However, economists worry that higher taxes will discourage people from working and investing, as well as distorting their purchases.
But if economic rent is bad for the economy – if it reduces efficiency and holds back living standards – doesn’t that mean taxing it, even taxing it quite heavily, can help reduce the budget deficit without harming the economy?
This is why the commission wants us to cut back ordinary company tax and start moving to a new 5 per cent tax on companies’ net cashflow. On one hand, ordinary company tax discourages investment even in companies that aren’t earning economic rent because it reduces their after-tax rate of return.
On the other, the commission argues, a cashflow tax would not distort decisions to invest via companies because it’s designed to tax only their earnings above their required rate of return. That is, it’s designed to tax only the companies’ economic rent – if any.
Remember, we’re supposed to be finding ways to improve our productivity. The commission notes that one of the main ways businesses have increased the productivity of their labour over the years has been to give their workers more and better machines to work with. Lately, however, firms’ spending on plant and equipment has grown only slowly.
That would be another benefit of transitioning from ordinary company tax to a cashflow tax. Under the old way, spending on new equipment reduces taxable income only over a number of years via annual depreciation.
Under the cashflow tax, they would get a full deduction for such spending in the year it was made – which should encourage companies to spend a lot more on productivity-enhancing equipment.
Now, tax economists have long been huge supporters of a cashflow tax. But no country has been game to try it yet, and I doubt if Anthony Albanese is the guy who would like to go first.
