This article is by Chris Evans, Professor of Public Policy, UNSW Australia. It originally appeared on The Conversation.
opinion/analysis The Turnbull government will release its innovation statement in the next few weeks, and it’s widely expected to include tax breaks for startups.
The government may abolish capital gains tax (CGT) for investments in early stage companies, especially in the high-tech sector. The idea, promoted by Coalition backbencher David Coleman, is that those who invest in early stage private companies with an annual turnover of less than $1 million will be able to exit their investment at no tax cost.
Innovation – the creation and diffusion of new products, processes and methods – is, and will continue to be, a key driver of productivity, growth and wellbeing. As the OECD notes, it plays an important role in:
“helping address core public policy challenges like health, the environment, food security, education, and public sector efficiency. Innovation-led productivity growth will become even more important in the future to address key challenges like ageing populations and climate change.”
Innovation clearly matters, and it matters a lot. On the surface, therefore, the idea of abolishing CGT on startup investments seems like a great idea. It would achieve the double whammy of showing the government is “doing something” to promote innovation at the same time as giving tax dollars away – always popular.
But using the tax system in an attempt to foster innovation may not be the sensible policy choice.
Tax systems are excellent at achieving the principal objective for which they are designed – raising revenue. They are often notoriously bad at achieving some of the other objectives for which they are so often used and misused, such as attempting to change the behaviour of corporate and private citizens. The tax history of the world is riddled with examples that illustrate the folly of seeking to promote one particular outcome – favour this activity rather than that one, help these taxpayers rather than those – by using parts of the tax system as an often blunt policy instrument.
A history of failure
In the 1970s and 1980s the UK had a disastrous experience when it attempted to establish something similar to the current Australian proposal – the Business Expansion Scheme (BES). The BES became a byword for some of the most blatant and aggressive tax exploitation by unscrupulous investors and their advisers. It was eventually so hedged in with anti-avoidance measures that it became virtually unworkable.
In Australia those familiar with the failure of the so-called Simplified Tax System for small businesses in the early part of this century (subsequently abandoned), or with the current malfunctioning and highly distortionary Wine Equalisation Tax, will readily attest to the perils of trying to use the tax system to achieve non-tax outcomes.
Providing a CGT break for investors in startups falls foul of the three key criteria of efficiency, equity and simplicity by which tax systems are judged.
Inefficient, unfair and complex
In the first place it will lead to distortions in the (market) allocation of capital. It would reduce tax system neutrality and fail the efficiency test so highly prized by economists.
Second, it would be grossly inequitable in its impact. Capital gains are made overwhelmingly by wealthy taxpayers. Yet another tax break for that demographic, on top of the well-publicised preferences they already enjoy from the superannuation, income tax and existing CGT regimes, would not sit well with concept of vertical equity (those with more should pay more). And it is horizontally inequitable in that it will favour one group making capital gains as opposed to another. In simple terms, a “buck is a buck is a buck” and the capital gain made by one group of investors should be no more heavily, or lightly, taxed than the capital gain made by another group.
And finally, there are no simple means by which legislative effect can be given to the policy intent. Yet another CGT exemption (there are already countless CGT exemptions and deferrals – too many to list) would require extensive rules to ensure the relief only went to those for whom it was intended. Such integrity measures would add yet more layers of complexity to a tax system that is already groaning under the weight of existing provisions, and which is clearly showing signs of distress.
By the criteria of efficiency, equity and simplicity, therefore, the CGT break for startups begins to look like a bad idea.
Alternative solutions
So how can the government help to promote innovation without using the tax system?
The answer is relatively straightforward. The OECD suggests it needs to concentrate its policies on five concrete areas for action. These are: effective education and skills strategies; a sound, open and competitive business environment; sustained public investment in an efficient system of knowledge creation and diffusion; increased access and participation in the digital economy; and sound governance and implementation.
Interestingly the OECD notes that support for business innovation should not overly rely on tax incentives. Well designed and competitive grants, access to (government) contracts and support for networks can be better suited to the needs of young and innovative firms than tax incentives.
The government should think long and hard about using yet more tax breaks to stimulate a key sector of the economy. It might also do well to look at the much vaunted success of Silicon Valley, where tax incentives are, and always have been, negligible. An innovation policy that relies too heavily on the tax system for its sustenance is unlikely to be one which can provide the sort of long term viability and success that Australia’s innovation policy is surely capable of providing.
By Chris Evans, Professor, School of Taxation ＆ Business Law, UNSW Australia This article was originally published on The Conversation. Read the original article.
A better question would be, what could we have done with our investment and income taxes to prevent a company like Atlassian, an Australian software success story, from moving to the US and listing on the NASDAQ instead of staying in Australia?
@gr nothing. In their case size of market too attractive.
Currently preparing strategy doc with one of the big four for a new start-up in the final stages of funding (yes Rizz whilst travelling).
HQ in Oz is uncompetitive, Singapore the standout in our region (HK also). Company tax 17% (no dividend imputation, however dividends exempt from income tax), free-trade (& tax) agreement with Oz, greater labour market flexibility, strong english, excellent legal protection and stable govt, much greater pool of competent talent (easy visas for relocating high value talent), personal income tax half of Oz, start-up tax concessionsj for 3-years, closer to markets (in this case Asia, Europe & North America), …
It’ll take a least a generation to change Australian’s mindset ( heading the wrong way for sometime ).
@Richard “a[t] least a generation to change Australian’s mindset…”
Are you sure it will take that short a time to convince the big money to get off the sheep’s back and climb down from the mining train? It’s been very comfortable for nigh on 200 years…
Gordon.
@g our agriculture and mining industries are both great Australian performers; selling their products and expertise overseas where it is in big demand. Whilst popular to knock by the underperforming inner city “geniuses”. These talkers & rent seekers haven’t done so well for the economy (very well for themselves) now have they, but then it must be (insert other person’s) fault.
Actually, changing tax is relatively easy (from a government point of view) and has immediate benefits to small businesses. The R&D tax exemption applies to businesses spending over $10,000 a year on their R&D, however, the ridiculous hours I do isn’t classed as “expense” so I don’t qualify.
Grants would also be nice. I’d like to see something similar to the apprenticeship grants given to startups so they can employ university students, graduates etc.
It’s a start.
It would be nice if any business employing more than (say) 5 tradies be required to employ 1 apprentice for every 5 tradies… We should lose this stupidity of importing tradies from OS to make up for the apprentices we can’t be bothered to train up locally. IIRC that was another Liberal initiative?
Gordon.
Chris I think you’re missing the point…
We cannot compare Australia to Silicon valley, nor today’s fast make or break environment to what happened in the past.
Investors in Australia generally do not behave like US based investors, they’re more risk averse, prefer hard assets, and given the tech revolution in this country is in its infancy they’re also uninformed and nervous about investing. In this regard time and education will certainly help, but in the meantime we need something to to encourage investors to risk big bucks on something they consider out of their comfort zone.
Several VC Funds are helping with this, but given investor sentiment and a unhelpful tax regime even they’re nervous of making mistakes.
Let’s look at what’s happening…presently there are something like 20,000 Aussies in Silicon valley, an over representation due mainly to a lack of funding here in Australia. Our tech brains eventually get sick of trying to convince Australian based investors and are drawn to the valley, where US investors are very prepared to invest large sums on businesses with little or no revenue, but grand plans.. A great example of this is a good Aussie friend of mine that made hundreds of millions on the exit of his last business (by going to the valley) is about to launch another business. When I questioned whether he would look to raise money here and make it an Aussie success story, not surprisingly he said not a chance. He’d even been offered $13 mio by a US VC on the back of a quick sketch of his idea. That would NEVER happen here, with the status quo.
Then let’s look at the success of the enterprise investment scheme in the UK that combined with its history as a financial center now has the worlds leading fintech environment. So much so the UKTI is finding it relatively easy to cajole our best Fintech founders to head to the UK
In truth when we look at the Australian Investment arena we see a growing number of Angel investors willing to invest small sums across a number of tech companies and then the VC’s willing to invest larger sums usually on the back of revenue, but very little in between. This “funding gap” is what the tax incentives are meant to address, and re your point about benefiting the rich, of course it is, but they’re the ones risking their funds. Who else will do it? Therefore I believe that offering traditional hard asset investors the ability to fill this gap with less risk and greater reward is very necessary.
I do appreciate that these schemes create a race to the bottom as jurisdictions battle for top position, but in the end its better to be in the race and have a chance than sit on the sidelines with a hope..
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