Senator Nick Xenophon and the Federal Government recently agreed to a compromise that should see the Federal Government deliver some of its long-promised (and politically needed) tax cuts to “small business”.  This has been the topic of much debate amongst interested commentators since the announcement.

Not surprisingly, the two major compromises extracted by Senator Xenophon involve South Australia – a loan for a solar thermal plant and a study (yes, only a study!) into a gas pipeline between the Northern Territory and South Australia (presumably, coast to coast, not just at the NT-SA border!).

But leaving South Australia aside, let’s look at what this means for Australia.

The headlines are plain to see – an increase in the budget deficit by $24 billion over the next 10 years.  Is it worth it?

The amendments are phased as shown below:

The first phase involves a cut from 28.5% to 27.5%.  This 1% drop is expected to benefit 870,000 companies employing 3.4 million people with turnover of less than $10 million.

The second phase of extending the turnover threshold, first to $25 million and then to $50 million only benefits 10,000 more companies, according to some.  However, the Prime Minister claims 3.2 million “businesses”, as opposed to companies, would benefit and they employ 6.5 million people – he claims “unincorporated businesses” will benefit from the tax cuts to companies.  In this regard, he is referring to the consequential adjustments to the small business tax offset.  However, this offset remains capped at a mere $1,000, so it is hard to believe the numbers being employed to sell the deal.

The final phase is to drop the tax rate from 27.5% to 25% over a further 6 year period.

The Government says it will push ahead with tax cuts for the bigger end of town.  This is where the real prize is, with fewer companies but more money at stake and more indirect stakeholders, such as employees and customers and shareholders.  That is going to cost the budget another $24 billion.

The benefit to the economy of this deficit is a mere 1% growth in the economy over 10 years (or 20 years, depending on who you speak to).  Treasury’s modelling of this gain assumes the Government takes measures to soften the impact of the tax cuts on the budget, but so far, there is no such proposal.  Perhaps there will be when the 2017 Federal Budget is released in May.  Taking the 1%, that works out at a growth in GDP of about $20 billion.  Of course, not all that flows to taxable income, but assuming it does to be generous, the corresponding increase in corporate tax intake is just $5 billion – and we have to wait 10 years (or maybe 20) to get that.

So let’s distil that down – the Federal Government is proposing to spend $48 billion to make $5 billion.  For anything more, the Government is banking on small businesses passing on the benefit of the cuts by employing more people or spending more, neither of which is a guaranteed outcome.

As we wait to see what the outcome will be in time, taxpayers will find greater incentive to restructure their affairs to fall within the concessional rates for companies carrying on small(er) businesses, creating further distortion in taxpayer behaviour and increasing the Tax Office’s compliance costs.  If the Government has not learnt from the mess caused by the capital gains tax discount and the distortive effect that has by having two different effective tax rates for fundamentally the same gain, it needs to rethink its policy settings.  On top of that, the Prime Minister is applauding the passing of his measures on the diverted profits tax (DPT) – the irony is that, if these cuts (particularly to bigger companies) are passed, it will be harder for the Tax Office to successfully apply the DPT!