Do investment tax breaks work? A new study finds the evidence is ‘mixed at best’

The Reserve Bank of Australia (RBA) released a discussion paper^[1] this week on investment tax breaks. The study looks at whether tax incentives, such as instant asset write-offs for utes^[2], boost business investment.

Business investment is an important contributor to overall economic growth, and has been sluggish in recent years.^[3]

The authors conclude the evidence for these tax breaks is “mixed at best”. They say that income tax breaks used during the global financial crisis increased investment significantly, however:

[there is] no substantial evidence that other policies, including those implemented during the pandemic, increased investment.

In an election year, further promises of tax breaks for businesses are likely. The Coalition has already announced a tax break for meals and entertainment^[4]. But are they a good idea, and at what cost do these promises come?

Small business in Australia

Small businesses^[5] with fewer than 20 employees make up 97% of all Australian businesses. More than 92% of Australian businesses have an annual turnover of less than A$2 million. It is these businesses that are doing it tough.

These businesses are offered tax breaks for spending on capital assets such as equipment or vehicles. For the 2023-24 tax year, they can immediately write off the cost of eligible assets up to $20,000. In the May 2024 Budget^[6], the government announced that the tax break would be extended to the 2024-25 tax year.

When a small business is operated as a company, the base tax rate is 25%. This effectively means that the business still contributes 75% of the cost of the asset. This requires businesses to have the cash flow to invest. Even if there is cash flow, businesses may not want to spend on large purchases.

It’s a question of trade-offs

Investment tax breaks are also costly in terms of government tax revenue. Each year, the Treasury^[7] estimates the cost of tax breaks. These tax breaks are known as tax expenditures.

For the 2023-34 tax year, the instant write-off tax break for small businesses is estimated to cost more than $4 billion by reducing taxes collected.

Tax expenditures are normally designed to offer incentives to one group of taxpayers. However, they come at the expense of broader groups of taxpayers and at a cost of lost revenue to the government. This is money that could be spent through direct spending programs.

Tax expenditures can be thought of as government spending programs hidden in plain sight.

The true cost of tax breaks

Tax expenditures play a central role in Australia’s collection of taxes and redistribution. During the pandemic, the instant asset write-off was increased ^[8]to $150,000.

The current government introduced the latest instant asset write-off to improve cash flow and reduce compliance costs for small business. As the RBA discussion paper notes, these types of incentives are also designed to encourage additional business investment.

However, that study indicates this is not being achieved. They suggest the reasons may be the tax policies themselves or differences in the economic environment. Put simply, businesses may not want to invest.

If the stated benefits are not realised, the result is less tax collected. Take the $4 billion cost above. Without the incentive, the government would have an additional $4 billion to spend. The $4 billion in 2023-24 could have been directed to funding small businesses through a direct spending program.

Targeted programs

The RBA discussion paper highlights the need to determine whether investment tax breaks achieve their intended benefits. Many factors must be considered, and assessing the influence on the economy is vital.

However, evaluating these measures within the tax system means that important questions are not asked. This includes whether the benefits are distributed fairly, whether the program targets the right group of taxpayers, and whether there are unintended distorting effects.

The latest Treasury Tax Expenditures and Insights Statement^[9] provides data on 307 separate measures. This number continues to grow.

The government’s “Future Made in Australia^[10]” contains two examples. Its economic plan to support Australia’s transition to a net zero economy contains two tax incentives, one for hydrogen production and another for critical minerals.

The proposed hydrogen production tax incentive^[11] is estimated at a cost to the budget of $6.7 billion over ten years. The measure will provide a $2 incentive per kilogram of renewable hydrogen produced for up to ten years. Eligible companies^[12] will get a credit against their income tax liability.

The proposed critical minerals production tax incentive^[13] is estimated to cost the budget $7 billion over ten years. Eligible companies^[14] will get a refundable tax offset of 10% of certain expenses relating to processing and refining 31 critical minerals listed in Australia.

Support for tax breaks

Tax breaks for businesses, such as the immediate write-off, disproportionately benefit those that spend. Often, this is by design^[15]. If this is a government objective, supported by the general population, then it is viewed as a good use of public money.

The same principle applies to tax breaks in the Government’s Future Made in Australia plan. A government objective is to transition to a net zero economy. A stated priority^[16] is to attract “investment to make Australia a leader in renewable energy, adding value to our natural resources and strengthening economic activity”.

The question remains as to whether tax breaks are the best way to achieve this. The answer often changes when viewed as a direct spending program.

References

1. ^{^} discussion paper (www.rba.gov.au)
2. ^{^} such as instant asset write-offs for utes (theconversation.com)
3. ^{^} and has been sluggish in recent years. (www.abs.gov.au)
4. ^{^} meals and entertainment (theconversation.com)
5. ^{^} Small businesses (www.asbfeo.gov.au)
6. ^{^} May 2024 Budget (www.ato.gov.au)
7. ^{^} Treasury (treasury.gov.au)
8. ^{^} the instant asset write-off was increased (theconversation.com)
9. ^{^} Treasury Tax Expenditures and Insights Statement (treasury.gov.au)
10. ^{^} Future Made in Australia (futuremadeinaustralia.gov.au)
11. ^{^} hydrogen production tax incentive (treasury.gov.au)
12. ^{^} Eligible companies (www.ato.gov.au)
13. ^{^} critical minerals production tax incentive (treasury.gov.au)
14. ^{^} Eligible companies (www.ato.gov.au)
15. ^{^} design (theconversation.com)
16. ^{^} stated priority (futuremadeinaustralia.gov.au)