RDP 9011: Inflation and Corporate Taxation in Australia 2. Some Facts

It is widely accepted that, prior to the introduction of dividend imputation in 1987, the type of corporate taxation system operating in Australia was one which gave a strong advantage to debt over equity financing. On its own, this would suggest an incentive for firms to have higher leverage than would otherwise be the case, although it would not necessarily explain a steadily rising level of leverage, as in fact occurred during the 1980s (see Figure 1, and the Appendix for a description of the data). To explain this, it would also have to be argued that the system is inherently slow to adjust, or that firms came only gradually to the view that they were under-geared relative to the incentives built into the tax system. There is some evidence for this in the fact that there was no immediate step down in leverage after the tax advantage was removed.

Another way of presenting this information is to show the growth of business credit outstanding to Australian financial institutions (Figure 2). This aggregate has grown almost continuously as a ratio to nominal GDP since the mid 1970s and showed particularly rapid growth between 1983 and 1989, roughly doubling over this period.

The growth of leverage was far from uniform across companies and across industries (see Tables 1 and 2). Table 1 shows how the aggregate was influenced by the behaviour of a relatively small number of companies. When the top ten contributors to the rise in leverage are excluded from the aggregate, the increase is much smaller.

While there were indeed incentives to gear up, the behaviour of some of these ten companies can now be seen to have departed from sound management policies.

There were also some important variations in leverage across industries (Table 2). Three groups in particular experienced very large increases in debt, mainly as a result of leveraged takeovers or asset acquisition. These were the entrepreneurial investors, media, and diversified resources groups. Again, the aggregate excluding these groups showed a much more modest increase in leverage.

Table 3 illustrates the increase in corporate takeover activity which occurred in the late 1980s. The source of these data (Corporate Adviser (1990)) attributes much of the increased activity to “financial restructuring or opportunistic purchasing rather than growth related strategies based on the offeror's existing business activities” (op. cit., p.5). In other words, companies were perceived to be undergeared in relation to the incentives toward high gearing contained in the tax system.

Against this background of rising leverage during the past decade, it is of interest to consider in more detail the nature of the tax biases that have affected corporate leverage, and the extent to which those biases have been removed by recent tax reforms. These issues are examined in the next section.