Treasurer Peter Costello has warned against corporations getting carried away with the boom in private equity deals, telling The Australian that “People ought to remind themselves they are living in a golden period with low commercial interest rates, small spreads and high profits”.

As The Oz pointed out, there is an element of self-interest in this:

All of the deals involve large debt components, which could cut the amount of tax paid to the Treasury, because companies taken over by private equity firms use their profits to make tax-deductible debt repayments.

But one of Costello’s colleagues, no doubt quite unintentionally, hinted at the solution yesterday. Senator Gary Humphries put out a press release saying that “The lack of a savings culture in Australia has been overlooked” in the housing debate, and that saving has become “almost unfashionable”.

Among measures that Humphries said should be considered was “abolishing taxation of interest earned by savings”.

Now there’s a real issue here. Bank accounts these days are earning interest at about 5%, if you’re lucky. With inflation at 3%, that’s a real return of only 2%. But you pay tax on the whole lot, not just the real component, so if your marginal tax rate is more than 40% you’re actually going backwards.

Humphries is right: penalising savings is a bad idea. The equitable solution would be to discount the effect of inflation before calculating tax, just as we used to do with capital gains (before the government decided to cut the capital gains tax in half instead).

But here’s the link to Costello’s problem: tax deductibility of debt is just the other side of the same coin.

If a company borrows, say, $100m to buy out other companies – or to gold-plate the executive bathrooms, or whatever else they do with all that cash – and pays 6% interest on it, then the whole of that interest payment is tax deductible.

However (again assuming inflation at 3%), only half of it is real interest – the other half is just maintaining the value of the capital. There’s no earthly reason why that should be deductible.

And it wouldn’t be surprising if that hidden taxpayer subsidy is fuelling a lot of uneconomic borrowing.

Peter Fray

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