F R 0 M C 0 R P 0 RAT I SAT I0 N TO P R I VAT1 SAT1 0 N : HOW TAXES AFFECT THE PRICES OF

GOVERNMENT BUSINESS ENTERPRISES

by PETER DODD* and JUSTIN WOOD**

1. Introduction Australia in the 1980s saw the development of a new class of corporation.

These were Government Business Enterprises (GBEs) structured as corporations with 100% of the equity owned by the Government. One objective was to move these enterprises to a “half-way house” on the road to privatisation. In many cases the Government Owners have acquired “notional” corporate income tax payments from their GBEs, calculated in the same manner as in the private sector!

In Australia, the Federal Government exempts all State Government activities from Federal Income ’Fax. This means that when State GBEs are privatised these corporations lose their tax exempt status and Federal income tax consequences arise on any future taxable income attributable to the corporation or its new private sector shareholders.

In this paper we examine the case for Federal compensation to the States for the switch from notional tax to actual revenues paid to the Federal Government when State GBEs are privatised.* The withdrawal of Federal compensation announced on July 6, 1993, will decrease State privatisation programs if Federal compensation is shown to be necessary for State

0 1994. Economic Society of Australia. ISSN 08124439. * Fay Richwhite.

** Citibank Senior Lecturer, Australian Graduate School of Management. We wish to thank Bob Officer, Garry W t e and seminar participants at the University of ’IBchnology. Sydney, for helpful discussions on this paper. All remaining errors are solely attributable to the authors.

1. The policy implications that flow from the payment of “notional” corporate tax to the (Government) shareholder are not necessarily the same as those that flow from the payment of Federal income tax in private sector firms. For example, the payment of fees to tax lawyers to reduce the level of corporate taxes is not likely to be in the best interests of the Government shareholder who also collect the tax payments.

2. Subsequent to the first draft.of this paper, the Keating Labor Government announced, at the Premier’s Conference on July 6, 1993, that Federal compensation to the State’s on privatisation of their GTEs would be withdrawn, with some exceptions. The Federal Government has said that States will be compensated for one major sale of a bank or insurance office, and would also consider case by case situations. (Source: Sydney Morning Herald 7/7/93).

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Governments to achieve the value they place on GBEs. If compensation is shown to be unnecessary, State Governments will concentrate on efficiency reasons for privatisation. GBEs are responsible for approximately 10% of GDP in Australia and privatisation is yet to have any marked impact on the size of the GBE sector. Data for 25 major State GBEs compiled by the Office of EPAC estimate the net capital in these enterprises at $39.3 billion for 1990-91. Thus privatisation of State GBEs and concerns over tax compensation remains an important issue in Australia.

We show that Federal compensation is only necessary if equity investments are taxed more heavily than debt under the Australian tax system and investors do not expect the GBE to adopt an optimal capital structure after privatisation.

2. The case for federal compensation on the privatisation of state GBEs While the income from State GBEs is not subject to Federal income tax,

many State GBEs pay “notional” income tax to their State government owners. The notional tax is generally calculated in an identical manner, and at identical tax rates, to Federal corporate income tax. Thus when GBEs are privatised, the position of the GBE may not be significantly affected in terms of its tax commitments. Absent efficiency gains, the privatised company will pay the same amount of corporate tax that it would have paid had it not been privatised.

The difference is that, after privatisation, the corporate tax payments are collected by the Federal Government whereas prior to privatisation the corporate tax payments were collected by the State Government. On privatisation the State Government also loses its claim to the after-tax returns of the organisation, in terms of future dividends and capital gains. These claims now are owned by private sector investors from whom the State Government will have received the proceeds of the privatisation.

The party that appears to experience a windfall gain from this exercise is the Federal Government who collects future corporate and investor income taxes at no apparent cost. It is in this context that provision has been made, in the case of some State organisations that have been privatised (e.g. the State Bank of Victoria and the G I 0 in New South Wales), for a payment from the Federal Government to the State Government reflecting the present value of these future tax receipt^.^

In essence, one way to characterise these transactions is that, prior to privatisation, the State Government has a claim over the gross returns of the GBE. On privatisation it sells the after-tax claims to private sector

3. When New South Wales privatised the Government Insurance Office (GIO) in 1992. the public float raised $1.2 billion and the State Government received $600 million in compensation from the Federal Government. This compensation was estimated as the present value of corporate income tax revenues foregone by the States rather than an estimate of total taxes, both corporate and investor income taxes.

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investors and claims to future tax revenues to the Federal Government. If the Federal Government were not to pay compensation to the States for these future tax revenues, the GBE would be worth more to the State Government than could be achieved from the sale of just the after-tax claims to the private sector. This would provide a large disincentive for State Governments to privatise their organisations. These cash flows are illustrated in Figure 1 below.

FIGURE 1 STATE GBE PRIVATISATION WITH FEDERAL COMPENSATION

STATE G O V E R N W T r - - -b I I I x. . . I I

Afkr I I Tax I rouoMl

Tax I I Roceeds 8 ofthe I Rivatisatior

I I"RISE I

I I

\ After I

GOVERNMENTTRADING

Tax

/ I

1 Glpuate I Tax

/ I

\ I

' Tax ' Return

PRIVATE INVESTORS I

. 'Could be positiveor negatiw under Australia's dividend imputaticn tax system

l q e n d - Fbwp bdneprivatisslion - - Fbwp arts privalisatim 9 I F b w s at piva€katicn

The implicit assumptions made in the arguments presented above are: 1. That the present value of the after-tax claims to private sector investors

is less than the present value of the before-tax claims to the State Government.

2. That the Federal Government receives a windfall gain on privatisation. In Section 3 we examine each of these assumptions in turn.

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3. The case against federal compensation on the privatisation of state GBEs Consider the first implicit assumption, notably that the present value of

the after-tax claims to private sector investors is Jess than the present value of the before-tax claims to the State Government. If this is true, State Governments will be unable to obtain the value they place upon GTJ3 through privatisation.

It is not generally true that investors facing different rates of tax on returns from an asset will place different values of that asset. Taxable investors will earn less than tax exempt investors from all taxable investments. It is the relative tax on different assets for a single investor that is important in determining investor demand and hence the prices of financial assets. There are many examples of investors with different marginal tax rates all being prepared to pay the same price for financial assets. Examination of the shareholder register of almost any large Australian listed company will confirm this fact.

The conditions under which asset values are independent of the marginal tax rate of investors are derived in Samuelson (1964). Samuelson assumes that the opportunity cost of capital for taxed investors is (1-7) times the opportunity cost of capital for non-taxed investors where 7 is the marginal tax rate of the investor. That is, returns from the benchmark asset are fully taxable at the investors marginal tax rate. With this assumption, Samuelson shows that, so long as economic depreciation (the change in the market value of assets) is fully taxable or tax deductible, the value of assets will be invariant to the tax rate facing investor~.~

4. Samuelson's arguments can be summarised in terms of risk-adjusted cash flows and risk-adjusted rates of return as follows. The value of an asset to a tax exempt investor that can borrow or lend at R(x) is given by:

where N-t = the total life of the investment

C(x) = risk-adjusted cash flows after reinvestment at time x R(x) = risk-adjusted discount rate appropriate for term x

Differentiating this equation with respect to time gives

v' (t) = V(t)R(t)-C(t)

Re-arranging gives an expression for V(t) in terms of variables at time t .

The value of an asset to a taxed investor that can borrow or lend at R(xX1-r) after-tax is given by: N C(x)(l-r) + D(x)r

(1 + R(x)(l - r]y-' V(t1 = E

x = t

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The implication of Samuelson’s insight is that the values placed on a GBE by State Governments and private sector investors can be compared by considering the relative tax treatment of a GBE investment versus some benchmark investment for each class of investor. The benchmark asset in each case is taken to be a floating rate bond.5 The risk-adjusted rate of return on the floating rate bond before-tax is Rb.

The value of the GBE to a State Government will depend upon the before- tax cash flows from the investment and the before-tax required rate of return. The before-tax rate of return from the benchmark asset is Rb. State Governments, who are exempt from tax on all investments, will require a risk-adjusted before-tax rate of return from the GBE (R be) equal to the before-tax rate of return from the benchmark asset (Rbf

The value of the GBE to private sector investors will depend upon the after- tax cash flows from the GBE and the after-tax required rate of return. The risk-adjusted after-tax rate of return from the GBE is Rgbe* (l-~gbe) where Rgbe* is the risk-adjusted before-tax rate of return required by private sector investors and 7gbe is the effective (total) tax rate for private sector investors with respect to their investment in the GBE. The after-tax rate of return from the benchmark asset is Rb (1-7b) where 7b is the marginal tax rate for private sector investors on floating rate bonds. In equilibrium, private sector investors will demand a risk-adjusted *after-tax rate of return from the benchmark asset, i.e. Rb (1-Tb) = Rgbe (1-7gbe).

Only if 7b = 7@e, that is the effective tax rates for private sector investors is equal for an investmeFt in floating rate bonds and for an investment in the GBE, will Rb = Rgbe . Singe Rb = R be for the State Government, only if 7b = 7 be will Rgbe = Rgbe which w d imply that private sector investors and the ha t e Government place similar values on the GBE.

where D(x) = depreciation permitted at time x

T = tax rate

Differentiating this after-tax valuation equation with respect to time gives

v (t) = V(t)R(t)(l-r) - C(t)(l-r)-D(t)r

Re-arrapging gives an expresssion for V(t) in terms of variables at time t. So long as D(t) = -V (t). the valuation equation is identical to that for the tax exempt investor, viz

V(t) =

5. Following Samuelson. the (risk-adjusted) opportunity cost of capital is taken as the return available from a benchmark asset with returns that are fully taxable at the investor’s marginal tax rate, hence the choice of a floating rate bond. With floating rate bonds, the full return is in the form of interest income which is fully taxable. The choice of a floating rate bond for the benchmark asset is also useful for two other reasons: (1) it allows the argument to be seen as a trade-off between the tax consequences of debt versus equity-a relatively frequently discussed topic, and (2) it leads naturally into the discussion of the overall tax gains of the Federal Government since privatisations are often associated with the repayment of State Bonds.

v (tl + C(t)

“1

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Recognising this allows the question as to whether Federal compensation is necessary or not to be rephrased as a question of whether there is a tax advantage to debt (the benchmark asset) or equity, in equilibrium, for private sector investors under Australia’s current tax legislation. If there is a tax advantage to debt versus equity, this implies that the before-tax returns to equity must be higher than the before-tax returns to debt to leave investors with the same after-tax returns.

The tax advantages of debt versus equity and the implications for optimal capital structure has received extensive coverage in the literature. Some seminal papers in this debate include Modigliani and Miller (1963), Farrar and Selwyn (1967), Miller (1977) and DeAngelo and Masulis (1980).6 Consider first the demand by investors. The after-tax returns must be equal for debt and equity for the marginal investor in equilibrium. This requires Rdl -~b) = Re(l-~c)(l-~S)

where

Rb = the before-tax return from bonds Re = the before-tax return from equity 7b = the effective tax rate on bonds 7c = the effective corporate tax rate on equity rs = the effective shareholder tax rate on equity

The before-tax return on debt and equity will thus depend upon (1-7b) versus (1-7c) (1-7s). The effective tax rate on bonds is likely to be similar to the investors’ statutory marginal tax rate since all the return from bonds is fully taxed each year. The effective corporate tax rate and effective shareholder tax rates are much more difficult to determine. They will depend upon many variables including the nature of the investments of the GBE, the dividend policy, the shareholder clientele and the tax rates and rules governing corporate distributions to name a few.

Before trying to analyse the issues, suppose we assume that Australian tax legislation still does favour company debt. That is, (1-7b) > (1-7~)(1-r~) which implies that Re > Rb. This will imply that a 100% equity financed GBE will be priced by private sector investors at less than the value of the GBE to the State Government. However, if the tax legislation favours corporate debt over equity, shareholders can benefit from using debt rather than equity to fund the corporation. They will continue to use more debt until the benefit from using additional debt falls to zero.’ Thus, unless the optimal capital structure for Australian firms is 100% debt, firms will

6. Two excellent reviews of this literature are Haugen and Senbet (1986) and Kim (1989). 7. As more debt is used the profitability of being able to fully utilise the interest tax shield

declines and hence the relative return to equity increases. since the effective corporate tax rate on the next unit of equity will have fallen.

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employ debt until, at the margin, there is no advantage to debt or equity.* The implication is that, even if the Australian tax system favours debt

over equity, private sector investors will capture this benefit if the privatised GBE adopts the appropriate capital structure. This implies that, in the absence of efficiency gains, private sector investors will place a similar value on the GBE to the value placed on the GBE by a State G~vernment.~

We now consider the second implicit assumption. This assumption is that the Federal Government obtains a windfall gain when the GBE is privatised. If the Federal Government obtains no windfall gain, then the State Government can only lose on privatisation if private sector investors gain. Since the price on privatisation is set without any element of compulsion, it is unlikely that such a two-party voluntary contract will lead to one party consistently losing at the expense of the other.

The argument that the Federal Government gains from State Government privatisation rests upon the fact that tax revenues from the privatised GBE flow to the Federal Government. However, these are not the only tax flows that are affected by the privatisation.

Consider a scenario in which the risk-adjusted before-tax rate of return from the GBE and State bonds are equal and the State Government uses the proceeds of the privatisation to repay State bonds held by the private sector. The tax revenues to the Federal Government are increased from the privatised GBE, but are reduced as a result of the decrease in private sector interest income. So long as the effective total tax rate on the GBE investment and bonds is equal for private sector investors, the position of the Federal Government is unchanged by the privatisation. The cash flows are illustrated in Figure 2.

So long as there is no tax advantage to debt or equity, as must be the case in equilibrium, the question of windfall gain to the Federal Government may be rephrased as a question as to whether the aggregate supply of taxable assets increase with the privatisation.

Generally, whenever a State Government, or any other tax exempt body, transacts with the private sector some Federal tax consequences will arise. For example, the issuance of new State Government debt will increase the supply of taxable assets in the hands of private sector investors and increase

8. Optimal capital structure will also be influenced by non-tax costs and benefits of alternative forms of finance. For example, expected bankruptcy costs may limit the use of tax advantaged debt. Taking these non-tax costs into account may imply that the before-tax cost of capital for private secfor investors is higher than for an investor who faces no tax disadvantage to using equity.

9. Note that this does not necessarily imply that the GBE must have the appropriate capital structure when it is privatised. Even a 100% equity financed GBE should attract the full value from a private sector sale so long as private sector investors expect the new private sector management to quickly adopt the appropriate capital structure. This ignores the (potentially substantial] cost of altering the existing capital structure to a more appropriate structure.

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the revenues of the Federal income tax authorities. From this perspective, it is unusual to consider tax compensation for just one of many transactions of State Governments, namely privatisations.

FIGURE 2 STATE GBE PRIVATISATION WITHOUT FEDERAL COMPENSATION

STATEGOVERNMENT I I

I GOVERNMENT I

GOVERNMENT I STATE TRADING

ENTERPRISE After

I ‘ , Tax

I I Rocedsof

1 Rivatisation

I

he

\ Return \

Cuporatel Tax 1 \

InvestuTax 4 FEDERAL

GOVERNMENT

on Ink res t

Repay merd

I State Debt

I ’ I Intelest

PRIVATE INVESTORS

Legnd *Could be positiveor ngat iw

- - Flows after privatisatim imputaticn tax system. I I Flows at privatisation

Flows before privat isat icn undcr Australia’s dividend -

Compensation to the State Governments for increasing the aggregate supply of taxable assets, without damaging compensation when the aggregate supply of assets is decreased, provides the State Government with a “money machine”. It cannot be an equilibrium outcome.

Consider a State Government that sells a GBE for $1.2 billion and receives $600 million compensation from the Federal Government. One month later it might decide to buy back the newly privatised business. Assume that it pays the full price $1.2 billion. A month later, on reflection, it decides to sell the GBE again for $1.2 billion and receives another $600 million compensation. One month later. . .

So far we have ignored the impact of risk. Using risk-adjusted discount rates, we have shown that private sector investors will only place a lower value on the GBE than the value to a State Government if equity investments are taxed more heavily than debt under the Australian tax system and

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investors do not expect the GBE to adopt an optimal capital structure after privatisation. The use of risk-adjusted discount rates obscures the possibility that the private sector and State Governments require different premiums for risk. This is likely only if the diversification opportunities of the residual risk bearers in each case, investors and citizens of each State or of Australia respectively, are constrained in some fashion. We assume this is not the case.

4. Conclusions This paper has presented some arguments to show that, provided the

privatised GBE, financed in an appropriate fashion, is not a tax-disfavoured asset relative to alternative investment (e.g. bonds) for the private sector investors, compensation is unnecessary. Even if equity is tax-disfavoured relative to bonds, investors can overcome this through the choice of an appropriate capital structure. The after-tax cash flows to private sector investors from the GBE will be valued at an amount similar to the value of the before-tax cash flows to the tax exempt State Government. Under these circumstances the decision to privatise a State GBE is neutral with respect to taxes and privatisation decisions can be made on the grounds of efficiency gains.

If the privatised GBE will be taxed more heavily in the hands of private sector investors than the benchmark asset (bonds), or if the non-tax costs associated with the adopted capital structure exceed those facing the State Government, the value realised on privatisation will be below the value that the State Government places on the GBE. Federal compensation will be necessary to ensure privatisations are evaluated in terms of overall economic efficiency.

Overall there appears be a case for the continuation of relatively modest Federal compensation on the privatisation of some State GBEs. This appears to have been contemplated by the Federal Government which has promised that there will be a case-by-case examination of future privatisations to ensure that neither the States nor the Commonwealth will be financially advantaged or disadvantaged. However, compensation of $600 million, such as was paid on the privatisation of the G I 0 in New South Wales, appears unjustified.

An argument for compensation based purely upon the fact that the Federal Government will experience a windfall gain on privatisation, is less compelling. Federal tax revenues will rise whenever the supply of taxable assets increase and tax revenues will fall whenever the supply of taxable assets decrease. While it is true that privatisations may increase the supply of taxable assets, many other State Government transactions will also change the supply of taxable assets (e.g. the issuance or repayment of State debt). Unless compensation, in both directions, is contemplated for all such transactions there does not appear to be a powerful reason for compensation on the privatisation of State GBEs based on this type of argument.

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A final point worth noting is that the arguments for compensation may be reversed in the case of Federal GBEs that are privatised. 100% owned Federal Government corporations are generally not liable for a variety of State charges (payroll taxes, land taxes, etc.). On privatisation of these GBEs, the exemption from State charges is lost and the Federal Government will achieve lower proceeds on privatisation as private sector investors price protect themselves from these charges. The States will gain from the increase in State charges post privatisation.

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Bernasek, A. a n d Mychasuk. E.. "States' sa les plans in disarray", Sydney Morning Herald, July 7, 1993.

Bureau of Industry Economics. "Does the Australia Tax System Favour Company Debt". Business income Taxation Paper 4, 1990.

Clare. R. a n d Johnston, K.. 1992. "Profitability a n d Productivity of Government Business Enterprises", EPAC Research Paper No. 2. August 1992.

De Angelo. H. and Masulis. R.. "Optimal Capital Structure Under Corporate Taxation", lournal of Financial Economics, 8:5-29. March 1980.

Farrar. D. a n d Selwyn. L.L.. "Taxes. Corporate Financial Policy and the Returns to Investors", National Tax journal. 20:144-154, December 1967.

Haugen. R.A. and Senbet. L.W.. "Corporate Finance a n d Taxes: A Review", Financial Montrgement. 5-21. Autumn 1986.

Kim. E.tl.. "Optimal Capital Structure in Miller's Equilibrium''$ in Financial Markets a n d Incomplete Information ed. Bhat tacharya. S. a n d Constantinedes, G.M.. Rowman & Littlefield Publishers Inc.. Maryland, USA, 1989.

Miller. M.H.. "Debt a n d Taxes", Iournal of Finance, 32:261-276. May 1977. Modigliani. F. and Miller. M.H.. "Corporate Income Taxes and the Cost of Capital: A Correction",

Sarnuelson. Paul A.. "Tax Deductibility of Economic Depreciation to Ensure Invariant

Scholes. M. e n d Wolfson, M.. Taxes a n d Business Strategy: A Planning Approach, Prentice-

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