Australia has a problem. Across the economy, business investment has been sluggish for the past decade, leaving policymakers reaching for solutions.

Weak business investment can leave the economy stuck in low gear, operating without enough equipment or technology and failing to meet its potential. It’s tempting to think that if investment could be revived, higher living standards would follow. But it is not that simple.

In a recent report on creating a more dynamic and resilient economy, Australia’s Productivity Commission proposed some big changes to the way businesses are taxed in Australia, including lowering the corporate tax rate for most businesses and introducing a unique new cash flow tax.

So, what exactly is the Productivity Commission proposing – and would it help boost business investment? And crucially, would it improve living standards for Australian people?

Lower tax rates – with a catch

Right now, there are two rates of company tax. Businesses with turnover of less than A$50 million a year are taxed at 25%. Larger businesses, with turnover of more than $50 million, face a 30% tax rate.

The proposed reform of the corporate tax system has two key elements. First, almost all businesses would be taxed at 20%. Very large corporations, with turnover above $1 billion, would face a rate of 28%.

Second, all businesses would pay a new 5% tax on their “net cash flow”. The government would collect less revenue through company tax, but it would get some of it back through the net cash flow tax. More on this later.

The profitability problem

The Productivity Commission is concerned about potentially profitable business ideas that become unprofitable when company taxes are taken into account.

For example, $1 million invested in building a restaurant might generate profits of $1.3 million over its lifetime, making it a profitable activity. But after paying 25% in corporate tax, or $325,000, the restaurant only generates $975,000 for the investor.

Knowing she will make a loss, the investor will decide not to make the investment.

Now, suppose the corporate tax rate was cut to 20%. Corporate tax paid by the restaurant would be $260,000, leaving $1.04 million for the investor. The investor sees she will make a positive return and decides to finance the restaurant. This argument is at the heart of the Productivity Commission’s recommendation to cut the rate of company tax.

In reality, the picture isn’t quite this simple. The investor must also account for the time value of money, various risks and opportunity cost, and the returns she could be making if she invested the money in other ways.

When calculating profits, the tax office includes depreciation as a cost. This deduction reduces the corporate tax bill significantly compared to our hypothetical example. Depreciation deductions are spread over many years so they are worth less than if the deduction on the whole investment was allowed up front. This is important when we talk about a cash flow tax later.

Foreign and domestic investors

Another complication is Australia’s unique dividend imputation system. If the investor lives in Australia, the tax the company has already paid on its profits is treated as if she paid it herself.

When she does her tax return, that company tax counts as a franking credit towards the income tax she owes on all her income. This means the investor is indifferent to the company tax rate because it works like an advance payment towards the personal tax she has to pay anyway.

If dividend imputation was available to everybody, the corporate tax system would be a very leaky bucket indeed – all the revenue it collected would be lost again when credited to the personal income tax paid by investors.

But a lot of the money invested in Australia comes from foreign investors. They don’t pay personal income taxes to the Australian government, so the company tax we collect from them stays in the bucket.

This is the key to making corporate income tax cuts have an impact. But it is also the reason we need to be careful about how we assess the success of the proposed policy.

With lower corporate taxes, foreign investors will likely invest more in Australia, leading to a larger economy. Our economic modelling at the Centre of Policy Studies, published in the Productivity Commission’s interim report, finds the economy (or GDP) will be larger by 0.2% in the long run. This sounds good – but there’s a catch.

When the Australian government collects less tax from foreign investors, Australia’s income falls. Our modelling finds gross national income will be smaller by 0.3% in the long run. The economy will be larger, but less of it will belong to us.

A new tax on cash flow

Alongside recommendations to cut the corporate tax rate, the Productivity Commission has proposed introducing a cash flow tax.

This is a relatively rare form of taxation used in only a few countries. Like corporate tax, a cash flow tax is levied on profits.

But the big difference is that a cash flow tax treats investment costs as an immediate tax deduction, rather than gradually depreciating the investment.

This is attractive because it does not change the incentive to invest. By treating the investment as one big tax deduction at the beginning of its life, an investment that is profitable in a tax-free world will also be profitable under a cash flow tax.

This means the government can collect tax revenue from companies without having a negative impact on investment.

Under a cash flow tax, highly profitable businesses will pay a relatively large amount of tax, while businesses that are just breaking even will pay very little. Unsurprisingly, lobbyists for big business have urged Treasurer Jim Chalmers to ignore the recommendation.

A company tax cut results in lower income for Australians, but adding a cash flow tax reverses these losses by collecting more revenue from foreign investors and multinational corporations. Our modelling finds this package would lead to gains in Australia’s gross national income of 0.4% in the long run. The Productivity Commission’s report now rests with the treasurer for consideration.