We're told that cutting the company tax rate will lead to greater economic output, higher wages and more jobs. But the modelling used to support these claims is based on assumptions that are divorced from reality. Stephen Long writes.

There's an old joke about an economist, a physicist and a chemist stranded on a desert island with no implements and a crate of canned food that washed up from a shipwreck.

While the physicist and the chemist set about devising novel ways to open the cans, the economist says: "Let's assume we have a can opener."

The punch line satirises the tendency of economists to make unrealistic assumptions, and devise elegant models based on those assumptions that are at odds with the real world. It's highly relevant to the debate about cutting company tax.

Cutting the company tax rate is central to the Coalition's "10 year plan to boost jobs and growth": the core of its pitch to voters in the federal election.

To support its claims, the Coalition is relying on modelling by the Treasury, and modelling by a firm of consultants hired by the Treasury, which concludes that the benefits of a company tax cut won't be captured by business, but lead, over time, to greater economic output, higher wages and more employment.

Unsurprisingly, vested interests such as the Business Council of Australia, a lobby group for the CEOs of the nation's 100 largest companies, have jumped on the bandwagon; those who stand to gain most are using the Treasury modelling to claim that workers will be the real winners from cutting company tax.

Even economists and economic commentators who oppose the planned company tax cuts are somewhat wowed.

The Age's economics editor Peter Martin, for example, has concluded that while the case for a company tax cut is weak, it is backed by "serious modelling".

I disagree. Like the economist on the desert island who conjured up a theoretical can opener, the model's assumptions are divorced from reality.

The modelling is at the heart of the problem.

The starting point for the Treasury's analysis is that "all markets are assumed to clear: wages adjust to clear the labour market ... and prices adjust to clear goods and services markets."

This is a state of nirvana that economists refer to as "equilibrium". There is full employment. Competition "adjusts" prices and the "laws" of supply and demand achieve a perfect state of balance.

Needless to say this economist's paradise exists only in theory - yet those unrealistic assumptions determine some of the findings that government and business are using to market the company tax cut to the electorate.

For example, once you understand the assumptions, it's hardly a surprise that the Treasury estimates that, over time, a company tax cut will result in real wage rises. If the model assumes there is full employment, it couldn't really find anything else.

The flip side of that assumption is that the Treasury analysis finds that employment growth resulting from a company tax cut will be trivial - on most scenarios just 0.1 per cent over the long term.

The fiscal assumptions are as questionable as the assumption of full employment.

Australia's chief economic mandarins, the secretaries of the Treasury and Finance, warned in the Pre-Election Fiscal Outlook that without major spending cuts or the highest taxation levels in 30 years, Australia may not achieve a significant budget surplus in the next 10 years . Even a wafer-thin surplus is only achievable if Australia manages a significant, sustained lift in the pace of economic growth and a big boost to productivity growth that is impossible without reform.

Yet debt and deficit magically disappear in the theoretical nirvana Treasury uses to model the effects of a company tax cut.

"For simplicity," it says, "the government is assumed to have no debt and maintain a zero primary budget balance."

Deficits are kept at bay during the transition phase from the current 30 per cent company tax rate to a 25 per cent rate because government announces the tax cuts "well in advance" and companies "bring forward investment activity and tax revenue" in anticipation of the goodies to come.

Gee. In our volatile political climate, it would be a brave board of directors that signed off on investment decisions on the assumption that tax cuts announced "well in advance" were a done deal.

Rich and poor are also assumed away in Treasury's model. The reality of high income earners and low income earners, small business people, workers on wages and people on welfare is all too complex: "For analytical tractability (i.e. ease of modelling), Australian households are modelled via a single representative household."

It's a super household that incorporates capital and labour. The "single representative household" derives income from dividends, wages and welfare benefits. Forget the fabled complexities of the taxation system, and the different tax scales in the progressive income tax regime: again, for "tractability" Treasury assumes a flat income tax rate. It also assumes there is a fixed savings rate, even though the rich save more than the poor.

Keep this in mind when a politician implies or states that you will be better off, or that all of us will be better off, under a company tax cut. The so-called "welfare gains" that Treasury's super household enjoys under the model might not apply at all to you or me in the far more complex real world.

It'll depend, for a start, on how the company tax cuts are funded.

Treasury modelling, indeed all modelling, finds that cutting company tax will have a significant impact on government revenue and the shortfall will have to be made up - either by imposing other taxes or by cutting government spending.

The Treasury analysis looks at three scenarios: funding company tax cuts through an unspecified "lump sum" tax; through an increase in personal income tax; and through a cut in government spending on goods and services.

The gain to its representative household from funding the company tax cut through an increase in personal income tax is trivial: 0.1 per cent. And that's an average tax rate for a "representative household" incorporating capital and labour; a large share of wage earners could be far worse off financially if a future government lifts income tax rates to claw back revenue lost in company tax.

The gain from funding the company tax cuts through an unspecified lump sum tax aren't much better: a mere 0.2 per cent.

And those negligible gains rest on the dubious assumption (as we'll see) that cutting company tax cuts will primarily benefit workers.

The only scenario in which Treasury's "representative household" gains a significant so-called "welfare benefit" - 0.7 per cent - involves the slashing of government spending on public goods and services to fund a company tax cut. How on earth could this boost household welfare? Because "government spending is assumed not to affect directly the welfare of households".

Only in the world of neoclassical economic theory could such an assumption be made. Only in the world of neoclassical economic jargon could cutting a swathe through government spending on goods and services be described as improving household "welfare".

As Treasury puts it, "the implicit assumption is that the spending is wasteful." (An assumption that's explicit in modelling commissioned by the Treasury from economist Chris Murphy, who proposes that the billions lost year after year from the planned company tax cuts could be funded through "government efficiency savings".)

Treasury at least has the good grace and common sense to acknowledge that its model overstates the supposed "welfare gains" that would apply in the real world, because:

Government spending provides goods and services that would otherwise not be provided by the market sector; households derive direct utility from government spending; and infrastructure spending can improve market sector productivity.

But it fails to assess the cost that Australians will bear as government services are either scrapped, pared back or privatised - a cost that might well fall disproportionately on more vulnerable members of society. Who wins and who loses when government services funded through progressive taxation and company tax receipts become private services run for profit on a "user pays" basis?

It's quite possible, too, that the tax hikes or spending cuts needed to accommodate a lower company tax rate might be bigger than the econocrats imagine.

Its model assumes that companies aim to maximise profits, yet it also assumes that a 5 per cent lower company tax rate will discourage companies from avoiding tax by shifting profits to tax havens and that will boost revenue.

What's striking overall is that the supposed "welfare gains" are tiny; the Treasury couldn't find much of a gain despite the unrealistic and favourable assumptions in its model.

Yet we're still told that workers will be the main beneficiaries. Treasury modelling finding that, albeit decades down the track, the company tax cuts could lift real wages by up to 1.4 per cent.

"In the long run," it argues, "around one-third of the benefit accrues to ... shareholders ... with the remaining two-thirds flowing to households, primarily through rises in real wages."

The argument is that lower company taxes will encourage more direct foreign investment by multinational companies, which will boost capital expenditure (on plant, technology and equipment) and that, in turn, will lift labour productivity. Ultimately, the higher labour productivity will flow through to higher wages.

But be sceptical. There are good reasons to question this rosy picture.

Despite cuts in corporate tax rates and rising labour productivity, the share of national income going to workers has been falling substantially in almost all advanced economies for decades. Labour has been losing to capital. In Australia, despite high rates of labour productivity growth in recent times, wages are growing at the slowest pace since the last recession.

One reason is that workers' bargaining power had diminished as a result of globalisation, deregulation and the decline in trade unions - yet bargaining power is conspicuously absent from the Treasury model.

Another is that the "capital deepening" Treasury assumes will flow from a company tax cut has defied its theory; most of the gains from the higher productivity that results from the investment go to capital, not labour.

"Labour-saving - or even labour-replacing - technical change, induced by continuous innovation in ICT-based technologies, was one of the most important forces behind the decline of the labour share," an OECD study found.

Remember, too, that Treasury's model assumes full employment while, in the real world, there's almost certain to be unemployed and underemployed workers that will act to suppress wage rises.

Even if the company tax cut does ultimately lead to higher wages on average, don't imagine that everyone will benefit.

Rising inequality of earnings has been one of the defining features of our times.

According to the OECD, the wage income share of the top 1 per cent of income earners increased by 20 per cent in the past two decades, while the wages share of those down the bottom collapsed.

In Australia, the wage gains from the flood of investment into mining construction in recent years were largely contained to construction and mining; employees in the low-wage hospitality sector actually saw their real wages go backwards.

Across the globe, the unequal distribution of income, and the rising share going to capital rather than labour, are seen as threats to social cohesion.

But needless to say, distribution is not included in the Treasury modelling.

Stephen Long is an investigative reporter with the ABC, covering business and finance.