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Putting up corporation tax is a risk the chancellor may come to regret

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It’s a long way behind the big three — income tax, national insurance and VAT — but corporation tax comes in as our fourth biggest revenue raiser. It brought in a pretty handy £60 billion in 2019-20, just before the pandemic struck. As a fraction of national income that’s the most it has raised this century, a little more even than its pre-financial crisis peak when the economy was running hot and the headline tax rate was a lot higher than it is today.

So the decision to raise the main rate by a hefty six percentage points in the budget was a big one. It was also a surprise, and a remarkable U-turn. For a decade, Conservative chancellors have prioritised reducing the rate of corporation tax, taking it from 26 per cent down to 19 per cent. In fact, assuming it happens, this will be the first increase in the headline rate since 1974 when Denis Healey was chancellor, Harold Wilson was prime minister and we had yet to have our first referendum on membership of the Common Market.

Intended to raise another £17 billion a year, this is a big change indeed. So what to make of it?

The chancellor reassured us that even after this increase the UK’s corporation tax rate would remain the lowest in the G7 group of nations. Just about true of the headline rate if you take account of state-level taxes in the US. Not really true if you look at what matters, which is the effective rate — ie the rate that actually gets paid either on average or on the return to the marginal investment.

That’s already in the middle of the pack internationally rather than especially low, because we have a rather broad tax base. More of the corporate income that is made in the UK actually gets taxed than is the case in many other countries.

That’s one reason why UK corporate tax revenues are already above those in some other G7 countries and, like the effective tax rates, middling rather than low by international standards. It’s also part of the reason why consistently lowering the tax rate has not led to any consistent reduction in tax revenues. Revenues in 2019 were above the average of the previous 40 years despite a far lower headline rate. They had been climbing since 2010. That is not evidence that cutting rates raises more revenue. The tax base has been further broadened over the past few years and, of course, revenues were due to rise from their post-financial crisis cyclical low.

Given the fashion for predicting the demise of corporation tax in the face of globalisation, the advance of big tech, and increasingly sophisticated financial engineering, the robustness of corporate tax revenues has taken many, myself included, by surprise. We are still able to extract large sums from big companies.

Just as I do not believe that cutting the rate after 2010 was responsible for the rise in revenues, nor am I of the view that raising it will lead to reduced revenues. It is, though, unlikely to lead to the additional £17 billion a year that the chancellor is banking on, at least in the longer term. Higher rates do have effects on investment decisions and not all those effects are captured by the official estimates.

There are certainly risks involved in such a steep rise. Professor Michael Devereux of the Oxford University centre for business taxation estimates that the proposed increase could reduce foreign direct investment by 5 per cent from 2023, with a considerably bigger negative effect on investment overall. If that does happen it will be damaging for UK productivity and living standards. Both will already have suffered as a result of the dreadfully poor investment levels of the last several years.

Don’t forget that the effect on living standards will be on top of the direct tax take of £17 billion, or whatever it turns out to be. That’s £17 billion which, one way or another, will come from the customers, employees or shareholders of the companies affected. One of the things that makes a rise in corporation tax politically attractive is the fact that it is not at all obvious who ends up paying the bill. Rest assured, somebody will.

All that pain is for the future though. The rate increase is not due to come into force until April 2023. In the intervening two years there is to be another very big change to corporation tax: the introduction of a “super-deduction”, allowing companies to deduct 130 per cent of the cost of investment in plant and machinery from taxable profits. Costing more than £25 billion over two years, this is intended to bring forward, and it is hoped boost, investment to support the economy as it emerges from the pandemic. It represents a significant subsidy to large investments over this two-year period.

It is in fact also necessary simply to avoid disincentivising smaller investments, up to the normal annual investment allowance. Without this additional deduction it would otherwise be preferable to wait until 2023 in order to deduct the investment against the higher 25 per cent tax rate. Announcing rate rises for the future can have undesirable short-run effects.

It’s easy enough to see the politics behind Rishi Sunak’s tax increase of choice. Opaque, in the future, jam today, well-hidden pain tomorrow. The scale of the increase, though, makes the economics more concerning. Not only is he unlikely to get as much revenue as he’s banking on, he risks reducing investment levels and hence wages and living standards over the long run.

He may also want to reflect on how hard it can be to unwind supposedly temporary giveaways as he prepares to get rid of his formidably expensive super-deduction in two years’ time.

This article was first published in The Times and is reproduced here with kind permission.

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