Observations

Rate cutting, base broadening: a reduced incentive for investment?

Date: 01 November 2011
Authors:
Publisher: IFS

As part of a large package of corporate tax reforms, the coalition government announced a series of cuts in the statutory rate, alongside broadening of the tax base. The main rate of corporation tax was reduced from 28% in 2010 to 26% from April this year and will fall to 23% by April 2014. From April 2012, the main rate of capital allowances will fall from 20% to 18%, the special rate from 10% to 8% and the Annual Investment Allowance from £100,000 to £25,000. These changes operate to reduce the proportion of the previous year's expenditure on certain types of capital that can be deducted from revenue to calculate taxable profits.

Ed Miliband's accusation that the coalition's policy will be to the detriment of manufacturing firms appears to be based on the fact that the package of tax changes will be relatively more beneficial to high-profit firms that invest less in plant, machinery and buildings. This assertion is correct. However, the conclusion that this leads to a tax system rigged against investment fails to acknowledge that firms invest in many types of capital, importantly including intangible capital. Some of the relative winners will be those firms that make important long term investments in skills and ideas, which benefit relatively less from current allowances.

In addition, the OBR predicts that the cost of capital will be lower for new investment by non-financial companies. As ever there is a trade-off here. Corporate taxes are known to be distortionary. Rate cutting and base broadening have opposing effects on firm incentives to invest. Overall the package of measures will give the UK a slightly more competitive tax system. In the longer term making the system significantly more competitive may mean raising less revenue from corporation tax.

On the specific issue of the appropriate level of capital allowances an important principle to consider is that of neutrality - the tax system should aim not to distort firms' decisions over how to organise their activities, how much activity to undertake and where that activity is located. To do so creates inefficiencies and is therefore costly. Since we don't know the actual economic rate for depreciation for each asset, there is debate over the relevant rates. Broadening the tax base alongside cuts to the rate is a policy mix that that has been favoured by policy makers across the developed world for the last 30 years. Indeed, this was a trend followed by the last Labour government.

Changing the tax burden

The Treasury estimates that the package of tax rate and allowances cuts will be broadly revenue neutral - the 2014-15 revenue gain from reducing allowances, allowing for some changes in behaviour but not accounting for any change in the level of investment, will almost exactly offset the estimated cost of reducing the main rate. Within this there will be relative winners and losers.

Taken together the cuts to the statutory tax rates and capital allowances will benefit high-profit firms with lower investment in plant, machinery and buildings (excluding those subject to the Bank Levy) relatively more since they gain more from the rate cuts than they lose from the base broadening. The base broadening will have the largest impact on those firms that invest intensively in the types of capital-long-lasting equipment and machinery - that are subject to capital allowances.

However, this does not mean that the policy necessarily favours low investment firms. Some firms in the manufacturing sector, as well as some in capital-intensive service sectors such as transport, will be relative losers. But there are high investment firms that benefit relatively less from current capital allowances. Importantly, this includes firms that invest in intangible assets that are not subject to allowances (even though investments in skills and ideas can depreciate in conceptually the same way as a machine). Intangible assets represent an important input into production for most firms; in the UK knowledge investment overtook fixed capital investment in the mid-1990s and is now about 50% higher. Many firms, including those in high tech manufacturing, that make long term investments in skills and ideas, are likely to be relative winners of the package of reforms. Therefore, while the package of tax changes does represent a redistribution of the tax burden, the outcome cannot be characterised as simply as saying that high investment firms are losers and low investment firms winners.

The crucial point about a lower rate is that it will help attract (and avoid deterring) internationally mobile capital, which is often highly related to investment in intangible capital.

The OBR forecast included in the June 2010 Budget sets out its judgement that overall the cuts in the corporation tax rate will more than offset the reduction in investment allowances such that the 'cost of capital for new investment is lower for all non-financial companies, and the rate of return from the existing capital stock is higher'.

This is wholly consistent with the figures reported in the Commons library briefing note, showing that the reduction in the Annual Investment Allowance (from £100,000 to £25,000) is estimated to affect between 100,000 and 200,000 businesses. The report also highlights that the package is expected to boost investment and that more than 95% of businesses in the UK will be unaffected (because their qualifying capital expenditure will continue to be completely covered by the annual investment allowance).

How competitive is the UK corporate tax system?

The key aim of the government's package of corporate tax measures - which includes reforms to the 'controlled foreign company' (CFC) rules, a cut to the small profits rate and the introduction of a Patent Box - was to "create the most competitive corporate tax regime in the G20".

A recent report by the Oxford Centre for Business Taxation set out that while the UK has a relatively low statutory tax rate - it ranks 7th out of the 19 independent G20 countries (excluding the European Union) - accounting for less generous capital allowances means that the improvement in UK competitiveness is lower for some measures.

 

  • The UK's effective average tax rate (EATR) - the relevant measure for considering where firms locate discrete investment projects - is just over 26% in 2011, ranking it 9th. This represents a fall from 4th in 2002, and places the UK above the G20 average. The coalition's package of reforms, conditional on other countries not changing their tax systems, would place the UK 5th in the ranking.

 

  • The effective marginal tax rate (EMTR) - the measure relevant for considering the level of investment - is just under 23% in 2011, giving it a rank of 15th, which will fall to 14th by 2014.

 

Research suggests that part of the fall in statutory rates that has been seen across countries in recent decades can be attributed to governments lowering tax rates in response to lower rates elsewhere, in an attempt to attract and retain increasingly mobile capital. Over time, in the face of even more mobile capital and potentially greater tax competition, governments should expect to raise less revenue from corporate tax. Indeed, it may be difficult to substantially increase the competitiveness of the UK tax system with revenue neutral tax changes.

Cuts to corporate tax - which raises significant revenue; around £43 billion, or 8% of total revenue in 2010-11 - are often politically unpopular. However, it is worth noting that the ultimate incidence of corporate tax always lies with households and is borne either by the owners of capital (in the form of lower dividends), by workers (in the form of lower wages) or by consumers (in the form of higher prices). Capital tends to be much more mobile than workers or consumers, and so corporate tax tends to get shifted to domestic factors - and specifically labour - but with a higher associated deadweight cost than if those factors had been taxed directly.