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Institute of Economic Affairs – gloriously wrong on corporation tax.

Saturday, November 5, 2016 10:11
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From page 204 of pdf here.

There’s a lot of good stuff, but they relapse into Faux Libertarianism when it comes to the question of what’s worse, VAT or corporation tax.

Corporate profits

The OECD found that corporate income taxes (such as the UK corporation tax) have the most negative impact on economic growth, among consumption taxes, property taxes and income taxes (Arnold 2008). Specifically, corporate income taxes have the following problems:

• They weaken the signal to reallocate resources from low-value activities to high-value activities between different companies and also within the same company by reducing after-tax profits.

No they don’t “weaken signals” particularly. I know that the OECD said that but it’s nonsense. A good pre-tax decision will nearly always be a good post-tax decision. When businesses are decided which projects to undertake, it is educated guesswork, for a given amount of £100,000 to be invested in a new project, if they expect an overall pre-tax profit of £50,000 from Project A and £30,000 from Project B, they will choose Project A. If the business compares post-tax profits, they will still choose Project A with a post-tax profit of £40,000 rather than Project B with a post-tax profit of £24,000.

That is quite different to VAT. Assuming we are looking at the same time frame/effort, compare:
- Project A involves producing/selling 100,000 small, high turnover items which can be made and sold within five weeks. They cost £1 each and can be sold for £1.05 gross = £50,000 profit over a year.
- Project B involves producing/selling 1 very large slow-moving item, which costs £100,000 and, takes a year to make/sell, and which can be sold for £130,000 gross = £30,000 profit.

If you knew nothing about VAT, you would say that Project A is better. But once you take VAT into account, Project A actually makes a loss of £160,000 and Project B makes a profit of £4,000. That strikes me as being hugely distortionary.

VAT similarly distorts activity in favour of VAT-exempt or zero-rated items and against fully VAT-able items. Corporation tax does no such thing.

• They bias ownership structures in favour of debt capital and against equity capital.

This is another of those myths that I have been railing against for decades to little avail. The UK tax system was heading towards a system (it is now heading away again thanks to George Osbrown’s constant meddling) where the amount of tax (corporation tax plus income tax) would be exactly the same whether it is funded by share capital or loans. It would be quite easy to enforce the default rule that interest payments are liable to 20% withholding tax and get rid of Osbrown’s stupid tweaks, so that by and large, it makes no difference.

• They distort spending patterns in favour of current expenditure, which is fully tax deductible, and against capital expenditure, which is not (capital allowances partially ameliorate this).

Not really. A good pre-tax decision is a good post-tax decision, see above. I’ve never heard a businessman yet decide to stop using ‘capital’ (i.e. labour saving devices) because they will not get 100% capital allowances in the first year. And if the IEA really thinks this is a problem, then they could suggest giving businesses 100% first year capital allowances on all the equipment they buy. Most small and medium sized businesses have been able to claim 100% first year capital allowances on all additions for the last few years anyway. I don’t really see the harm in extending this to all businesses, it would result in a corporation tax shortfall in the first few years but slightly higher receipts once it has bedded in and an end to all this Faux Lib bickering.

• They discourage investment by reducing retained earnings, which would otherwise be spent on capital investment goods directly by the company or invested with financial intermediaries to the same effect by third parties.

Nope. By definition, corporation tax is not a tax on reinvested profits, which is what we care about. ‘Retained profits’ merely means all profits not paid out as dividends, how much of the retained profits are actually reinvested is a separate topic.

Once a business has shown itself to be viable, it will grow organically. The first outlet/machine/project has to be funded by share capital (assuming banks won’t lend to start-ups); if there is sufficient demand and it is profitable, it will grow. If the business decides to just roll up profits in cash instead of expanding, then yes it will pay full corporation tax on them.

I spend all day completing tax returns, and it is only tax return in twenty where the capital expenditure in a year is greater than the profits, so if the business can claim 100% capital allowances on all its expenditure, it has a loss for tax purposes. The other nineteen returns show that capital allowance expenditure was a lot less than the profits for the year, ergo full corporation tax relief and/or the expansion is funded out of pre-tax profits, whichever way you want to look at it.

Admittedly, there is a timing issue here but this can all be fed into IRR calculations, or the loss carry back period could be extended from one year to three years again, to give the one business in twenty a better chance of reclaiming all the corporation tax it paid on the earlier years’ profits which it has now genuinely reinvested.

One of the few sensible measures in the UK corporation tax system is that there is no tax relief for buying land, and rightly so, as people selling land to each other does not increase our productive capacity one jot, land is not capital. Annoyingly, there is precious little tax relief for the cost of new buildings, even though buildings are capital in the true sense of the word. Again, that can easily be fixed by reintroducing Industrial Buildings Allowances and extending them to all new buildings.


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