Tax reform Q3.qxd 8/3/10 09:51 Page 1 22 Big Picture

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2 Tax making the UK competitive 23 Tax making the UK competitive The IoD s Richard Baron, Head of Taxation, and Corin Taylor, Senior Policy Adviser, set out a 10-year programme of tax reform to restore the UK s attractiveness to business. When the UK is running a record fiscal deficit, making it urgent to maintain tax revenues as well as to cut spending, it is tempting to push longer-term thinking about the state of the tax system onto the back burner. But that would be a mistake. The UK s tax system has got less and less competitive in recent years. Fortunately, it is pretty clear what needs to be done. In this article, we outline a 10-year programme of reform that can restore the UK s attractiveness to business. It is important to restore confidence by committing to such a programme now, and by starting to implement it within a year, even though a full programme would only be affordable if implemented over a considerable time. THE COMPETITIVE PRESSURE The UK s corporation tax used to be on the low side among developed economies. That is no longer so. The UK s main rate has come down, most recently from 30 per cent to 28 per cent in 2008, but other countries rates have come down faster. For a multinational choosing a country in which to invest, the issue is exactly the same as for a consumer who can go to one supermarket or another. The multinational, like the consumer, will go where the costs are lowest, so long as the quality is acceptable. For businesses, corporation tax will be a very significant cost, and the quality in question will be that of infrastructure and of public services. Rates of corporation tax are far less competitive than they were a decade or so ago: 1 In 1996, the UK s corporation tax rate was joint fifth lowest in the OECD. In 2009, it was joint 17th lowest. In 1996, the UK s corporation tax rate of 33 per cent compared favourably with the OECD average rate of 37.7 per cent. In 2009, the UK s rate of 28 per cent was above the OECD average of 26.3 per cent. SNAPSHOT The size of the UK s fiscal deficit should not be used to push longer-term thinking about the tax system on to the back burner. The UK s tax system is far less competitive than it was a decade ago. Whether on corporation tax or other business taxes, the UK is no longer a low tax country. If the UK is to attract international capital, and if entrepreneurs are to think it worth expanding their businesses, there needs to be a programme of reductions in tax rates, particularly the rates of taxes that directly deter investment and employment. The IoD s central recommendations are to reduce the main and small companies rates of corporation tax to 15 per cent in a phased manner over 10 years, and to reverse the planned increases in employee and employer national insurance. These reforms are key to restoring the UK s competitiveness. If we do not enact them, the economy will suffer, foreign investment will go elsewhere and tax revenues will be held back. 1 KPMG, Corporate and Indirect Tax Rate Survey 2009

3 24 Big Picture Compared with the EU15, the UK had the third lowest rate of corporation tax in 1996, and its rate was well below the EU15 average of 37.9 per cent. In 2009, the UK s rate was only the ninth lowest, and above the average EU15 rate of 27 per cent. Among the 27 EU countries as a whole, in 2009 the UK s corporation tax rate was the eighth highest, and well above the average rate of 23.2 per cent. Businesses of course pay far more than corporation tax, which is just one of 22 different taxes affecting companies, although it is the largest. Measures of the total taxes paid by businesses show that the UK is far from competitive: In a survey of FTSE 100 companies, PricewaterhouseCoopers found that total taxes borne were 45 per cent of pre-tax profits in Out of the other countries on which data were collected using the same total tax contribution methodology, the UK FTSE 100 companies faced the third highest average total tax rate, behind Belgium and the US; the third highest average total tax rate as a percentage of turnover, behind Canada and the Netherlands; and the second highest average figure for employment taxes per employee, behind Belgium. 3 The World Bank has also produced estimates of the total tax rate for 183 countries around the world. The UK ranks 67th on this measure, only slightly below the average. 4 So that is the problem. If the UK is to attract international capital, and if domestic entrepreneurs are to think it worth expanding their businesses, there needs to be a programme of reductions in tax rates, particularly the rates of taxes that directly deter investment and employment. CORPORATION TAX RATES Many reforms to corporation tax can be considered, from changing rates of capital allowances to reducing the deductibility of interest expense. But only one reform will address the central issue of competitiveness. The rate of tax must come down. We propose a single rate of 15 per cent, to be phased in over ten years. In each of the first seven years, both the main rate and the small companies rate (assumed to be 22 per cent by the time the reform starts) would come down by one per cent a year. Then the small companies rate would be frozen at 15 per cent, while the main rate would be reduced by a further two per cent in each of the next three years. The cost would depend on the revenue from corporation tax, which fluctuates greatly from one year to the next. A safe estimate 2 PricewaterhouseCoopers, Total Tax Contribution: PricewaterhouseCoopers LLP 2008 survey for the Hundred Group, Ibid. 4 World Bank and PricewaterhouseCoopers, Paying Taxes 2010: The global picture

4 Tax making the UK competitive 25 of the cost, which is likely to be on the high side, would be 1.5bn per percentage point reduction, with most of the cost being attributable to the reduction in the main rate. But this would be on a static basis, ignoring the benefit to business of a lower tax rate. Economists recognise that tax cuts lead to increased economic growth, so that the tax base is larger than it would otherwise be and tax revenues are at least partly restored. Such dynamic effects could very easily reduce the long-term cost of reductions in corporation tax rates by half, to 0.75bn a percentage point, giving a total cost of the reduction to 15 per cent of about 10bn. This may sound like a lot, but it, as well as a range of other tax cuts, should be achievable over a 10-year period, so long as public spending is firmly controlled. There are several other reasons to reduce the corporation tax rate, as follows: A low rate would make the tax base less exposed to manipulation, because it would reduce the incentive to divert profits to other countries. There is no point in diverting profits to countries with higher tax rates, and it may not be cost-effective to divert them to countries with only moderately lower tax rates. Measures to prevent such diversion, such as the controlled foreign companies regime and transfer pricing rules, could be less severe and would need to be applied less frequently. A low rate would reduce the bias that is inherent in the tax system in favour of debt finance rather than equity finance. The bias in favour of debt arises because debt interest is tax-deductible, whereas dividends are not. An alternative way of reducing the bias would be to restrict the deductibility of debt interest, but that would have huge repercussions for many groups, and would remove one of the UK tax system s most conspicuous attractions. Some special reliefs would be less significant than with a high rate, allowing their restriction or elimination in order to create a simpler tax system which was even less open to manipulation, and in order to finance a still lower rate. A significant reduction in the rate would facilitate any such phasing out of special reliefs, because it would compensate businesses that currently benefit from those reliefs. CORPORATION TAX OTHER CHANGES While reductions in the corporation tax rate are the most important measure, there are others that would also make the tax regime more attractive to business. These include the following: Allow deductions for spending on capital items that are currently disallowed. There is a somewhat artificial distinction in the tax system between revenue expenditure, which is in

5 26 Big Picture principle deductible so long as it is for business purposes, and capital expenditure, which is in principle not deductible and which needs to qualify for a specific allowance before it can be deducted. A leading example of capital expenditure that cannot be deducted is a tenant s payment to get out of an onerous lease. The result of the disallowance is that it can be better for the tenant to retain the lease and continue to pay rent, which is deductible, rather than choosing another property and returning the property to the landlord who, being a specialist in the property business, may well be able to re-let it to a tenant who can make better use of it. Exempt companies gains on shares. When capital gains are to be taxed, or capital losses relieved, the ideal is to tax each real gain, or allow each real loss, once and only once. Gains and losses are made on assets that are owned by companies. But when a company buys and sells assets, the gains and losses that it makes will influence the value of its shares. Another company, owning those shares, can find that it makes a gain or loss which replicates the gain or loss made by the company that owned the assets. Thus double-counting, or worse when there are several companies in a chain of ownership, can easily arise. This can be the source both of unfair tax charges, and of the multiplication of losses through astute tax planning. If capital gains and losses that companies make on shares were ignored for tax purposes, such double-counting would be avoided and purchases and sales of companies would be simpler than they are now. 5 Reduce restrictions on the relief of companies losses. A good system of loss relief is one that allows relief for all genuine losses, and does so reasonably promptly so as to reduce tax bills enough to help businesses over their lossmaking phases. The current system is reasonable, but it is not perfect. In particular, while relief is available against profits of other types in the year of loss and in the previous year, relief in future years is generally limited to relief against profits of the same type as the loss. There is a case for liberalising the use of losses carried forward, so that losses do not get trapped and go unrelieved. NATIONAL INSURANCE One of the Government s responses to the need to address the deficit has been to propose increases in national insurance. Both the rates on employers and the rates on employees are to increase by a full percentage point from April 2011, bringing in additional revenue of 8bn a year. 6 This proposal, to increase the tax burden on employment, will damage, and not help, the economic recovery that is urgently needed. The increases therefore need to be reversed right at the start of 5 The substantial shareholdings exemption already has the desired effect in relation to many disposals, but the conditions for it are complex, some groups genuinely cannot be sure whether they qualify, and the strictness of the conditions make it possible to ensure that gains are exempt but losses are allowable 6 Budget 2009, table A2, lines j to n, page 154; Pre-Budget Report 2009, table B4, page 173

6 Tax making the UK competitive 27 a programme of tax reform, even if the cost has to be a temporary increase in the rate of VAT. All tax increases are damaging, but taxes on spending tend to be less damaging than taxes on production. Beyond that, we should look at simplification, and in particular at the removal of irritants that may deter people from going into business, or from taking on employees. Class 2 contributions by the self-employed should be abolished, so that when someone starts a business, there is no need to worry about whether a liability to them will arise immediately and to make immediate contact with the Revenue. Instead, someone could go into business and see how it went, and then simply account for income tax and class 4 contributions after the end of the first tax year. Some of the complications that surround employment could also be removed. The last remaining small differences between the bases for income tax and for national insurance on employment could be eliminated (the difference in relation to pension contributions, however, is a large one, and should not be removed simply as part of a tidying-up programme). And in due course, employers national insurance could be transformed into a more straightforward payroll tax, albeit one that retained the current bias in favour of a large number of moderately-paid employees rather than a small number of highly-paid employees. It is often suggested that national insurance should be abolished, and other tax rates increased accordingly. If one were designing a tax system from scratch, it would certainly be bizarre to create two separate taxes, income tax and national insurance, which to a large extent apply to the same income. But we are not starting from scratch. A merger of income tax and employees national insurance, and a re-allocation of the revenue from employers national insurance to other taxes, would involve the reallocation of huge amounts of tax revenue, about 100bn a year from all forms of national insurance. The very substantial redistributional effects would be very hard to handle politically. So we do not advocate the abolition of national insurance in the course of an initial 10-year programme of reform. Having said that, there is clear merit in reducing this tax on jobs. We therefore propose a long-term goal of reducing rates of national insurance. Once rates have fallen enough, a merger of national insurance with other taxes should be feasible. INCOME TAX Increases in income tax have also been proposed. The Government intends to introduce a 50 per cent rate, and to phase out the benefit of personal allowances as income climbs above 100,000, with effect from April Both changes need to be reversed. The proposal to phase out personal allowances should be reversed immediately. It is not only impossible to administer through PAYE, because the correctness of PAYE codes will depend on income. It is also based on a bad argument. The argument is that personal allowances give more benefit to high-income taxpayers

7 28 Big Picture than to taxpayers on lower incomes, because they save tax at a higher rate. But if one thinks of the personal allowance as a band in which income is taxed at zero per cent, before the 20 per cent band and the 40 per cent band are reached, the fallacy becomes plain. Everyone can have an initial slice of income taxed at zero per cent, then another slice taxed at 20 per cent, and so on. The legislation talks of total income, from which an allowance is deducted before tax is applied, and that may lead to the impression that the allowance takes the highest-taxed slice of a taxpayer s income out of charge. But the effect is exactly the same as would be achieved by a progressive scale that started at zero per cent. The 50 per cent rate is a clear deterrent to the ambitions of those who seek to expand their businesses. Even the 40 per cent rate can be a deterrent to a great many middle-ranking employees, in both the private sector and the public sector, who might seek to better themselves. We therefore propose reducing the 50 per cent rate to 40 per cent over the first five years of our reform programme, in steps of two per cent a year, and then reducing the 40 per cent rate to 35 per cent over the next five years, in steps of one per cent a year. As with the corporation tax rate, a pre-announced programme of reductions that starts to be implemented immediately should play a valuable role in restoring confidence and in reducing disincentives for those who think long-term. ENCOURAGING SAVING There is a case for using the tax system to encourage saving. There is economic evidence that saving is below the optimal level. In the short term, additional saving reduces aggregate demand and economic growth. But in the longer term, stocks of capital can be increased, leading to a permanent increase in the level of output. There is also a social case for encouraging saving. Life expectancies are rising, and there is increasing pressure both on the system of state pensions and on private pension provision. People may well find that they will, in later life, need more savings than they currently expect to need. The obvious way to encourage saving is to reduce the tax rate on income from savings. This might seem to clash with an important principle that income from all sources should be taxed to the same extent, because all income increases the ability to pay taxes to the same extent. But there is a counter-argument to the effect that a great deal of saving is made out of income that has already been taxed, reducing the capital saved and therefore reducing the income that may be obtained on savings. That is, the income has, in one sense, already suffered tax. This argument is not decisive, but it is not worthless either. There is no easy way to resolve the conflict between the arguments for and against taxing all income at the same rates, but what we can conclude is that it is at least legitimate to consider taxing income from savings at lower rates. To some extent, the UK tax system already does this. Individual

8 Tax making the UK competitive 29 savings accounts (ISAs) offer tax-free income on some savings, although the benefits are rather limited, especially for basic-rate taxpayers. We propose simplifying and liberalising the ISA regime by allowing the annual investment limit to be divided between shares and interest-bearing investments in any proportion. Going further, there is a case for reducing the tax burden on interest even outside ISAs. We propose charging tax only at the difference between the taxpayer s marginal rate and the basic rate. Thus a basic-rate taxpayer would pay no tax on interest, and a 40 per cent taxpayer would only pay tax at 20 per cent. Finally, income tax is not the only tax burden on savings. Inheritance tax may deter people from building up a reasonable level of financial investments. A home can easily absorb the whole of the nil rate band, leaving other assets liable to tax at 40 per cent (although married couples and civil partners can now benefit from using two nil rate bands on the second death). Few people like the idea of leaving assets to the state instead of to their families. They may therefore be deterred from building up enough resources to see them through old age by the thought that in the event of early death, tax liabilities would arise. We therefore propose replacing inheritance tax by a charge to capital gains tax on death. This would be a lower burden, because it would only apply to gains, not to the entire value of estates. It would also have the merit of bringing into tax gains that currently escape tax altogether. URGENCY OF REFORM A great many tax reforms will be proposed by politicians and commentators after the General Election. We have a programme of reform to put up for debate. Not all of it is likely to be taken up and legislated. But the key proposals, to reduce corporation tax rates and to reverse the damaging increases in national insurance, are central to restoring the UK s competitiveness. If we do not do that, then the economy will suffer, foreign investment will go elsewhere and tax revenues will be held back. Both the private sector and the public sector will then be hit hard. For a much fuller discussion of the problem, the options,! the IoD s proposals (including several that have not been covered in this article) and the costs, please see the policy paper Tax Making the UK Competitive, by Richard Baron and Corin Taylor, available at