Unbiased capital: making tax work for business. India Keable-Elliott & Tom Papworth

Transcription

1 Unbiased capital: making tax work for business India Keable-Elliott & Tom Papworth

2 : making tax work for business India Keable-Elliott & Tom Papworth

3 About the authors India Keable-Elliott is an Economic Policy Researcher at CentreForum. She holds a BA (Hons) in Politics, Philosophy and Economics from the University of Oxford. Previously she worked for Voluntary Service Overseas and Street Child in Sierra Leone, and the responsible investment charity ShareAction. Her CentreForum publications include: Hypothecated Taxation and the NHS (December 2014), and The liberal case for aviation (March 2015). Tom Papworth is Associate Director for Economic Policy at CentreForum. He holds degrees from the Universities of London and Kent and has over 15 years public policy and research experience, having worked for government, the private sector, policy institutes and membership organisations. His CentreForum publications include The path to IPO: funding SME jobs and growth (February 2013), The business case for immigration reform (December 2013), SMEs and Health & Safety (February 2015), The liberal case for aviation (March 2015) and Reforming retail energy markets (April 2015). Published May 2015 CentreForum This work is licensed under a Creative Commons Attribution-NonCommercial- ShareAlike 4.0 International License. For more information visit creativecommons.org 2

4 :: Contents Executive summary 4 Introduction 8 1 How equity and debt are treated in UK tax policy 10 2 Why the unequal treatment of equity and debt is a problem 13 3 Stamp Duty Reserve Tax 20 4 Reforming corporate income tax: eliminating the debt bias in non-financial firms 25 Case Study 1: Comparing the Belgian and the Italian ACE systems 28 Case Study 2: Sweden 32 Case Study 3: Germany and the earnings stripping rule 34 5 Reforming corporate income tax: eliminating the debt bias in the financial sector 35 6 Risks of reform: how to address concerns among businesses 39 Recommendations and conclusions 43 Bibliography 46 3

5 :: Executive summary How businesses finance their operations how they attract the investment capital necessary to create or expand the firm is one of the most crucial entrepreneurial decisions that an owner or manager must make. That finance can take broadly two forms: either firms give investors a share in their business including both the upside and downside risk and in the decision making process (equity); or they borrow money against a set repayment schedule, giving investors only minimal risk and little control (debt). Which of these is most appropriate depends on the nature of the firm and the judgement of its leadership. What is certain is that this decision should not be influenced by exogenous factors. Yet the reality is that one exogenous factor bears heavily upon financing decisions: namely, the tax system. The fiscal position of equity and debt are very different. Equity investments are taxed four times: on purchase (through Stamp Duty Reserve Tax), when they turn a profit (Corporation Tax), when a dividend is paid out (Income Tax) and when any increase in the value of the firm is crystallised through sale (Capital Gains Tax). By comparison, interest payments on debt are treated as a business expense and so are tax deductible. These taxes increase the cost of equity as a form of capital relative to debt, creating a bias towards the latter that at the margin pushes firms to take on debt rather than share equity, leading to capital structures that are sub-optimal from an economic perspective. The deadweight welfare losses that the debt bias generates are magnified by the negative externalities of excessive debt: high levels of debt raise the probability of businesses and banks collapsing, exacerbating business cycles, and making banking crises more likely and more dramatic. The fiscal distinction between debt and equity also enables financial engineering and arbitrage. The debt bias has a particularly deleterious impact upon disruptive, innovative, potentially high growth firms in the early stages of their development, for which debt is less accessible, and less suitable as a form 4

6 of capital. They are forced to pay more for capital than their incumbent rivals, so retarding the process of creative destruction that leads to rising productivity and prosperity. While personal taxes (Income Tax and Capital Gains Tax) clearly add to the cost of equity capital, it is not possible to determine the magnitude of this impact, and therefore designing a policy that would eliminate the bias without creating other distortions is problematic. By comparison, the effect of Corporation Tax and Stamp Duty Reserve Tax ( Stamp Duty ) are clearer. In this paper we therefore focus on reforms to Corporation Tax and Stamp Duty while acknowledging that Income Tax and Capital Gains Tax will also affect the equal treatment of equity and debt capital. In 2013 CentreForum advocated the abolition of Stamp Duty, or failing that at least its abolition for firms trading on growth markets. HM Treasury introduced the latter reform and it has been a resounding success. The role of Stamp Duty in contributing to the bias towards debt is one more reason why this successful trial should now result in Stamp Duty being abolished for all shares. Stamp Duty Reserve Tax is capitalised in prices, increasing the cost of equity and so exacerbating the bias towards debt. This not only drives capital abroad but also makes debt capital (lending) more attractive than equity (investing). It also reduces the efficiency of the stock market for UK listed companies, imposes a disproportionately large burden on marginal investment projects compared with a Corporation Tax, and distorts merger and acquisition activity, producing a bias towards overseas rather than UK ownership. In respect of Corporation Tax, there are broadly two approaches to eliminating the bias. The first is to cease taxing equity; the second is to remove the tax deductibility of debt. We consider particular approaches to solving each of these in detail. The excess taxation of equity can be addressed by the creation of an Allowance for Corporate Equity (ACE) which would allow an imputed rate of return on equity to be deductible against corporate profits. This would result in taxes falling solely on economic rents and not reasonable returns on capital. Alternatively, debt could be taxed by introducing a Comprehensive Business Income Tax (CBIT), resulting in a broad tax on all corporate income return to capital and economic rents regardless of the source of finance. ACE is the preferred option of many scholars due to its neutrality: it both equalises the treatment of debt and equity, and is neutral with 5

7 respect to marginal investment decisions. By lowering the cost of equity finance it would be of particular benefit to high growth disruptive industries. Much of the gain from implementing the system is expected to benefit employees, as additional investment would most likely drive up productivity, which in time tends to drive up wages rather than profits. The major challenge is that an ACE reform could reduce tax revenues, perhaps significantly. However, this could be ameliorated by an incremental introduction affecting only new equity. The main advantage of CBIT is that it is potentially revenue positive, which may be why it is so popular in government circles. However, as CBIT translates to higher business taxes, it raises the cost of capital on investments financed by debt. This could reduce investment, could put the UK at a disadvantage with its key competitors for investment capital and would hit already indebted firms (including small businesses and infrastructure companies) hard. The cost to business could be reduced by combining CBIT with a reduction in the headline rate of Corporation Tax, at the expense of the revenue gain to government. A significant challenge for CBIT is that it has never been implemented in any country, and as such there are no jurisdictions from which we can learn. Such a reform would likely have a number of transitional problems; the treatment of pre-existing debt would, for example, need to be carefully considered. With regard to the financial sector, a CBIT reform would necessitate complex treatment of financial institutions. ACE, on the other hand, would likely reduce bank leverage and consequently the probability of banking crises. This could save taxpayers a considerable sum. In addition, the substantial costs to the taxpayer associated with excessive debt in the financial sector may justify policies that go beyond correcting the debt bias, and limit or discourage the use of debt financing. We conclude that the welfare benefits of eliminating the debt bias would be substantial. We recommend abolishing Stamp Duty Reserve Tax and introducing an Allowance for Corporate Equity incrementally, so that it only affects new capital. In the absence of a policy to eliminate the corporate debt bias in the financial sector, we recommend the introduction of Thin Capitalisation rules, which could substantially reduce the tax incentive for excessive debt financing. In light of the commitment of the three main political parties to eliminate the deficit over the next parliament, we cannot conceive of any more radical proposal getting political support. 6

8 The effect of these reforms would be to eliminate, or at least greatly ameliorate, the bias towards debt. This should result in a more socially optimal mix of capital, reducing the probability that businesses and banks will fail, leading to greater economic stability. Small, innovative, potentially high growth firms would particularly benefit, being able to access growth capital more readily and more cheaply. In the long run, the beneficiaries would most likely be workers, whose enhanced productivity would yield higher wages. 7

9 :: Introduction This paper examines the bias towards debt that results from the differential treatment of debt and equity in the UK tax system. We begin by looking at the nature of the bias and the welfare costs that result from it, before turning to examine possible solutions. We conclude with recommendations for how the bias can be eliminated or greatly reduced, creating a more efficient tax system that does not incentivise welfare sub-optimal capital structures. In Chapter 1 we consider the differential treatment of debt and equity in the UK tax system. Equity and debt are simply different approaches to financing investment, one of which involves shared (upside and downside) risk and shared control, while the other is more predictable and reliable but also less flexible. However, while interest payments are tax deductible, equity is taxed four times. This creates an imbalance that affects financing decisions. In Chapter 2 we explain why the resulting bias towards debt may be problematic for the economy and for social welfare. The bias creates deadweight losses owing to inefficient capital structures. These welfare costs are magnified by the externalities of excess debt; overindebtedness has likely increased business cycle volatility, while excess debt in the financial sector has had significant fiscal and economic costs. Debt is particularly popular as a source of finance among SMEs and yet at least for those innovative early stage firms that have the potential for rapid growth it is probably inappropriate; by over-taxing equity the government discourages investment in the potential champions of tomorrow. The differential treatment also allows for tax avoidance and erosion of the tax base. Chapter 3 looks at one of the four ways in which equity is taxed by examining the UK s financial transaction tax Stamp Duty Reserve Tax which is levied on equity but not debt. Stamp Duty increases the direct cost of investment and reduces liquidity (the ease with which equity can be sold), further pushing up the cost of equity capital relative to debt. 8

10 There are other problems with Stamp Duty which are beyond the scope of this paper, including that it reduces the value of (and thus also the incentive to invest in) pension funds and insurance, and the fact that it drives investment away from the UK. CentreForum has previously called for the abolition of Stamp Duty and we do so again in this paper. Abolition would reduce the bias towards debt and improve the efficiency of capital markets. Despite the obvious challenges of doing so in a time of fiscal consolidation, we find that this reform will pay for itself over the course of one parliament. In Chapter 4 we turn to the taxation of corporate incomes. There are broadly two approaches to resolving the bias towards debt through reforming corporate income tax either introducing an Allowance for Corporate Equity or introducing a Comprehensive Business Income Tax. While both offer a means of eliminating the bias, the former is likely to encourage greater investment whereas the latter will fall particularly heavily on small businesses and already highly indebted firms. Though an Allowance for Corporate Equity would potentially see a decline in tax revenues, incremental introduction could ameliorate this, and in the long run greater investment may result in higher overall revenues. While it is too early to draw firm conclusions, the Italian experience suggests that the first half of this proposition, at least, is correct. In Chapter 5 we focus specifically on financial institutions. We find that while an ACE reform would likely eliminate or significantly reduce the bias towards debt in the financial sector, a CBIT reform would require complex treatment of banks. Alternatively, Thin Capitalisation rules could be applied to the financial sector, which may reduce or eliminate the tax incentive for excessive debt financing. Finally, given the substantial fiscal and economic costs associated with over indebtedness in the financial sector, taxation that goes beyond the debt bias and discourages the use of debt may be warranted. Chapter 6 turns from the problems with the existing system to potential problems with reform. If reform takes the form of an Allowance for Corporate Equity, the main challenge is revenue losses to the Exchequer. If interest payments are no longer tax deductible, the challenge would come from the increased tax burden for business. This would fall especially heavily on small businesses. We conclude by recommending that the government abolish Stamp Duty Reserve Tax and introduce an Allowance for Corporate Equity to be introduced incrementally along the lines of Italy s 2011 reforms. 9

11 :: 1 How equity and debt are treated in UK tax policy Businesses can raise capital to finance operations in broadly two ways: through issuing equity or taking on debt. :: Equity involves exchanging finance capital for a stake in the business, which usually involves the financer ( investor ) sharing both the upside and downside risks of the business and having a say in how the business is run/operated; :: Debt involves borrowing finance capital against a guaranteed repayment schedule, which involves the financer ( lender ) sharing neither the upside nor downside risks of the business and having no say in how the business is run/operated. 1 Equity and debt holders have different rights, which reflect the differences in the two types of investment. For example, those with an equity stake in a firm have a legal voting right, reflecting the fact that they own a share of the company. Table 1.1. identifies four key distinctions between debt and equity. However, the development and use of complex hybrid financial instruments, which have characteristics of both equity and debt, has blurred the legal dichotomy. Table 1.1: Status of equity and debt Equity Variable returns Unlimited maturity Residual claim Voting rights 10 Debt Fixed returns Limited maturity Prior claim No voting rights 1 This is slightly simplified. Lenders face downside risk in extremis and can exercise some influence over company decisions. For example, German banks frequently sit on the boards of companies to which they have lent long term ( patient ) capital to ensure that their investment is secure and to provide confidence to the firm that they will not withdraw their loans.

12 For the firm, the choice between raising capital through equity or debt revolves primarily (though not solely) around the cost of capital the share of future profits given up versus the interest rate though this can also be influenced by other factors, such as the willingness of owners to sacrifice (share) control, the price of risk 2 and owners confidence that capital will not be withdrawn unexpectedly. This decision is part of the entrepreneurial process. The bias towards debt In the UK, equity is taxed four times, whereas debt is deductible against Corporation Tax (table 1.2). Table 1.2: Tax treatment of equity and debt Equity investor Taxed when shares are bought (Stamp Duty) Taxed when profits are declared (Corporation Tax) Taxed when dividends are paid (Income Tax on dividends) Taxed when the shares are finally sold (Capital Gains Tax) Lender No tax when money is lent / bond bought Interest payments deductible from Corporation Tax Taxed when interest paid (Income Tax on interest) No tax upon sale of bond This differential fiscal treatment affects the cost of different forms of capital. Equity investors will price in the cost (tax) of buying a share, the expected cost of selling it, and the tax wedge between the profit a company makes and the amount that they finally see in dividends. These factors raise the cost of equity finance. In contrast, while (some) lenders pay income tax on the interest they receive, they benefit from the interest tax shield which reduces the after tax cost of debt. The net effect of taxes at the corporate and personal level is to create a bias towards debt within the fiscal system which tips the scales against equity finance by rendering it more expensive and therefore less attractive relative to borrowing. 2 As its name would suggest, all equity investors are equal. Lenders generally have prior claims in the event of insolvency. As debt finance is therefore less risky for the lender they are likely to charge a lower risk-premium than equity investors. 11

13 Calculating the impact of personal taxes (e.g. Income Tax, Capital Gains Tax) on corporate financial structure requires knowing whether or not the marginal investor is exempt from these taxes. But as Graham (2008) notes, the tax status of the marginal investor and therefore the empirical magnitude of the personal tax penalty is an open empirical question. In contrast, numerous empirical studies have identified a clear bias towards debt in corporate income tax. The majority of studies have focused on non-financial institutions, and suggest that the fiscal bias towards debt has caused company leverage to be substantially higher than it would have been under a neutral tax system (Cottarelli, 2009). More recently, academics have begun to develop empirical evidence on the effects of tax on leverage in the financial sector. Both Keen and de Mooij (2012) and de Mooij et al (2013) find that the debt bias leads to an increase in the aggregate leverage of banks. Because the effect of the debt bias in corporate income tax is clear and well documented, whereas the overall effect of personal taxes on financial structure remains open to debate, the rest of this paper will focus on the former. The exception is Chapter 3, in which we discuss Stamp Duty Reserve Tax. 12

14 :: 2 Why the unequal treatment of equity and debt is a problem In fiscal and accounting terms, interest payments on debt are viewed as a business cost. Returns on equity are viewed as the reward or remuneration for the owner, and consequently not a true cost of business (Cottarelli, 2009). This argument makes no sense economically: interest and return on equity both represent a return on capital; there is no a priori reason to tax one differently from the other. The Modigliani-Miller Theorem tells us that a firm s value is independent of its financial structure. 3 Modigliani (1980) explains that: with well-functioning markets (and neutral taxes) and rational investors, who can undo the corporate financial structure the value of the firm should not be affected by the share of debt in its financial structure Modigliani, 1980 A company s choice between debt and equity should be socially efficient, and there should be no unique optimal choice of debt. The presence of capital market imperfections (e.g. information asymmetries) could, however, lead firms to choose a socially sub-optimal capital structure. This gives weight to a suggestion that the tax system be used to redress the balance. Such a suggestion is unworkable. There is no consensus on what the optimal finance structure of firms should look like in the presence of capital market imperfections, so there is no way of telling ex ante 3 Assuming market efficiency, the absence of agency and bankruptcy costs, asymmetric information, and a level fiscal position. The latter assumption is the subject of this paper. 13

15 whether the debt levels chosen are too high or too low. 4 Consequently, neutrality of tax arrangements should be the core benchmark for policy evaluation and design (Cottarelli, 2009). The welfare cost of the debt bias If corporate financial structure is efficient under a neutral tax system, then the fiscal debt bias would create a welfare cost. Alternatively, if corporate financial structure is inefficient but the government cannot determine in what way, the debt bias may make the welfare costs higher rather than lower. A number of studies have used Harberger (deadweight loss) triangles to estimate the size of the welfare cost, and have found it to be fairly modest (de Mooij, 2011). For instance, Sorenson (2014) finds the deadweight loss of the tax distortion to be between 2% and 3% of corporate tax revenues in Norway. 5 However, debt particularly a high level of debt has a number of externalities which may result in much larger welfare costs than current estimates. While the debt bias is unlikely to have created the recent financial crisis, it may have aggravated it, leaving the taxpayer to pick up a hefty bill (Fatica et al, 2012). What is more, the bias towards debt is detrimental to innovation and growth, and has allowed for erosion of the corporate tax base. Business cycles Excessive debt across an economy increases economic instability. High levels of debt raise the probability that businesses will fail. This makes an economy more vulnerable to and can amplify the effects of adverse shocks, as well as exacerbating business cycle fluctuations. OECD (2012) notes that high levels of indebtedness across an economy increase the probability of it entering a recession, while Bianchi (2010) finds that over borrowing magnifies the depth of a crisis. This cost to society is not internalised by firms when they decide how much debt to take on and consequently their chosen leverage ratios are socially sub-optimal. 4 See de Mooij (2011) for a description of four models of optimal corporate financial structures in the presence of information imperfections, based on: bankruptcy costs, agency costs (between managers and shareholders, and shareholders and debt holders), and signalling costs. The models offer different rationales for distortions between debt and equity financing, and go in both ways, so there is no clear indication of the direction or magnitude of distortions. 5 Weichenrieder and Klautke (2008) also estimate the deadweight loss of the debt bias, and find the marginal loss to be between 0.05% and 0.15% of the capital stock, or between 0.08% and 0.23% of GDP for a capital stock of 1.5 x GDP. Gordon (2011) estimates that the welfare cost is about 0.25% of GDP. 14

16 Debt and the financial sector The debt bias has caused significant over leveraging in the banking sector (Langedijk et al, 2014; de Mooij et al, 2013). Keen and de Mooij (2012) finds that, on average, the effect of the debt bias on bank leverage is about as large as for non-financial corporations. 6 As with non-financial firms, excess debt increases the probability that financial institutions will collapse. Keen (2011) contends that two potential types of externality can arise when [a] bank fails: those associated with an institution s unmitigated collapse, and those associated with the bailouts by which such collapse can be averted. These collapse and bailout externalities result in substantial fiscal and economic costs, to financial institutions and society as a whole. The collapse externality The systemic importance of financial institutions means that the failure or distress of one bank can have a domino effect on others. This is most likely to occur if the bank in question is large, interconnected and if substitutes to the services provided by the institution are unavailable (IMF, FSB, and BCBS, 2009). Key channels for the domino effect include: :: Direct financial exposures; :: Market exposures when leverage and funding constraints at many institutions lead to fire-sales and downward asset price spirals; :: Reputational exposures when asymmetric information causes creditors to run from many financial institutions when faced with uncertainty (IMF Staff, 2010). de Mooij et al (2013) models the probability of banking crisis at different levels of bank leverage and finds that the marginal impact of bank leverage on the probability of a crisis increases rapidly, and increasingly rapidly, at higher levels of leverage (see also Barrell et al, 2010; Kato et al, 2010). Since a functioning banking system is fundamental to the working of a modern economy, distress in the financial sector can trigger 6 The responsiveness of banks to taxation varies considerably; the tax impact on leverage is much smaller for large banks than it is for smaller ones (de Mooij et al, 2013; Keen and de Mooij, 2012) However, this does not mean that the welfare impact of tax distortions is in aggregate negligible: even small changes in the leverage of very large banks could have a large impact on the likelihood of their distress or failure (de Mooij et al, 2013). 15

17 wider failures, and damage the real economy (Keen, 2010). Systemic financial crises almost always result in significant costs. Aside from any direct financial system support, this includes automatic stabilisers and discretionary stimulus programmes, as well as large economic costs such as a cyclical loss of output and possible impacts on potential growth (IMF Staff, 2010). Consequently, the overall effect of systemic risk on the financial system and the real economy can be significantly larger than the initial shock (as was evident when troubles in the relatively small U.S. subprime mortgage market generated disproportionately wide and deep repercussions) (IMF Staff, 2010). The bailout externality Governments have the option of bailing out failing financial institutions so as to avert the damage described above. However, not only would this involve a substantial transfer of resources from taxpayers to the financial sector, but the very prospect of bail out generates an externality. 7 Large financial institutions are aware that their failure could have severe ramifications on the wider economy. Consequently, there is an expectation that the government will bail out such institutions in times of crisis. This leads to moral hazard. Noss and Sowerbutts (2012) explains that: The implicit guarantee reduces market discipline, which distorts banks risk-taking incentives as investors no longer fully price the risks they are aware the banks are taking, allowing banks to take more risk... A pernicious spiral can therefore develop, where the existence of an implicit guarantee encourages banks to take more risk, raising the likelihood and cost of bank failure Noss and Sowerbutts, 2012 SMEs, innovation and growth SMEs contribute to overall UK productivity by acting as a seedbed for innovations, acting as disruptive industries and heightening competition, thus driving creative destruction (Mole, 2002). Excluding microbusinesses (those with fewer than ten employees), over a third of 7 Kocherlakota (2010) refers to this as the risk externality. 16

18 SMEs undertake innovation activity. Yet the Department for Business, Innovation and Skills (BIS) believes that this level of innovation activity is likely to be below its optimal level (BIS 2013). SMEs also create a disproportionately large number of new jobs and are more likely to employ formerly unemployed workers (Ward and Rhodes, 2014; Anyadike-Danes et al, 2011). 92% of movements from unemployment or non-participation into private sector employment are due to an SME 8 and those working in SMEs are more likely to come from groups that have experienced relatively more hardship during the recent recession (Urwin and Buscha). Medium-sized businesses in particular are responsible for a greater proportion of employment in areas of the UK with higher unemployment (i.e. not the south or east of England) and especially in the North East and Wales (CBI 2011). 9 Favouring mature companies The primary source of funding for SMEs is bank lending (Papworth and Corlett, 2013). But the industry task force established by the Chancellor of the Exchequer and chaired by Tim Breedon estimated that a third of SMEs applying for loans in were rejected: a higher level of refusal than earlier in the decade and one of the highest refusal rates in Europe (BIS, 2012b). Innovative start-ups in particular are far less likely to have easy access to credit. They lack a reputation or track record, and they may not expect to make a profit in the near future, thus making immediate and regular repayments problematic. Large, mature firms have much easier access to credit, and thus the debt bias inherently favours established firms over SMEs. The right type of financing for SMEs The interest tax shield gives all companies including SMEs an incentive to use debt financing. Yet it is far from clear that bank lending is the appropriate form of credit for SMEs, especially for innovative startups which hope for rapid growth but do not expect to turn a profit in the near future. Creditors generally expect a predictable repayment schedule that begins to provide a return on capital from the outset. They also leave entrepreneurs solely responsible for downside risk a particular disincentive where these loans are secured against personal property. 8 Including both employment by and creation of an SME. 9 Note that the exception to this pattern is London, with high unemployment and a low proportion of employment in medium sized businesses, and Northern Ireland, with low unemployment and a large proportion of jobs in medium sized businesses 17

19 Equity investors, by comparison, understand that they may need to wait for years before enjoying a return, and share in the downside as well as the upside risk of the business. As we noted in an earlier report (Papworth and Corlett, 2013): London Stock Exchange Group Chief Executive Xavier Rolet argues that bank debt is the wrong way to fund small start-up firms. He feels that bank finance creates a mismatch between the level of risk that entrepreneurs take and that which is shouldered by banks; put simply, the entrepreneur has to extend the mortgage on their house, while the bank gets a fixed rate of return. By comparison, an equity investor [may] want 30% of your business, but they won t want you to pay for a mortgage. There is no immediate cost to the businesses and there is less personal risk to the entrepreneur. Most (68%) SMEs that have used equity finance believed that the investment had a positive effect on their business. 10 Yet CBI (2015) suggests that Equity finance is under-utilised in the UK. This, at least in part, is because equity financing is penalised by the UK tax system, while debt is given favourable treatment. The lack of, and inappropriate forms of, financing for SMEs acts as a barrier to innovation and growth, constraining the potential of our economy by putting some of the most exciting and promising companies at a disadvantage from the get go. Tax avoidance and erosion of the corporate income tax base The differential tax treatment of debt and equity, at a national level and between countries, leads to tax arbitrage and erodes the Corporation Tax base. de Mooij (2011) distinguishes between two relevant types of tax arbitrage: 1. The use of hybrid financial instruments 11 these instruments have characteristics of debt and equity, enabling investors to decide whether they wish to be taxed at the [corporate income tax] rate by investing in equity or at the individual [personal income tax] rate by investing in debt (de Mooij, 2011); 10 CBI (2014), op cit. 11 For example: preference shares, convertible debt, junk bonds, subordinated debt, warrants and indexed securities 18

20 2. Debt shifting within multinational firms this involves multinational companies changing their corporate structures so as to take advantage of different tax rates between countries. For example, to minimise its tax liability, a multinational parent company would prefer to finance a subsidiary in a high tax country through debt (so that it could deduct interest at a high rate), and to finance a subsidiary in a low tax country through equity (to have income taxed at a low rate). Tax arbitrage creates substantial administration and compliance costs; as firms engage in tax planning, tax authorities devise ever more complex laws to prevent tax avoidance. It also erodes the Corporation Tax base. Firstly, the use of hybrid financial instruments for the purpose of attracting interest deduction results in a loss of revenue compared to equity financing. Secondly, debt shifting in multinationals results in high tax countries forgoing substantial revenue (and thus sustaining welfare losses), while low tax countries gain from international tax arbitrage. In welfare terms, the erosion of the corporate income tax base is primarily a distributional issue. However, it is concerning for reasons of distributional justice, both within and between countries. What is more, should such practices intensify international tax competition (as countries compete for taxable income), it could ultimately make all countries worse off by making it more costly for governments to raise public funds (de Mooij, 2011; emphasis added). 19

21 :: 3 Stamp Duty Reserve Tax I have long argued that there is a powerful case for looking at Stamp Duty on shares, which raises the costs of capital and reduces investment 20 George Osborne, 2009 The UK securities transaction tax, known as Stamp Duty Reserve Tax (henceforth Stamp Duty ), 12 is a tax on share transactions in UK incorporated companies that is chargeable wherever the transaction takes place, irrespective of whether either party is resident in the UK (Hawkins and McCrae, 2002). It is one of four taxes on equity capital (Table 1.2). The Institute for Fiscal Studies describes Stamp Duty as a relatively inefficient way to raise revenue compared with other taxes on capital income (Hawkins and McCrae, 2002). Stamp Duty and the bias towards debt Stamp Duty pushes up the cost of equity capital in two ways. Firstly, it reduces relative returns directly by adding to the price that must be paid for a share in the firm. Bank of England (1997) finds that Stamp Duty is capitalised in prices, supporting our hypothesis that Stamp Duty increases the cost of capital and, because a similar tax is not levied on bonds, contributes to the bias towards debt. Secondly, Stamp Duty reduces liquidity (the ease with which a stock can be sold), further depressing prices. This reduces the efficiency of the stock market for UK listed companies (Hawkins and McCrae, 2002). By reducing liquidity, Stamp Duty depresses share values because it increases the required return on a stock (Amihud and Mendelson, 1986). This liquidity premium shifts the balance between shares and other investment opportunities. This not only drives capital abroad but also 12 But not to be confused with Stamp Duty Land Tax, which is levelled on the sale of property.

22 makes debt capital (lending) more attractive than equity (investing). The effect is particularly pernicious for small companies. Amihud (2002) finds that market liquidity has a stronger effect on the returns of small cap companies because if there is a flight to liquidity, it is harder to sell small cap stocks, and this risk of illiquidity is priced in. In 2008, the Quoted Companies Alliance called for the abolition of Stamp Duty on the grounds that that it represented an impediment to accessing capital for SMEs, for which access to capital continues to be a major issue (Quoted Companies Alliance, 2008). The case for abolishing Stamp Duty CentreForum has previously called for the abolition of Stamp Duty (Papworth and Corlett, 2013). In this it is joined by the Institute for Fiscal Studies 13 and the Institute of Directors. 14 As we noted in our earlier report: Stamp Duty is a tax on liquidity. If liquidity is the oil that ensures the engine runs smoothly, Stamp Duty is like sugar: it gums up the markets, reducing the extent to which buyers and sellers can find a mutually satisfactory price at which to trade. Stamp Duty is a highly damaging tax; it makes up a substantial part of the cost of buying shares and so reduces the number of transactions in the market. Papworth and Corlett, 2013 KPMG (2010b) estimates that abolishing Stamp Duty would: :: encourage the use of capital markets as opposed to bank debt finance, making the market far more efficient by increasing volumes by up to 40%; :: reduce the cost of equity by 7.5% to 9%, and by 10% to 13% for tech companies, which account for up to 35% of total early stage (seed and start up) funding; :: increase investment by up to 7.5 billion (assuming it were applied across the whole market). 13 Hawkins and McCrae (2002) 14 Baron and Taylor (undated) 21

23 Oxera (2007) suggest that the abolition of Stamp Duty would lead to a reduction in the cost of equity. This would be evinced by an increase in share prices of 7.2% corresponding to a reduction in the nominal posttax cost of equity of 7 8.5% (or percentage points), and in the nominal post-tax cost of capital of % (or percentage points). This would especially benefit technology sectors. Abolition would also increase capital expenditure by UK companies (Oxera, 2007). These calculations are based on earlier work by Domowitz and Steil (2001) that estimates that the elasticity of the post-tax cost of equity to transaction costs is 0.14 to The past two years have provided powerful evidence for the effect abolishing Stamp Duty would have on capital markets. As we noted above, in our earlier report (Papworth and Corlett, 2013) we called for the abolition of Stamp Duty. Recognising that this was a radical step, we also proposed that if the government was not ready to abolish it on all shares, they should at least abolish Stamp Duty on growth markets. This latter measure was subsequently adopted by HM Treasury; Stamp Duty was abolished for shares trading on growth markets from 28 April The results have been extremely encouraging and provide evidence for our suggestion that abolishing Stamp Duty on all shares would reduce the cost of capital (which would reduce the debt bias) and increase liquidity was a very successful year on the UK s main growth market, AIM, with 80 initial public offerings that raised 2.8 billion (an average of 35 million per firm). Stamp Duty abolition was not the only innovation; the 2013 budget also saw rules for ISAs relaxed so that growth market shares could be shielded from Income Tax and Capital Gains Tax. Combined, these measures dramatically improved liquidity, with the average daily value traded on AIM increasing by 54% (London Stock Exchange Group, 2015). Abolishing Stamp Duty in an era of fiscal consolidation Inevitably, the main objection to the abolition of Stamp Duty is the cost to the Exchequer; Stamp Duty is expected to net 3 billion in 2014/15, rising to 3.9 billion in 2019/20. During a period of spending cuts and tax increases elsewhere, tax cuts are challenging. However, they can be justified if they lead to a greater level of economic activity, as a result of which either the tax cut is self-funding over the medium term or the welfare gains are so great that the tax is worth foregoing. 22

24 In the case of Stamp Duty, there are reasons to believe that both of these situations would be realised. Oxera (2007) estimates that the abolition of Stamp Duty could result in A permanent increase of GDP of between 0.24% and 0.78% and that it could lead to higher tax receipts elsewhere. There would also be additional welfare benefits owing to better returns to pension funds. Stamp Duty reduces the final size of pension funds by between 1.52% and 2.38%. This falls especially heavily on Stakeholder Pensions, which were deliberately aimed at those on low to moderate earnings, reducing the final pot by 2.44% to 3.11% for equity portfolios. KPMG (2010) estimates that Capital Gains Tax and Corporation Tax receipts would increase by 1.5 billion over one to three years and that increased GDP from greater investment would deliver an additional 3.2 billion over five years. Additional benefits to abolishing Stamp Duty As well as rebalancing the fiscal treatment of equity and debt and improving the efficiency of capital markets, abolishing Stamp Duty would have a number of positive effects that are strictly outside the subject of this report. We will briefly summarise them here. The immediate effect of abolition is likely to be a one-off increase in share prices. As the value of a share is based on its discounted future earnings, with future transaction costs priced in, eliminating future transaction costs makes the discounted future (i.e. current) value greater. This would be a major boost to shareholders. While some critics may object that benefiting shareholders should not be a government priority, it is worth noting that almost half of all equity is owned by UK pension funds, investment funds, insurance companies, charities and the public sector. This therefore increases the value of private pensions (reducing future demands upon taxpayers), makes insurance cheaper (with broad benefits to households), increases the incentive to both invest in pensions and take out insurance (both of which are seen as merit goods that are under consumed), and strengthens the financial position of charities and the private sector (KPMG, 2010). As noted earlier, Stamp Duty is a transaction tax that falls on UK incorporated companies irrespective of where the transaction takes place. In an international context this has two negative effects. Firstly, it makes investments outside the UK relatively more attractive than investments in the UK. Secondly, it makes listing in the UK less attractive 23

25 than listing elsewhere. Stamp Duty thus incentivises investors (in the UK and elsewhere) to invest outside the UK, and firms to incorporate outside the UK. Both of these represent a loss of welfare. 24

26 :: 4 Reforming corporate income tax: eliminating the debt bias in nonfinancial firms In Chapter 2 we noted that the favourable treatment of debt has (likely, significant) welfare costs. In Chapter 3 we dealt with the UK s financial transaction tax. In this and the next chapter we examine the options for reform of corporate income tax. We begin by focusing on non-financial corporations, and address the financial sector in Chapter 5. Typically, proposals to equalise the treatment of debt and equity have fallen into two broad categories: allowing tax relief for the cost of equity (i.e. treating equity more like debt), or restricting the deductibility of interest on debt (i.e. treating debt more like equity) (Cottarelli, 2009). 15 Allowance for Corporate Equity An Allowance for Corporate Equity (ACE) was proposed by the Institute for Fiscal Studies Capital Taxes Group in Under the proposal, an imputed rate of return on equity would be deductible against corporate profits. Mirrlees at al (2011) explains that the basic idea is to provide explicit tax relief for the imputed opportunity cost of using shareholders funds to finance the operations of the company. An ACE-type system for the UK was recently advocated by the Mirrlees Review, which emphasised that it could bring important economic benefits (Mirrlees et al, 2011). It was also recommended by de Mooij, Deputy Division Chief of the International Monetary Fund s Fiscal Affairs Department, who labels it the most promising reform (de Mooij, 2011). 15 A radical proposal, developed in the Meade Report, is a cash-flow tax. This would replace a tax levied on company profits or income with a tax based on a measure of net cash flow. This reform is not discussed here. For further discussion, see Meade et al (1978) and Mirrlees et al (2011). 25

27 Neutrality From a theoretical point of view, an ACE-type reform is the preferred option of many scholars, due largely to its neutrality properties (European Commission, 2014). The first is that it equalises the treatment of debt and equity, making Corporation Tax neutral with respect to financial choices. The second is that ACE is neutral with respect to marginal investment decisions. Since interest and the imputed rate of return on equity are both deductible, any project for which returns equal the cost of capital are not taxed. Thus an ACE system transforms Corporation Tax into a tax on economic rents. 16 In economic terms this is attractive because in principle ACE would not distort the scale of investment (de Mooij, 2011). Of course, the neutrality of ACE depends on whether the imputed rate of return on equity is set at the right level (Griffith et al, 2008) Lowering the cost of equity financing Taxing only economic rents would reduce the overall tax burden on (and thus the price of) equity capital. This should stimulate investment (European Commission, 2014). This is of particular benefit to SMEs. The debt bias primarily benefits mature companies and so its elimination would level the playing field, enabling SMEs to compete more effectively. By reducing the cost of equity it increases its availability to firms for which debt financing, though popular and common, is nonetheless not readily available. Perhaps most significantly, it should increase both the supply and the attractiveness of patient, engaged capital. By patient we mean investments that do not require immediate, steady, regular repayment irrespective of the immediate profitability of the firm; by engaged we mean investments that are accompanied by involvement in strategic decision making and a share in risk taking. 16 Economic rents are returns in excess of competitive levels. 17 So long as a company is certain that it will receive the relief for equity at some point, the appropriate imputed rate of return on equity is the risk-free (nominal) interest rate (Bond and Devereux 1995, 2003). This could be approximated by the interest rate on medium-term government bonds (Mirrlees et al, 2011). See Griffith et al (2008) for further discussion of the imputed rate of return on equity in the ACE system. 18 Another attractive feature pointed out by Boadway and Bruce (1984) is that the ACE offsets the investment distortions caused by deviations between true economic depreciation and depreciation for tax purposes. See Griffith et al (2008) for further discussion. 26

28 Benefits to employees A further feature of an ACE reform is that much of the gain from implementing the system is likely to benefit employees, as opposed to equity holders (Cottarelli, 2009; de Mooij, 2011). de Mooij (2011) explains that: The return on capital after source taxes is determined by the world market since investors can move their assets freely across borders. Removing the tax on the normal return through an ACE will thus attract an inflow of capital, which boosts labor productivity and raises wages. Recent empirical evidence by Hassett and Mathur (2006) and Arulampalam and others (2010) suggests indeed that workers bear the lion s share of the tax incidence of CIT If so, employees rather than firm owners will most likely benefit from an ACE. Revenue impacts The most notable drawback of an ACE system is that it would narrow the tax base. The revenue cost is estimated at approximately 15% of corporate income tax revenue, or 0.5% of GDP (de Mooij 2011). However, in practice the revenue impact of ACE has differed significantly between countries, depending on the type of reform implemented (see Case Study 1 overleaf). Initial analysis of the ACE system in Italy suggests that an incremental reform alongside an extensive anti-avoidance framework could significantly reduce revenue losses in the short run. What is more, Zangari (2014) contends that this [foregone revenue] argument does not seem decisive against the ACE, considering that the investment expansion associated to an ACE reform may lower even substantially its long-run budgetary cost. Indeed, by increasing investment and entrepreneurship, ACE may increase overall budgetary revenues in the longer run, with any revenue losses in the medium run being primarily a transitional issue (European Commission, 2014). A revenue neutral reform An ACE reform could be revenue neutral if offset by increased taxation elsewhere. Recent academic literature has focused on the welfare 27

29 impacts of a corporate income tax (CIT) revenue neutral ACE reform that is, an ACE accompanied by an increase in the Corporation Tax rate to offset any lost revenue. This would leave the overall burden of the tax on corporate income unchanged, altering only its structure. The required increase in CIT could be substantial (and calculating a revenue neutral rate would be challenging) since it would have behavioural effects: a higher Corporation Tax rate is likely to incentivise international profit shifting to lower tax jurisdictions and adversely affect the discrete location choices of multinationals, thus lowering CIT revenues. Simulations from de Mooij and Devereux (2011) suggest that, on average, CIT would need to rise by 17% in order to offset revenue losses from an ACE. 19 The simulations show that the overall effect of such a reform would be to decrease welfare by 0.2% of GDP on average across Europe. There is no obvious reason why CIT specifically should be used to offset any revenue losses. For example, de Mooij and Devereux simulate the effects of a revenue neutral increase in taxes on consumption, and find that overall welfare increases by 0.4% of GDP on average (de Mooij and Devereux, 2011). Moreover, since (depending on the design of the reform) revenue losses may primarily be a transitional issue, tax increases may not be necessary. Case Study 1: Comparing the Belgian and the Italian ACE systems The Belgian ACE was introduced in 2006 to replace the Coordination Centre regime (which was judged by the European Commission to be an instrument of harmful taxation), with the aim of addressing the debt bias, whilst providing an attractive tax system for capital intensive companies, multinationals headquarters and treasury centres. The Italian ACE was introduced in 2011, with the aim of promoting firms capitalisation and boosting growth (Zangari 2014). While in Italy the reforms are generally considered as a stable feature of the corporate and business income tax system, the Belgian ACE s survival is being discussed (Zangari, 2014). The reforms are quite different (see Table 4.1). Whilst both have been effective in promoting more balanced corporate financial structures, the revenue losses under the Belgian ACE are likely to be far more substantial 19 17% is the increase necessary to balance the government budget ex-ante, i.e. before behavioural changes (e.g. in investment or employment) are taken into account. This is an unweighted average across 23 European countries. 28