What is wrong with corporation tax?

by Ben Ramanauskas, Policy Analyst

Today marks April Fools’ Day. We all know the drill: unfunny pranks played on unsuspecting and irritated victims. Perhaps this is why, on this day in 1965, corporation tax was put into effect.

It was believed at the time by the tax consultant John Chown that, while not quite an April Fools’ prank, "the government and its advisors had three or four months for second thoughts and, recognising some of the dire consequences, would modify their original proposals." Unfortunately, the then chancellor of the exchequer, Jim Callaghan, was not joking. In fact, Chown and a few other economists and tax experts founded the Institute for Fiscal Studies (IFS) - essentially to stop this type of thing happening again.

From our vantage point in 2019, we can see the damage caused by corporation tax, and why people were rightly so concerned when it was first introduced.

 

So, just what is wrong with corporation tax?

Some commentators love the idea of increasing it, as they think it will be a way to squeeze more money out of big businesses. They are mistaken. It discourages investment, makes the UK a less attractive place to do business, hurts employees, and can lead to companies racking up large amounts of debt.

Corporation tax is a levy on capital. As such, it is one of the most economically damaging taxes. This is because, as pointed out by Scott A. Hodge, the President of the Tax Foundation, capital is the most mobile factor in the economy. While it is very difficult to move property, and moving to a different country raises lots of issues for people themselves, it is very easy to move capital.

On a basic level, taxing capital discourages firms from investing in their facilities, staff, or equipment. There is a great deal of evidence which backs this up. For example, one study found that higher levels of corporation tax adversely impact the level of investment by businesses. Further research showed that it slows down the rate at which low-productivity firms make investments which would allow their productivity levels to catch up. This makes perfect sense. Let’s say you’re a business owner who is deciding whether or not to invest in a new machine. You’ll only make this investment if the return you get from it is higher than the cost of the investment. Slap a tax on the machine and the cost goes up.

Why does this matter? Investment in businesses increases productivity - which is the main driver behind increasing economic growth and living standards. As the Nobel Laureate in Economics, Paul Krugman, stated: “Productivity isn’t everything, but in the long run, it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.”

So, by deterring investment, corporation tax keeps productivity low and which means the economy grows slowly and our standard of living does not increase. Corporation tax is, in the words of the IFS, “one of the more damaging taxes on growth”. Or, as some American economists concluded in a 2013 study: “Eliminating the US corporate income tax has the potential to raise the welfare of all US generations.”

The tax is also bad news for employees. Remember, businesses do not pay taxes - people do. In much the same way that your TV doesn’t pay the BBC licence fee, and your house doesn’t pay stamp duty, ultimately businesses do not really pay corporation tax. That’s why introducing it was no laughing matter. All the employees and shareholders who make up a businesses are the ones who pay.

And corporation tax means lower wages. Ben Southwood undertook a substantial review back in 2014 of 45 of the most important studies on this area for the Adam Smith Institute, and found broad agreement among economists that the burden of corporation tax falls heavily on employees in the form of lower wages. Time and again, studies have shown that this is the case. For example, a study from Harvard University found that high levels of corporation tax lead to lower wages. Research from the University of Oxford concluded that a rise of £100 in corporation tax would lead to wages falling by £75. It isn’t rocket science: businesses have limited resources, and corporation tax reduces the amount of money a company has available to spend on wages.

A low rate of corporation tax means that businesses are more likely to set up operations in that country, whereas a high rate of corporation tax makes this less likely. Take Ireland, for example. It slashed corporation tax and so many of the world’s largest technology decided to move to Dublin. The companies brought jobs, investment, and revenue for the Irish Treasury to spend on essential public services.

A less obvious side effect is that corporation tax can also encourage businesses to become heavily indebted. This is due to the bias towards debt over equity. As a result of the UK tax system, if a business decided to fund a new project or development through borrowing, then it can deduct interest repayments - leading to a lower tax bill. However, if the company decides to finance its activities by selling shares, then it can’t deduct dividend payouts as a cost - meaning a higher tax bill.

High levels of debt increases risks for businesses. Although it might be sustainable while the economy remains strong, any downturn could be disastrous for companies with high levels of debt. It could lead to businesses going broke, meaning more people out of work and less money coming in to the Treasury’s coffers to fund schools, the police, and the NHS. Or, the government might decide to use hard-earned taxpayers’ money to bail the businesses out. Either way, it would be bad news for ordinary working people.

There are a lot of bad taxes out there, but corporation tax is one of the most damaging. During this time of uncertainty over Brexit, this would be a great opportunity for the government to respond by making the UK an even better place to do business by lowering, and ultimately scrapping, corporation tax. This will mean more investment, more jobs, higher productivity, higher wages, better living standards, and a stronger economy. And that is not a hoax.