Eurfyl ap Gwilym sets out a new model for corporation tax
Corporation tax is a dry subject and because most voters are not directly affected it receives too little attention either in party manifestos or in the media. It is also a policy area where the major political parties have shown little or no creativity and have simply concentrated on whether to cut or raise the headline rate. The purpose of this short paper is to propose a more creative approach which could be of benefit to Wales and help rebalance the UK economy in the post-Brexit world.
The level and structure of corporate tax can be a powerful influence on the behaviour of companies and on the wider economy. Most companies in the private sector generate profits and pay corporation tax on those profits. They can use the net profit in a variety of ways: they can return some of the net profit to shareholders either through dividends or by share buy-backs; they can invest the money in plant and machinery to raise productivity and become more competitive; they can use the money to expand the business; or they can sit on the cash and hold it as a reserve to be employed in the future.
When considering corporation tax, it is a mistake to concentrate exclusively on the headline rate because although that rate is important, as the Centre for Business Taxation at Oxford University has argued, businesses are concerned with the whole corporation tax package, including allowances and reliefs as well as the headline rate. Perhaps inevitably political parties in their manifestos focus on the headline rate.
The Policies of the Political Parties.
Labour is advocating raising the headline rate from 19 per cent to 26 per cent. This is major hike although it should be remembered that the headline rate was 28 per cent a recently as 2010. This policy is key to Labour being able to pay for a number of its key manifesto pledges. According to Labour’s estimates this rate hike will raise an additional £20bn of revenue every year. This estimate is the mechanical effect of raising the tax rate. Mechanical effect encompasses those financial factors that can be quantified in the light of the current policy framework. While this may be a reasonable guide in the short term a key question is what will be the longer-term effect on business and employment which is often impacted by behavioural responses? Such a sharp increase in the headline rate will almost certainly lead to a range of behavioural responses ranging from increasing tax avoidance to relocating activities to countries with a more favourable tax regime. Some may seek to counter this concern by pointing out that under Labour’s proposals the headline rate of corporation tax will still be moderate compared with many other advanced economies but this ignores the fact that when the UK cut the tax rate from 28 per cent there was a cut in investment allowances which could in the past be used materially to reduce the corporation tax bill actually paid. The Labour manifesto does not promise to increase investment allowances and reliefs to off-set the rise in the headline rate and in any event this would be self-defeating given the desire by Labour to increase the yield from corporation tax.
Another objection to Labour’s proposals is that in the case of foreign direct investment (FDI) corporate tax levels, both headline and actual, together with availability of relevant skills, good infrastructure and unfettered access to markets is a key determinant in selecting suitable locations for new investment. Wales and the rest of the UK will already face the increasing challenge of attracting FDI post Brexit without the additional drawback of high rates of corporation tax.
The Conservatives plan to continue with their policy of reducing the headline rate from 19 per cent currently to 17 per cent by 2020. Cutting the tax rate to 17 per cent will cost the Exchequer approximately £5.5bn per year and a question is whether such a measure is the most cost-effective way of stimulating business and the best use of the £5.5bn.
Plaid Cymru has long been an advocate of devolving corporation tax where it could then be used as part of the tool-box for revitalising the Welsh economy and attracting more foreign direct investment. Until now such devolution was thought to be contrary to EU rules but with the coming of Brexit this obstacle will disappear. As well as considering the headline rate Plaid Cymru has advocated devolving powers over investment allowances and reliefs. This approach was mirrored in the recommendations of the Silk Commission. In its 2017 manifesto Plaid Cymru calls for variable or discounted rates of corporation tax as part of its post-Brexit strategy.
The Liberal Democrats are committed in their manifesto to reversing the cuts in corporation tax from 20 per cent to 17 per cent.
Are the options being offered by the political parties the best way forward or is there scope for more imaginative approaches particularly post-Brexit? Corporation tax is not only an important source of government revenue: in 2017-18 it is forecast to raise £52bn out of total tax take of £744bn (7 per cent of the total) but it can also be used by government to influence business behaviour by such devices as allowing capital investment to be offset against the tax. Thus, one unintended consequence of cutting corporation tax, is that the tax incentive to invest is reduced although the business will have additional cash at its disposal. Raising the headline rate will reduce the propensity to invest unless capital allowances are made more generous.
A New Model for Corporation Tax.
One of the challenges facing the UK is the chronic inequality across the nations and regions of the UK. Could corporation tax policy be used to help redress some of this imbalance? A way of doing this would be to vary the rate of corporation tax across the UK with a reduced rate been levied in the poorest areas and a slightly higher rate being applied in the most prosperous.
To illustrate what might be possible let us assume that the headline rate of corporation tax is set at 20 per cent (the current rate is 19 per cent). In the three NUTS1 regions of the UK where relative GVA per capita is less than 80 per cent of the UK average (North East England, Wales and Northern Ireland) the headline rate of corporation tax is cut to 10 per cent i.e. halved and in the two most prosperous regions with relative GVA per capita of 110 per cent or higher (London and South East England) it is raised marginally from 20 per cent to 22 per cent. Assuming for these purposes that corporate profits generated in a region are proportional to GVA (a rough and ready assumption but given that corporate surplus is a factor in the computation of GVA it is not too bad a guide) then these measures would be revenue neutral with the North East of England, Wales and Northern Ireland having a headline rate of 10 per cent and London and South East England levying tax at 22 per cent. The headline rate in the other NUTS1 regions of the UK would be 20 per cent. The setting of the threshold at a relative GVA of 80 per cent in this illustration is arbitrary as is the reduction of the headline rate to 10 per cent but if such a policy is to be an effective stimulus there must be a material reduction in the rate in the very poorest nations and regions of the UK. Another consideration is that outside the two most prosperous regions and the three poorest, relative GVA is closer to 90 per cent and this is effectively the base level for the UK (excluding London and the South East of England) from which the 80 per cent and 110 per cent thresholds should be viewed. The additional 2 per cent levied in the two most prosperous regions should be politically palatable. In the case of Wales such an approach could provide a stimulus of between £600 million and £700 million a year. In the model proposed the cost of this stimulus would not be deducted from the annual block grant, an action which would be self-defeating, but would be a transfer from the most prosperous areas of the UK to one of the least prosperous. The parameters used here are for illustrative purposes and could be varied but the two principles are that: the scheme is self-funding; and only the least prosperous and most prosperous nations and regions are affected.
Practical Considerations.
In implementing such a policy, a factor to be considered is how would the profits on which the corporation tax is levied be assigned across the NUTS1 regions in the case of multisite businesses? There are a number of possible ways but one approach would be that described in the Final Report of the Holtham Commission. The report stated that ‘many countries, including the USA, have well tried formulae for allocating corporate taxes across regions. The simplest approach would be to allocate liability by proportion of payroll.’ Payroll is probably as good a proxy to profit generation as any other measure all of which are quite problematic. When the Hotham Commission reported, there was serious doubt, as they noted, as to whether devolution of corporation tax in this way was permitted under EU law. With Brexit this obstacle will disappear.
Conclusion.
Brexit will pose significant economic challenges to Wales and to the UK including, given the UK Government’s decision to leave both the Single Market and the Customs Union, the loss of attraction as a location for FDI. Since the UK joined the then EEC, regional policy has effectively been delegated to the EEC and then to the EU. It remains to be seen how effective will be the regional policy put in place by the next UK Government. As well as ensuring that Wales continues to receive development funds to replace the loss of EU structural and social funds a measure to reduce the rate of corporation tax as described here could mitigate the damage wrought by Brexit as well as helping geographically to rebalance the UK economy. Willingness to adopt such a model would be an acid test for how serious the next UK Government is about geographically rebalancing the UK economy post-Brexit.
This is the sort of thing we need at least to be considering more, even if, pace Hotham, the practical difficulties of defining the actual location of a company for tax purposes can only increase with information technology.
The report of the Commissionthat I chaired proposed explicitly linking permissible cuts in corporation tax by a regional government to the region’s shortfall from the UK average GDP per head. That has the advantage that the concession is self-abolishing if the region prospers so there is not a political battle over withdrawing it. The advantage of the payroll criterion for allocating corporation tax liability is that it gives companies an incentive to locate high-paying jobs in the region enjoying the corporation tax concession. That is true however “digital” the business may be.
Incidentally, the dominant interpretation of the Azores judgement was that this scheme was permissible for Wales under EU rules – the key being that the Welsh budget bore the consequences of any change in the corporation tax rate without compensation from the UK. EU rules would probably have precluded the scheme from applying to English regions, however, since they do not have separate government budgets to identifiably take the strain. I understand that people are looking for the economic silver linings to Brexit but so far as Wales is concerned this is not one of them.
Another interesting article by Eurfyl ap Gwilym. The problem is that corporation tax is on profit and using internal transfer pricing and intellectual property internal charges the profits of multinationals can be made where they want them to be.
The point is that it is already possible to alter the location of an employee quite literally at the flick of a switch.
The capacity to do so can only expand dramatically over the next decade if the technologies of telerobotics, telepresencing, and ‘the internet of things’ improve as predicted.
A factory or office in Wales might be run from anywhere in the world – just as people in Wales might run factories or offices located in other regions or nations or even continents. The technology is developing now.
I can well understand the concerns raised regarding the increasing challenge of pinning down where taxable profits arise. This issue is destined to become ever more significant with the growth of digital and internet based businesses although it also encompasses more traditional industries – witness the Starbucks case. The model I propose is not intended to address this issue which I leave, at least for the moment, to HMRC and the EU. My note simply proposes that once HMRC has determined the corporation tax liability arising in the UK then that tax revenue be distributed in the way I suggest. When companies in the private sector calculate their corporation tax liability that calculation is subject both to independent audit and then review and agreement by HMRC. The geographic distribution of headcount could also be subject to such audit which should discourage aggressive avoidance or evasion by means of manipulating headcount numbers.
I agree with Gerry Holtham that my proposal is not a Brexit ‘silver lining’. The relevance of Brexit is that it frees the UK Government from some of the constraints, one of which, as he points out, appears to preclude the redistribution of corporation tax revenues to regions of England. The model I propose is not one for devolving corporation tax but is a cost-neutral way of redistributing funds raised centrally at a UK level and one which could act as a powerful lever for stimulating business in the poorest areas of the UK. The model also addresses the understandable concern of central UK governments that they do not wish to see a ‘race to the bottom’ due to intra-UK competition although recent rate reductions mean that the UK is leading that race in the case of the larger economies of Europe.