There are pitfalls in both Tory and Labour plans for corporation tax

Last week the Labour Party set out plans to raise corporation tax as a way of funding additional spending on education. Corporate tax rates have been cut aggressively since 2010. School funding is being squeezed. A better-educated workforce would be good for economic growth. This looks like a win-win policy.

Inevitably, the reality is more complex. On the school funding side, it matters how well any additional resources are spent, but we can all see that there are potential benefits. The effects of changes in corporation tax are much more opaque, but the scale of the increases suggested by Labour, and indeed the scale of cuts introduced since 2010, means that we cannot use that opacity as an excuse for careless thinking. It really does matter whether we have an effective and efficient corporate tax system.

Let’s start with the scale of change proposed. The main rate of corporation tax is presently 19 per cent and is due to fall to 17 per cent over the next couple of years. Under a Labour government it would rise to 26 per cent. That sounds, and is, a big increase, though it is important to remember that the main rate was 28 per cent back in 2010. So it would by no means take us into uncharted territory.

The immediate effect of such an increase might be to increase revenues by nearly £20 billion a year. That’s a lot, nearly 1 per cent of national income. It would represent one of the biggest single tax increases in decades. And despite the fact that it would not quite be returning the main rate to its 2010 level, it would still leave the level of corporation tax higher for some companies than it was back then. That’s because alongside the big cuts in the headline rate introduced over the past few years, there have been a number of other changes that have increased revenues.

Labour quite rightly points out that the UK’s headline rate at the moment is way below that in any other G7 country and is one of the lowest in the OECD. Even raising it to 26 per cent would leave it, just, below other G7 rates. Yet the headline rate is not the only thing that matters. The British system is rather less generous in the way it treats investment: we allow a smaller share of capital expenditure to be deducted from profits. Raising the headline rate to 26 per cent, whilst changing nothing else, would make the UK a less attractive place to invest.

There, perhaps, lies the biggest risk. Corporation tax changes companies’ behaviour. High rates discourage investment, especially in a system like ours where allowances for investment are not terribly generous. This could mean domestic companies investing less.

Perhaps more important would be the effect on foreign direct investment. Of course other things matter in determining whether and where companies invest. Corporation tax is neither the only nor the most important determinant of such choices. But it is a determinant. Lower rates of investment, and particularly lower rates of foreign direct investment, are bad for productivity in the long run. Lower investment and productivity translate into fewer jobs and lower wages. These are among the reasons why the OECD worries that corporation taxes are among the most economically damaging taxes around.

That’s also why a government introducing a big increase in the rate of corporation tax would be foolish to bank on it providing a long-term boost to revenues as big as the boost it might provide in the short term. Lower investment and, yes, more determined efforts at avoidance would see to that.

The wider environment matters, too. There seems little doubt that Brexit will reduce the UK’s attractiveness as a place to invest and do business, unless we have a very clear strategy to improve the business environment and actively attract investment. That is not a call for an Irish rate of corporation tax, but it does require a joined-up view of the role of the tax system alongside all the other things that make for an attractive destination for investment — high skills, good infrastructure, easy trading relationships and so on. A better-skilled workforce and better infrastructure may be able to offset the detrimental effects that come with increasing corporate tax rates. But it takes time, a long time, to upgrade skills and infrastructure. Raising corporation tax before these benefits are visible looks risky.

That is not to say there is nothing we should be doing either to raise taxes in general or to change corporation tax, in particular. There is a case for measures to narrow the corporate tax base such that investment is not disincentivised. That might be a better use of revenues than the Conservative plan to continue cutting the rate. Even without reform, the case for the further planned cuts to the headline rate may not be all that strong given all the other calls on the public purse.

What we really need, as ever, is an honest debate about tax. There can be little doubt that one of the great attractions of raising corporation tax is that it looks like it is paid not by you and I but by faceless corporations. Of course, it isn’t. Tax has to be paid by people — by the employees, customers or shareholders of these faceless corporations, including all of us who are indirectly shareholders through our private pensions. I’m afraid I don’t know, nobody knows, quite who would end up bearing the cost of a big increase in corporation tax. That’s why it can look so attractive to some politicians, and perhaps rather less so to those of us who prefer a degree of transparency.

Paul Johnson is director of the Institute for Fiscal Studies. Follow him on @PJTheEconomist.

This article was first published by The Times and is reproduced here in full with permission.

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