Philip Booth, IEA Editorial and Programme Director writing in the CBI's Magazine, Business Voice

In the mid 1980s, Nigel Lawson made changes to the corporate tax system that were remarkable at the time and of international significance. Lawson abolished first-year investment allowances and reduced the rate of corporation tax from 52% to 35%. Lawson’s reforms were opposed by a number of business leaders at the time, including by many at the CBI. The reforms removed the incentives for reinvesting profits within companies and thus worked to the disadvantage of the managers of larger companies.

Since that time, many other countries have followed Britain’s example – and they have gone further. Britain is no longer a good place to locate a business for tax reasons. It is essential that the Chancellor takes the next logical steps of reform and begins to align the corporate tax system more fully with the income tax system.

In Britain, we have an income tax system that, with a few exceptions, taxes all income, including returns to labour (wages), property (rents) and capital (interest and profits). Except in the case of profits we attribute, as far as is possible, the income from different sources to the ultimate beneficiary and then tax the beneficiary at their marginal rate of tax (0%, 10%, 22% or 40%). There are some exceptions and reliefs such as for charitable giving and for pension funds. If a company finances its activities by issuing debt or bonds, the interest is taxed in the hands of the individual or institution that holds the bonds at their marginal rate. However, we treat corporate profits differently. Insofar as a company finances its activities by issuing equity capital, its profits are taxed in its hands at the corporation tax rate of 30%. Non-taxpayers (including pension funds and charities) and basic rate taxpayers cannot reclaim any of this tax. Higher rate taxpayers must pay further tax on dividends equal to the difference between the basic rate of income tax (22%) and 40%. So they too pay a higher rate of tax on returns from equity than on returns from other investments.

This system is crazy. It encourages companies to gear their balance sheets more than they would do so in the absence of distortions. It discourages investment in shares and discourages risk-taking. It biases portfolio investments of pension funds and insurance companies away from equities and towards bonds. Expensive opaque tools of financial engineering are developed to circumvent the higher rates of tax paid on the returns to equity capital. Businesses and investors then get bound up in red tape as the government tries to avoid the problems caused by the opacity of financial vehicles used to avoid the quirks of the tax system! The recent zero-dividend preference share scandal in the investment trust industry might well not have happened had it not been for the differential tax treatment of bonds and equity finance.

Because, for very small businesses, profits are more or less synonymous with earned income, further complexity is introduced into the corporate tax system as the government tries to merge the corporate tax system with the income tax system at the bottom end.

This whole charade must be wound up. A truly radical proposal would be to introduce a full imputation system for corporate tax so that profits were only taxed in the hands of the ultimate beneficiary. Clearly this is not on the agenda now. A short term “fix” would be to reduce the corporation tax rate to 22% and abolish the special 10% income tax rate. Little revenue, if any, would be lost. Many regulations could be abolished and the tax system would be simplified for individuals. There would be no need for a special small companies’ regime. Higher rate taxpayers would still pay extra income tax on dividends: just as they do on income from bonds. The corporation tax rate should then never again deviate from the basic rate of income tax.

In principle, of course, non-taxpayers, including pension funds and charities, should receive the corporation tax back, just as they can claim back bond interest deducted at source. The pre-1997 system of dividend tax credits helped steer the tax system in that direction but Gordon Brown has demolished all that. Clearly he will not reinstate ACT credits. Putting such unworthy causes as charities and pension funds ahead of feeding the ever-growing government apparatus did not appeal to the Chancellor in 1997 and it will not appeal to him now. Nevertheless, the other changes to the corporation tax system proposed above should be attractive to a Chancellor who does not wish to see British business re-domiciled abroad.

See also:
Living with Leviathan: public spending, taxes and economic performance by David Smith.