Friday, 28 December 2007

Business taxation

For some reason, politicians always harp on about cutting corporation tax (raises about £45 bn annually, Tab C4). Let's go back to basics and look at a supply-demand chart in absence of any taxes. It's easiest, for the purpose of this post to assume that the 'supply' line = the costs that producers face, the more efficient ones having low costs; and the 'demand'  line is the price that consumers will pay (the price falls as quantity increases). So those producers whose income exceeds costs remain in business, and the equilibrium price is where price = costs, and the quantity produced results from that. This basic position is assumed to be the optimum allocation of resources. 



Now, let's look at what happens if producers have to pay corporation tax or income tax. Yes, of course these discourage enterprise and employment, but the tax is only a slice of producers' net profits, i.e. income (price) less costs (the supply line).

Very efficient producers (those at the left hand of the chart) pay a lot of tax, but they are still profitable so remain in business (and in any event, in the grander scheme of things, reinvested profits are not taxed - it is only unreinvested profits, whether retained or paid out as dividends that are taxed) and the tax does not affect marginal producers (whose costs are more or less equal to their income) as they are simply not making profits. So I'm not disputing that corporation tax slows down the rate of growth of businesses a bit, but it certainly doesn't drive anybody out of business, so it doesn't affect the total output very much.



Now let's look at the impact of VAT (raises nearly £80 bn per annum, see Tab C4, link as above, considerably more than corporation tax). It raises prices paid by consumers, reduces income of producers, drives marginal/low profit producers out of business, reduces the value of output and hence employment, and reduces corporation/income tax receipts, as well as adding another layer of bureaucracy and scope for fraud etc. and, apparently, is regressive (poor people are said to pay a slightly higher percentage of their income in VAT than rich people). I'm afraid the grey line for "Supply (tax-free)" is not visible, but it's in the same place as in the first chart.



The next worst tax is Employer's NI, for similar reasons - it reduces wages received by workers while raising the cost to employers, thus reducing employment levels and adding an extra layer of bureaucracy and crap.

I rest my case.

19 comments:

Newmania said...

I do not understand these graphs but the proble with high copration tacx is the fluididity of business in the word compared to Labour and demand ...I think

Mark Wadsworth said...

Yup, people say that but it is patently not true.

1. What's bad for business in the UK is bad for business in the UK, whether the potential entrepreneur is from here or from overseas.

2. As labour and demand aren't fluid, businesses have to go where there is labour and demand. Or else why don't all UK businesses shut down and relocate to the Republic of Ireland etc.

Newmania said...

. Or else why don't all UK businesses shut down and relocate to the Republic of Ireland etc.

In the financial services sector at least many of the do or would.

Mark Wadsworth said...

Yes, a lot of banks etc have shuffled loans round so that the interest income ends up in Ireland.

The Irish collect a bit of corporation tax, but it doesn't create jobs or anything. Anyway, the Dutch and the Baltic states are going to tax interest income at zero per cent, and then all the banks will shut their Irish subsidiaries and open them up in Holland etc.

Mrs Smallprint said...

Hi Mark

My husband and I have looked at your graphs and we get the gist but I for one am not sure about the effect on the third graph demand line being as shown. I only say this because as you know the actual effects of VAT on price particularly at the bottom of the food chain falls on the supplier as much as the consumer. Consider the position of a plumber who goes over the VAT threshold he can't instantly put his price up so he probably takes at least some of the pain himself. So much for it being a tax on the consumer.

I think the threshold should be much increased as this would help start up businesses especially, particularly as they have so much to take in already.

I think I will try and come up with some top tips for David Cameron to help small business and reduce red tape.

Mark Wadsworth said...

Mrs SP, indeed, VAT is shared between producer and consumer (it hurts both), if the grey line for 'Supply (tax free)' hadn't gone AWOL, that would be perfectly clear.

As against corporation tax, which obviously hurts the producer, but it doesn't increase prices (much) or put producers out of business.

neil craig said...

The other side of that coin is that CT, because it costs nobody enough to drive them out of business, costs the most productive most. True that is unlikely to drive them out of business but it will slow their expansion. It is a tax on the most innovative & successful part of the economy.

Perhaps this is simply a matter of whether it is more important to maximise present or future productivity. Most politicians & electorates would go with current but because the future is longer & the effects of compounding of growth so spectacular I go for future.

Also cutting VAT cuts the cost of imported good whereas CT cuts manufacturing (granted also distribution) cost here.

Mark Wadsworth said...

NC "It is a tax on the most innovative & successful part of the economy"

Yes and no. But I covered all that. While those businesses are expanding, they reinvest all their profits and so don't pay very much tax. It is only once they become 'mature' businesses with surplus profits that they don't need to reinvest that they pay significant amounts of tax.

And in any event, we don't need to worry about them in a downturn, it is the more marginal businesses that will go under first. Is it worth sacrificing a hundred marginal businesses (hairdressers, restaurants, whatever) in order to retain one cutting edge one?

"Also cutting VAT cuts the cost of imported goods ..."

VAT applies to services as well as goods. 80% of the UK economy is purely domestic. And the retail price of imported goods is 50% profit for UK-based distributors and retailers. If you are a protectionist, then why not go for import duties and use them to subsidise exporters? (I think that this is a terrible idea, BTW)

"... whereas CT cuts manufacturing (granted also distribution) cost here."

The largest cost of manufacturing in the UK is wages and rents. Rents we can sort out via LVT, we can't do anything about market wages but we could quite easily scrap Employer's NI that would make us 12.8% more competitive in wage costs.

Do not forget that corporation tax in China is 35% or so - higher than ours. it is attractive as a manufacturing base because their wages are much much lower than in Europe. Even if their corporation tax were 90%, it would still be cheaper to manufacture over there.

I am not saying that corporation tax is A Good Tax, but it is certainly The Second Least Bad Tax (after LVT).

neil craig said...

Fair point about reinvestment of profits in growing companies - on the other hand knowing that their profits will be reduced in the long run is still a disincentive.

However thinking about that does encourage me with a compromise I have suggested elsewhere - that government should make somme CT cut & a promise not to increse business tax takings so that if/when the Laffer Curve kicks in & the tax take increases they will reduce the rate further. That would encourage such reinvestment since their future tax rate will be lower.------

"Is it worth sacrificing a hundred marginal businesses (hairdressers, restaurants, whatever) in order to retain one cutting edge one?"

Not 100 but maybe 2 though this is a matter of long term V current. Particularly if they are selling horse drawn carts, sliderules & the stuff you get in Woolworths.---

I don't hold up China as a paragon. It has improved enormously which, together with low labour costs, is why it is doing so well bit I think the problem is not that they are doing unnaturally well but that we are doing so godawful badly. I suspect they would be doing somewhat better with a lower rate. If it was a 90% rate only multinational industry would survive in China since their accountants would prove all the value was added by transhipment or copyright holding in Ireland.

Anonymous said...

MW: Do you have any links to papers backing the effects of what as showed in the second graph? If there is one flat rate, and it doesn't have any allocative effects, I don't see how it can have that effect other than when shifting from CT, but I'm in this to learn.

-Kj

Mark Wadsworth said...

Kj, no links, this is all just basic economics, you can look in any textbook or think about real life - or ask an insolvency expert - and they all say much the same thing. VAT is far more damaging than corp tax or income tax, end of.

In relative terms, VAT clobbers the marginal businesses, the new entrants, the borderline ones, so they go out of business - conversely, it is quite good for established profitable businesses. Yes, they still have to pay it, but their market share is protected because there is less competition.

Corp tax does the opposite, the established profitable businesses pay most, but that doesn't put them out of business (by definition) and the marginal ones, the new entrants etc aren't making profits so they don't pay any.

diogenes said...

if Benelux really stop taxing bank interest income...bye bye City of London......and bye bye UK

unless LVT kicks in and the very few people who lose out on the absurd rail link to Birmingham actually cash in on tax reductions.

Anonymous said...

MW: Ok I'll get down to it, to be honest I haven't come across a proper handling of the microeconomic effects of VAT in most of the current textbooks I have, and find it hard to find it online. To start me off, are the effects on small businesses/startups etc. just a function of supply/demand and corresponding elasticities, or in practice compliance-cost?

By the way, on CT, in your opinion as top accountant. Hypothetically would it be possible to have and easily enforce a CT (on benefit of incorporation grounds), low rate, simple rules, without taxing wages? Or would shifting to "wages" be the norm and unenforceable in smaller companies?

-Kj

Mark Wadsworth said...

Kj: "are the effects on small businesses/startups etc. just a function of supply/demand and corresponding elasticities, or in practice compliance-cost?"

Both. There's also the problem of crossing the VAT threshold, if the threshold is £70,000 and your turnover is £60,000, you have to jump to about £90,000 before your profits start going up again.

But the fact that VAT acts as a barrier to entry is more subtle, it is perhaps my own idea. it has to do with maths and the way that a market is shared.

If you read the comments to that post you'll see that a Faux Libertarian dropped in to insult me - they love VAT, they do (or "Fair Tax' as it's called in USA). He didn't try to refute the argument, it was just brainless insults from a smartarse.

As to CT, forget it, of course it is borne by wages. It is not "the company" itself which benefits from limited liabilty, it is the shareholders. You could try and find a way round this problem by taxing dividends not profits or wages, but then shareholders would just pay themselves salaries instead of dividends. CT is not such a bad tax as it stands, best leave well alone.

Anonymous said...

You could try and find a way round this problem by taxing dividends not profits or wages, but then shareholders would just pay themselves salaries instead of dividends.

So essentially, wages has to be taxed for CT to exist?

Ok, getting there with VAT.

In New Hampshire they have something called BET (Business Enterprise) Tax. It is based on adding together wages, dividends and interest payments, and putting a rate on top of that (currently 0,75%). Compliance is dead easy (I don't know about enforcement), and at least retained profits is left.
Ofcourse it doesn't really raise that much (little less than a hundred dollars per capita at that rate)

-Kj

Anonymous said...

You could try and find a way round this problem by taxing dividends not profits or wages, but then shareholders would just pay themselves salaries instead of dividends.

In listed companies however, isn't this less of a problem, as they have an incentive to report as much profits as possible (in theory)?

-Kj

Mark Wadsworth said...

kj, if we are to tax earned income (and we are), then let us at least tax it all at the same flat rate, preferably at source. I see no reason to dice and slice into categories like corporate profits, business profits, wages, bonuses, interest, dividends etc.

While such a tax is a distortion, we make things worse by trying to tax them at different rates or some sources not at all.

Anonymous said...

Ok, so if we remove NI, and add wages and interest to the current CT calculation base, you'd have a flat income tax. More or less a VAT, but you'd be able to have a deduction in the bottom.

-Kj

Mark Wadsworth said...

Kj: "OK, so if we remove NI, and add wages and interest to the current CT calculation base, you'd have a flat income tax."

Yes.

"More or less a VAT, but you'd be able to have a deduction in the bottom."

Like VAT but much better, because VAT is only applied to wealth generating activity. Monopoly income is largely exempt. Either way, profits+wages are a far better indicator of ability to pay than merely turnover.

Consider two sole traders: one has profit margin 10% and turnover £100,000. The other has profit margin 1% and turnover £1 million.

With flat income tax, they pay the same amount in tax and both continue trading. With VAT, the latter is driven out of business.