Thursday, 11 July 2019

Gloriously muddled thinking on corporation tax.

Article in City AM this morning by John Penrose MP who "is Jeremy Hunt's policy guru".

After some fawning drivel about the German Mittelstand and dissing of UK businesses...

The OECD says that corporation tax is the most damaging and distortive, stopping investment flowing to wherever in the economy it is needed most.

This is clearly nonsense. Tariffs and turnover taxes (VAT) are the most distortionary and damaging taxes. Things like currency controls and foreign ownership restrictions (which the UK doesn't have, by and large) are awful non-tax distortions.

The distortionary effects of corporation tax are minimal:

Our businessman has some money to invest in starting or expanding his business. He ignores tax, and identifies Project A with an expected 20% return on investment and Project B with an expected 10% return on investment. He chooses Project A.

His accountant reminds him that he'll have to pay corporation tax on his profits, so actual expected returns are only 16% for Project A and 8% for Project B. The businessman will still choose Project A; corporation tax makes no difference for decision making purposes.

Also, UK plc pays twice as much in cash dividends to shareholders as it pays in corporation tax. If they really needed to retain cash for re-investment, they'd pay lower dividends.

At the moment, we've only got ourselves to blame, because our company tax system rewards firms which borrow much more than ones that invest... So why not reverse the incentives? Stop rewarding borrowers so lavishly and encourage investment instead? It would be fairly simple to do; we could make capital expenditure fully tax deductible as soon as it is spent, and stop company debt interest being tax deductible.

How thick is he? "Borrowing" is money coming in to the business and "investing" is money leaving it. These are completely separate things and have nothing to do with each other.

For example, a company could borrow from a bank and spend it on expanding the business. Does he count this as borrowing or investing? Similarly, it could borrow money without investing it (paying the cash out as dividends or a share buy back); or it could expand the business out of retained profits without borrowing.

The UK corporation tax system is pretty neutral on all this. If a company borrows from a UK bank, it gets a tax deduction for the interest paid and the bank pays an equal and opposite amount of tax on the interest it receives. If one company invests in shares of another, dividends paid on those shares are not an allowable expense of the paying company but are exempt from tax for the investing company. Both of these are completely tax neutral overall.
UPDATE - to illustrate
Co A lends to Co B, receives £10 interest
Co B saves £2 tax (tax relief on interest paid)
Co A pays £2 corp tax on interest income
Co A ends up with £8 after tax.

Co A invests in Co B, receives £8 dividend
Co B makes £10 profit that 'belongs' to Co A, pays £2 corporation tax
Co B pays £8 dividend out of post-tax profits
Co A receives £8 dividend, on which it does not have to pay tax.
He also has a very old fashioned view of modern business. Sure, some businesses make massive investments into physical plant and machinery. But by and large, businesses spend a lot more money on other things which help them grow - market research, R&D, staff training, advertising, renting larger premises and taking on more staff etc.

Such expenditure is fully allowable as a tax deduction when incurred; small businesses can claim 100% first year capital allowances but larger businesses are stuck with laughable 8% or 18% reducing balance capital allowances on qualifying items. So for this and many other reasons, 100% first year capital allowances for all businesses large or small are a good idea as it levels the playing field. So he's right for the wrong reasons - there is no particular reason to assume that the overall amount spent on plant and machinery would go up much.

Treating interest payment as a distribution of profits rather than as an expense is also a good idea, but not for the reasons he gives. The flip side would have to be that lenders don't pay tax on the interest they receive, so overall, the effect would be minimal; interest rates would just fall to the net of tax amount.


Dinero said...

The article is up.

Dinero said...

" exempt from tax for the investing company"
is that a Typo.
the dividend are less after the tax are they not.

Are you saying the tax system is neutral What do you think of this 90 second video. It seems to say the opposite.

Mark Wadsworth said...

Din, thanks for link.

I have updated to include example.

Corp tax is pretty neutral. VAT or NIC are not at all neutral and actually change decisions and reduce activity and employment.

Miller Modigliani is not about tax, it says that total value of a business is the same whether funded by debt or shares (which is a reasonable assumption).

Lola said...

Of course we could scrap all this bollocks and move to full on LVT....or have we already decided that?

Dinero said...

Yep I see it after tax the investor or lender gets the same.
But the MP thinks different and maybe there is a connection with the video
" The company that uses some amount of debt financing will be more valuable than is otherwise equal counterpart that finances itself entirely with equity , this is because of the advantage of deducting the interest from the indebted companies tax liability increasing the debt laden company more profitable and and making the debt laden company more valuable, the m and m theorem is used by financial advisers to recomend how much debt a company should use to maximise its value."
end quote.

Mark Wadsworth said...

L, one step at a time. The order of being replaced by LVT is...
1. Council Tax, BR, SDLT, IHT and so on, that happens on Day One.
2. VAT (worst tax)
3. Employer's NIC (second worst tax)
4. Employee's NIC
5. Basic rate income tax
6. Corp tax and higher rate income tax (which are the least bad taxes after LVT).

Mark Wadsworth said...

Din, that MM tax theory is bollocks now and always was.

I started in tax in 1989, and had to advise clients what was 'better' for tax, put money in as loan and take interest or as shares and take dividends. Some factual situations pushed in one direction, some in the other and some were pretty marginal. It's a stupid and unnecessarily complicated distinction, but not a game changer.

I started a BA in accounting and finance in 1993 and the teacher spouted that MM stuff, I pointed out it was bollocks then and have spent the last 26 years pointing out it is bollocks but the myth continues.

I'm sure I've covered the topic before. Maybe I haven't, or maybe I should.

Mark Wadsworth said...

4. Employees NIC includes self-employed NIC of course.

mombers said...

Did the OECD actually say that corp tax was the worst? I imagine they said that in the context of avoidability, i.e. profit shifting, it's bad, but I doubt it was more than that

Mark Wadsworth said...

M, disappointingly the OECD did say exactly that.