What We Really Don’t Like About Corporate Tax — Adam Smith Institute

Most readers of this blog know that we don’t like corporate tax very much. In various blogs, articles and reports, we have called for its abolition and replacement. We have argued that it weighs heavily on workers, discourages investment and encourages excessive accumulation of debt.

But I think it’s worth explaining why we think corporation tax is so harmful and what you should be doing about it.

Put simply, corporation tax taxes capital (goods that produce other goods, from new machinery to training and professional development) and taxing capital deters companies from investing in their workforce. labour, which reduces productivity and wages.

People invest money today to spend it later. By taxing investment, you are essentially imposing an unequal tax on consumption. You tax people who invest and wait to spend their money at a higher rate than those who spend it immediately. And it’s worse: the longer you wait to spend your money, the higher the consumption tax rate will be when you do. In fact, relatively low tax rates on investment can imply extremely high rates on consumption down the line. I wrote a blog a few months ago explaining the math behind this.

But while there are a lot of problems with corporate tax, it’s actually quite simple to fix it. Let’s think about this from a business perspective. Imagine you own a widget factory and you are deciding whether or not to invest in a new Widgetmatic 3000 widget making machine. You will only make a marginal investment if the return you get outweighs the cost of the ‘investment.

There are many things to consider. First you need to know how much the machine really costs to buy, then you need to know at what rate it will depreciate and what the interest rate is. You also need to know what tax rate you will be subject to on the investment. If the return on the investment is taxed, this will also increase the cost. For example, if the corporation tax rate is 20% and you cannot deduct the cost of the investment from your taxable income at all, this adds 25% to your cost of capital. (Think of it like sales tax: 20% off a £125 jacket nets £25, leaving the retailer with £100. In essence, sales tax raised the price from £100 to £125, a 25% increase.)

But suppose you can deduct half the value of the investment from your taxable income. This would reduce the cost of capital to 12.5%. The larger the deduction, the smaller the effect of the overall tax rate on the cost of capital. If it is a full deduction, the tax rate is irrelevant. If you want more mathematical proof, check out Alan Cole’s Tax Foundation report on this.

Currently, businesses can gradually deduct the cost of an investment from their tax bill over the years as it depreciates. But unlike normal business costs like buying pens and papers, buying a new widget machine wouldn’t necessarily deduct the full year of its purchase.

Therein lies the problem – things are worth more now than they are worth tomorrow. It’s simply better to have £50 today than £10 every year for five years. This is because you can put that £50 in the bank and earn interest. You also have to deal with the value of that £50 being eroded by inflation.

If you let people deduct the full cost of an investment like any other business cost, the tax rate doesn’t matter. Corporation tax would become what we call a cash flow tax, a much easier way to generate income. This would effectively tax consumption and profits above the normal rate of return (what economists call rents).

Instead of complicated corporate rates where businesses must hire accountants to manage a range of investment allocations and depreciation schedules, a business would only be taxed on its annual revenue minus its investments and normal business costs.

Moving to such a system would be rocket fuel for investment, boosting GDP and wages. When Estonia replaced its corporate income tax with a cash flow tax levied on shareholders, it attracted significantly more investment than neighboring countries. It’s the idea at the heart of many free-market plans to abolish corporation tax, with Diego Zualaga’s single income tax plans of the IEA and TPA featuring taxes on Estonian style dividends.

Many economists have argued in favor of increasing and accelerating capital cost allowances, but this has been difficult to prove empirically because we generally cannot isolate the effect on investment from other larger macroeconomic changes. . However, a new paper from the Oxford Center for Business Taxation backs up the intuition that it’s the deductibility of an investment that really matters with proper empirical evidence.

On the recommendation of the EU in 2004, the Labor government changed the definition of SMEs, allowing many more businesses to qualify for First Year Allowance (FYA). FYAs allow you to immediately deduct the full cost of an investment up to a certain amount (rather than deducting it as it depreciates). Devereux and his colleagues compared companies that now qualify for these deductions with companies that never qualified throughout the process. They found that investment rates increased by 11% compared to non-eligible companies.

In recent years, the government has focused on reducing the corporate tax rate. This is generally a good thing: corporate tax as it stands deters investment and a lower rate will deter it less. But as the Tax Foundation’s Kyle Pomerleau points out, there was a big problem. As they reduced the headline rate, they also extended the amortization schedules. Think back to the widget example, they may have the main rate, but they also reduced the deduction to offset the income.