Tory leadership: is this a job for super deduction?

UK Policy

Tory leadership: is this a job for super deduction?

Commentary
Posted on: 14th July 2022
James Browne
Head of Work, Income and Inequality Analysis

The leadership contest has sent the Conservatives zigzagging wildly on corporation tax once again. After a decade of cuts to corporate tax rates during the Cameron and May premierships, when the main rate of corporation tax fell from 28% to 19%, these reductions were partially reversed under Boris Johnson. The 2019 election manifesto promised to cancel a proposed cut to 17%, which was duly implemented in Rishi Sunak’s first budget. Chancellor Sunak then proposed to increase the rate to 25% from next April in the 2021 Budget. Having voted for this tax rise at the time, the leadership candidates have been falling over themselves to promise to cancel it with the aim of boosting investment and growth.

Focusing tax cuts on corporation tax to make the system more pro-growth is not in itself a bad idea. A study from the OECD suggests that corporate taxes are more harmful to economic growth than other tax bases. Cutting corporation tax might therefore give more bang for the buck in terms of increased growth than tax cuts elsewhere.

But this would seem to be contradicted by the evidence of the last ten years. Although economic headwinds from austerity, Brexit-related uncertainty and Covid make it hard to ascertain what would have happened if corporation tax rates hadn’t been cut, the UK’s economic performance in terms of investment and growth has been disappointing to say the least. The OBR has consistently revised its forecasts for business investment lower since 2010, suggesting that corporation tax cuts have not had the anticipated effect.

One possible reason behind this is that the UK’s investment allowances – the rate at which investment costs can be deducted against profits – are relatively ungenerous compared to other countries. As a result, despite having a relatively low headline corporate tax rate compared to other G7 and Western European countries, the effective tax rate on a marginal investment – that is, one that only just breaks even given the cost of capital – is mid-table at best. Cutting the headline corporation tax rate may have largely increased the post-tax returns to profitable investments that would have happened anyway rather than stimulating more marginal investments that corporation tax made unprofitable.

Figure: Comparing the UK’s corporate tax rates with other advanced economies

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Panel A: In 2017, the UK had a low headline corporation tax rate…

Panel B:…but the effective marginal tax rate on investment was above the average for the G7 and Western Europe

Source: CBT Tax Database

Ironically, the debate in the Conservative leadership election is currently ignoring another policy announced in Budget 2021 that has (temporarily) changed this situation. The so-called ‘super deduction’, which allows 130% of investment in plant and machinery to be immediately deducted from profits reduces the effective tax rate on marginal investments below zero, but is set to expire next April.

Maintaining full expensing of investment in plant and machinery and industrial buildings (that is, deducting all investment spending in the year it is made), as one leadership candidate has suggested, would keep the effective tax rate on marginal investments at zero at an estimated cost of £18 billion a year in 2026–27. This is not cheap by any means, but costs around the same as cancelling the tax rise due to come in next April and is likely to be more effective at boosting investment and growth.

Of course, given pressures on public services and weak economic growth following Brexit and Covid, it seems strange to be talking about tax cuts at all. The Johnson government, after all, ended up increasing taxes because of these factors despite a stated desire to lower taxes. Although some of the static cost from lowering corporate taxes could be recouped through the higher growth that results, the measure would be almost certainly not pay for itself, even in the long run.

But whether or not there is scope for overall tax cuts, the case for strategic tax reform is unanswerable. Making the corporate tax system more growth friendly should be a key part of such a strategy. Moreover, setting out a coherent strategy for corporate tax reform, as the coalition did in 2010, would not only give us better policy, but also make its effects stronger. Businesses value certainty when making investment decisions, so are likely to respond more strongly to well-thought-out policy that will remain in place for the long term. Repeated U-turns risk giving away revenue without stimulating any additional investment.

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