Why cut business taxes?

26 January 2011

Graph and penDespite planning the harshest cuts to public spending in living memory, the coalition government has announced a reduction in the tax rate on corporate profit from 28 per cent to 24 per cent. The reduction will be phased in over several years, but by the end of this parliament, the tax cut will cost nearly £3 billion a year.

Why has the government not resisted the urge to show such support to business? Indeed, why did it not aim to generate much-needed tax revenue by instead raising the tax rate on profit? Professor Michael Devereux, director of the Oxford University Centre for Business Taxation, has been exploring these questions.

He first puts the reduction in context. In 1995, Britain’s tax rate on corporate profit was 33 per cent, which was then the tenth lowest rate of the 27 countries that now form the European Union. By 2009, despite having already lowered the rate to 28 per cent, Britain’s ranking had slipped to 20th.

This happened because Britain was overtaken in a race to reduce taxes on profit. Multinational companies locate their activities in the most favourable environment, which depends on many factors, including wages, regulation - and taxes. By lowering taxes, countries make themselves more attractive to inward investment. Evidence suggests both that location decisions depend on taxes, and that countries compete for such investment.

This sounds like bad news. To attract or keep investment in Britain, the government is being forced gradually to reduce the taxes that it could otherwise levy on businesses located here. Other governments are doing the same. Overall, businesses are profiting from lower taxes at the expense of everyone else, which does not seem fair.

Professor Devereux says that there is some truth in this view, but we need to be more careful in thinking about taxes on business. Most people would agree that businesses should pay their 'fair share' of tax. But what does that really mean?

A business is, in the end, just a collection of people: shareholders, creditors, directors, employees, customers and suppliers. Any tax on the profit earned by a business must ultimately be borne by these people. Judging whether a tax on 'business' is fair requires looking through the legal entity that is the business to ask which individuals are worse off as a result of the tax.

It may seem that the answer is the shareholders: after all, they receive the profit, and if profit is reduced by taxation, then they must receive a lower amount. This would be true if the profit level were fixed, but it is not.

Economic theory has a counter-intuitive explanation of the effects of tax on profit. According to this view, the required after-tax rate of return that a business must earn is fixed on the world market. This is because investors - such as fund managers who look after people’s savings and pensions - can invest in a huge number of assets.

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