A mystery solved

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Gordon Brown should be criticised if he does not propose a root and branch reform of corporation tax within the life of this parliament.

The only thing on which everyone agreed after Gordon Brown’s first Budget was that corporation tax was very complicated. It is certainly sufficiently complicated that you cannot produce a definitive reform in six weeks. But it is not that complicated, so here is an attempt to explain the relevant principles.

Begin by noticing that there is no such thing as a tax on corporations. All the tax bills that corporations foot – whether for VAT, national insurance or corporation tax – are ultimately paid by individuals; the individuals who own shares in corporations, or consume products made by corporations, or who work for corporations, or who derive pensions from corporations. But sometimes it is difficult to work out who these individuals are.

Much of the difficulty surrounds advance corporation tax. And there the mystery falls away once it is understood that advance corporation tax is not corporation tax at all. It is income tax. Every penny that was paid in advance corporation tax between its introduction in 1973 and its reform in 1993 would have been paid at exactly the same time, in exactly the same amount, and in exactly the same way, if corporation tax had been completely abolished. Advance corporation tax is simply the withholding of income tax on shareholders’ dividends. It is precisely analogous to the deduction of income tax at source on rents and interest, and the retention of tax on earnings under PAYE.

It was called advance corporation tax for technical reasons now lost in the mists of time. But this semantic issue created much subsequent confusion. The changes to advance corporation tax, made first in 1993 and now again in 1997, had consequences for the structure of both income tax and corporation tax which are difficult to unpick and which would probably not be adopted if their consequences were more transparent.

So what are the purposes of corporation tax? To raise money, of course; but to do so in a way which, taken together with all the other taxes people pay, does the minimum of economic damage. So one objective of the structure of corporation tax and income tax is that people should pay tax on the returns from company securities in much the same way they would pay if they deposited in banks or invested in property; otherwise you will see tax avoidance and investment which is motivated by tax advantages rather than underlying profitability. The Budget takes us away from this objective, not towards it.

Now many firms earn returns which are substantially higher than is needed to persuade people to invest in the activities concerned. Sometimes this is because they have monopolies – utilities or lotteries; sometimes because they have access to scarce resources – oil reserves or radio spectrum or valuable copyrights or patents; and sometimes simply because these companies are very good at what they do – Rolls Royce or Marks & Spencer. Taxing these returns – which economists call rents – is attractive to Chancellors who can raise large revenues from them at little cost. You can collect a lot of money from these activities before any of them will close down.

A good structure is one whose inherent effect is to tax these rents more heavily than the returns on capital. Otherwise the consequence is, as was often true in the past, that the general rate is too high for many companies easily to bear; or, as today, that the rate is too low to yield the revenue that the government might hope to obtain from companies that are doing well. The unsatisfactory alternative is ad hoc taxes – windfall taxes on utilities, levies and franchise fees for broadcasters, the morass of interacting taxes that apply to North Sea oil and gas. The spirit of ‘grab the money where you can find it’ – the central strategy of the Budget’s raid on utilities and pension funds – is not a defensible or sustainable long-term basis for tax policy.

And then you can levy a modest charge for the privilege of trading through a company which is incorporated in the UK. Not too much, or else people will stop incorporating or locate their headquarters somewhere else. But Britain is a nice place to do business, and many managers have their children at schools here.

When companies retain profits rather than distribute them, you want to make sure the tax that is paid later is related to the tax that would otherwise have been paid sooner. Otherwise the consequence again is avoidance and revenue loss. Worse, it defeats your investment objective. That is, or should be, to ensure that company tax does not discourage investment but equally does not induce people to undertake projects which would not make commercial sense otherwise. It is not easy to achieve that objective. The Budget neither greatly hinders or greatly helps.

But the most serious weakness of corporation tax is that it is ill-suited for dealing with companies which operate multinationally. The world of international corporate taxation is like the fantasies of Tolkien, or the rites of an obscure religion. Its practitioners communicate only with each other and in language that means nothing to anyone else. They use terms like ‘thin capitalisation’ and ‘the arm’s length principle’, which have no firm intellectual foundation but have no connection with economic or business realities either.

We are not well served as a result. Reliable information is almost unobtainable. But most observers would agree that if we look at the outcome from a national perspective, British companies pay far more tax to foreign governments than foreign companies pay to us. And a citizen of the world would note that companies that operate in many countries pay less tax, and often much less tax, than the same firms would if all their affairs took place within a single jurisdiction. A good measure of the problem is the howls of anguish which arose when California attempted to tax British companies on that fraction of their world-wide income which corresponded to the fraction of their world-wide activities that took place in California. It created the greatest furore in Anglo-American relations since the British burned down the White House in 1814.

And then there is the current row over foreign income dividends. Large and profitable British companies are arguing that to pay any tax at all to the British government is too much, and that they would pay less if they were domiciled elsewhere or acquired by another firm. The astonishing fact is that they are probably right. And as the government capitulates to their demands, it ought to question the rationale of a system that brings these results about. No one should criticise Gordon Brown for not proposing a root and branch reform to corporation tax after two months. But he should be criticised if he does not propose such a root and branch reform within five years.

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