Economics and similar, for the sleep-deprived

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Update: seemingly not

Update: Oh yeah!


Monday, March 19, 2007

 
When is a tax cut not a tax cut?

When it's funded by changes in the capital allowances, is the answer. The front cover of the FT[1] is basically a great big sloppy kiss on the cheek of George Osborne for proposing a 3% reduction in the headline rate of corporation tax. The FT has really got ahead of itself on this one – if you have a paper copy, take a look at p3 for a wonderful example of the genre"charts that provide graphic refutation of most of the important claims in the article" as they demonstrate clearly that the UK is a low tax jurisdiction – and they keep on talking about "reducing the tax burden on British business" when Osborne himself keeps on pointing out that he's proposing no such thing.

The key idea here is (and it is amazing how many people, including lots of economists, get confused about this) that when you're discussing a corporation tax system, the headline rate is very much the tip of the iceberg. You also need to be aware of:
  • the dates of payment – UK corporation tax is paid substantially in arrears, which makes a difference of a fair couple of per cent to the effective cash tax rate.
  • the generosity of the group relief and tax loss carry-forward arrangements, which are pretty generous in the UK by world standards
  • the capital allowances regime (more about this below)
  • the tax treaties in force which determine the overall tax rate on overseas income earned.
  • other taxes falling outside the corporation tax remit, like employers' NI, North Sea oil taxes, etc
  • the deductibility of various types of interest cost, the dividend taxation regime etc
  • and these are just the big ones


How do you boil these down into a single number representing "the tax burden on business"? Well, as far as I'm aware, the answer of most reputable economists and tax experts is "you don't". The Institute for Fiscal Studies[2] will from time to time, usually after budgets, express an opinion on the overall direction of the UK tax system and how it stacks up relative to other countries, but anyone compiling a great big league table is almost certainly doing something that they shouldn't. The EEF numbers in the FT article look really, really, semi-attached to me.

The point here is that the UK is a low corporation tax jurisdiction. It's the lowest-tax country in the G7, and substantially lower tax than the USA (which, oddly enough, doesn't seem to have anything like as much of a domestic cottage industry in pretending that it's a high-corporation-tax country, even though it is). The "competitiveness" of our tax system is just fine, if you assume that we are competing with the USA, Germany and Japan rather than with Austria or Portugal, which I think is a reasonable assumption. This is presumably why, as I reiterate, George Osborne has no plans to change the corporation tax burden.

So what's his proposal? Basically, to lower the headline rate of corporation tax by 3%, which will cost about £4.5bn. Of this, £1.2bn will come[3] from scrapping the British films tax credit (which is a good idea – it's simply a loophole) and the research & development tax credit (rather more controversial I would have thought; there's a number of principled reasons why one might want to subsidise R&D given that it's an activity which might at least in principle provide benefits which are not fully captured by the company carrying it out).

But the rest of it apparently comes from "the capital allowances system". Hmm.

Jargonbusting! "Capital allowances" means "depreciation, for tax purposes". Basically, if you own stuff, then you deduct a proportion of its value every year from your taxable profits, to reflect the eventual cost of replacing it when it wears out. It is one of the most complicated things in the tax code. This is partly because of all the "rent seeking, political lobbying, accountants and lawyers! how evil! flat tax!" hooha that economists love to bore you with. But it is mainly, IMO, because depreciation is a bloody complicated business, precisely because it involves the change in the value of a capital asset, and "the value of a capital asset", as readers of this blog (and more so, Robert Vienneau's) will know, is not a well-defined quantity, since it is dependent on the rate of profit, in an utterly circular fashion.

So anyway, while true economic depreciation is definitely difficult and possibly impossible to calculate, capital allowances are much simpler, because they are rigorously defined by the Revenue as "what we say they are". They put up a big old schedule of the kinds of capital allowances you can claim against all sorts of different capital asset. These tend to bear at least a family resemblance to our best guesses at the true depreciation rates, but there is a whole lot of arbitrariness in there too. It's seriously big business – the entire leasing industry is based on capital allowances, more or less.[4] So there's plenty of money available in the capital relief regime for Osborne to find a spare £3.3bn.

The question is, should he? Osborne claims in the FT that his intention is to "simplify the tax code" - he even claims that he thinks that people who lose their capital allowances will benefit overall from a simpler tax code, which surely can't be literally true - and that this is his main reason for putting forward these proposals.

In general, you will usually find a lot of economists in favour of this sort of tax reform; reducing the marginal rate and broadening the base of taxable income. The idea is that any tax creates a deadweight efficiency loss, because it drives a wedge between the actual rate of return on some activity and the rate earned by the person carrying it out, so the lower the marginal rate, the smaller the wedge and the less the deadweight loss. Broadening the tax base allows you to reduce the marginal rate on a revenue neutral basis, and reduces the distortions caused when people do things because of differential tax treatments between different kinds of income, rather than for the underlying efficiency. This is why economists tend not to like targeted "tax breaks", or implicit subsidies to things like British films through the tax system.

But on the other hand, capital allowances in general aren't really a subsidy to anything; they are the tax system's way of recognising that depreciation is, although non-cash and difficult to define, a real cost of doing business. If you're doing deliveries in a van and clearing £100 a week net of fuel and overhead, then you don't have £100 a week to spend, because if you don't put aside some money to buy a new van then your business is going to disappear when your van breaks down. If you are paying 30% corporation tax and not getting capital allowances, then your effective tax rate is higher than someone else who is making £100 a week profit from a business that doesn't involve the ownership of depreciating assets. A reduction in capital assets is an increase in the tax rate on physical capital; although this looks like a "low marginal rate, broad base" tax proposal, this is not intrinsically the case.

It seems really weird to me that the Osborne policy appears to be against capital taxes when they take the form of taxing the rate of return on financial capital but in favour of increasing them on physical capital. It also strikes me as very weird indeed that the EEF, the manufacturing industry employers' association, seems to be in favour of this move, as my guess would be that manufacturers are heavier users of capital allowances than the average UK corporation (and that they benefit from much more of the especially generous capital allowances on some kinds of high-tech equipment that Osborne might be looking at eliminating).

It also doesn't make a lot of sense that this is being sold as a measure against tax competition and to protect Britain against the (alleged) trend toward domestic companies moving overseas. If you're seriously in the tax avoidance business, three percentage points isn't going to make a bunch of difference – it certainly doesn't close much of the gap between us and Ireland for example[5]. On the other hand, if you're in a business with lots of capital allowances, it is quite likely to be the case that capital allowances are utterly dominant in your tax planning. The Osborne plan seems almost purpose-built to drive companies offshore, in that it the way it is structured is likely to create dispersed small benefits and concentrated large costs.

Finally, although I hate to get all Brad DeLong and "why oh why can't we have a better press corps" about this, surely to hell the FT ought to be the one newspaper on the stand which doesn't get confused about marginal rates of corporation tax? The article is a miasma of apples-to-onions comparisons, tendentious charts and semi-detached statistics. One might almost think that they'd got so carried away with Cameronmania that they'd lost all critical faculties.


[1] Although this article was a great big steamer, the rest of the paper isn't bad. Oddly enough, when I'm working, I can't hate the FT enough for its numerous inaccuracies on subjects close to my heart, and particularly for the utterly unacceptable omissions in the index on the front of the Companies & Markets section. When I'm off work and have time to leaf through the articles, it's really quite a good newspaper after all, particularly on international news. They publish about 50% too many ill-informed and breathless articles about the property market (I see that "sub prime lending" is the beast of today), but if we were hanging people for that there would basically be no newspapers left in the UK.
[2] Just in passing, the IFS really is a fantastic thinktank.
[3] These figures came from the last Tory tax policy commission, which recommended a 5% cut. Osborne hasn't actually specifically said that films and R&D are for the chop but I bet they are.
[4] do what? Easy example: say you are Easyjet and you have just bought a jet plane for GBP100m. The revenue will allow you capital allowances at 20% (I have not checked this), so you can deduct £20m from your taxable profit this year. But you don't actually make £20m of profit, so you're not going to get the full benefit of that tax deduction – the best you can hope for is to claim it at some point in the future, but this would mean that you're losing the interest on your money. So what you do is that you don't buy the jet – you get someone who makes huge pretax profits (like a big bank), and can therefore make full use of the capital allowances to buy it and then lease it to you. So they get the deduction, and they kick back some of the benefit to you in the form of cheaper financing than you could otherwise get. I don't think Easyjet actually does lease its planes but if it did, this would be why. Note that this isn't really a "dodge" in the pejorative sense – the point of the capital allowances regime is to give some benefit to purchasers of capital assets, and this is exactly what Easyjet has got in my example. It would be perverse if the capital allowance subsidy was restricted only to profitable companies. Naturally you can take a good thing too far, and some leasing-based schemes do stray well into tax avoidance territory, but vanilla leasing is not something that any sensible tax collector would object to.
[5] Although unless I am wrong, it would close the gap between the corporation tax rates of the UK and Hong Kong, which might be significant as HSBC is certainly one of the companies that has occasionally toyed in public with the idea of moving its head office over there.
17 comments this item posted by the management 3/19/2007 06:29:00 AM


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