Sunday, April 15, 2007
Tax incentives can transform the UK
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Now the dust has settled on Gordon Brown’s budget of a month ago, things are pretty clear on the nature of the tax-and-spend debate for the next few years.

The chancellor and his team, while taking a battering after accusations of political chicanery, think they have proved that the only way you can generate tax cuts these days is by raising taxes elsewhere.

Thus, the flashy 2p cut in the basic rate of income tax had to be paid for by abolishing the 10% starting rate of tax, and the 2p cut in the main rate of corporation tax was financed by slashing capital allowances. The political message was clear; even with a tight spending round in prospect there is no money left over for tax cuts and “simplification” — rearranging the deckchairs — is the best that can be done.

The Tories, unsurprisingly, took a different message from it. By announcing public-spending increases below the economy’s rate of growth, Brown implicitly accepted their policy of “sharing the proceeds of growth”, they claim.

Not only that, but by going to so much trouble so he could whip out a 2p income-tax reduction, the chancellor showed tax cuts still have enormous political potency.

There you are, two sets of spin — take your choice. But I would rather leave both the main parties to what is essentially a sterile debate over tax and spend. It is sterile because it is “static” — changes in taxation are not reckoned to have any behavioural or “dynamic” effects on the economy.

This is an important issue, which is being pushed hard by campaigning groups such as the Taxpayers’ Alliance. In America, the US Treasury has recently created a new Division of Dynamic Analysis, intended to provide a technical assessment of the dynamic consequences of tax changes.

What this means is that a tax increase that appears on the face of it to be a revenue-raising measure could have the opposite effect over the medium and long term if the impact of the higher tax is to dampen incentives and reduce the level of economic activity.

In the opposite situation, where a tax cut looks initially to be rather expensive — particularly when the budgetary situation is tight — may more than pay for itself in the medium to long term if it sharpens incentives and boosts activity.

Precise cause and effect is hard to prove, but consider Britain’s higher rate of income tax. In 1978-9 the higher rates of tax on earned income ran from 40% to 83% and there were 674,000 higher-rate taxpayers. In those days the top 1% of taxpayers contributed 11% of income-tax revenues and the top 10% were responsible for 35%.

Last year, 2006-7, with a top rate of income tax of 40% (in place since 1988), 3.29m people paid it, and the top 1% of taxpayers coughed up 21% of revenues; the top 10% 52%. It is hard to argue that cutting the higher rates of tax reduced revenues over the long term. The evidence, taking into account dynamic effects, points strongly in favour of a large net revenue boost.

Now the Taxpayers’ Alliance has tried to take the argument further by commissioning a consultancy, the Centre for Economics and Business Research (CEBR), to incorporate dynamic effects into its model of the UK economy and assess the results. As a test, it steered clear of income tax and instead concentrated on the impact of changes in corporation tax.

There is a body of evidence suggesting that changes in corporation-tax rates can have a powerful impact on investment by attracting internationally “footloose” capital — companies that could set up and expand anywhere but choose to do so where the tax regime is most favourable.

The CEBR tested this by first assessing the impact of Brown’s budget, and it found that the biggest impact was the cut in the main rate of corporation tax from 30% to 28%. This had the effect of boosting private investment, initially by a small amount but eventually by more than 1%. It also had the effect of boosting Treasury revenues from business taxes, reducing government borrowing. The long-term effects, indeed, suggest a £3 billion to £4 billion annual fall in public borrowing. For a modest budget, that is quite a big impact.

The CEBR then tried a more dramatic simulation. What if the government preannounced a phased reduction in corporation tax to the Irish level of 12.5%? Ireland’s low rate has proved to be a magnet for inward investment.

In the simulation, the CEBR assumed a cut in UK corporation tax to the Irish level by 2016, achieved in steps of two percentage points annually. The fact that it is preannounced is important — if companies anticipate changes they will amend their behaviour.

The effects were dramatic. After a slow start, the level of investment in Britain is boosted by more than 60% after 15 years, correcting the problem of UK underinvestment at a stroke. Gross domestic product eventually ends up 9% higher (£120 billion in today’s numbers) than would otherwise be the case.

The interesting thing about this simulation is that there is no downside. The additional investment means extra capacity, so faster growth does not add to inflationary pressures; the inflation impact is negligible. Meanwhile, the public finances benefit enormously, because of the boost to activity, with public borrowing £20 billion to £30 billion lower than in the absence of the tax cut.

“We commissioned this dynamic model because it is essential to make and win the argument that reducing taxes is not an optional extra to sensible economic management, but key to it,” said Corin Taylor, head of research at the Taxpayers’ Alliance. “The results show that substantial, phased business tax reductions are noninflationary, pay for themselves over time, and deliver large benefits to GDP, employment, investment and family incomes.

“We hope that the Treasury and opposition parties can build on our work and make dynamic analysis part of their economic thinking. Reductions in taxes do not have to mean equivalent reductions in spending on public services.”

Is it all too good to be true? Perhaps. But that is for the Treasury to test. And the only way to do that is for officials to conduct their own dynamic analysis of the consequences of tax changes.

It would certainly be a big improvement on the sterile and static debate we normally have on these matters.

PS: Two weeks ago, I started my piece on the return of firms’ pricing power with an observation on sheds, and one manufacturer’s imminent increase in list prices. Little did I realise what a Pandora’s box I was opening. The e-mails have been flooding in from shed folk up and down the land.

It appears that men, and it does appear to be mainly men, widely use their sheds as refuges from their wives and the rest of the family. In these days of smoking bans, which now appear to extend to many homes, sheds have become the place to retire to for a cigarette break, or to settle down for a longer session with a pipe and a tin of ready-rubbed.

I have been given a guide on how best to assemble a shed — it apparently involves a group of friends and copious quantities of Stella Artois — as well as a copy of The Shed, the magazine “for people who work in sheds and shedlike atmospheres”.

Included in the latest edition of The Shed are features on sheds as installation artworks, “crossover” sheds and the advisability of having a barbecue in your shed. There is also mention of a book, Barkitecture, of shed designs for faithful hounds (we used to call them kennels).

Anyway, all this shed talk brings me to yet another stealth tax from Gordon Brown. If I get rid of the old shed, I’ll have to hire a skip. Thanks to yet another increase in landfill tax in the budget, hiring a decent-sized skip will soon cost more than £100.

My skip index, which has been looking pretty healthy recently, may not survive such a price increase. The search goes on for a reliable alternative economic indicator.

From The Sunday Times, April 15 2007

Comments

David

I find the whole corporation tax issue very interesting. We have been fighting to have this looked at for a long time in Northern Ireland, in particular because of what the Republic of Ireland is doing just across the border.

We know we are fighting a losing battle with Brown to reduce it to 10% or less purely for here, but our concern is that we can't kickstart the public sector dominated economy without some focus on fiscal incentives to bring in FDI organisations. I would be interested in your views on the economic challenges for the regions, in particular Northern Ireland.

Regards.

Ian

Posted by: Ian Savage at April 16, 2007 03:43 PM

Dear David,
I would imagine that research conducted by the CEBR does not condition on the business cycle state of the economy. If the tax cut takes place when the economy grows above its trend level, the benefits could be different (perhaps higher??) than in the case where the economy is under-performing. This is important in the current context where (based on Bank of England estimates) the economy is expected to grow by some 2.8%-3% per annum for the next 2 years, which is higher than the (historical?) 2.5% trend level.
Best regards,

Costas Milas
Keele University

Posted by: Costas Milas at April 16, 2007 03:45 PM
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