Cutting corporation tax doesn’t work — but beware raising it now
When The Sunday Times and others reported at the weekend that the Treasury was examining tax-raising options before the autumn budget, mainly involving business and the better-off, there was a range of responses. Some saw it as a signal by Rishi Sunak, the chancellor, to show that he was serious about fixing the public finances. Others detected a carefully choreographed routine, in which the Treasury machine is champing at the bit to raise taxes but the prime minister can earn brownie points by rejecting its proposals. Most economists reacted with horror at the idea of big tax increases at this time.
For one observer, George Osborne, one of the suggested tax rises, an increase in the main rate of corporation tax from 19 per cent to 24 per cent, struck a nerve. Cutting the tax was one of his signature policies and no politician likes to see their legacy end in the dustbin.
In a tweet, he railed against The Sunday Times for describing his corporate tax cuts as a “fetish” that had not boosted investment, pointed out that the paper had backed his policy and claimed that it had made the UK “the No 1 destination for investment in the G20”. He was supported by David Gauke, the former justice secretary and Treasury minister, and Sajid Javid, the former chancellor. The Tory government, I should say, is seriously diminished without these three.
He was right to claim backing for his policy, And, after the Brexit referendum, this newspaper and its Sunday sister called for a cut in the corporation tax rate to 10 per cent. But this government abandoned a planned cut to 17 per cent (from 19 per cent) and its agenda is more Stockton-on-Tees than Singapore-on-Thames.
He was wrong, however, to suggest that cutting corporation tax had a transformative impact on investment. You would think that it should — surely a cut in taxes increases the incentives to investment — but it does not.
The closely followed EY attractiveness survey shows that within Europe, Germany was the favoured destination for new foreign direct investment projects over the period 2012 to 2018, beating the UK. Britain, to be fair, was the favoured European destination for investment in new and existing FDI projects during the period, but this was a position it held, according to EY, from 1997 to 2018. It is hard to argue that this was the result of low corporation tax rates. For much of this period, under New Labour, the main rate of corporation tax was 30 per cent or more.
“When we have probed investors for what drives their decisions, quality of infrastructure and skills were the top two criteria identified in every year,” Mark Gregory, EY’s chief economist, said. “Specific initiatives to boost innovation, education and training, incentives for R&D and support for SMEs are the priorities. For foreign investors, their ability to move tax liabilities [between different jurisdictions] means low corporation tax is of limited benefit.”
On the world stage, the UK’s low corporation tax rate certainly appears to have been of limited benefit. Every year the United Nations Conference on Trade and Development produces its World Investment Report. It has a broad definition of foreign direct investment. Over time it shows a consistent picture for the 2010s. At the top of its league table for FDI inflows is usually America. Sometimes China is there and Hong Kong, often a conduit for investment in China, is highly placed. The UK reached the giddy heights of second place in 2016, as a result of a large foreign acquisition of a British company. More typically it has been around eighth, as in 2012, 2018 and 2019, or lower. In 2017 it was not in the top 20.
Neither does cutting the corporation tax rate do much for domestic investment. Britain has underinvested for years. The recovery in business investment after the financial crisis was unremarkable, until it was snuffed out by the 2016 referendum.
The evidence on this is even clearer in America. In 2017 President Trump cut the corporation tax rate from 35 per cent to 21 per cent. He lit the blue touch paper and waited for investment to explode. It didn’t. A study by the International Monetary Fund by Emanuel Kopp, Daniel Leigh and Suchanan Tambunlertchai found that any increase in investment was thanks to stronger demand, not the corporate tax cut. One reason was that big American corporations already had market power and did not need to invest further to increase it. As the authors put it: “The rise in corporate market power in recent decades appears to have muted the effectiveness of corporate tax cuts as a means of boosting business investment.”
Filippo Occhino of the Federal Reserve Bank of Cleveland, suggested that the effects of the 2017 tax reform on investment were small, a mere 0.2 per cent, and that over the medium term cutting corporation tax may even reduce business investment. “Contrary to the expectation of some observers, the permanent cut in the corporate tax rate may have held investment down rather than stimulated it,” he wrote in a study.
The reasons are complex — to do with limits on interest deductibility and the scheduled amortisation of R&D spending — but confirm that the assumption that cutting corporate tax rates will boost investment does not work. Does this justify reversing the Osborne corporate tax cuts? A rise from 19 per cent to 24 per cent, almost the 26 per cent that Jeremy Corbyn proposed last December, would raise £17 billion annually after a couple of years. But economists are right to say that timing is everything. The chancellor may want to lay down a marker this autumn for future fiscal consolidation and repairing the public finances — that is entirely right — but whacking business immediately with a tax rise when it is emerging groggily from the deepest recession in living memory would make little sense and would do more harm than good.
David Smith is Economics Editor of The Sunday Times david.smith@sunday-times.co.uk
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