13 August 2019

Full expensing: the small change that could reap big economic rewards

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Even as the United Kingdom hurtles inexorably closer towards October 31 – the legal default date for exiting the European Union with no deal – official data continues to confound the received wisdom of most economic commentators.

Just yesterday, figures from the Office for National Statistics showed wages rising at their fastest level in more than a decade, while the number of people in work has never been higher. Though national output might have contracted by 0.2% in the last quarter, the UK economy remains remarkably healthy.

These encouraging data have not occurred by chance. Credit must be given to the careful stewardship of the British economy since the 2008 financial crash, whereby successive governments have pared back the state, and cut the headline rate of corporation tax. Indeed, next spring, it will stand at a much more manageable 17%, down from the 28% which the then Chancellor, George Osborne, inherited in 2010.

Doubtless, the reduction of the corporate tax burden has been a welcome reprieve for hard pressed firms and small traders who just want to get on with producing more stuff and hiring more people. It should also be noted that the cuts to corporation tax actually went hand in hand with increasing government revenues – up from around £36.6 billion in 2009-10, to £56.2 billion in 2017-18. Once again, the scaremongering peddled by left-wing commentators of the time has been proved false.

That said, some of the positive effects of the cuts to corporation tax were blunted by changes to the tax code which allow businesses to write off the cost of capital expenditure – known as ‘cost recovery’. According to the Tax Foundation’s International Tax Competitiveness Index (which evaluates the merits of OECD countries’ tax systems), the UK ranks second to last in terms of cost recovery – and the aforementioned changes have certainly not helped in this regard.

In a nutshell, cost recovery refers to the extent to which businesses can subtract capital investments against income for corporation tax purposes. Typically, corporate tax systems let firms deduct day to day expenses – like labour and materials – right away. However, the cost of longer-term investments – such as those in machinery and industrial premises – can only be deducted in a piecemeal manner, over a set period of time. The rationale behind this is that because capital investments generate income for a firm over many years, they should be accounted for that way within the tax system.

But this creates a problem for businesses, because the more a tax deduction for capital investment is spread out, the less valuable it becomes to a firm. This is not only because of inflationary effects, but also due to what economists would call the time value of money – the intuitive idea that it is almost always better to have resources which can be made use of now, rather than at some point in the distant future.

This unequal treatment embeds a structural distortion within the corporation tax system that reduces the return to capital, discourages businesses from investing, and ultimately inhibits the expansion of the productive capacity of the economy. Thankfully, however, a solution is at hand to iron out this peculiarity.

‘Full expensing’ allows firms to immediately and entirely deduct the cost of any investment they undertake from their corporation tax bill. The evidence from places where it has been adopted illustrates just how much of a difference it can make.

A 2017 study, from Eric Ohrn, found that in parts of America, full expensing has increased investment by 17.5%, and has increased wages by 2.5%. Employment also rose, by 7.7% after five years, as did production, by 10.5%. If the same results were replicated in the UK, the average worker could stand to earn a staggering additional £700 a year.

Another academic study, this time from the UK itself, found that access to more generous capital allowances for small and medium sized enterprises which were offered prior to fiscal year 2008/09 increased the investment rate by 11%. While this was not full expensing per se, it nonetheless tended in the principle of allowing full deductions.

The benefits do not stop there, however. There is good reason to think that full expensing could help the government to make good on its desire to spread the prosperity enjoyed in affluent parts of the country – namely, London and the South East. In Boris Johnson’s first speech as Prime Minister, he effervesced for the need to “level up across Britain with higher wages […] and higher productivity”. Full expensing could just be the way to do that, and in more ways than one.

While lots of companies, wherever they are based, would likely reap the rewards of full expensing, the advantages of the policy are naturally going to accrue to those firms which invest – or would like to invest more – in capital goods. Think here of the manufacturing sector – reliant on big plants and machine equipment – which plays a more central role in the regional economies of places like the West Midlands and the north than it does in service-dominated London and the South East.

Full expensing would tip the business case more in favour of investing in those types of capital goods, allowing manufacturing firms expand their businesses, become more competitive, and recruit more local people. Coupled with other promising initiatives, such as establishing free ports – which the Centre for Policy Studies has long advocated for – Johnson’s rhetoric on levelling up economic opportunity across the whole of the UK appears to be matched by substantive and serious action.

Scarce few policies can point to the potential dividends which this minor tax tweak promises. If Johnson truly wants to unleash the economy of places outside the capital, he need look no further than full expensing.

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Eamonn Ives is a researcher at the Centre for Policy Studies