25 March 2022

To incentivise investment, Sunak must make tax less taxing

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In the wake of the Spring Statement, much ink has been spilled debating whether or not Rishi Sunak is the tax-cutting Chancellor he claims to be. But far less attention has focused on the equally important question of tax reform.

To the Chancellor’s credit, he has already pushed through a radical simplification of alcohol duties. A solid start, albeit on relatively low hanging fruit.

At the Spring Statement, he signalled his next priority for tax reform: tackling productivity by raising Britain’s sluggish levels of business investment.

He set out his thinking at the recent Mais lecture, ‘despite the UK’s highly competitive headline corporation tax rates, the overall tax treatment provided for capital investment is much less generous than the OECD average’. In fact, the Chancellor was sceptical that Osborne and Hammond had the right strategy on Corporation Tax altogether. As he put it, ‘It is unclear that cutting the headline corporation tax rate did lead to a step change in business investment; we need our future tax policy to be targeted and strategic’.

That’s why when he hiked Corporation Tax in 2021, he also announced an investment super-deduction. It echoed calls from a range of think tanks such as the Adam Smith Institute, Onward, and the Centre for Policy Studies to allow businesses to deduct capital costs from their tax bill upfront and in full, just as they can with any other kind of costs – so-called ‘full expensing’.

Our tax system is more complicated and less efficient than it needs to be, in part, because it is easy for Chancellors to put off reform and instead focus on the issue of the day. But either by accident or design, Sunak has no choice but to act at the next Budget.

If he does nothing then next April, when the Corporate Tax rate hits 25%, the super-deduction expires, and the Annual Investment Allowance drops to just £200,000, the UK will have one of the most investment punishing tax codes out there. In fact, Oxford tax academic Michael Devereux estimates the impact will be enough to depress investment by as much as 20% relative to the pre-2021 position.

The temporary nature of the super-deduction may be something of a political masterstroke as a result. Until recently, full expensing was a niche interest for policy wonks who specialised in tax. But now, groups such as the CBI and British Chambers of Commerce are lobbying the Chancellor hard for it to be made permanent.

In the Spring Statement documents, the Chancellor set out the options. Alongside full expensing, he also floated raising the Annual Investment Allowance, increasing the rate at which businesses can write down capital assets, and granting an additional first year allowance that will allow businesses to deduct more than the full cost of an investment.

The Chancellor has hinted that he’s attracted to the idea of full expensing, but is somewhat daunted by the cost. He needn’t be. In a recently released paper for the think tank Bright Blue, I explain how to do full expensing without blowing up the deficit. The answer is not to be timid on reform, but to be more radical.

He should aim to reduce the marginal effective tax rate on new investment to zero for all types of investment. But, if he were to introduce full expensing on its own, he would end up subsidising debt-financed investments, as interest payments to lenders are also tax deductible. This, by the way, is a bigger problem the higher corporate tax rates are. One solution, historically popular among tax economists, would be to cut interest out of the tax system altogether. Not only would this remove a pernicious bias that makes financial crises and bank bailouts more likely, it’d also offset a big chunk of the costs of full expensing.

It is also time for a long overdue review of targeted tax reliefs. As Britain’s arguably most successful Chancellor William Gladstone first observed, ‘in every case exemption means a relief to A at the charge of B’. When Chancellor’s try to play favourites and promote one activity over another, taxes end up higher than they otherwise would be. In my paper, I set out a few that should be in the Chancellor’s crosshairs. Top of the list is the £1.8bn Patent Box, which inexplicably offers a lower tax rate for corporate profits from patentable innovations. The economic logic for this relief, beyond aggressive tax competition, is rather lacking. Patents themselves should be incentive enough. It is the ideas that are hard or impossible to patent which require relief. Similarly, targeted tax reliefs for Film and High End TV are hard to justify. A number of papers suggest their impact on production is limited at best. And is subsidising the next Marvel movie really a policy priority?

The Employment Allowance, which he expanded to £5,000 at the Spring Statement, should be in the crosshairs too. It’s a substantial relief costing upwards of £3bn, but there’s very little evidence that it increases employment. In fact, Stuart Adam from the IFS said it was essentially impossible to evaluate. It also raises the question, do we need special tax breaks for employment anyway when it’s already back to pre-pandemic record levels?

But as I argue in the paper, the Chancellor shouldn’t stop at fixing Corporation Tax. He needs to look again at Business Rates too. Under the status quo, businesses who invest in improving their premises, for instance by making it more energy efficient, are rewarded with higher Business Rates bills. At the last budget, Sunak introduced an Improvements Relief, but it’s woefully inadequate at the moment. He should go further and fix the Rates system altogether by levying the tax on land instead of what’s on top of it.

To be fair to Sunak, he has often been hit with problems he has had little control over and little time to prepare for. Now, he has six months or so to prepare a bold pro-growth, pro-investment, and reforming budget. The clock is ticking.

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Sam Dumitriu is Research Director at The Entrepreneurs Network

Columns are the author's own opinion and do not necessarily reflect the views of CapX