Britain s Corporate Tax System: time to lead the world again

Philip Booth, IEA Editorial and Programme Director writing in the CBI's Magazine, Business Voice

In the mid 1980s, Nigel Lawson made changes to the corporate tax system that were remarkable at the time and of international significance. Lawson abolished first-year investment allowances and reduced the rate of corporation tax from 52% to 35%. Lawson’s reforms were opposed by a number of business leaders at the time, including by many at the CBI. The reforms removed the incentives for reinvesting profits within companies and thus worked to the disadvantage of the managers of larger companies.

Since that time, many other countries have followed Britain’s example – and they have gone further. Britain is no longer a good place to locate a business for tax reasons. It is essential that the Chancellor takes the next logical steps of reform and begins to align the corporate tax system more fully with the income tax system.

In Britain, we have an income tax system that, with a few exceptions, taxes all income, including returns to labour (wages), property (rents) and capital (interest and profits). Except in the case of profits we attribute, as far as is possible, the income from different sources to the ultimate beneficiary and then tax the beneficiary at their marginal rate of tax (0%, 10%, 22% or 40%). There are some exceptions and reliefs such as for charitable giving and for pension funds. If a company finances its activities by issuing debt or bonds, the interest is taxed in the hands of the individual or institution that holds the bonds at their marginal rate. However, we treat corporate profits differently. Insofar as a company finances its activities by issuing equity capital, its profits are taxed in its hands at the corporation tax rate of 30%. Non-taxpayers (including pension funds and charities) and basic rate taxpayers cannot reclaim any of this tax. Higher rate taxpayers must pay further tax on dividends equal to the difference between the basic rate of income tax (22%) and 40%. So they too pay a higher rate of tax on returns from equity than on returns from other investments.

This system is crazy. It encourages companies to gear their balance sheets more than they would do so in the absence of distortions. It discourages investment in shares and discourages risk-taking. It biases portfolio investments of pension funds and insurance companies away from equities and towards bonds. Expensive opaque tools of financial engineering are develo