How to better align the U.K.’s corporate tax structure with national objectives

Successive Chancellors have been keen to lower corporation tax to help UK business and attract inward direct investment. Starting with Nigel Lawson in his budget of 1984, the mainstream corporation rate has been progressively lowered and tax breaks for investment and other expenditures progressively withdrawn. However, it is now clear that these reforms have had untoward effects. They removed a bias towards investment but left a strong bias towards debt finance, which was accentuated by Gordon Brown’s abolition of Advance Corporation Tax (ACT) in the 1997 Budget. They have favoured service industry at the expense of capital-intensive manufacturing industry and so added to the imbalances in the economy caused by globalisation. Moreover, the latest literature on economic growth, reviewed in the Appendix, suggests that effect of industrial investment on productivity has been seriously underestimated. That is because the conventional analysis upon which these reforms have been based, focuses on the return on investment for the individual firm and neglects the benefits for the wider economy and in particular the gains from knowledge spillovers. These spillovers largely stem from the complementarities between R&D, innovation and investment and the way that new ideas and practices spread from organisations that invest and innovate to others. This synergy means that supporting capital investment can have the same effect on long-run growth as subsidizing R&D. However, because capital is easier to monitor than the production of intangible knowledge, supporting investment is less vulnerable to agency problems and gaming. Although the fiscal system recognises the importance of innovation for economic growth by supporting R&D, this is an argument for subsidising investment as well as research. Moreover, support for investment would help ensure that UK innovations build factories and jobs here rather than overseas. Moreover, by favouring debt over equity, the corporate tax system discourages knowledge creation. That is because intangible assets such as knowledge and expertise are difficult to finance with a corporate tax and capital structure that is tilted towards debt. Proposals for the reform of corporate taxation have aimed at achieving tax neutrality by removing the bias towards debt finance. However, these proposals neglect important innovation externalities, which mean that we should also be tilting tax relief towards investment. We would do this by using savings from reducing debt interest relief to restore capital allowances on industrial plant and machinery, which the empirical evidence shows, plays a key role in the growth of a knowledge-based economy.