Principles of tax policy - Treasury Contents


Written evidence submitted by EEF

ABOUT EEF

1.    EEF is the representative voice of manufacturing, engineering and technology-based businesses with a membership of 6,000 companies employing around 800,000 people. A large part of its representational work focuses on the issues that make a difference to the productivity and competitiveness of UK manufacturing, including investment, innovation and tax issues.

SUMMARY

2.    To build a better balanced economy, the UK needs the right type of growth, built on long-term investments in innovation, technology and exports. Consequently, the UK needs a competitive and predictable tax regime that gives the private sector - including fast growing manufacturers - the long-term confidence it needs to invest in the UK.

3.    At the start of 2010, however, the UK had a business tax regime - including corporate, personal, environmental and indirect taxes - that stood in the way of growing a better balanced economy through long-term investments in innovation, technology and exports.

4.    The government's commitment to reforming the corporate tax system has been commendable in that it has sought to provide stability and reduce the corporate tax burden on business. In practice, however, its reforms have yet to deliver the improvements to the business tax system needed to drive growth.

5.    For example, its "New Approach" represents a much needed change in how tax policy is developed, yet the government has got off to a rocky start in implementing it. In addition, the government has put reforms in silos, focusing narrowly on individual aspects of corporation tax rather than looking holistically at business taxation and how tax reform should support growth.

6.    EEF are therefore concerned that the government's current approach to tax reform risks leaving business facing a patchwork of reforms in which the whole is significantly less than the sum of the parts.

7.    Consequently, EEF believe that the government's tax reform agenda is in danger of falling short of the government's own priorities, and most importantly, what businesses - including manufacturers - need from the tax system to invest in growth.

8.    Government, however, can ensure its tax reforms support growth through the following actions:

—  Commit to the "New Approach to Tax Policy Making". Businesses will begin to question the government's credibility on tax reform if its implementation does not improve.

—  Revisit reforms that are neither neutral nor efficient. This includes rethinking planned reforms for capital allowances and environmental taxes.

—  Take a more holistic approach to business tax reform. Doing so would help government in its efforts to reduce the cumulative burden of business taxation and ensure its proposals - such as on the R&D tax credit and the patent box - make the best use of Exchequer revenues in terms of supporting broad-based investments in innovation.

INTRODUCTION

9.    The Select Committee's inquiry provides the ideal opportunity to assess how this government's tax policy is affecting investment and growth.

10.  Private sector growth in 2011 and beyond will be driven by investments in innovation and new technology in the UK (see Chart 1). But despite the recovery, many businesses still perceive too many undue risks around making long-term investments in the UK.

Chart 1

INNOVATION & CAPITAL INVESTMENT IN UK IS KEY TO SUCCESS

% of companies citing how strategic priorities will be met


Source: EEF Shape of British Industry Survey

11.  At the start of 2010, the UK had a business tax regime - including corporate, personal, environmental and indirect taxes - that was tilted against manufacturing and stood in the way of growing a better balanced economy through long-term investments in innovation, technology and exports.

12.  The government's commitment to reforming the corporate tax system has been commendable in that it has sought to provide stability and reduce the tax burden on business. In practice, however, its reforms have yet to deliver the improvements to the business tax system needed to drive growth.

THE FUNDAMENTALS OF TAX POLICY

13.  If tax policy is to support growth, government needs to refocus on competitiveness and predictability, two principles which provide a real-world context for academic concepts like neutrality and efficiency.

14.  According to academic literature on tax, a truly neutral tax regime would treat all taxpayers, regardless of size or sector, the same, while an efficient tax regime should not artificially distort investment decisions.

15.  As noted above, the private sector recovery and sustainable growth needs to be driven by long-term investments in new technologies, innovation and exporting. In a global economy, manufacturers - even small ones - can choose to invest in growth outside the UK if the tax system remains uncompetitive.

16.  Consequently a neutral and efficient tax regime would be competitive if it reflected modern businesses' investment cycles and payback periods, recognised the costs and risks inherent to developing innovations quickly and to scale, and it provided the stability and predictability needed to confidently make long-term commitments to the UK.

17.  EEF believe that it is possible for the government, through simple reforms, to create a competitive tax regime for growth without resorting to special carve outs and tax breaks that distort investment decision across the economy. Maintaining neutrality and efficiency across the tax system is essential for broad-based growth in the UK. Doing so, however, requires the government to shift from its narrow focus on individual aspects of corporate tax reform to take a holistic view of how to improve the competiveness of the business tax system.

18.  Consequently, it is important to understand that the current tax system and the government's proposals for reform are far from neutral or efficient for businesses planning for growth, including manufacturers. In fact the tax system is becoming increasingly tilted against the investments in technology and innovation that the government believes are critical to private sector growth.

TAX POLICY AND THE RIGHT TYPE OF GROWTH

19.  The tax system, through its various rates, reliefs and allowances, creates incentives and barriers for businesses planning for growth. However, the financial crisis and the painful recession have shown that not all growth is equal. To build a better balanced economy, the UK needs the right type of growth, built on long-term investments in innovation, technology and exports. Consequently, the UK needs a competitive and predictable business environment - including tax - that gives manufacturers the long-term confidence to invest in the UK.

20.  Manufacturers', however, have concerns about the UK's business tax regime (as shown in Chart 2 below). Given this negative view, the government's early commitment to tax reform has been commendable. The 4p cut in the headline rate of corporation tax over the next four years sends a strong signal that the UK wants to create a competitive corporate tax regime. The government's "New Approach to Tax Policy Making", which is based on more effective consultation and scrutiny of tax reform proposals, could improve the quality of legislation and reduce the likelihood of unintended consequences. Similarly, the government's broad road map for reforming corporation taxes underscores its commitment to improving predictability for businesses making long-term investment decisions.

Chart 2

UK MANUFACTURERS CONCERNED ABOUT BUSINESS ENVIRONMENT

% citing business environment as bad or challenging


Source: EEF Shape of British Industry Survey

21.  However, these positive improvements to the tax system have been more than offset by the government's other reforms and proposals. For example, the cut in corporation tax rates was financed by lowering the level of capital allowances (from 20% to 18%) and by lowering the threshold of the Annual Investment Allowance (from £100,000 to £25,000). The result was a tax rise and a significant cashflow loss for growing, capital intensive companies. EEF is also concerned that future cuts to the headline rate of corporation tax will be financed by higher and inefficient environmental taxes placed on manufacturers. The government's reforms of the Carbon Reduction Commitment and Controlled Foreign Companies tax rules were not in keeping with the spirit of its the "New Approach to tax policy making". And by focusing too narrowly on individual aspects of corporate tax reform, the government may miss opportunities to think strategically on how tax reforms can stimulate growth and investment. Each of these issues is discussed in detail below.

22.  Consequently, EEF are concerned that the government's current approach to tax reform risks leaving business facing a patchwork of reforms in which the whole is significantly less than the sum of the parts.

TAXING GROWTH?

23.  A modern, competitive and predictable tax system would not only recognise the significant costs of investing in modern machinery. It would enable small businesses to invest in growth. It would attract mobile multinational investment to the UK. And it would provide the predictability needed to minimise the tax risks to returns on those investments.

24.  However, EEF believe that the government's tax reform agenda is in danger of falling short of the government's own priorities, and most importantly, what the private sector need from the tax system to invest in growth.

Predictability

25.  While the "New Approach" represents a much needed change in how tax policy is developed, the government has got off to a rocky start in implementing it. For example, the Spending Review included an unexpected and costly reform to the Carbon Reduction Commitment. The £1bn reform of environmental taxation removed tax incentives for companies to reduce carbon emissions, even though thousands of companies had made significant investments in complying with the scheme. Far from the government's commitment to consult on changes in advance, the £1bn tax change came as a surprise in the fine print of the Spending Review announcements.

26.  Recent announcements on changes to Controlled Foreign Company tax rules have also increased uncertainty that the "New Approach" was designed to tackle. In November, the government published wide-ranging road map for reforming the corporate tax system. The initial reaction from manufacturers was positive. But their confidence in the government's ability to deliver on the important and otherwise well received proposals was dented by aggressive new anti-avoidance legislation announced on the 6th of December - days after the road map was launched - via a written Ministerial Statement from David Gauke, Exchequer Secretary to the Treasury. One of the measures that was introduced in the statement with immediate effect, effectively blocked what the road map indicated government would allow from 2012.

27.  These departures from the "New Approach" have fostered uncertainty and left manufacturers questioning its patchy implementation: there is little clarity on which tax reforms would use the "New Approach" and which reforms would not. The resulting loss in predictability adds unnecessary uncertainty to firms making long-term business decisions.

Competitiveness

28.  Given that their growth is driven by investment and innovation, the UK's headline corporate tax rate is unlikely to be the only consideration for firms debating whether to make long-term investments in the UK or abroad. Changes to environmental taxes, capital gains taxes, pensions relief, personal allowances and the top rate of income tax, are also crucial to determining whether the serial entrepreneurs and multinationals that could invest in growth and jobs choose to invest in the UK. Apart from changes to capital gains taxes in the June Budget, businesses have heard very little on how the government plans to address the cumulative drag on growth from the breadth of business taxation.

29.  Instead, government has put reforms in silos, focusing narrowly on individual aspects of corporation tax rather than looking holistically at business taxation and how tax reform should be support growth.

30.  Taxation and innovation provides one such example. Rather than look in the round at the best way to support innovation and growth, the government's proposals for the Patent Box (a 10% rate on profits earned from patented products) and R&D tax credit unnecessarily split into two the singular process of innovation. The R&D tax credit offsets costs at the front-end of innovation, where market failures limit firms' ability to finance the expensive and relatively risky development of new technologies, processes and services. The patent-box, by contrast, provides a very narrow tax break to patent-reliant sectors (such as biotech and pharma companies) at the back-end of innovation after the profit has been made.

31.  The economic and policy rationale for such the patent box as currently defined is weak. Patents are only a small proportion of intellectual property, which is only a small proportion of innovation. By narrowly focusing on patents, the proposal erodes the tax base in favour of patent-reliant sectors, to the detriment of sectors that, for commercial reasons, choose not to use patents to protect their intellectual property. Nor is the proposal likely to resolve the thorny issue of firms shifting their IP to low tax countries. As Table 1 shows, the proposed UK scheme is not internationally competitive - other countries either offer a lower rate of tax, or include income from R&D activity as well.

32.  By treating each separately, the UK could potentially be left with a narrow, inefficient and uncompetitive patent box and limited reforms to the R&D tax credit. The preferred option would have been to use the £2bn in combined costs of the two to design reforms that would provide significant incentives to the breadth of business to invest in innovation in the UK.

Table 1

IP TAX INCENTIVES IN THE EU
CountyETR Qualifying IPCap Can work be performed abroad?Objectives policymakers
Netherlands0%-5%Patented IP or IP for which an R&D declaration is obtained (R&D IP) NoYes for patent IP. For R&D IP stricter condns Attract more R&D activities
Luxembourg0%-5.72%Software, subject to copyright, patents trademarks, domain names, designs and models No YesAttract IP ownership
Belgium0%-6.8%Patents and extended patent certificates NoYes, if qualifying R&D centre Retain and attract R&D + stimulate Belgian patents
Hungary0%-9.5%All IPR (guidelines) NoYesEU R&D policy/strategy
Ireland0%-12.5%Patent=0%. Other defined IP for amortization € 5 Mio for 0%Yes, relevant for R&D tax credit Retain and attract R&D
?? UK somewhere in here ??
France15.92%Patents and extended patent certificates NoYesRetain and attract R&D

Source: IBM

33.  The government's narrow focus on the headline rate also ignores other aspects of the UK tax system which are particularly distorting and leaves the UK in the damaging position of taxing growth. Two such areas are capital allowances and environmental taxation.

—  Capital allowances - The UK's regime is inefficient and internationally uncompetitive. In the June Budget, the Chancellor reduced the rate on capital allowances from 20% to 18% and lowered the threshold on the Annual Investment Allowance from £100,000 to £25,000, effective April 2012.

—  However, the cost of capital investment is rising and investment cycles are shortening as new technologies render existing equipment obsolete. The faster the rate of this depreciation, the earlier manufacturers are forced to reinvest in new, more productive equipment. A report by Statistics Canada estimated that, from 1995-2001, the average depreciation rate for machinery and equipment, based on the declining balance method, was 27%.

—  In the intervening decade, modern machinery has become more productive by increasingly incorporating the latest technologies and software. Empirical and anecdotal evidence suggests that manufacturers are replacing their machinery and equipment, on average, every seven to eight years. Yet the UK's current rate of 20% means that manufacturers are only able to recoup their costs after 30 years, adding a premium to investing in the UK.

—  The new 18% rate from 2012 will widen the gap between the UK and our closest competitors and dampen down the capital investment and growth our economy needs.

Table 2

AVERAGE RATE OF ECONOMIC DEPRECATION
1971-1990(1) 1985-2001(2)1995-2001(2) UK tax regime(3)
Industrial Sector 12.3 ---
Machinery and equipment- 23.026.818.0
Manufacturing buildings- 8.79.90.0

Source: (1) Institute of Fiscal Studies, (2) Statistics Canada and (3) HM Treasury - figure for 2012

Table 3

AVERAGE SERVICE LIFE OF MACHINERY AND EQUIPMENT, YEARS
1985-1989(1) 1995-2001(1)2005-2011(2)
Machinery and equipment12.3 9.87.3-7.8
Manufacturing buildings35.6 27.920.2-21.8

Source: (1) Statistics Canada and (2) Statistics Canada & EEF

Table 4

INTERNATIONAL TREATMENT OF USEFUL ECONOMIC LIVES IN 2011
CountryRecovery period
US2011: Immediate

2012: 7 years

Ireland5-10 years
Germany10-16 years
FrancePlant, machinery, equipment & tools: 10-20 years
Canada20 years
UK 2011: 30 years

2012: 33 years

Singapore30 years

Source: US Congressional Research Service, PWC & EEF

—  The UK's proposed triple taxation of carbon inefficiently saddles manufacturers with additional costs not faced by other UK sectors or competitors abroad. The Carbon Price Floor (CPF) Consultation sets out how government intends to encourage investment in low-carbon electricity generation by providing a clear, long-term price for carbon, by taxing input fuels for electricity generation.

—  The government's concern is that the EU-wide carbon price set by the EU Emissions Trading Scheme may not provide sufficient certainty over returns to encourage the required level of investment in low-carbon technologies. The CPF would thus be an additional, UK-specific tax paid by power generators on their use of fossil fuels. The current proposals will undoubtedly increase costs to all electricity consumers, as generating companies pass on costs arising from this new tax.

—  This carbon price would sit alongside the Climate Change Levy, which taxes businesses' energy consumption and the £1bn Carbon Reduction Commitment. This triple taxation of carbon inefficiently imposes costs on energy-intensive sectors, including manufacturing.

—  EEF's previous support for a carbon price floor was conditional on countervailing measures ensuring that the overall cost burden on manufacturers did not increase. For example, imposing a carbon tax on electricity generation would imply that the Climate Change Levy on electricity consumption is inefficient. In order to decarbonise the energy supply, the government should tax carbon either during generation or consumption, but not both.

—  Consequently the government should substantially lower the CCL on electricity from the current £4.85 per MWh rate to the EU-mandated minimum of £0.42 per MWh and scrap the Carbon Reduction Commitment, which represents a third layer of carbon taxation for 5,000 businesses.

CONCLUSION

34.  The UK's business tax regime will, in part, determine the pace and sustainability of growth and the long-term competitiveness of the economy. Despite making tax reform central to its plans for deficit reduction and growth, the government's current approach is unlikely to address the cumulative burden that business taxes place on growing businesses. Moreover, the government's plans for reform fall short of its own principles of tax reform it set in November 2010, as Table 6 shows.

Table 6
Government principle Government actionResult
Lower tax rates while maintaining the tax base The 4p cut in the headline rate provides a strong boost to competitiveness. But the patent box - as currently defined - provides an unnecessary distortion in the tax base without a corresponding benefit to the UK's competitiveness. The government has not yet signalled its intentions on the 50p rate. x
Maintaining stabilityThe government's "New approach to tax policy making" provides a strong foundation for introducing predictability in the tax regime. However, the government's reforms to the CRC and the Controlled Foreign Companies rules are not in keeping with the "New Approach". The resulting instability in taxes has eroded government's credibility with business. x
Being aligned with modern business practices By lowering the level of capital allowances, the UK's regime will become increasingly antiquated. Manufacturers replace their machines, on average, every seven to eight years. The tax system will only reflect that cost after 30 years. x
Avoiding complexityAlthough the Office of Tax Simplification will have an important role to play in simplifying the tax regime, the government has given it an overly narrow objective. The OTS should be free to analyse the structural reforms that would deliver significant simplification for UK businesses.

The government has also struggled to avoid introducing complexity in to the tax regime. For example, days after announcing its road map for corporate tax reform, the government implemented legislation that effectively blocked commercial activity that the road map proposes to allow in 2012.

?
Maintaining a level playing field for taxpayers Given recent changes to capital allowances and environmental taxes, and relative to other sectors in the UK and to their competitors abroad, UK manufacturers face a playing field increasingly tilted against them. x

January 2011


 
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