The principles of tax policy

Written evidence submitted by the CBI

The CBI is the UK's leading business organisation, speaking for some 240,000 businesses that together employ around a third of the private sector workforce. With offices across the UK as well as representation in Brussels, Washington, Beijing and Delhi the CBI communicates the British business voice around the world.

1. What are the key principles which should underlie tax policy?

The primary purpose of taxation is to raise revenue to fund government expenditure programmes. Ultimately, different groups will have different ideas regarding the additional purposes of taxation. These will include redistribution and changing behaviour.

It is up to governments to decide on the appropriate balance between these competing priorities, but, in all cases, the objectives should be achieved as efficiently as possible. From an aggregate welfare perspective, the ideal tax system would be "neutral", i.e. would not distort decisions in areas such as business investment and recruitment. But policy priorities inevitably result in a non-neutral system.

Instances where the tax system works in the opposite direction to non-tax policy objectives should be minimised. This requires those responsible for setting tax policy to be aware of other Government policy priorities. In the current economic climate, it is particularly important that taxation policy is undertaken in a way which supports, or, where possible, does not inhibit, economic growth. This means that tax competitiveness is also a critical principle.

2. How can tax policy best support growth?

UK tax competitiveness

The competitiveness of corporate taxation influences not only the decisions of internationally mobile companies to locate and/or remain in the UK, but also the incremental investment choices made by international groups with operations in the UK. As well as affecting the stability and breadth of the tax base, multinationals tend to have higher rates of productivity and produce positive spillover effects in the countries in which they operate. Therefore, an uncompetitive corporate tax system can have negative implications for both tax revenues and economic growth.

The UK’s tax competitiveness has been slipping in recent years. The Coalition Agreement published in May announced the government’s commitment to aim for the most competitive corporate tax regime in the G20. This is necessary for ensuring a stable and broad tax base as well as a more vibrant economy, generally. Many elements will inform a company’s view of whether a country’s tax system is competitive.

All taxes create distortions through their effect on prices. Prices are used by producers to set the most profitable level of production and by consumers to maximise their utility. Taxes disrupt these signals by driving a wedge between the price paid by the buyer and the price received by the seller. The taxation of corporate income in the UK creates distortions over how firms raise funds (debt or equity finance), over investment decisions, and over decisions to incorporate. Recent research also shows a close correlation between corporate taxation, wages and employment (put slightly differently, much of the incidence of corporate taxation falls on labour [1] ). An additional behavioural response for internationally mobile companies is to opt out of a particular tax system altogether. Where taxes are levied on bases which are particularly responsive to price changes, the potential impact on behaviour and, therefore, growth is greater.

Tax levels

Source: KPMG’s Corporate and indirect tax survey 2010

Headline corporate tax rates are an important indicator of tax competitiveness, though not the only one. The UK’s lead on corporation tax rates has been eroded in recent years, as other countries have cut their corporation tax rates further and faster. The UK currently has the 7th lowest rate of corporation tax in the G20 and the 20th lowest rate in the EU27. In 1997 the UK had the tenth lowest main rate among the EU27 countries; by this year it had slipped to twentieth.

The introduction of the 50% personal tax rate has also affected the UK’s competitiveness. In particular, combined with the implications of other tax changes, such as the banking levy, "one-off" bonus taxes and restriction of pension tax reliefs, the competitiveness of the UK as a financial centre has been affected. Research has shown a strong link between tax rates on high earners, and levels of FDI. [2]

Companies will tend to look at effective tax rates rather than marginal tax rates in their assessment of whether to invest and the costs of doing business in a particular tax jurisdiction. The effective average tax rate (EATR) is the proportionate difference of the net present value of a profitable investment project in the absence of tax and the net present value of the same investment in the presence of tax. Effective rates are a more accurate reflection of the true burden of corporation tax on UK business. Our members confirm that this is borne out in practice. For discretionary "big ticket" investments, such as installations in the infrastructure or energy sectors, the combined cash effect of the tax on project profits and the tax relief on the upfront investment can influence which country is the most deserving location when there is limited capital available.

According to analysis by the European Commission, the UK had an (EATR) for corporations of 29.3% in 2007 compared with an EU27 unweighted average of 22.3%. The UK’s effective rate is somewhat below that in, for example, the US (36.9%), Canada (36.0%), Germany (35.5%). Countries with lower effective rates include Ireland (14.4%), Switzerland (18.8%) and Norway (24.5%). [3]

Tax structure

The tax system as a whole can also be structured so as to support economic growth, minimising the distortionary impact on economic decisions and maximising revenues. The OECD has done some valuable work in this area, culminating in its recent report on growth-oriented tax policy reform. [4]

Recurrent taxes on immobile property are consistently found to have the least distortive effects on long-run GDP per capita, followed by consumption taxes, other property taxes, environmental taxes, personal income taxes and corporate taxes. However, the OECD acknowledges that it is politically difficult for governments to shift the tax base onto property, which tends to receive tax breaks.

An alternative is to shift towards consumption taxes and away from income taxes as has been occurring over the past few decades since the Meade report. This has happened to some extent in the UK, following the increase in personal allowances for basic rate taxpayers and the recent increase in VAT. The recently published Mirrlees review into the UK tax system looks comprehensively at the different options for optimal tax structure. Changes in income taxes will have implications for both the number of working hours undertaken by those already in work, and the labour market participation decision. The review notes that, taking into account the interactions between the benefit and tax system, many of those with the lowest incomes face the highest marginal tax rates. The sharp increase in tax rates for mobile higher earners, for example, is expected to affect the choice of entrepreneurs to locate in the UK. The OECD finds that a reduction in the top marginal tax rate is found to raise productivity in industries with potentially high rates of enterprise creation.

Corporate income taxes are viewed as the most harmful for growth as they discourage the activities of firms that are most important for growth, namely productivity and profitability enhancing investment. The OECD finds that lowering headline corporate tax rates can lead to particularly large productivity gains in firms which are dynamic and profitable. However, lowering the corporate tax rate substantially below the top personal income tax rate incentivises high-income individuals to shelter their savings within corporations, i.e. is counter to the principle of tax neutrality.

The Mirrlees review looks at the effect of the corporate tax system and the differential tax treatment of debt and equity and the effects on investment. Alternatives proposed include cash flow taxes, the Allowance for Corporate Equity (ACE) and the Comprehensive Business Income Tax (CBIT). Any of these would result in the equalisation of the treatment of debt and equity finance (something similar to ACE was introduced in Belgium in 2008). The first two proposals essentially extend tax relief to equity-raising, while the third abolishes tax relief for debt finance. All would be difficult to implement as the first two would involve narrowing the corporate tax base, while the last would put the UK out of kilter with international competitors.

In the latest HMT publication on Corporate Tax Reform, [5] and in line with our Tax Task Force report recommendations, the Government has committed to maintaining the position of interest as a legitimate business expense, and thus tax deductible, given that this is considered one of the more competitive features of the UK tax system.

Broad base-low rate

The OECD also looks at base broadening accompanied by rate lowering as a means of increasing the efficiency of the tax system. [6] Benefits of a broad base-low rate combination include:

· Fewer distortions due to fewer exemptions

· Higher tax compliance due to reduction in arbitrage opportunities and lower rates

The Mirrlees review notes that the UK corporation tax rate has fallen from 52% in 1982-83 to 28% in 2009-10 and is set to fall further to 24% by 2014-15. Despite this, corporate tax revenues have remained stable at a little over 3.5% of GDP. This is at least in part because cuts in corporation tax main rate have been accompanied by reductions in reliefs and allowances or other extensions to the corporate tax base.

The Office for Tax Simplification (OTS) recently published a list of UK tax reliefs and exemptions. They will be making recommendations for action in the 2011 Budget on 23rd March.

Other features of a good tax system

This section outlines the characteristics associated with a "good" tax system. In its 2008 Report on Tax Reform, the CBI Tax Task Force identified the following key principles which should underlie tax reform:

· Neutrality (i.e., tax should not distort business decisions)

· Simplicity and clarity

· Certainty and stability

· Flexibility in response to changing business practice and competitive pressures.

Tax policy making which takes these into account can help minimise the burden of tax compliance. However, some of these will trade off against each other. For example, a complex tax system would benefit from simplification to help reduce compliance costs. But, changes in the tax system create uncertainty and, therefore, impact on the longer term investment plans of companies.

Neutrality

Tax neutrality essentially means that the tax system should not distort choices and behaviour, i.e. that taxpayers in similar situations and carrying out similar transactions should be subject to similar levels of taxation. So, for example, the incomes of employees, the self-employed and small companies should be taxed at the same rate. A non-neutral system creates incentives to reduce tax payments by changing behaviour – the behavioural response. This may be either a deliberate policy choice, such as in the case of taxing polluting industries more heavily, or incidental to the revenue collection objective. Revenue-reducing behavioural responses may be countered by the government developing anti-avoidance legislation, which tends to increase legislative complexity and compliance costs. It should also be noted that, in the cross-border context, the Treasury has explicitly abandoned Capital Export Neutrality, i.e. trying to exactly equalize the tax treatment of foreign and domestic investments.

Clarity and Simplicity

Legislative clarity is important as it enables companies to comply more easily as tax liabilities are easily understood, and should reduce costly and time-consuming disagreements with the tax authorities. Tax compliance should not require an excessive amount of company resource, which would divert energy from more productive and profitable business activities. Tax complexity may be a particular issue for SMEs as compliance costs represent an almost fixed cost and SMEs are also less able to afford to take the steps to minimise their tax liability. Unfortunately, there may be a trade-off between clarity and simplicity. To provide greater clarity on the scope of a tax, for example, legislation may need to be lengthy, which may be considered to reduce simplicity.

Tax incidence is important when considering ways in which the tax system can be simplified. For example, both employers and employees pay national insurance contributions and employees also pay income tax. But employer contributions affect employer decisions about pay and employment levels which ultimately are borne by employees. Tax incidence is particularly important when considering changes to corporate taxation as taxes are ultimately paid by individuals, i.e. employees or customers. In general, corporate taxes lead to a lower level of investment leading to lower capital per worker, which lowers wages.

Stability, certainty and predictability

Companies make long term investment decisions over substantial time periods and need to do so in a tax system which is stable in order to receive the expected return on investment (which may then, for example, encourage further investment). Stability in the tax system gives companies certainty about their ongoing tax liabilities and when they fall due. However, changes in the tax system that reduce complexity introduce instability so an assessment needs to made about the relative importance of these factors. For example, businesses may have a preference for government flexibility in tax setting where it is an appropriate response to tax developments in competitor jurisdictions. The government can work to minimise the adjustment costs associated with changes in the tax system. An adequate notice period for tax changes, the involvement of tax professionals in the design of taxes and an avoidance of retroactive tax changes (including by grandfathering provisions) can all help companies adapt. An appropriate balance obviously needs to be struck between government having flexibility in policy making and the business need for stability.

Administration and collection

Changes in the way in which taxes are collected can be every bit as disruptive as changes in the underlying legislation. As well as bearing the economic burden of some taxes, companies also act as unpaid collector of many other taxes [7] for government, and the systems costs and complexity to do so can be highly material. A change in the interpretation of tax law by HMRC makes it difficult for businesses to predict the impact of complying with tax legislation.

The Mirrlees review states that the tax system should be judged by its impact on the trend rate of economic growth. An appropriate tax policy, taking into account the issues raised above, will help support economic growth. Adherence to these tax principles will give companies the confidence to invest in the UK, helping boost investment and productivity.

3. To what extent should the tax system be structured to support other specific policy goals?

To reiterate, we believe that the tax system should be as non-distortive as possible. And, furthermore, even if a policy aim is thought to be worth pursuing, the question should always be asked whether the tax system is the most efficient method of delivery. The tax system is often a blunt and indirect tool, and, additionally, using the tax system in this way inevitably increases complexity. However, taxation is often chosen as the policy instrument for changing behaviour to deliver a government policy objective, such as promoting innovation or to support environmental objectives that the market seems unable to deliver. In such cases, the importance of the behaviour change for increasing growth or addressing other policy objectives is believed to outweigh other principles of tax design.

The haste with which some tax policies with a behavioural objective are developed, however, may mean that insufficient consideration is given to the principles of good tax policy. A number of taxes have been, or are set to be, introduced to counter perceived market failures in the financial services sector, namely the bonus tax, 50% higher tax rate and bank levy. These have a number of objectives, including countering excessive risk taking by individuals and inadequate regulatory structures. The 50% personal tax rate, for example, was implemented partly with a revenue-raising objective and partly following the backlash against aspects of the financial system following the crisis. It was arguably aimed at correcting a market failure, namely that financial sector pay was inappropriately structured to encourage excessive risk-taking. But there are, arguably, much better ways of approaching this issue, and many of the principles of good tax policy making were set aside in the announcement of this policy. The way in which the 50% rate fitted with other policy announcements, such as changes to NICs and pensions taxation, and the scaling back in the tax free allowances for particularly high earners, led to substantial distortions in the tax treatment of earnings above £100k. In particular, it failed the competitiveness test, making London less attractive relative to other jurisdictions for mobile high earners.

4. Are there aspects of the current tax system which are particularly distorting?

From the perspective of a neutral tax system, there are a number of taxes which are distortionary. Again, the ideal of a neutral tax system needs to be considered alongside other government policy objectives which distortionary taxes may be designed to address. There are some areas of the tax system, for example, which are distorting but can be justified on other grounds.

· The tax treatment of foreign earnings

· Taxation of financial services

· Taxation of innovation

· Tax treatment of those with non-domiciliary status

· Zero tax relief for a significant part of the cost of investment in the UK’s infrastructure

There are also, however, a number of areas within the the business tax system which definitely require changes to remove distortions. These include:

· Taxable profit to comprise all business income less all genuine business expenditure;

· Abolition of the schedular system;

· Elimination of tax nothings.

5. How much account should be taken of the ease and efficiency with which a particular tax can be imposed and collected?

To be able to levy a tax, the tax authorities need to be able to identify the base on which the tax is to be levied. Changes in tax rates often lead to a behavioural response where the affected individual or firm work out the best way to organise their activities so as to minimise their tax liability. The government will then often respond through tightening up anti-avoidance legislation. This leads to a steady escalation in complexity and compliance costs.

Those taxes which are easiest and most efficient to collect are more likely to be supportive of economic growth. Such taxes would have lower compliance and administrative costs and be straightforward in their coverage, minimising the uncertainty which undermines competitiveness. However, this should be considered alongside other important characteristics for an efficient tax system.

The current source-based corporate income taxes have very high administrative and compliance costs, for example, in the setting of intra-firm transfer prices. The generally favourable tax treatment of debt encourages multinationals to raise debt in high-tax jurisdictions to maximise the tax relief. This then leads to the development of complex anti-avoidance rules, such as thin capitalisation which seek to limit the tax deductibility of interest. The worldwide debt cap also seeks to limit the amount of debt that multinationals can set against tax in the UK. The tax treatment of interest is a particularly good example of excessively complex and largely unworkable legislation aiming to set limits on reliefs.

Another example is the CFC regime, where the current rules make it difficult for UK headquartered multinationals to finance their non-UK operations in the most efficient way, for example using surplus cash from one foreign subsidiary to fund another foreign operation. The UK has become perceived as particularly aggressive both in terms of the rules themselves and the way that they are interpreted. Any move into a low tax jurisdiction is likely to be treated as tax avoidance regardless of the existence of commercial motives, and the available exemptions are both restrictive and administratively burdensome.

CFC reform has been needed for many years, and the complexity of the rules and uncertainty over reform has contributed to decisions of a number of high profile UK listed companies (eg Wolseley, WPP, Shire) moving their tax base offshore/inverting. While tax rate competition is an obvious factor, many of these companies have cited the prolonged uncertainty over CFC reform as the main reason.

The CBI has, therefore, welcomed publication of the Government’s Roadmap for Corporate Tax reform, which includes major reform of the CFC rules. Complexity and uncertainty in the tax system has a major impact on the competitiveness of the UK as a place to do business, and it is essential that tax policy takes this into account.

January 2011