What’s the problem?
The UK’s tax system taxes investment too much. Nearly all taxes create some deadweight loss. By raising the cost of the activity the tax is levied on, you get less of it than you would otherwise. The more taxes create a wedge between price signals that reflect supply and demand, the less the economy will produce things that people want constrained by what scarcities allow us to produce.
Sometimes this is a good thing: taxing congestion gives you less of it, and prices in to people’s behaviour the costs they impose on others. The taxes that do not create deadweight losses tend to be ones that are or seem unjust, being based on things that we cannot control — some economists have, half-jokingly, proposed taxes on height on the basis that taller people tend to earn more and it is difficult (if not impossible) to become shorter than you are to avoid a tax.
Most of the time deadweight losses are unavoidable in taxation. But different taxes we already have affect behaviour to different degrees, and so create different amounts of deadweight loss. With this in mind, tax ought to strive for neutrality, disincentivising economic activity as little as possible.
The second priority is that tax and benefit system’s progressivity ought to be considered overall, and not in the context of specific tax changes. The system overall, as James Mirrlees pointed out, can be progressive without every individual tax being progressive.
Our goal
The implication of these two principles is that Conservatives should consider the tax system as a whole, reforming or eliminating the most distortionary taxes and aiming for progressivity overall, not in each individual tax (where progressivity can be economically harmful). One of the worst features of political debate today is the focus on the distributional effect of individual tax changes, the obsession with ‘winners’ and ‘losers’, which ignores that some taxes have a powerful effect on the total amount of wealth that can be shared around.
Our growth-focused tax agenda is designed to fix or eliminate taxes with the largest deadweight losses per pound raised. The worst among these are taxes on investment and transaction taxes. Levying tax every time an asset changes hands is deeply distortionary. Overall, the tax system should shift away from taxing the investment of the rich, towards taxing the consumption of the rich.
Abolish stamp duty land tax. Stamp duty may be Britain’s worst tax. As a transaction tax, it is levied every time a property changes hands, with the incidence falling on both buyers and sellers. This means that fewer transactions take place than would without stamp duty, so housing is kept in the hands of people who do not want it as much as some potential buyer elsewhere. Fewer older people downsize, for example, and the housing stock we have is inefficiently allocated. According to Savills, “people used to move house roughly four times after their first purchase. Now it is more like twice.”
A study in Australia found that a similar tax to SDLT there was costing 72p for every £1 raised, making stamp duty around four times more damaging than income tax per pound raised, and nearly eight times more harmful than VAT. Stamp duty is also the UK’s second most unpopular tax, after inheritance tax.
Stamp duty is a top-heavy tax, and eliminating it for homes under £1 million in value would mean that 98% of the market was now exempt, but only 68% of the revenues were lost (around £6 billion). However, there would also need to be a tapering-in of the tax on homes above £1 million to avoid a large tax cliff-edge, so the true cost would be higher. It may be most prudent to scrap stamp duty altogether, eliminating the worst tax on the books, and making up some of the lost revenues with new council tax bands for expensive properties.
Introduce ‘full expensing’ by making investment allowances unlimited. ‘Full expensing’ means letting businesses deduct the cost of any investment they do from their corporation tax bills straight away. At the moment, for ongoing expenses like pens and paper, businesses can do this already. But for longer-term expenses, like investments in a new building or in new machinery, they can only deduct a small fraction of the cost of investment each year over the accounting lifespan of that investment.
This means that, in fact, businesses don’t actually get back the full cost of the investment. £100 today is worth more than £100 in ten years because of inflation and the things (like other investment) you could have done with the money in the meantime. The longer the deduction period lasts, the less of the cost of the investment you can write off.
Between 2008 and 2013 the UK reduced the value of deductions for machinery and property — from 87.5 percent to 84 percent for machinery, and from 59.2 percent to zero for industrial buildings, so corporations cannot write off the cost of investing in buildings over time at all. This likely blunted the economic effects of the reductions in the headline corporation tax rate under the coalition.
If we allowed businesses to deduct their investments from their tax bills immediately, we’d effectively be allowing them to deduct the full cost of those investments, with corporation tax no longer disincentivising investments in tangible capital.
Evidence from the US and the UK suggests that full expensing could be a boon to investment and growth.
Research by Eric Ohrn looks at states that adopted a full expensing policy temporarily in 2002 and 2008. Using a quasi-experimental approach, Ohrn finds that full expensing increased investment by 17.5% and grew wages by 2.5%. Five years after the full expensing window had been available, states that adopted it had 7.7% higher employment levels than comparable states that did not adopt it, and 10.5% higher production output (which means lower prices too, though not necessarily concentrated in that state).
This is such a large result that it sounds unbelievable, but is consistent with a paper that looks at UK evidence as well — the introduction of a policy that allowed small- and medium-sized firms to write off more of their investments in plant and machinery early on. This was not full expensing, but closer than before — a 40% write-off in the first year instead of 25%. Among eligible firms, compared to similar firms that were not, access to more generous capital allowances increased investment by 11% (2.1%–2.6% percentage points). This is roughly consistent with the other paper (where the policy was more generous), and still shows a large effect. Both seem to suggest a high elasticity of investment, where every extra pound raised results in much less investment.
Finally, Estonia’s system of cashflow taxation, which is equivalent to full expensing, has helped to give it the most competitive tax system in the developed world, even though its headline rate of 20% is higher than that of many others, including the UK’s. In the four years after introducing full expensing in 2000, along with other reforms to its corporation tax, investment growth was 39 percentage points higher there than in its Baltic neighbours.
The simplest way to do this would be to make the Annual Investment Allowance unlimited for all businesses. This would reduce Corporation Tax receipts by around £18 billion.
End the debt financing bias. Full expensing of investment would allow the government to end the tax bias towards debt financing of investment, which would also significantly reduce the overall cost of full expensing. Currently, businesses that finance their investment with debt can deduct the cost of interest repayments on that debt from their corporation tax bill, artificially lowering the cost of debt financing compared to equity financing. Eliminating the tax deductibility of corporate interest expenses would end the bias towards debt financing in the tax system (which also creates greater risks to the financial system) and reduce the cost of full expensing to around £7 billion.
Turn business rates into a commercial land tax. Although business rates are a fixation of business groups, and often seem like the easiest way of ‘reducing the burden on business’, business rates are actually paid by landowners, not the businesses that rent from them. Because the supply of land for commercial space is relatively inelastic, the total rental value of a property is largely determined by demand — how much would-be renters are willing to pay to rent there. When rates are cut, businesses bid up rents in proportion to the cut, because the value to them of occupying the property has not changed.
That means that the level of business rates makes no difference to the operating costs of businesses that rent their premises, and cuts to business rates will end up giving money to landlords, not business. So if we cut business rates, within a few years rents will increase and the burden will be unchanged. This will mean there’ll be no credit for the govt — costs on businesses will not have changed, and only landlords will have benefited in the medium- and long-run.
The empirical evidence supports this. Evidence from the introduction of the Uniform Business Rate in 1990, which replaced property taxes that differed greatly before then, shows that across London, property values adjusted so that total occupancy costs between matched properties equalized over time. In other words, where rates fell, rents rose; where rates rose, rents fell.
The Institute for Fiscal Studies’s paper “Who Pays Business Rates?” looked at the same event on a national level and produced a similar finding, in the long run.
But how long is the long run? In the time it takes for rents to rise (as old rental agreements expire and new ones are made), businesses will capture the reduction in rates. But this may not be very long. A paper by the British Property Federation looked at five revaluations between 1990 and 2010 and found that within two to three years 75% of the value of a business rates change had been factored in to rents.
So while we should expect this business rates exemption to fairly quickly be offset by higher rents, how does the fact that small businesses only are exempted factor in? In this case, while rents rise overall, recipients of the exemption (small businesses) will end up being slightly better off. Unfortunately this comes at a cost to other businesses, and most of the benefit will still go to landowners.
This also creates a “Francification” problem of having hard cut-off points for business benefits based on their size (which the small business exemption does, based on property values). Hard cut-offs lead to situations like France’s where firms cluster at the cut-off point — many French firms have restricted themselves to 49 employees to avoid all the legislation that kicks in for ‘big’ firms with 50 employees or more. The second problem is that small businesses are not inherently better than big businesses, and rewarding them at the expense of larger firms is likely to be wealth-destroying overall.
The main problem with business rates is that they tax the property value, rather than the underlying land value, so they disincentivise investment in better property or machinery, when that machinery is rateable. Tata Steel’s rates bill rose by £400,000 a year when it rebuilt the blast furnace at Port Talbot, for example.
The solution is to replace business rates with a commercial land value tax, which would be payable by the landowner, not the business. This would be levied on the value of the land itself, rather than the property on top of it, and because it was paid by the landlord it would end the confusion that business rates are a tax on businesses, and hopefully the lobbying for business rate cuts.
We already tax mostly landowners through business rates — however, because of the way this is done it is unpopular, and the incidence still partially falls on businesses, disincentivising them using land properly. If we liberalised planning to make conversion between commercial and residential uses easier, having a higher tax on commercial use would distort the system, artificially depressing the supply of commercial land.
Therefore, in the long run as we ease planning controls, we should switch to an explicit land value tax to replace council tax as well. This may be politically difficult, and should not be a priority as long as the commercial land tax does not increase the distortion compared to the status quo, but would eventually eliminate another significant distortion in how we tax property.