Surprisingly, a lower corporate tax rate may actually discourage investment in the UK

The Autumn Statement is tomorrow, and the press is full of speculation that our new Chancellor Philip Hammond will not only hold to previously announced cuts in the corporation tax rate, but will announce a further reduction, despite an expected hit to the public finances from lower economic growth.

A reduction from the current rate of 20% is planned for this April when it is due to come down to 19%, with a further cut to 17% in April 2020. As a consequence it is likely that any new announcement will be in the form of a commitment to reduce the rate to 15% at some point in the next decade.

This definitely sounds attractive – the UK should be an even more rewarding place to base your business than higher tax jurisdictions, such as Germany with its 30%-33% rates, or the US with its combined federal and state tax rates in the order of 40% (albeit Donald Trump is proposing to reduce federal taxes so that the combined rate would come down to around 20%). The UK will perhaps be in touching distance of Ireland with its comparatively low 12.5% rate.

However, a 5% cut in the corporate tax rate is going to cost a lot of money – at least £10 billion a year. Will we really make up for this through increased economy activity and encouraging businesses to invest in the UK?

Perhaps it will. A lower tax regime should encourage businesses to invest in the UK, shouldn’t it? And more investment should mean more jobs, more spending in the UK and and more profits, each generating taxes to offset the cost of the lower corporation tax rate.

But, and there is a but. This change will provide an incentive for international businesses to shift spending out of the UK and into higher tax jurisdictions.

This may sound counterintuitive, but remember that most investment and spending in the UK economy comes from businesses already operating in the UK and internationally. And for them the equation is a little different.

For example, take a business already operating in both the UK and Germany, paying taxes on its profits in each jurisdiction. The lower corporation tax rate will provide an incentive to increase profits in the UK and to decrease them in Germany.

The orthodox answer is to do what the government would like – to prioritise investment in the UK over Germany. But in reality, there is a much easier way to take advantage of this tax differential and that is to do the opposite – to increase spending in Germany and reduce spending in the UK.

After all, this would provide a 30% or so tax deduction on the additional German costs, at the cost of 15% on the higher profits it would generate in the UK – a 15% saving for each pound (or euro) of spending shifted over to Germany.

Of course, life is a bit more complicated than this simple example. In theory the international tax system of “transfer pricing” should offset this sort of cost shifting. But in reality, outside of a straightforward manufacturing or product business, it probably wouldn’t. Especially as this would not necessarily be a clearly linked event, perhaps not even a conscious decision. It would just make financial sense to prioritise cost cutting in the UK over cost cutting in Germany.

There are many arguments for lowering the corporation tax from its current level of 20%; not all of them about the effect on the public finances and on economic activity. Indeed, in years to come, a 20% rate may seem very high, just like the 52% rate that applied in the 1970s seems extremely high to us today. Arguably those historic rate reductions have generated positive returns to the economy, certainly in making the UK an attractive place to do business.

But, I do wonder. Are we getting to the point where cutting the rates below 20% will be effective at stimulating the economy or is this a case of diminishing returns?

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