The new UK government is seeking to increase the trend rate of growth from the average of 1.4% over the last decade up to 2.5%.
Achieving this would certainly make a difference to average living standards. A 2.5% growth rate would double average living standards in a generation (28 years). Over the same period, a 1.4% growth rate would raise average living standards by just under 50%.
That is an ambitious aim when the economy is suffering from the huge increase in energy costs – now to be partly funded by an unprecedented contribution from government borrowing, inflation at around 10%, and consequently rising interest rates.
The key means by which the government hopes to achieve this substantial change to the growth rate is to cut taxes - income tax, national insurance, stamp duty and corporation tax – at an estimated cost of £45 billion by 2026/27. There is little evidence that cuts to top income tax rates, national insurance and stamp duty will have any serious impact on long-run economic growth.[i] The best hope is from corporation tax, a tax on business profit. More specifically, the government is cancelling the previously planned rise in the corporation tax rate from 19% to 25%. Is this likely to be successful?
To consider this this we need to make two important distinctions. The first is between the size of the economy and its rate of growth. The second is between two routes in which corporation tax may have an impact. Let’s start with the second.
What we might term a 'consensus' view of how business investment decisions are made in the absence of tax is that a business has to earn a rate of return on its investment high enough to cover the cost of that investment – this rate of return is known as the cost of capital. That cost is made up of two main components – the cost of finance over the period of the investment, and the normal loss in value over time of any assets purchased. Rising interest rates are already increasing the first of these costs, which will tend to depress investment.
There is empirical evidence that lowering the cost of capital does stimulate investment.[ii] But – as the former Chancellor, Rishi Sunak has argued – the effect of the tax rate itself on the cost of capital (and hence investment) tends to be small; in particular it is much smaller than the extent to which the two components of costs are deductible from the tax base. The key reason why the effect of the tax rate tends to be small is that a lower tax rate lowers the value of tax deductions, thereby raising costs. For example, a tax deduction of £100 is worth £25 to the business at a 25% rate, but only £19 at a 19% tax rate. So the cost to the business is £6 higher at the lower tax rate. This effect needs to be set against the lower tax on the income received. The extension of the Annual Investment Allowance to cover investment up to £1 million is a step in the direction of maintaining deductions for new investment but is less relevant for larger businesses.
A second mechanism by which taxes can affect investment is its location. That is, multinational businesses can choose whether to locate their activities in the UK or elsewhere. The key issue for business in this case is whether post-tax profit is expected to be higher in the UK or an alternative location – and for that decision, the tax rate plays a more significant role. There is also empirical evidence that location decisions are more sensitive to the corporation tax rate.[iii]
There is plenty of evidence that the corporation tax rate plays an important role in determining whether multinationals locate their activities in the UK. It also plays a smaller role in determining the size of investment of businesses that are located in the UK.
In sum, there is plenty of evidence that the corporation tax rate plays an important role in determining whether multinationals locate their activities in the UK. It also plays a smaller role in determining the size of investment of businesses that are located in the UK. It is very plausible then that keeping the UK corporation tax rate down to 19% will prevent a tax-induced reduction in investment.
Note that that does not amount to supporting the claim that keeping the tax rate at 19% rather than increasing it to 25% will raise higher corporation tax revenue. That would require a very substantial response in investment, well beyond the empirical estimates, and hence very unlikely.
But let us return to the first distinction. Is it at all likely that a rise in investment will lead to a very significant rise in the long-term growth rate? The answer has to be no, for two reasons.
First, the UK corporation tax rate is already 19%, so there is no actual cut in the rate. It is possible that UK investment has been lower because businesses have expected it to rise back to 25%. If businesses now believe it will be kept at 19% they may therefore respond by raising investment. But that seems to be clutching at straws if the aim is a change in the long-term growth rate.
The more important reason is that the rise in investment would only be a short-term effect. More investment raises the stock of capital owned by businesses – which could be in the form of tangible assets like machines, or intangibles assets like IP. Reducing the tax rate should raise the long-run level of that stock of capital, generating more investment as we move to that new level. But this is a one-off effect. It would raise the current size of the economy, but not its long run growth rate.
The economy can only continually grow in the long term if there are continual increases in productivity. Tinkering with investment incentives may provide a useful short-term, or one-off, stimulus, but it is very unlikely to affect the long-term growth rate. Of course, raising productivity is by no means straightforward. It is likely to require long-term support for education and training of the workforce, and long-term support for research and development. To significantly affect the long-term growth rate, such policies would need to be introduced at large scale. By comparison, cutting (or not raising) corporation tax is a quick fix, which is very unlikely to significantly impact long-run growth.
[i] For example, Piketty, Saez and Stantcheva (2014) find that top income tax rate cuts are associated with increases in the income share of the top one percent, but not higher economic growth. See Piketty Thomas, Emmanuel Saez, and Stefanie Stantcheva (2014) “Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities”, American Economic Journal: Economic Policy 6(1): 230–271.
[ii] See, for example, Devereux, Michael P., Giorgia Maffini and Jing Xing (2019) “Corporate tax incentives and capital structure: new evidence from UK tax returns”, American Economic Journal: Economic Policy 11.3, 361-89.
[iii] See the survey: Feld, Lars P. and Jost H. Heckemeyer (2011) “FDI and taxation: a meta-study”, Journal of Economic Surveys 25.2, 233–272.