Taxation can reduce investment, distort the allocation of resources, and reduce individuals’ efforts to earn money. All these have a negative impact on economic growth. Investment and innovation are particularly important for driving long-term growth (Acemoglu et al, 2018), and while many forms of tax can be a drag, capital income taxes such as corporate tax and capital gains tax may have the most direct impact.
The relationship between taxation and growth is important in the UK, as government debt is high and productivity is stagnant (Financial Times, 2024). Because fiscal space for large tax cuts is limited (tax cuts without a reasonable surplus mean cuts to public services and are politically unpopular), the most useful tax reform would be to reduce government revenue. There is a possibility that this reform can promote growth without significantly reducing the amount. If policymakers can stimulate growth and increase the tax base, they may be able to reverse some of the damage to public finances.
How does investment tax work?
Corporate profits are the main source of capital income for individuals. In the UK he is taxed at two levels. First, a company pays his 25% corporate tax on taxable profits. Shareholders then pay taxes when the company’s profits are transferred to individuals as dividends or capital gains. Currently, the top tax rate on dividends is 39.35%, while capital gains from company shares are taxed at up to 20%.
But not all profits are treated the same. Traditionally, corporate taxes provide full tax relief for debt investments, but not for equity investments. And in last year’s Spring Budget, Chancellor of the Exchequer Jeremy Hunt announced an increase in corporate tax rate from 19% to 25% and full spending on investment in plant and machinery (Treasury, 2023).
Full expense means that the cost of a qualified investment can be immediately deducted from a company’s taxes. This provides stronger incentives for companies to invest in targeted investment types (Maffini et al, 2019; Zwick and Mahon, 2017).
Governments also offer direct tax incentives for innovation. Ideally, such a system would generate more growth for an equivalent loss of income than if the overall tax rate on corporate profits were lower. There is evidence that such incentives have a significant positive effect on investment (Guceri and Liu, 2019). Additionally, research shows that companies’ research and development (R&D) revenues vary, so increasing subsidies for companies that conduct less R&D could improve the spread of technology across companies. (Akcigit et al, 2022).
On the other hand, if highly successful individuals are the main innovators, taxation may be less important because the economic benefits are large anyway (Bell et al, 2019). A balance needs to be struck between providing incentives for innovation across the economy and simply easing the tax burden on already successful innovators.
What is the role of international investment?
Corporation income tax applies to all company investments in the UK. However, dividend tax and capital gains tax primarily apply to UK-domiciled investors on domestic and international investments. The UK is an open economy, so many companies raise capital domestically as well as internationally. This means that savings by UK residents need not equal the capital available for investment. Beyond UK household savings, there is a pool of capital from which UK businesses can benefit.
Therefore, investment conditions by domestic and foreign investors may be more important than policies that increase residents’ savings. One such condition is financial stability. Research shows that the effectiveness of investment incentives varies with stability (Guceri and Albinowski, 2021). Large and frequent tax changes can undermine stability. Remember to create a stable environment. Change isn’t always a good thing.
But which system is better from a growth perspective? Because corporate tax applies to investments by all investors, it is more important than taxes on dividends and capital gains on international mobile activity. can have a significant impact on investment (and growth) (Alstadsæter et al, 2017; Devereux et al, 2014; Yagan, 2015). The implication is that multinationals may prefer to carry out certain forms of activity that have lower corporate income tax rates, even if fully expensed (Devereux and Griffith, 1998).
Corporate income tax rates have declined in a wide range of countries over the past few decades due to tax competition and profit shifting to low-tax jurisdictions (including “tax havens”) (de Mooij et al, 2021). Currently, the average statutory corporate tax in Europe is 21.3% (Tax Foundation, 2024). But again, statutory tax rates do not provide the complete picture unless differences in tax bases are taken into account.
How can profit tax reform foster growth?
One reform to increase investment and reduce debt bias in corporate taxes could be to extend full expensing to all forms of investment. This could be combined with the abolition of tax deductions for debt interest.
The current design of corporate tax provides strong incentives for investment in plant and machinery compared to other forms of investment (such as intangible capital). This restriction is not considered beneficial for growth. Businesses are probably better placed than governments to decide which forms of investment offer the greatest potential for growth. Providing instant expense for any form of investment may be a wise choice, but tax avoidance opportunities should also be considered.
A more fundamental tax reform would be a reduction in the corporate income tax rate combined with an increase in the dividend and capital gains tax rates (Berg, 2024). This will create a greater incentive for both foreign and resident investors to invest in the UK, as the after-tax returns on investment in the UK will be higher compared to other countries.
Lower corporate tax rates could attract mobile activities by multinational companies. Even though dividend and capital gains taxes may rise for resident investors, these taxes apply to investments in any country (except non-residents), making investing in the UK less expensive than in other countries. This will increase incentives.
Some of the revenue loss from the corporate tax cut will be offset by dividend and capital gains taxes. Dividends and capital gains depend on after-tax profits, so if the after-tax profits of a company owned by a resident investor increase, dividends and capital gains will also increase in the long run, reducing the tax base of dividends and capital gains. and tax revenue will increase. Their bases will increase.
One of the downsides of such reform proposals is that higher dividend and capital gains taxes could reduce savings and lead to an exodus of wealthy people overseas. However, this may be less important for investment in open economies such as the UK, provided that migrating investors keep their portfolios fixed and shortfalls in domestic investment are replaced by overseas investments.
Although reduced savings and migration abroad can reduce tax revenues, the revenue impact of tax migration need not be large (Advani et al, 2023). The risk of scaring wealthy investors away from living in the UK should not be overstated.
Many European countries appear to be moving towards higher tax rates on dividends and capital gains relative to corporate tax rates (see Figure 1). This has primarily been done by lowering corporate tax rates, although some countries have also increased taxes on dividends and capital gains.
Figure 1: Relative tax rate on dividends compared to corporate profits in Europe
Source: Author calculations based on OECD data (Berg, 2024)
Overall, the corporate income tax base is large. This means that concerted reforms of various tax bases may not have a neutral effect on tax revenues, unless they significantly increase dividend and capital gains taxes.
Other measures to strengthen the tax base for dividends and capital gains include stricter tax rules for exits due to emigration, and restrictions on profits when investors delay paying taxes by keeping their funds in the company. This may include the introduction of interest payments (Auerbach, 1991). .
Still, policymakers face a trade-off between relying more on corporate taxes to raise revenue or relying more on dividends and capital gains taxes to increase investment. Getting the balance right is an important challenge.
conclusion
Taxes on capital are important for financing and can be used to distribute funds to encourage investment and innovation. Still, total tax rates do not provide the whole picture and understanding the tax base and who is liable to pay tax (corporate or resident investor) is important to assess the broader impact on your investment. is. Further evidence on the differential investment effects of corporate, dividend, and capital gains taxes is needed to draw firm conclusions about the most desirable policy direction.
Given these caveats, one potential way to boost growth could be through tax reforms that increase taxes on savings and reduce taxes on investments. Pro-growth taxation generally requires tax policies that are more investment- and innovation-friendly, rather than tax cuts on capital itself.
Boosting economic growth is high on the UK policy agenda and finding the appropriate fiscal means to achieve this is likely to remain a key objective for years to come. Investment is essential to fostering growth, and the design of tax policy has a significant impact on economic conditions that determine the level of investment.
Where can I find more information?
Who is the expert on this question?
- Stuart Adam (Institute for Fiscal Studies)
- Arun Advani (University of Warwick)
- Michael Devereux (University of Oxford)
- Irem Guseli (University of Oxford)
- Helen Miller (Institute for Fiscal Studies)
