Are Jaffa Cakes really a biscuit or a cake? It is a question McVitie’s spent considerable time and money on in 1991 in order to convince a British tribunal that the sweet treat was indeed a cake. In doing so, it was able to gain a subtle retail edge: avoiding a sales levy on chocolate-covered biscuits, despite often being sold alongside them on supermarket shelves.
Taxes have a powerful impact on business behaviour. Though the difference between a cake or a biscuit may seem trivial, the cumulative effect of hundreds of different levies and reliefs across the tax system has an impact on companies’ decision-making and, consequently, economic growth. Corporation tax — a tariff on profits — is particularly influential.
By raising the cost of doing business, the levy impacts on investment plans and where internationally mobile groups decide to set up. Allowances, meanwhile, enable businesses to deduct part or all of the cost of certain expenditures from their pre-tax profits, easing the tax’s negative effect on investment decisions.
Britain has the lowest corporation tax rate in the G7, despite raising it by 6 percentage points to 25 per cent in April. Last year the tax secured £83bn for the UK Treasury, its fourth-largest revenue stream. While the headline rate is competitive, Britain’s permanent investment allowances are among the least generous across advanced economies, and they also create distortions that hinder its economic performance. Since lacklustre business investment is one reason for the UK’s dire productivity growth, which has also stunted tax revenues, fixing its corporation tax system is vital. Three reforms could make a significant difference.
First, the UK should make “full expensing” permanent. Jeremy Hunt, the chancellor, announced a short-term version of the measure — which allows businesses to deduct 100 per cent of plant and machinery investment expenses from their taxable profits — at the March budget. Since the relief expires in 2026, the Office for Budget Responsibility assumes the measure will have no impact on boosting the UK’s overall capital stock. Businesses will simply pull forward investment they would have carried out anyway.
A permanent relief would raise companies’ expenditure plans overall. Research by the CBI and Oxford Economics shows this could boost real GDP by 2 per cent, and offset the large upfront cost to the Treasury in the long run by raising tax receipts. Stability in the headline tax rate would also be helpful.
Second, a wider range of capital investments should qualify for full expensing. Expenditure on assets including buildings and green structures such as wind turbines should also be included. This would involve a significant upfront cost, but would further raise long-term growth, which matters most for debt sustainability. Generous allowances are particularly important against the backdrop of high interest rates, which disincentivise investment.
Third, the bias in the corporation tax system towards debt should be reduced. Debt interest payments can be deducted from taxable corporate income, whereas equity financing receives no such treatment. This encourages businesses to load up on debt. Higher corporate indebtedness leads to lower investment and innovation, and greater economic volatility. Allowing full expensing as well only raises the subsidy for debt-financed investment. One option would be to gradually curb the amount of interest that can be deducted, which would help cushion the short-term outlay of extending allowances too.
As it stands, the corporation tax system constrains the business dynamism and investment needed to drive up Britain’s long-term productivity and revenues. With reforms to mitigate its deleterious effects and spur growth, the government could have its cake and eat it too.
This is the second in a series of editorials on reforming the UK tax system. The first, on the need for reform, can be found here.