Productivity under the Coalition

In this piece Ken Mayhew (Oxford) considers the low level and low growth of productivity in the UK, especially in the ‘disastrous’ period since the crisis. He argues the UK needs not just more human capital but a higher ratio of investment to GDP, and a labour market which offers better and higher paying jobs. An article on UK productivity in the Labour government period can be found on the Labour government 1997-2010 page, free to download.

The IFS reported that real take home pay was 1 per cent lower in the third quarter of 2014 than in the third quarter of 2001. Though real wages have started to rise slowly in recent months, there has been a real threat to standards of living in the UK. This is closely associated with a disastrous performance on productivity since the beginning of the recession.

Defining productivity

Productivity can be defined in a number of ways: output per head of the population, output per worker, output per worker hour. Which is the appropriate measure to use depends upon precisely what one is attempting to analyse. Commentators have voiced concern about the UK’s performance on all three measures since the onset of the 2008 recession. Not only has it been linked with the very slow recovery in the standard of living but it is also an important indicator of an economy’s productive efficiency and of the quality of jobs on offer.

Output per head of the population will be influenced not just by the productivity of workers but also by the employment rate. Output per worker is affected not just by the number of workers employed but by the hours they work; for example, it used to be said in the 1960s and 1970s that higher Japanese manufacturing productivity per worker was largely explained by the fact that the Japanese worked much longer hours than people in other developed economies. This note concentrates on efficiency and jobs and therefore highlights output per worker hour.

Productivity under Labour

First, however, it gives some historical background. In his article for OXREP’s issue on the Labour Government’s Economic Record, John van Reenen discussed this background. He split GDP per capita into two components: output per worker and the employment rate. He argued that the growth of UK GDP per capita “outstripped” the US, France and Germany under the 1997 – 2010 Labour Government. The growth of output per worker was better than in Europe but worse than in the US. Conversely the growth of the employment rate was better than in the US but slightly lower than in Europe. He went on to remind us that GDP per capita also grew healthily under the previous Conservative Governments (1979 – 1997) when the country did well in terms of output per worker.

Rehearsing the various reasons advanced by researchers for Thatcher’s and Major’s success, van Reenen considered the argument that Labour might simply have continued to reap the rewards for their policies. However, he argued, it is important to distinguish between levels and growth and that it was implausible to believe that growth could have continued without some further stimuli.

He suggests that Labour’s specific contribution was in three areas.   The first was Labour’s product market competition policies. Noting the increase in higher education participation rates and in staying on rates at school, he tentatively suggested that improvements in human capital might also have had a role to play – though he does acknowledge that there may have been quality problems in what our education and training system was producing. The third explanation he advances is innovation, which he believes may have been stimulated by tax policies to encourage R & D and by science spending via the research councils.

All of this is against a background of long-standing governmental concern about the country’s poor productivity performance when compared with other OECD countries.

And indeed there have been several, at least partially, false dawns. The so-called productivity miracle of the 1980s still left us lagging. Indeed once it was realized that that there had been significant over-recording of capital stock at the beginning of the 1980s and that therefore its growth through the decade was greater than had originally been thought, a significant part of the miracle disappeared. Output growth had been attributed to productivity gains when in fact it was attributable to an increase in capital stock.

In any event it was a strange miracle that took us back to more or less the productivity growth of the 1960s. What in effect we saw was a recovery from the disastrous performance of the 1970s, at a time when most other OECD countries had not experienced such a recovery.

Productivity since the crisis

Whilst it was reasonable for the last Labour government to claim some further catch-up, on output per worker hour we were still behind some of our traditional comparator countries. By just before the onset of the recession, though the gap with rest of the G7 as a whole had been closed, we still lagged the US, France and Germany. Since the beginning of the recession, the UK’s productivity has flat lined whilst other countries have experienced slow growth in output per hour. So, on Office for National Statistics (ONS) numbers for 2013 (Figure 1), we are 31 per cent behind the US, 28 percent behind Germany, 27 per cent behind France, 9 per cent behind Italy and 1 per cent behind Canada. Only Japan performs worse.

Figure 1: Output per hour, 2013

Capture11

Source: Reproduced from ONS, “International Comparisons of Productivity”, 20 February 2015

According to the ONS (Figure 2) output per hour is probably just about at the level it was in 2007, just before the onset of the recession, and the ONS suggests that the gap with the average for the rest of the G7 is at its widest since 1992. In fact output per hour actually fell slightly in 2013 despite the signs of economic recovery and the ONS calculates that it is 15-16 points “below a counterfactual level had the UK’s strong productivity growth prior to the downturn continued”. The ONS continues, “ the productivity gap on the same basis for the rest of the G7 is around 6 percentage points”.

Figure 2: Productivity gaps, 1997-2013

Capture12

Source: Reproduced from ONS, “International Comparisons of Productivity”, 20 February 2015

So this raises two questions.

  • First, why could we not catch up with the likes of France, Germany and the US before the recession?
  • Second, why did we fare so relatively badly during the recession?

Why the limited UK productivity catch-up?

Productivity growth can be enhanced by improvements in dynamic efficiency and static efficiency. Dynamic efficiency is all about obtaining productivity improvement via investment – through technical progress embodied in new physical plant and equipment, in knowledge generated by R & D and in increasing human capital through education and training. Static efficiency is about improving the efficiency with which existing productive assets are deployed.

It is conventionally thought that the productivity gains under Thatcher were largely achieved by enhancing static efficiency. Whatever else motivated them, Thatcherite policies towards the labour market had this as a central aim. This was one explicit justification for the measures taken to reduce the power of unions and increase managerial prerogative, as it was for the removal of various forms of low pay protection and for reducing the extent of employment protection.

Similarly privatization and the introduction of quasi-markets into public sector activities, notably health and education, were justified partly on efficiency grounds. It was also argued that private business pursuing the profit motive in competitive and/or suitably regulated product markets would operate more efficiently than state-owned enterprises run by civil servants.

Reform of the tax and social security systems had similar intent. The reduction of higher rates of income taxation was meant to increase the incentive to work; so were attempts to reduce replacement ratios – the ratio of incomes from social security whilst out of work to income in work.

The Labour and Coalition governments maintained and probably increased static efficiency. However the UK’s long-standing failure was in dynamic efficiency. Investment/GDP ratios have been stubbornly low compared to many of our competitors, as has investment in R & D. The component of investment on which all governments from Thatcher onwards have placed massive emphasis has been on increasing human capital both via the formal education system and via work-based training.  Even the Thatcher government devoted significant subsidies to private sector training.

Under Blair and Brown the emphasis on human capital became even greater and this emphasis has continued under the Coalition. Originally this emphasis was part of the high skills vision which had initially been popularized in the US by economists such as Thurow and Reich. They asked how a rich country like the US could compete in an increasingly competitive world as more and more “developing” countries became serious players in international trade.

They argued that, for any well- defined product, US producers could not compete at the low end. Imagine a range of specification for that product – it becomes more highly specified the more characteristics it possesses, the more its producer is willing to customize the offer for different segments of the market and the more frequently it changes its specification. Any emerging economy could produce the low spec version of that product and the only factor which could give competitive advantage was price or unit labour cost. US producers would be beaten on price and therefore should move up-market where price was not such a constraining factor.

All OECD governments espoused this vision – the high value-added vision. Accompanying it was the belief that as a country moved up-market, production processes would become more skill intensive. Thus the high value-added vision became the high skills vision. Improving human capital was a necessary condition for successfully implementing such a national strategy. However it was not a sufficient condition.

If firms did not change their product and production strategies the human capital investment could be wasted. As noted above, van Reenen voiced some justifiable doubts about the quality of some of the human capital that was produced. The content of some of the lower vocational qualifications has been dubious, whilst exactly what our universities are producing bears some scrutiny.

But, even if there were no quality problems, there are certainly underutilization problems. Cedefop, studying the 2001-2011 period, estimates that between 10 and 15 per cent of UK workers reported that they did not need their highest qualification to get their job. We were not alone in this.

More revealing, in 2010, again according to Cedefop, about 60 per cent of UK workers reported that they believed themselves to be over-skilled for their jobs. This was a higher percentage than for all but four of the EU 27 countries. These four were Slovenia, Cyprus, Greece and Romania.

So the UK’s experience before the recession suggests that our failure to fully catch up with our comparator countries may well have been down to investment, and not even the stress on human capital investment had the leverage that governments had hoped for.

At the time some commentators were widening the discussion of investment deficiencies and arguing that inadequate infrastructure investment together with over-restrictive planning regulations were adding to our problems. They were also starting to suggest that officialdom often seemed to be slipping from regarding improvements in human capital as a necessary condition for achieving the high skills vision to thinking of it as a sufficient condition.

Why such poor progress under the Coalition?

So why have the last few years proved so disastrous? Investment and R & D performance have remained poor, whilst there is absolutely no evidence to suggest that the underutilization of skill has diminished. The ‘success’ story of the post-recession period has been the rapid growth of employment. Unemployment rose by less than in the major continental economies and fell fairly quickly. Unemployment rates are lower and employment rates are higher.

But the big doubt is about the quality of this employment growth.

Long before the recession struck Goos and Manning had introduced us to the notion of the hourglass labour market. They argued that over a couple of decades there had been growth in “top-end” jobs and in “bottom-end” jobs but that those in the middle had been squeezed – hence the hourglass shape.   Much of the employment growth during the recovery has been in lousy, low-end jobs where productivity is naturally low.

Late last year the TUC claimed that only one in 40 of the jobs created was full time and that the vast majority of employment created was either part time and/or self-employment. Of course neither part time work nor self employed work is necessarily less productive than full time work, but these figures are probably an indicator of this employment being created towards the bottom of the labour market.

A Joseph Rowntree Foundation Report found that in 2011-12 more households with members in work were in poverty than those with only workless members. The report attributes this to part time work and low pay. Thirteen million were classified as being in poverty. Even in better jobs, the fact that all power has been with management and that wage growth has been slow reduces the incentives for employers to increase the efficiency with which they deploy their workers.

Our recent productivity experience is historically unique for the UK and this adds to the worry is that it is not just a temporary blip on the route to a more productive and higher paying labour market. Investment in its many forms remains the key but so does trying to encourage a labour market with better and higher paying jobs.

 

References

Guardian, coverage of IFS report, 30.01.15

M. Goos and A Manning, ‘Lousy and Lovely Jobs – The Rising Polarization of Work in Britain’, Review of Economics and Statistics, February 2007.

The Coalition’s record on poverty and inequality

In this fourth article on Coalition Economics, Robert Joyce and Luke Sibieta (Institute of Fiscal Studies) consider the effects of the Coalition’s policies on inequality and poverty. They discuss the impact of the recession, which tended to reduce inequality, and then of government tax and benefits policies, which have tended to increase it, and the rising incidence of child poverty. Sibieta and Joyce’s earlier assessment of income inequallity under the Labour government, 1997-2010, is included in the special journal edition which is free to download until the election.

The coalition government came to power just after the Great Recession and during the associated fall in real earnings. One cannot properly understand the coalition’s record on inequality and poverty without considering that context. The Great Recession led to large falls in workers’ real pay between 2009 and 2011, which led to bigger falls in incomes further up the income distribution. However, the coalition government also had to implement a large fiscal consolidation in response to a hole in the public finances that had opened up or revealed itself due to the recession.

Decisions on how to implement this consolidation have had further important implications for inequality, with cuts to working-age benefits leading to reductions in income primarily towards the bottom of the income distribution and some net tax rises primarily hitting a smaller group towards the top.

Hence, falling real pay meant that incomes initially fell more towards the top of the distribution – partly at the end of Labour’s reign and partly at the start of the coalition’s – but the fiscal consolidation probably means that incomes are falling at the bottom of the distribution towards the end of the current parliament.

  1. Changes in household income during the Great Recession

The coalition came to power right in the middle of a period of large falls in workers’ pay. Between 2009 and 2011 – a period which neatly sandwiched the May 2010 election – median weekly earnings fell by 7% in real terms (http://www.ifs.org.uk/uploads/gb/gb2015/ch2_gb2015.pdf). Because earnings are a larger source of household income, on average, further up the income distribution, this acted to reduce income inequality. This came on the back of a reduction in inequality during the recession itself, as the real value of benefits and tax credits had been boosted by falling inflation and some discretionary increases, meaning that the bottom had been catching up with the middle. These patterns are shown in Figure 1.

The precise timing of this fall in real earnings was not entirely independent of policy choices. The Labour government’s temporary VAT reduction between 1 December 2008 and 31 December 2009, as a fiscal stimulus measure, had kept inflation very low and hence real earnings did not fall during this period. But ultimately the fall in earnings was an inevitable, if somewhat delayed, impact of the severe economic contraction.

Had the election happened a year earlier this would all have happened under the coalition; had it taken place a year later it would have been largely on Labour’s watch. In truth it would be economically arbitrary to attribute trends in the income distribution since May 2010 to the coalition and anything before that to the previous government. The large fall in income inequality between 2009 and 2011 was driven by the large scale of the recession and the historically unusual nature of the labour market shock that came with it – namely widespread falls in workers’ pay, rather than sharp rises in unemployment.

Figure 1. Real changes in real household income from 2007–08 to 2012­–13, by percentile point sibjoyfig1 Notes: Percentiles 1-4 and 96 to 99 are excluded due to high levels of statistical and modelling uncertainty. Incomes are deflated using the RPIJ index.

Source: Cribb et al (2015); http://election2015.ifs.org.uk/article/living-standards-recent-trends-and-future-challenges.

  1. Role of tax and benefit policy

It is more instructive to think about the coalition’s record on inequality and poverty by looking at what it has done since coming to power in response to the hole in the public finances. One obvious thing to look at, which affects inequality via direct policy levers, is tax and benefit policy. Considering all tax and benefit changes between January 2010 and May 2015 together, this group of measures have had the largest impact on a small group at the very top of the income distribution. This is mainly due to the implementation of tax measures pre-announced by the previous Labour government (such as the introduction of a 50% income tax rate, subsequently reduced by the coalition to 45%), which had their biggest effects just before or early in the coalition’s period in government.

The coalition government has chosen to implement a package of cuts to benefits and tax credits totalling £16.7 billion per year by 2015–16, and a net tax rise of £16.3 billion (all in 2015–16 prices). Figure 2 below (taken from Browne and Elming, 2015) shows the net impact of these changes on the incomes of different groups. Households are divided into ten equally sized deciles depending on their household income, but also different demographic groups within each decile (pensioners, working-age adults without children and working-age adults with children).

These measures (such as the increase in VAT and cuts to benefits and tax credits) have had the largest impact on approximately the bottom third of the income distribution but have been focused on those of working age. Low-income pensioners seem to have been largely protected from these cuts. Individuals in the middle and upper-middle parts of the income distribution have actually gained on average from tax and benefit changes under the coalition (such as increases in the personal allowance), though they had been more affected by cuts in earnings during and immediately after the Great Recession. In sum this probably means that inequality has risen in the latter half of the parliament, at least across much of the distribution.

Figure 2. Impact of tax and benefit reforms introduced between May 2010 and May 2015 by income decile and household type

sibjoyfig2Source: Browne and Elming (2015), http://election2015.ifs.org.uk/article/the-effect-of-the-coalition-s-tax-and-benefit-changes-on-household-incomes-and-work-incentives.

  1. Overall changes in inequality during recession and recovery

Figure 3 brings these stories together by showing expected changes in income across the income distribution between 2007-08 and 2014-15 (using simulation techniques beyond 2012–13 – the latest household income data – accounting for changes to taxes and benefits and trends in employment and earnings), covering the whole period of recession and coalition government. Perhaps contrary to popular perception, inequality will in fact still be lower in 2014–15 than in 2007–08. This is due in no small part to the nature of the labour market shock, which caused widespread falls in real pay rather than the kinds of rises in unemployment – concentrated on the low skilled – seen in previous recessions. Cuts to social security as part of the post-recession fiscal tightening have so far unwound only some of that sharp prior fall in inequality. This highlights the important point that, whilst the fiscal consolidation measures – which increase inequality across much of the income distribution – are the result of direct choices made by the coalition, these choices were of course made in a context where inequality had just fallen substantially and earnings levels had fallen relative to benefits.

There is a twist to this story though. Inflation has been hitting the poor harder over this period (primarily between 2007–08 and 2009–10), because they are less likely to have benefitted from plummeting mortgage interest rates and more likely to spend large shares of their budgets on food and energy, which have risen in relative price. The black line on Figure 3 shows that accounting for this does make an important difference. Nevertheless, even having done so there is no rise in inequality between 2007–08 and 2014–15.

Figure 3. Change in real household income from 2007–08 to 2014­–15, by percentile point sibjoyfig3Notes: Percentiles 1-4 and 96 to 99 are excluded due to high levels of statistical and modelling uncertainty. Incomes are deflated using the RPIJ index.

Source: Cribb et al (2015); http://election2015.ifs.org.uk/article/living-standards-recent-trends-and-future-challenges

  1. Poverty

When it comes to poverty, trends and policy have been somewhat more confusing. Measures of relative poverty – such as the proportion of individuals with incomes below 60% of the contemporary median – have fallen significantly since the start of the Great Recession and over the period of coalition government (from 18% in 2007-08 to 16% in 2010-11 and 15% in 2012-13). However, this is mostly because falls in median income have reduced the poverty line, rather than because of rises in the living standards of low-income households. Absolute poverty (defined as household incomes less than the 2010­-11 median) has risen since household incomes began to fall (rising from 15% in 2009-10 to 17% in 2012-13) and is likely to have increased further as a result of cuts to benefits and tax credits taking effect from 2013-14 onwards.

However, there has been a distinct lack of clarity over what the coalition government goals really are with respect to poverty. There is currently a legally-binding target to ‘abolish’ child poverty by 2020, defined as reducing relative child poverty to below 10% as well as targets across a number of other domains. The coalition government initially announced rises in the Child Tax Credit alongside other benefit cuts in order to ensure no net impact on child poverty; but swiftly abandoned this practice (and cancelled the second planned CTC rise). Child poverty stood at 17% in 2012-13 and is expected to increase to 21% by 2020 (http://www.ifs.org.uk/uploads/publications/bns/BN154.pdf ), clearly way off the legally-binding target. The coalition government has expressed some dissatisfaction with the current measure of child poverty and has consulted on a new measure of child poverty (https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/228829/8483.pdf), though this has led to nothing as of yet. We are therefore left in an odd situation whereby there is a legally-binding target to reduce child poverty by 2020 and no credible plan to meet that target.

The coalition government has outlined a number of strategies to reduce child poverty in the long-run (https://www.gov.uk/government/publications/child-poverty-strategy-2014-to-2017). For instance, it has emphasised improving work incentives, which have indeed been strengthened for most groups over the past five years (http://election2015.ifs.org.uk/article/the-effect-of-the-coalition-s-tax-and-benefit-changes-on-household-incomes-and-work-incentives). Improving work incentives and reducing complexity have been important motivations for the introduction of Universal Credit. However, the implementation of this has been fraught with delays and is unlikely to be fully implemented until at least 2020 on current plans (http://election2015.ifs.org.uk/article/benefit-spending-and-reforms-the-coalition-government-s-record).

The coalition has also emphasised improvements in education outcomes, which are likely to be crucial determinants of later-life earnings capacity. The introduction of the disadvantaged pupil premium was a major plank of policy to improve the educational performance of disadvantaged children. However, there were already very significant amounts of funding targeted at poorer pupils before the coalition came to power (http://www.ifs.org.uk/bns/bn123.pdf) and there is no evidence to suggest that this led to a larger reduction in the attainment gap. Moreover, any such improvements in educational outcomes are likely to feed through into the labour market in the long-run.

Looking to the future, an important challenge for the next government will be to set out a clear set of objectives in the area of child poverty alongside measures to meet those objectives, whatever they may be. For instance, are they still committed to the 2020 target and, if so, how are they going to meet it?

Corporate taxation under the coalition government

In this second article on Coalition Economics, Giorgia Maffini (Said Business School, Oxford University) analyses the changes in corporate taxation over the period. She argues that the UK’s international competitive position has been improved, but at considerable cost, while little has been done to assist the UK manufacturing sector and promote the rebalancing of the economy. Maffini’s earlier assessment of the Labour government, 1997-2010, is included in the special journal edition which is free to download until the election.

  1. Introduction

Over the last 30 years and until the global financial crisis, governments across the OECD have gradually cut statutory rates of corporation tax to attract mobile activities and profits (see figure 1). This trend had slowed by 2010. At the height of the global financial crisis, governments were struggling to reduce their budget deficits. There was little room for tax cuts and most OECD countries decided to avoid large tax reductions. The Coalition had a very different plan:

“Our aim is to create the most competitive corporate tax regime in the G20, while protecting manufacturing industries”

- The Coalition agreement, May 2010.

Over five years the government unrolled an intense reform programme which would substantially reduce the tax burden on business and make the UK business tax regime substantially more attractive.

  1. Changes to the statutory corporate tax rate and to capital allowances

As of 2015, the main statutory corporation tax rate has been cut from 28 to 20%. This is the (equal)[1] lowest corporation tax rate in the G20 and the lowest in UK history. The small profits rate applicable to profits below £300,000 was cut from 21 to 20% in 2011.[2]

In terms of tax revenue, rate cuts have been partially compensated for by enlarging the tax base. In 2012, writing-down allowances for the main pool of plant and machinery were cut from 20 to 18%.[3] Additionally, the government did not repeal Labour’s decision to phase out allowances for industrial buildings by 2011.

The value of allowances for small and medium sized enterprises (SMEs) differs markedly, due primarily to the Annual Investment Allowance (AIA). Introduced by the Labour government in 2008, the AIA gives a 100% deduction for expenditure in plant and machinery with a threshold of investment initially of £50,000 and then of £100,000. The Coalition announced temporary changes to the AIA threshold several times (mainly increases). If the government’s announcement were credible, a temporarily higher threshold could provide an incentive for business to bring investment forward.[4]

  1. Effects of rates cuts on the competitiveness of the UK tax system

Three measures are used to assess the tax costs associated with corporation tax: the main statutory rate and two summary measures that account for both the statutory rate and the tax base: the effective average tax rate (EATR) and the effective marginal tax rate (EMTR).

The statutory tax rate affects profit-shifting as the marginal incentive to shift an additional unit of corporate profits after all deductions depends on the corporate statutory tax rate. Figure 1 shows that the UK rate was substantially lower than the OECD average until 2004 when cuts in other OECD countries meant that the UK 30% rate was higher than the OECD average for the first time in 20 years.

Figure 1. Statutory corporate tax rates (1994-2015)

maff4fig1Source: OUCBT tax database

In 2012 the UK rate dropped again below the OECD average and by 2015, it is about 7.5 percentage points lower.[5] Although the UK rate is consistently lower than the French and German rates, smaller, low-tax OECD jurisdictions (e.g. Ireland) have had very attractive rates for profit shifting activities. Such small jurisdictions have now become less appealing if compared to the UK corporate tax rate of 20% or to the 10% rate available with the Patent Box, a scheme granting a reduced rate to income generated by patents held in the UK.

Figure 2 shows the evolution of the EATR which depends on the statutory rate and on capital allowances. It is the proportion of pre-tax profit of a typical investment project that would be taken in tax. It affects the location of investment in the UK, i.e. it affects inward foreign direct investment (FDI). Until 2013, the UK EATR was not particularly competitive compared to the OECD average, although the OECD average includes smaller countries which would not necessarily be competitors of the UK. Starting in 2011, the UK EATR began declining and by 2015, it is well below the OECD average. Historically, the UK EATR is lower than the French and German rates, with the gap widening substantially since 2011.

Figure 2. Effective average tax rates (1994-2015)

maff4fig2

Source: OUCBT tax database

If the UK has improved its competitive position substantially in terms of attracting profits and FDI, the EMTR which affects the size of investment remains relatively high. The EMTR measures the proportionate increase in the cost of capital due to the tax. It accounts for both the statutory rate and for capital allowances. It affects the size of investment, given the decision to locate in the UK. The EMTR focuses on the margin, i.e. it focuses on a project that just breaks even by earning a return equal to the cost of capital.

The tax base and hence capital allowances are very important for the marginal investment project and that is why the UK ranks low on this measure: the UK capital allowances regime is one of the least generous in the OECD (OUCBT, 2015). Historically, the UK EMTR has been higher than the OECD average (figure 3). It declined after 2011 but in 2015 it remains well above the OECD average.

Figure 3. Effective marginal tax rates (1994-2015)

maff4fig3Source: OUCBT tax database

  1. Effects of rates cuts on investment and FDI

At the beginning of the Coalition term in 2010, investment and FDI were considerably lower than their pre-crisis peak. There was little doubt about the need to stimulate investment at that time. To calculate the effect that the tax reform could have had, we use estimates in the economic literature (Feld and Heckemeyer, 2011).

The cut in the EATR from 26 to 18% could have increased inbound FDI by 12.5% and the reduction in the EMTR from 22 to 17% could have increased the capital stock by about 2%.This does not necessarily mean that FDI and the capital stock have increased. It could also be that they have decreased but less than they would have done without the reform. As explained in OUCBT (2015), although there is uncertainty in these estimates, economic evidence points to large effects of tax cuts on FDI and capital stock.

The assessment of the effect of the AIA is different. The AIA only affects the cost of capital of companies with investment below the AIA threshold[6] and these are likely to be smaller companies. The AIA threshold only covers investment of smaller firms, generally with less than 100 employees (OUCBT, 2015). These companies only account for about 20% of aggregate investment. Hence, the AIA is unlikely to have had a large effect on aggregate investment.

  1. Additional changes and impact on competitiveness

There are some very important elements of the UK tax system such as the controlled foreign corporation (CFC) regime, the Patent Box (PB) and the R&D tax incentives which are not reflected in the statutory rate, the EATR or the EMTR.[7]

CFC rules are anti-avoidance provisions whereby under certain conditions profits of CFCs located in low-tax jurisdictions are taxed upon accrual at the domestic corporation tax rate. The old UK CFC rules had been deemed very stringent and not in line with business practices. The Coalition continued Labour’s plan to reform the CFC rules and delivered the final regime[8] which is considered more business friendly.[9] Despite being controversial, some of its provisions create a competitive advantage to locating a headquarters company in the UK and certainly lower the cost of capital for multinationals, for example, by facilitating financing of the group through low-tax subsidiaries.[10]

The PB entered into force on 1 April 2013.[11] It provides that corporate profits derived from patents held by a UK-resident company are taxed at a reduced rate of 10%.[12] The scheme was welcomed by business but some countries, particularly Germany, raised concerns that the PB could be used as a tool to shift profits out of their high-tax jurisdictions.

Under the initial version, patents created elsewhere and possibly awarded tax incentives by other countries could have been easily shifted to a UK company and their income (i.e. royalties) would have enjoyed the reduced rate of corporation tax available under the PB.[13] In November 2014, after an agreement with Germany, the UK accepted to reform its PB regime with the aim of introducing a closer link between the jurisdiction where the patents have been developed and the jurisdiction where the income from such patents enjoys the benefits of a lower corporate statutory rate.[14]

Although the initial version was probably more competitive, the existence of a PB encourages companies to hold intellectual property rights in the UK, rather than shifting them to a low-tax jurisdiction. There are concerns that such schemes could provide a further incentive to profit-shifting[15] by multinational companies (Griffith et al., 2014). Legislation regulating the new PB regime will be implemented by the next government and its role in increasing the attractiveness of the UK for mobile, intangible assets and profits will depend on the details of the law.

The Coalition has also expanded the generosity of R&D tax incentive schemes for both SMEs and larger companies. It has simplified the system and made it more salient for larger companies by transforming R&D deductions into a credit (the so-called “above the line credit”).[16]

  1. Costs of the reform

Such a comprehensive reform of business taxation implies large costs. In terms of foregone revenues, the reform will cost £7.5 billion a year by 2015/16 (or 21% of average annual corporate income revenues). Adding the initial version of the PB brings annual costs to £8.2 billion (or 23% of annual corporate income tax revenues). By any standards, these are large costs which will translate into a higher deficit or lower public spending and/or they will need to be financed by other taxes, such as VAT.[17] Figure 4 shows that VAT revenues (as a share of total tax revenues) have increased under the Coalition, after the standard rate of VAT was raised from 17.5 to 20% in 2011. Revenues from other taxes remained stable or declined.

Figure 4. Own revenues, share of total tax revenues (%).

maff4fig4Source: OECD Revenue Statistics, series 1110 (personal income tax), 1210 (corporate income tax), 2000 (social security contributions), 4120 (Business rates), 5111 (VAT).

The Coalition has also introduced new taxes, in particular on the banking sector. The 2010 Budget introduced a Bank Levy applied to banks’ total liabilities.[18] Before the crisis, the financial industry contributed between 21 and 26% of net corporate tax receipts. From 2008/09 onwards, its contribution declined to between 11 and 16%. Figure 5 shows that even accounting for the Bank Levy receipts, the contribution of the financial sector remains well below its pre-crisis level.

Figure 5. Financial sector corporation tax revenues (% total corporation tax revenues)

maff4fig5Source: HMRC Corporation Tax Statistics, table 11.1A, 2014.

  1. Avoidance

The government has been very active on tax-avoidance.[19] It was one of the key priorities of its tax reform programme and overall the Coalition has not allowed a lax anti-avoidance strategy to affect its competitiveness agenda.[20] The fight against avoidance was considered as a way to finance rate cuts and other business tax reforms. The Coalition introduced significant measures such as the General Anti-Abuse Rule (GAAR), probably the most significant domestic development in the fight against avoidance over the past five years. The UK has also actively participated in the OECD/G20 Base Erosion and Profit Shifting (BEPS) project.

Nonetheless, some anti-avoidance measures have been controversial.[21] Very recently, in its 2014 Autumn Statement, the government introduced the Diverted Profits Tax (DPT) which applies a rate of 25% (instead of the standard 20% corporation tax rate) to profits “diverted” from the UK.[22] The DPT seems to target a small number of companies[23] but, in fact, some of its provisions could draw in companies not intentionally targeted. This creates uncertainty for business and some observers have wondered whether the DPT signals a change of course in the Coalition’s competitiveness agenda.

  1. Conclusion

The competitive position of the UK with respect to the OECD has improved substantially since 2011, and by 2015, the main corporate statutory tax rate and the EATR are well beneath the OECD average. This suggests that for the location of profits and of FDI, the UK has become very attractive.

The government has failed to make the tax component of the user cost of capital (EMTR) particularly competitive, though. The UK EMTR has historically been higher than the OECD average and this has not changed under the Coalition. For large companies, the UK capital allowances regime remains one of the least generous in the OECD. This affects firms’ cost of capital negatively and hence reduces their incentive to expand the size of their investment in physical assets such as plant and machinery and buildings. It is difficult to reconcile a regime of low capital allowances with the Coalition’s ambition of protecting the manufacturing sector.

Although relatively less attractive for industries with large investment in physical assets, overall, today’s UK tax system is very attractive for the location of company headquarters and more generally for the location of activities of multinational companies. There are seven main reasons.

  • First, the exemption system of taxation of foreign profits[24] allows parent companies located in the UK to receive dividends exempt from UK corporate income tax. Because of the substantial shareholding exemption introduced in 2002, foreign capital gains are also exempt.
  • Second, the rate of corporate income tax is low with respect to other OECD countries, reaching 20% in 2015.
  • Third, the presence of a PB regime with a rate of 10% lowers the tax burden on very mobile factors such as intangibles and together with a relatively simple R&D tax incentives regime makes it more attractive to research and own UK-developed patents in the UK, rather than locate them in a low-tax entity.
  • Fourth, the new CFC regime allows important exemptions which essentially lower the tax burden on CFCs located in low-tax jurisdictions. In particular, the finance company exemption allows financing of high-tax subsidiaries via a low-tax CFC.
  • Fifth, historically the UK system does not charge withholding taxes on dividends paid from UK companies to their foreign shareholders. And the UK has signed a large number of tax treaties reducing outbound withholding taxes on interest payments and on royalties.
  • Sixth, the UK is part of the European Union: the EU Parent-Subsidiary Directive provides that intra-EU dividends paid by EU subsidiaries to an EU parent are exempt from withholding taxes, and the Interest and Royalties Directive provides that withholding taxes on intra-EU royalty and interest payments are set to zero.
  • Finally, the UK has generous rules for the deduction of interest payments. Although a worldwide debt cap for large companies was introduced in 2009 under the Labour government,[25] current interest rules remain relatively generous by international standards.

In this competitive context, at the end of the Coalition’s term, some questions remain. Primarily, was the increase in competitiveness worth £7.5 billion (or more)? The economic literature points to large effects of tax cuts on FDI and on investment. The Government and a large part of the business community seem to agree that the gain in competitiveness was worth forsaking some revenues. Some of the specific reform proposals originated with the Labour government and the Coalition’s business tax reforms have not generally been strongly contested politically.

If the gain in competitiveness outweighs the loss in revenues, why not cut even further and, indeed, what’s the optimal corporate tax rate for the UK?

The Coalition and business seem satisfied with where the statutory tax rate is now. If elected, the Labour Party has pledged not to cut the statutory corporate tax rate to 20% in 2015 but to keep it at 21%. The difference between 20 and 21% is minimal and hence, there seems to be a broad consensus on the fact that, for now, the appropriate UK corporate statutory tax rate is around 20%.

The political debate has not yet addressed some of the weaknesses of the UK business tax regime considered in this paper. In particular, the relatively ungenerosity of the capital allowances regime has been subject to very little discussion. According to the latest data, business investment fell in quarter 3 of 2014, leaving the annual pace of growth at 6.3%.

The UK is today one of the fastest growing developed economies but its productivity has historically been lower than that of other comparable countries such as Germany and France. For productivity to increase, investment has to hold up. Capital allowances are a key policy tool for stimulating investment. The issue then becomes which capital assets should be incentivised.

With new business models heavily relying on information and communications technology and the growing importance of the services sector, the tax system should not only target traditional capital such as machinery, equipment and buildings but also intangible assets which have a high potential to increase productivity.

 

Notes

  1. In 2015, three other G20 countries have a statutory corporate tax rate of 20%: Russia, Saudi Arabia and Turkey.
  2. In fiscal year 2015/16, if after the election the new government confirms the changes introduced by the Coalition, the UK will have a single statutory corporation tax rate of 20%.
  3. The main pool attracts the majority of standard plant and equipment, including computers and software. The rate of capital allowances was reduced from 10 to 8% for the special pool. The main items in the special pool are long-life assets or cars with higher CO2 emissions.
  4. Frequent and close announcements of temporary increases reduce the credibility of each further announcement. In its first emergency Budget in June 2010, the Coalition announced a cut in the AIA threshold to £25,000 to be implemented almost two years after the announcement, for expenditures incurred on or after 1 April 2012. However, subsequently, the AIA threshold was kept at £25,000 only for eight months (between 1 April and the 31 December 2012). It was then raised tenfold, again on a temporary basis, to £250,000 for expenditures incurred on or after 1 January 2013 and then doubled – yet again on a temporary basis – to £500,000 for expenditures incurred on or after 1 April 2014. Although the AIA is available for all companies, it narrows the tax base for SMEs substantially as it covers all or most of their investment in plant and machinery.
  5. In 2015, the OECD average is about 25.7% against the 20% corporate statutory rate for the UK.
  6. The tax burden on the marginal unit of investment affects the incentive to invest and hence, the size of investment.
  7. Such elements will only affect some firms whilst changes in the statutory rate and in general capital allowances affect all corporations.
  8. The new regime is applicable to financial years starting on or after 1 January 2013. A reform of the CFC regime was first launched by the Labour government and in part motivated by a ruling of the Court of Justice of the European Union (CJEU). In September 2006 in the Cadbury Schweppes plc case, the CJEU held that the old UK CFC rules restricted the freedom of establishment within the EU.
  9. The new regime is now based on an estimate of the amount of profit diverted from the UK whilst the previous regime had an entity-based approach: all or none of the profit of a CFC was subject to the CFC rules. The new regime targets the “artificial” diversion of profits and passive income when there is no economic substance in the low-tax location of the profits whereas in the previous regime all passive income and profits located in a low-tax jurisdiction may have been subject to the CFC rules. The principles underlying the new regime are reflected in the introduction of specific exemptions. For example, the new regime provides for a 12 months’ exemption for foreign subsidiaries which come under UK control, after the restructuring of a group. This facilitates reorganizations involving UK companies.
  10. In particular, the finance company exemption provides that only one quarter of profits earned by a CFC from loans to overseas companies is taxable at the main UK corporate income tax rate. This implies that the effective tax rate for such companies in 2015 is 5%.
  11. The PB was first proposed by the Labour government in its 2009 Pre-Budget Report.
  12. The PB benefits are phased in gradually so that companies need to apply an appropriate percentage to the company earnings from patented inventions, i.e. 1 April 2013 to 31 March 2014: 60%; 1 April 2014 to 31 March 2015: 70%; 1 April 2015 to 31 March 2016: 80%; 1 April 2016 to 31 March 2017: 90%; and from 1 April 2017: 100%.
  13. In this form, the UK regime seemed to be in contrast with the principles emerging from the OECD Base Erosion and Profit Shifting (BEPS) Action Plan (in particular, Action 5). At the same time, the Council of the European Union and the European Commission started investigating the UK Patent Box (OUCBT, 2015, sec 2.3).
  14. This is the so-called modified nexus approach. The existing regime needs to be closed to new entrants by 30 June 2016 and should be abolished by 30 June 2021. A new regime incorporating the modified nexus approach will co-exist in parallel with the old one until 2021. After this date, all countries have to maintain “nexus-compliant” regimes (OUCBT, 2015). For a more detailed description of the challenges for the new PB regime, see OUCBT (2015), section 2.3 and Englisch and Yevgenyeva (2013).
  15. A multinational company would locate patents in low-tax jurisdictions or in jurisdictions where a lower corporate tax rate is available through a PB regime. Royalties for the exploitation of the patents will then be paid from the operational subsidiaries located in high-tax jurisdictions to the owner of the patents located in a low-tax jurisdiction. This mechanism reduces taxable income in high-tax jurisdictions to shift it to low-tax countries.
  16. This implies that such credit could be added to the corporate pre-tax profit and hence be more easily incorporated into the decisions of the research and operative departments. For a more detailed description of the British R&D regime, see OUCBT (2015), section 2.4 and 3.2.
  17. For an analysis of the UK public finances, see Crawford et al. (2015) and Emmerson et al. (2015).
  18. The Bank Levy is not applied to tier 1 capital, insured retail deposits, repos secured on sovereign debt, and policyholder liabilities of retail insurance businesses within banking groups. It only applies to financial institutions with aggregate liabilities of £20 billion or more from 1 January 2011. For more details, see OUCBT (2015), section 2.7.
  19. For a more detailed description of the anti-avoidance measures introduced under the Coalition government, see OUCBT (2015), section 4. For an evaluation of the principles which should guide anti-avoidance tax policy, see Vella et al. (2012).
  20. To get some order of magnitude of the revenues involved in the fight against avoidance, OUCBT (2015) estimates that revenues raised from specific measures implemented between 2010 and 2015 amount to about £7.5 billion a year. Although these estimates are uncertain, these are large numbers which could partially offset the cost of the reform to the business tax system.
  21. There are other examples of controversial anti-avoidance measures. For example, the Chancellor has asked banks to sign up to the Code of Conduct for Banks detailing that financial institutions should respect not only the letter but also the spirit of the law. The Code has also been used to introduce retrospective legislation. All this clearly raises serious concerns about the rule of law (OUCTB, 2015).
  22. These are profits generated but not taxed in the UK because the company involved does not have a taxable presence in the UK or because of other arrangements lacking economic substance.
  23. The government’s own costings also seem to confirm that the DPT is narrowly targeted (£270m in 2016/17).
  24. The system was introduced under the Labour government in 2009.
  25. The worldwide debt cap was introduced with the Finance Bill 2009 under the Labour government and applies to financial accounts beginning on or after 1 January 2010. The objective of the regime is to restrict deductions for interest payments and other finance expenses claimed by members of a large group. A group is defined as large if at least one of its members has at least 250 employees, an annual turnover of at least EUR50 million, and/or a balance sheet total of at least EUR43 million. The cap will only apply if the UK net debt of the worldwide group exceeds 75% of the group’s worldwide debt. Once the cap applies, complex rules provide that the excess deductions for interest payments will be disallowed.

References

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  • Emmerson, C., Johnson, P. and Joyce, R. (2015) “IFS Green Budget”, January.
  • Englisch, J., and Yevgenyeva A. (2013) “The ‘Upgraded’ Strategy against Harmful Tax Practices under the BEPS Action Plan”, British Tax Review, 5, 620-637.
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