We need to talk about Corporation Tax

The contenders in the Conservative Party election are mustard keen on the idea that Corporation Tax should be reduced.  Liz Truss, in particular, seems to think that it will encourage firms to expand and be more productive.  The evidence does not support her.

Corporation Tax is levied, not on activity, but on profit.  It’s possible, at one and the same time, to reduce profits while increasing the rate of return.  It’s done primarily through ‘leverage’ – taking on debts.  Reducing the apparent profit is done by  making the firm pay the costs of takeover.  If the firm pays, the purchaser doesn’t have to.  This is done by loading the debt onto the firm, rather than the purchaser.  This also has a tax advantage: the firm’s profits will be less because servicing the debt repayments is part of its costs.

Debt also increases the rate of return on the initial stake.  Let’s say, for the sake of argument, that a firm is worth £50m in assets and has a return of £5m per annum.  If it’s bought outright, the return is 10%.  If it’s bought with £10m in equity and £40m debt, the return depends on the debt repayment, but a debt repayment set at anything less than £4m – 10% – will increase the effective rate of return on equity.

There are three other factors that help to generate greater returns.  First,  inflation reduces the value of debt – effectively transferring money from creditor to debtor.  Second, the debt is often repaid abroad, so that this part of the return avoids  taxation.  Third, more parent firms are able to bump up costs to offset against profits, for example by the pretence of outsourcing functions such as management, payroll or IT to subsidiaries.

There are two egregious examples of this kind of financial chicanery at the moment: the conduct of residential care providers, and the water companies.   I’m always wary of economic analyses that claim to demonstrate an ‘incentive’ effect, because economic behaviour is far less rational than the textbooks like to claim, but it seems plausible to say, at least, that the effect of Corporation Tax as it is currently constituted is to reward some pretty undesirable behaviour.  In particular, Corporation Tax rewards firms  for financing themselves on debt. It creates opportunities for fly-by-night purchasers who contrive to buy firms with other people’s money.  It offers a bonus for outsourcing economic activities elsewhere in the world, removing them from the British economy.  I’m not going to claim that I have the answer to all this; the people who put together this kind of financial engineering are quick on their feet, and cleverer than I am.  But surely, there must be a better way?

The no detriment principle in operation

The Smith Commission proposed that neither administration should be better or worse off as a result of devolution, and argued for compensation if the effect of decisions were to push costs onto the other party.  A House of Lords Committee has described this as a ‘recipe for continuing conflict’, and they may well be right.  A small report from the Auditor General remarks on a small element in the costs of transferring responsibility from HMRC to Revenue Scotland.

HMRC has charged the Scottish Government £0.73 million for it to stop collecting Stamp Duty Land Tax.  HMRC charges the Scottish Government for costs associated with the devolution of Stamp Duty Land Tax. … It estimates this will cost £1 million, most of which is for changes to IT systems.  For the period up to the end of 2014/15, HMRC has invoiced the Scottish Government for £0.73 million.

So HMRC has charged the Scottish Government for the costs of not doing anything. This is an ominous precedent for the transfer of responsibility for benefits; if the DWP bills the Scottish Government for not doing disability benefits any more, it’s going to be an expensive business.

National Insurance: the Telegraph is looking for original ideas

The Daily Telegraph reports that the Conservatives are considered ending National Insurance contributions, combining them with income tax in an integrated ‘earnings tax’.   George Osborne actually announced this in 2011.  Whatever its merits, there are some obvious practical problems with the idea.  National Insurance Contributions are regressive, and levied on workers earning much less than the tax threshold: making up the difference would call for a substantial hike in the headline rate of tax, the sort of thing that political Chancellors tend to shy away from.

There are times when it seems that the Telegraph has a direct line of communication with the Conservatives’ mother ship, but I’m not convinced that this is one of them.  There are uncanny  similarities between Steven Swinford’s report this month and another one that appeared in the Independent a month ago, written by Nigel Morris.  For example, the Independent article writes:

The system of national insurance contributions dates back to 1911 when it was established to help working people insure against illness and unemployment.  It was expanded after the Second World War to help fund the health service and wider social security programmes, and is now charged at 12p for every pound of income.  It has grown up in parallel with income tax, which traces its roots to the 18th century and is administered separately.  But senior Conservatives believe the distinction has become academic, particularly as general taxation is routinely used to meet the cost of the NHS.  … In a consultation paper three years ago, the Treasury said the parallel taxes created bureaucracy and added costs for employers.  … In a survey in 2011, the Office of Tax Simplification, which is part of the Treasury, found almost unanimous  support for the idea.

The Daily Telegraph tells us:

The system of national insurance contributions dates back to 1911 when it was established to help working people insure against illness and unemployment.  It was expanded after the Second World War to help fund the health service and wider social security programmes, and is now charged at 12p for every pound of income.  It has developed in parallel with income tax, but senior Conservatives believe that the distinction has become increasingly academic as general taxation also funds the NHS.    … In a consultation paper three years ago, the Treasury said the parallel taxes created bureaucracy and added costs for employers.  … In a survey in 2011, the Office of Tax Simplification, which is part of the Treasury, found almost unanimous  support for the idea.

University teachers see this sort of thing all the time, but not, perhaps, in such a public forum.

Combining tax and National Insurance

The Conservatives are reported to be considering combining tax and National Insurance contributions; the move has apparently been postponed because of complications in combining computer systems.  There is a much fuller discussion in a parliamentary paper.

There are three separable issues here.  The first question is a matter of principle:  whether it makes sense to keep a distinct contribution for National Insurance.  One of the arguments made immediately in this respect can be dismissed, that the NI contributions pay for the health service; they don’t.   The insurance-based health system came to an end in 1948.  Four-fifths of contributions, Currently £85bn, go into the NI fund (itself an accounting fiction); the residual contribution from National Insurance to the NHS is about £21bn, roughly a sixth of health service costs.   There are good reasons to keep a major contributory element in the system, to cover (for example) unemployment, pensions, sickness benefits and long-term care.  Contributions are seen as a way of ‘earning’ benefits, and of legitimating them; they are also much easier to validate than means-tests.  However, that does not depend on using distinct, separate mechanisms for levying contributions – all that matters is what gets recorded on the wage slip.  It would be perfectly possible for the first 15% or 20% of tax to be described as “National Insurance”, and to be recorded as  contribution,  even if the systems were unified.

The second issue is a question of equity.  NI contributions at present are regressive: they cut in long before the tax threshold, affecting people on fairly low incomes, and they stop for higher rates of income (which means that richer people don’t pay as much).  One of the basic objections from the point of view of the Conservatives is that an equitable combined system would levy much more from higher earners – probably more than 50% on the top rate.  It’s also been objected that pensioners would have to be exempted – but they don’t have to be.  It is perfectly sensible for pensioners on higher incomes to pay something towards long-term care and for other people’s pensions.     That could be achieved simply enough by exempting only one element of a pensioner’s income, the basic State Pension.

The third issue is about the practicalities.  The question of computer systems is something of a smokescreen – if the systems were genuinely combined they would operate from the same system, and most calculations would be done by empoyers in any case.  It’s more important that National Insurance does something distinct from tax, which is to police employment  for people on lower incomes and  (in particular) immigrant labour.

The parliamentary report also emphasises an aspect of National Insurance contributions that must be important to chancellors of any party; NI is not identified or recognised as a tax.  A combined rate would be.

The Effects of Taxes and Benefits on Household Income

The ONS statistical release on the distributive impact of tax and benefits has attracted some attention, including concern that the tax system is not particularly redistributive.   I’ve used the figures in this series several times in the past, for example in my 1988 book Principles of Social Welfare and an essay on income and wealth published in 2001. The series has always been controversial, as much for what it doesn’t include as what it does. Having said that, it has shown a remarkably consistent pattern over time. In 1986, the final income of the bottom fifth of households was 28% of the final income of the top fifth. in 1996, it was 26%. In the figures for 2011, released yesterday, it was just below 28%. There has not been much change in the distributive impact, then.

This doesn’t reveal, however, the most striking change. In 1986, many households on lower incomes were pensioners, and others were single people. The average number of people in a household in the lowest fifth was 1.9, and in the highest fifth it was 3.3. In 2011, rather more of the households on the lowest incomes were families with children. The average number of people in a household in the lowest fifth was 2.7, and the average number of people in the households in the highest fifth was 2.4. So the relative share of an individual in the bottom fifth has fallen from 49% of the final income received by the top fifth in 1986 to under 26% now.

Replacing Tax Credits

With three months to go before the pilots, and nine months to enrolment of new cases, it’s being reported that HMRC’s “real time information” system is unable to cope with monthly returns. In a quarter of cases, HMRC cannot match the codes for employers and bank records. Records of employment make up only one link in the chain needed for Universal Credit to work – after that, the information has to be matched with Universal Credit receipt and processed both by DWP and local authorities.

While this has been going on, Iain Duncan Smith has been very critical of the Tax Credit scheme, which he says is “not fit for purpose.” He points to the disincentives it creates and the problems of error and abuse. He’s probably right about that – which makes it more incomprehensible that he has chosen to push through a complex, unworkable system based on the same principles. The new Universal Credit is going to take forward most of the things that don’t work about Tax Credits, and add problems of its own.

The main argument in favour of Tax Credits has been their distributive effect. The problems with Tax Credits have been considerable, however – among them, the staggering complexity, the unstable income they provide, the high marginal rate of deduction and the requirement for claimants to make up for miscalculations made by the administration. I think the Labour government made a serious mistake when it went down this road, but there’s not much help for that now, because any reform of the system has to begin from where we are. To replace Tax Credits, we’d need at least three major changes: a minimum wage well above current levels, a universal child care system (because the element for child care costs has to be replaced), and substantially greater Child Benefits. I suspect that would be still cheaper than what we’re doing now.

The proposal to limit Child Benefit to two children

This morning’s Daily Telegraph reports that the Treasury is considering limiting Child Benefit to two children. The Telegraph has been the conduit for a series of kites flown by government recently. The main purpose of speculating about policy changes – Norman Fowler, a former Conservative Secretary of State, used to do it with the Times – is to test the water, to see what people will put up with. This is the first attempt to put flesh on the bones of Iain Duncan Smith’s suggestion that large families should lose support, but it comes from outside his domain – Child Benefit is the responsibility of HMRC and the Treasury, not the DWP.

As ever, there are issues of principle and practice to consider. In principle, Child Benefit does four things:

  • It supports children in general;
  • it gives an income to women responsible for child care;
  • it supplements wages and other benefits, so that household income is adjusted for family size; and
  • it stands in place of a Child Tax Allowance, which it replaced.

The main effect of cutting benefits for larger families would have in three of these cases would be to limit the benefit, rather than to destroy it. There will still be a benefit, but it will be worth less. The aim that it negates is the principle of adjusting family income to the family’s size. Larger families are not going to say that the income they receive is intended for child number 2, and not for child number 3; what will happen is that all the family, and all the children, will have less, and that will happen regardless of whether people are in benefits or in work. In a nutshell, it will increase child poverty.

The issues of practice are more complex. Child Benefit works mainly because it is very simple. This reform looks simple on paper, but it adds a significant complication. People claim Child Benefit first for the oldest child. That claim runs till the child is too old, and it continues automatically until the youngest child is too old. If the benefit is paid only for the first two children, the claim will only be for the first two, and there will be no link to records for the younger children. Families will need to register a fresh claim for younger children – the ones HMRC will not know about – at the point where the oldest child reaches school leaving age. Fresh claims mean, inevitably, delay and non-takeup. It’s possible that this is an effect the government wants to produce – HMRC has been encouraging better-off families not to claim at all. If people don’t claim, they don’t cost.

Savings, however, will be limited. Only about a fifth of families have more than two children, and all of those will still be entitled to benefits for the first two. The cuts would, of course, affect the welfare of all the children in these families, but the actual savings would be about a sixth of the Child Benefit bill – far less than the government is aiming to cut from benefit. I am not sure exactly how much this would be, because from the previous £12-13 billion that Child Benefit costs, the government claims already to have taken steps to save £2.5 billion a year from the cut to higher earners. On paper, though, it seems unlikely to save more than about £1.5 billion. To put this in perspective, it’s worth about £2.50 a week on the pension. The effects of this saving would be disproportionate, however, because they will affect every person in a family with three or more children.

Confusion about Child Benefit

The news that HMRC is sending letters to parents about Child Benefit has prompted a series of articles about the muddle and confusion that goes along with the process. On one hand, there seems to be popular support from opinion polls to the effect that richer people should not receive Child Benefit. (See e.g. the Daily Telegraph, 29th October.) On the other, there is confusion about inequity, how the rules will work, whether people are being asked not to claim, and so forth. The Institutes of Chartered Accountants think the whole thing is far too complicated. There is no contradiction here. The first statement is a question of principle; the second part concerns questions of practice. It is possible to make sure that richer people don’t benefit disproportionately by using the tax system, ‘clawing back’ the benefits. There is no possible arrangement for means-testing Child Benefit, or introducing special tax rules for one benefit on its own, that isn’t going to be complicated. “What I find so frightening”, Richard Titmuss once wrote, “is the extraordinary administrative naivety of those who argue in such terms for ‘selectivity’.” That same naivety is at root of the Treasury’s current problems.

The Liberals and benefit cuts

Nick Clegg has apparently said that he will oppose plans to cut benefits by a further £10 billion. “Who should tighten their belts first? I just start from a very simple principle that when we’re all having to make sacrifices … you ask people at the top and then you work down. You don’t ask people at the bottom and then work up.” He did previously agree, however, to £18 billion in cuts to benefit, at the same time as a reduction in the highest rate of income tax. That does suggest that Clegg’s ‘very simple principle’ is open to negotiation. The Guardian has reported that, according to Conservative sources, the further cuts are already agreed.

Universality: a simple point

In reports from today’s Liberal Democratic conference, both Nick Clegg and Don Johnson have queried why the Winter Fuel Payment should be available to rich pensioners. The same argument is frequently heard about other benefits, including Child Benefit, and it could be extended to any non-means-tested benefit – health care, pensions, social care and so forth.

There are several arguments for universality – social inclusion, avoiding deterrents and so forth – but the simplest one is this. At present, everyone is already subject to one test of income: the tax system. The easiest way to manage any benefit is to pay a fixed sum and then to claw it back from tax. If there was to be a separate test for benefits like Winter Fuel Payment, everyone who might qualify would then be subject to a further test of income. Testing people’s income repeatedly is a recipe for unnecessary administration and intrusion. Why would anyone want there to be more tests than we need?