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?