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Stop, go or caution – should the government be using the tax system to give the green light to certain business forms?

Jason Piper
Freeze, stop, or go? Tax as a policy lever only works where the taxpayers have a choice.

150 years ago, the first red/green traffic lights were installed, just outside what is now the London headquarters of the UK tax authority on Parliament Street.

There are still traffic lights there (the original ones exploded), and still using the very familiar red/green pattern for stop and go. But one thing that’s never been entirely clear is why we ended up with the two colours which are the most commonly problematic for those with colour blindness, giving opposing, safety critical, messages. However, it’s something we’re stuck with, regardless of how we might have approached things differently given the chance.

In the same way, there are bits of the tax system that objectively don’t seem to make sense. Take for example that fact that we tax a business’s profits based on its form, not its function.

Incorporation is the creation of a separate legal entity, registered at Companies House, which can own a business, rather than a human. And an incorporated building business would be taxed on the same basis as an incorporated grocery or software developer; each, unincorporated, would attract completely different tax treatments, regardless of the relative merits or value to society of the activities undertaken.

The effect of that differential is to bring a tax bias into whether a business might choose to incorporate or not – and that’s a deliberately encouraged feature.

Companies are the pre-eminent business model for growth in the eyes of policymakers. The government wants to encourage economic growth, so it encourages the use of that enabling tool – companies’ profits are taxed at significantly lower marginal rates than sole traders’ or partnerships’.

Tax as a policy lever only works where the taxpayers have a choice. But using tax as a lever where people can make that “right decision” for the wrong reasons is never going to end well. A private company with the owners’ liability limited by share capital is on balance the most appropriate vehicle for a typical high growth start-up in the UK.

But there’s absolutely nothing to stop someone using it for pretty much any other type of economic undertaking, whether they need all the flexibility, and tax advantages, that the model offers or not – and tens of thousands of businesses do.

Why’s that a problem? Government is foregoing tax revenue, while businesses are operating in the wrong forms. We’re targeting the how, not the what, forgetting that if you pull on the wrong levers you’re going to trigger the wrong behaviours.

And what makes it worse is that on top of the blanket rate-based incentives to incorporate there are myriad tweaks to the tax base for specific types of company – these are the bits where government is actually trying to encourage specific activities, like investing or giving to charity.

But then people start applying those tax breaks based on what they could mean, rather than on what they were supposed to mean, and extra clauses get put in to either try to clarify the original meaning or prevent taxpayers from doing particular unintended things. Before long, a manageable 760 page set of tax manuals becomes a massive 20,000-pages, as complication begets complexity which in turn fosters confusion and noncompliance.

No sooner is one problem dealt with than another becomes apparent, especially when you have a system which positively encourages politicians to frame their policy responses as tax breaks rather than targeted expenditure.

The problem with legislative whack-a-mole is that you end up with a playing field full of flattened molehills and trip-hazards, no matter how much the politicians describe their reactive tinkering as “levelling the playing field”. What’s needed is fundamental reform, taxing businesses on the basis of what they do, not what they are. But just like the traffic lights conundrum, there’s too much invested in the status quo to make radical change likely.

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