Tuesday 29 March 2016 4:45 am

Corporation tax is a bad tax– but let’s make sure we replace it with something better

The lack of meaningful reform of business taxation is one of the great failures of recent governments. But with public pressure mounting, MPs will soon have to move beyond headline-grabbing at parliamentary grillings and consider the future of corporation tax.

We could of course muddle along and carry on taxing profits, perhaps gradually lowering the headline rate to align it with more competitive economies like Ireland. “An old tax is a good tax” goes a dictum among economists. Keeping things as they are enables people to plan confidently on the basis of current rules.

Yet it is likely that maintaining the existing system would have more costs than benefits. For one, corporation taxes discourage capital investment by lowering returns, which makes workers less productive, with long-term consequences for wage growth. Profits taxation encourages capital to move elsewhere, both because it makes the UK less attractive as a location for “real” economic activity and because it creates incentives for avoidance through complex business structures.

Half-hearted attempts to overcome these problems have played a key role in turning the UK tax system into the world’s most impenetrable. They have also poisoned the political debate, breeding contempt for business and undermining the public’s confidence that elected officials have their back. Given this resentment, it is likely that some change will be attempted – but what form might it take?

One option is to move in a more interventionist direction. Politicians could decide that it is more important to raise revenue than to encourage productive investment. To do that, they could radically change the way in which payable taxes are calculated, for instance by using a formula based on assets, staff and sales in each country where a company operates. Or they could use the location of customers as a proxy for determining where taxes should be paid – the so-called destination principle.

This would be a dramatic break with the past. It would end the long-standing principle that taxes are paid where value is created, rather than where sales are made or where the clerical staff work. But interventionist reforms could have damaging unintended consequences. A destination-based tax might well lead companies to stop selling in high-tax markets, to the detriment of consumers. And as far as the tax formula is concerned, can we really trust officials to come up with a calculation that is suitable for firms in many different sectors, with disparate cost and business structures?

It’s not even clear that these interventions would solve the avoidance problem. What would prevent firms from playing with intra-company sales to minimise payable taxes in high-tax countries? Would there really be no opportunities for arbitrage depending on how the tax formula was designed?

So, what could be done instead? We could move away from taxing profits at the company level, and towards taxing dividends. Note that this reform would still achieve the original purpose of corporation tax, namely to tax income from capital, but without the damaging side effects on investment and worker productivity.

Estonia, whose tax system has repeatedly been named the most competitive in the OECD by the Tax Foundation, already operates such a system. For practical purposes, taxes are withheld at the firm level, but only distributed profits – dividends – are taxable.

There’s no reason why the UK could not implement a similar reform. Importantly, while it would work best when coupled with a wider simplification and lowering of the tax burden, it could be designed to be revenue neutral and may even raise additional revenue through higher personal income tax and VAT receipts, among others.

The controversy around corporation tax is a chance to move away from the complexity and opacity of the status quo. It should be seized. We need a more rational and honest way of taxing capital income based on the unavoidable fact that only people pay taxes.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.