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Moira Chadwick: UK tax system essay competition

Moira Chadwick, UCL student

Moira Chadwick is from Reading and is currently in her final year of university, studying economics at UCL. In addition to her studies Moira mentors first year students within the economics department and supports the UCL investment society.

Moira was a runner-up in a PwC UK essay competition. We publish her piece with their permission.


How would you change the UK tax system to improve future employment prospects and drive the UK economy?

1. Introduction

Adjusting the UK tax system so as to increase employment requires either increasing employers willingness and ability to employ or making those otherwise voluntarily unemployed willing to volunteer their labor in the work place.

Though impossible to measure, voluntary unemployment in the UK is generally considered to represent a small fraction of total unemployment. It is for this reason that I turn my attention in this essay to making employers willing and able to employ more people through the tax system.

I will begin by exploring how we foresee the economy is likely to change between 2014 and 2050 and hence try to deduce how the UK can use the tax system to embrace these changes.

To summarise an OECD paper titled "Policy challenges for the next 50 years", we will see:

- Global GDP quadrupling and twice as much CO2 being omitted;

- The economic growth rates of "advanced economies" staying close to 2%, as an average, over the entire period;

- The economic growth rates of "emerging economies" decelerating from a current average of 7% to
a 2060 average of 3%;

- Exports as a share of global GDP increasing from 20% to 33%;

- Ageing populations that will reduce the scope to grow through increased population and hence
countries with ageing population will need to focus on productivity; and

- Policy will need to focus on "knowledge based high value-add economies".

In light of these changes we need to develop a tax system that allows us to:

- Ensure our exports are competitive in the long-term;

- Are equipped for the depletion of non-renewable energy sources;

- Support innovations which improve productivity; and

- Give incentives for the development of knowledge businesses.

If the UK was able to design a tax mechanism that insured these four things, I believe we can ensure a
much better economic position for ourselves in 2050.

2. Channel 1 - Ensuring our exports are competitive in the long-term

We want other countries to buy our goods and our services. They will only want to do if they are relatively cheap, relatively good quality, or, ideally, both.

We need to make adjustments to the tax system which encourage research and development which ultimately can increase productivity, decrease costs of production and improve quality of products.

Sir Stafford Cripps, who was chancellor under the Labour Prime Minister Clement Attlee introduced a profits tax to the UK. The aim of this tax was to induce investment and therefore innovation by making the tax on dividends higher than the tax on retained earnings.

In 1951 the tax on undistributed profits (retained earnings) was 10% and the tax on distributed profits (dividends) was 50%. Derick Heathcoat-Amory's Budget in 1958 replaced these two tax rates with a single tax on company profits.

If the tax rate on dividends is higher than that on profits companies will want to reduce their dividend payments. This may lead one to think that investors would become less interested in UK stocks. However if investors believe that the UK company which they are looking to invest in, and the UK government, are committed to innovation then this effect should be offset by improved long-term growth potential.

In an ideal world, this would be complemented with some sort of incentive to use those retained earnings to develop research that leads to innovation. In the UK the government already supports R&D tax credits for small business and R&D relief for large businesses as well as IP tax incentives. Despite this, our spending on research and development remains low in comparison with other EU member states.

Extending tax credits for research and development to businesses other than SMEs may be an important step in the right direction. In addition training tax credits, which are commonplace in the US, may help us to better compete against countries with stronger vocational training, such as Germany.

When considering the very long-term, it is also important that the UK has policies to support R&D incentivising creating products for markets not currently in existence. Clearly the IP tax incentives do not provide any incentive for this kind of 'blue-sky' research. A possible solution is government funding to research councils; this type of research and development could be aided by tax credits based on working with those academic institutions and research councils.

3. Channel 2 - Equipping ourselves against the depletion of non-renewable energy sources

Current oil prices act as an unfortunate distraction to the long-run problem that lies ahead for the global economy. Oil will become harder to find and hence more costly. Demand for energy will only increase. We need to be in a position where we are moving away from dependency on oil before it becomes an economically unviable energy source.

The movement away from coal-burning power stations to renewable energy sources requires investment. These investments often yield such low rates of return, or rates of return that are high enough but too far in the future for a normal private sector investor to consider. An example is the recent announcement of a possible cable between Norway and the UK that will cost €2bn and return £3bn over 25 years. The implied rate of return there is so low that the private sector would not invest. Tax incentives (e.g. no capital gains tax on the returns on investing in such a project) are not sufficient to get sufficient development within this sector.

Where tax can be used effectively to help us prepare for oil running out (scientists forecast that this will be in 40 years' time) include:

- tax credit for firms researching and developing alternative energy sources;

- higher taxes on oil products;

- not charging VAT on alternatives to oil products;

- an economy-wide CO2 tax;

- a removal of all taxes on public transport so that is more used and hence can be developed to become a better alternative to private transport;

- continuing to increase the passenger car fuel efficiency standards with higher taxes to be paid on less efficient cars; and

- aggressive performance-based tax credits for alternative motor vehicles

Although the benefits of all of these tax policies are likely to be small in comparison to those of the building of renewable energy infrastructure they are likely to be important in the inevitable transition to a much reduced use of fossil fuels.

4. Channel 3 - Supporting innovations which improve productivity

Many of the ways to support such innovations relate to my discussion in section 2. However we can add here a discussion about how we can change the tax system in a way that attracts more foreign direct investment.

FDI is fundamental in the rapid and efficient cross-border transfer and adoption of best practices. As companies enter the UK and, hopefully, operate profitably so as to pay corporation tax to the UK, we benefit not only from the tax revenue but also the knowledge transfer and the trickledown of the salaries of all the workers that the firm employs.

Foreign firms will invest in the UK if it is profitable to do so. We can make it profitable via maintaining a level of corporation tax and other business taxes that are competitive relative to other countries.

An OECD study regressed FDI on a range of variables including the effective corporate tax rate to find that it indeed had a statistically significant result. A decrease in the effective corporate tax rate by one percentage point increases FDI by about 1.9 percent.

This regression was based on a sample of countries comprising: the US plus six EU countries and four Central and Eastern European Countries. The analysis drew on industry-level data for 1995-2003.

With Corporation tax at 21%, one of the lowest in the EU's largest economies and will reduce it again next year to 20%, we are well placed on that front. Hence drawing our attention to other methods of attracting FDI is critical. Investment allowances and accelerated depreciation, loss carry forwards could be used to encourage foreign direct investment.

Loss carry forwards are beneficial for foreign direct investment projects that will not generate cash flows for a period after the project is begun. They work by allowing investors to carry losses forward (or backward) for a specified number of years for tax accounting purposes. This is potentially less relevant for knowledge businesses where fixed start-up costs may often be negligible.

Investment allowances and accelerated depreciation aim to lower the effective price of acquiring capital. They are given as a given as a specified percentage of qualifying investment expenditures.

FDI is particularly important to the UK, receiving the second highest amount of foreign direct investment after the US, with an 11 per cent share of the global inward FDI stock4. As a result the UK must take measures so as to ensure that FDI continues to grow.
Of all the policies I have discussed for attracting further FDI to the UK I think the most convincing is maintaining a low corporation tax. Both Investment allowances and loss carry forwards could provide good incentives to invest in capital intensive industries such as manufacturing. These could hence be an important contributor to attracting FDI, but as a services-focused economy, the corporation tax rate is likely to have a more important impact.

5. Channel 4 - Giving incentives for the development of knowledge businesses

It is impossible to put a price on knowledge. Nonetheless we cannot underestimate the value of knowledge.

Knowledge can be derived from education, training or research. Giving tax credit to firms who give their employees a lot of training may result in perverse incentives to give training (or just book training) that is not necessary or not even helpful.
The government is engaged in a number of activities to support the knowledge business sector. These include, but are not limited to: Knowledge Transfer Partnerships, Innovation networks, Knowledge Transfer Network (KTN), SME growth support, and Innovation Vouchers.

In addition to these spending programmes, the tax system could be used to support growth in knowledge businesses. Helping start-ups will be crucial: evidence from 15 OECD countries suggests that young firms generated nearly half of all new jobs over the past decade.5 These firms, aged less than five, often do not generate sufficient profit to make use of non-refundable tax incentives. Better policies to help them would be cash refunds, carry forwards, training tax credits (mentioned in section 2) or the use of payroll withholding tax credits for R&D related wages.

Many of the ways in which the knowledge business sector can be grown relates to points discussed in sections 2 and 4.

6. Conclusions

In order to adjust the UK tax system in a way that improves employment prospects within the UK I have identified four key channels: supporting exporting industries, knowledge based industries, encouraging a shift towards the use of renewable energy sources as well as supporting innovations in the economy generally.

I conclude that corporation tax, whilst remaining low should be split into one high rate on profits that are distribute and one low rate for profits that are not distributed. The reason for this is to encourage the accrual of retained earnings that can be used for research and development.

In order to ensure that these retained earnings are used on research and development incentives such as extending research and development tax credits to large businesses as well as the creation of training tax credits could be implemented.

The service sector is the largest component of the UK economy and so policies to encourage innovation and investment there will be essential. I argue that keeping a low corporation tax rate relative to other comparable economies will be more beneficial than introducing investment allowances or loss carry forwards.

Vis-à-vis a switch away from dependence on fossil fuels over the next forty years the tax system will play an important part if they can reduce the use of vehicles that are less fuel efficient by imposing higher taxes, abolishing tax on all oil-product alternatives and reducing any taxes on public transport.

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